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In this article, we propose a new way of thinking about a framework for the analysis of bubbles based on the theory of complex systems. We argue that the notion of rational asset prices is theoretically weak because it depends on the ability to determine the distribution of cash flows and discount rates in the infinite future. Because there is no way to forecast future cash flows precisely, we believe that is not possible to define bubbles as deviations from rational prices. We follow Sornette [2003] in defining bubbles in terms of anomalous price patterns.
This calls for differentiating normal from abnormal growth behavior in the economy and in asset prices. We observe that growth in modern economies is largely due to innovative products typically characterized by an increase in complexity. Departing from classical macroeconomics, complexity economics links economic growth to real physical growth in complex ways through the filter of markets and financial contracts.
Complexity economics entails the notion that price level and inflation are not well defined. This happens because in a rapidly changing, complex economy such as those of developed countries, it is not possible to define a price level. Rather we can compare the price level only of similar products, not of different products. Currently, the measure that is commonly used when referring to inflation is some average of those products that make up the market basket of groups of consumers; many of the products included in the basket do not change or change slowly, such as food. This leaves out large fractions of the economy. The end result is that in modern complex economies some subsectors might grow much faster than the bulk of the economy, and a large amount of money can be created/flow into these subsectors without any appreciable effect on the official inflation rate.
We suggest that bubbles can be characterized by a price path that diverges exponentially from the price path of the reference economy. But it might be that the growth path of financial assets is comparable to the growth path of subsectors of the economy that grow at a speed comparable to that of financial assets.
Based on this conceptual underpinning, our next step is to explore what causes bubbles and what makes them...