This remarkable sequence of events can be understood only if we abandon the prevailing theory of market behavior. As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.
It is important to recognize that regulators base their decisions on a distorted view of reality just as much as market participants—perhaps even more so because regulators are not only human but also bureaucratic and subject to political influences. So the interplay between regulators and market participants is also reflexive in character. In contrast to bubbles, which occur only infrequently, the cat-and-mouse game between regulators and markets goes on continuously. As a consequence reflexivity is at work at all times and it is a mistake to ignore its influence. Yet that is exactly what the prevailing theory of financial markets has done and that mistake is ultimately responsible for the severity of the current crisis.