It is well known and can be observed daily that these markets display great volatility and are highly unstable. Price charts of all assets - equities, commodities, derivatives, foreign currency and debt assets - show that prices in these markets are in constant movement up and down, never settling in any stable state. Also such charts are all very similar in their appearance because they reflect human behaviour rather than changes in the assets themselves.
What's happening? Can the underlying assets really be changing in value to such an extent and so quickly? Well it depends on what is meant by value. The exchange value certainly changes that much and that quickly because the price that willing sellers and willing buyers agree on is the exchange value. But the inherent value of that which is represented by the asset only changes when something specific happens that can affect it, such as poor company results, the appearance of a powerful competitor, changes in the rate of inflation or government or central bank action. These changes are of course immediately reflected in exchange values, but exchange values also change because market participants' estimation of the relevance and importance of these things differ, so not all revise their exchange valuations to the same extent.
So far everything that has been cited is to be expected, but there is another major factor that comes into play with assets, and that is that buyers' and sellers' emotions and therefore actions are very much dependent on other buyers' and sellers' actions, as reflected in price changes second by second, hour by hour and day by day, and all participants scrutinise these prices and therefore each other constantly. Buyers and sellers in these markets are therefore anything but independent, and the markets they engage in rarely if ever reach a stable state. Greed and fear are the two emotional and extremely powerful drivers - greed fuels the desire not to miss a likely price rise - buy! buy! buy!, and fear, which often turns to panic, fuels the desperation not to be left holding a worthless asset - SELL! SELL! SELL! The trader's philosophy, especially in the case of selling, is 'trade first and ask questions later'.
Hence positive feedback - participants watching and being guided by what others are doing - is at work in these markets constantly. The mechanism is that a watcher, seeing several buy orders go in for an asset and the price rising accordingly, thinks that others must know something that he or she doesn't, so they go along with the crowd and as others make the same deduction the price keeps rising. Before too long a few people start to become nervous that the rise can't continue and they sell to make a quick profit, and this causes the price rise to level off, bringing in more sellers and reducing the number of buyers. Eventually sellers exceed buyers and the price starts to fall, and that is the signal for yet more selling to gather pace. The reverse then happens as earlier buyers who missed out on the price they wanted find that they have another chance and take it, and up it goes again, the chart moving in a zigzag fashion, often in a fixed and easily identifiable price band where the upper level is known as the resistance level and the lower as the support level. These levels are the prices at which sentiment changes, and participants watch these avidly, some trading between the bands and others awaiting a 'breakthrough', which is interpreted as a strong signal to buy in the rising direction and a signal to sell in the falling direction. The remarkable thing is that similar zigzags and levels appear second by second, minute by minute, hour by hour and day by day, in fact in all time periods, reflecting the time frame that particular groups of speculators trade on. The second by second zigzags themselves zig and zag creating rising and falling zigzag patterns that last for minutes, and they create rising and falling zigzag patterns that last for hours and so on. And it's all driven by millions of buyers and sellers betting against each other, many of these buyers and sellers now being computer programs, betting against other similar computer programs and often buying and selling thousands of times a second to exploit tiny price differences.
What makes the financial situation even more dangerous is that the major players in these markets use what is called 'margin trading' - where banks lend them the money to buy the lion's share, often as much as 90% (known as margin factor) or even more of the exchange value of the assets, with the assets themselves acting as collateral for the loans. This is called 'leverage', where the amount bought is levered up from the amount paid. Leverage amplifies the price movements and the positive feedback by the margin factor. It works by allowing a buyer to buy five or ten times as much of an asset as they have money for, thereby amplifying the buy order and price rise accordingly and the corresponding sell order and price fall when sold (Reiss 2011 Chapter 6).
As has been seen in chapter 52 bank lending is itself subject to positive feedback, and a process with positive feedback of its own applied to another process with positive feedback creates one with a level of instability that can be explosive. This is how it happens: if prices move against a player who has assets on maximum margin then the allowable margin is exceeded, and the bank issues a 'margin call' - it demands either more money from the player or the selling of some of the assets so as to restore the margin factor. The bank also has the power to sell a player's assets when necessary so if the margin call is not heeded then the bank itself makes the required correction. In this situation assets are sold not because the seller thinks they are worth less but because a margin call has been issued and the margin factor must be re-established. The seller might not think the value has changed, but everyone else in the market who sees the corresponding price drop does, and then they too sell and the price falls even further and then they too are likely to be issued with margin calls and the effect rapidly snowballs (Buchanan 2013 pp212-213). The same effect is seen in interbank lending, where the collateral that is posted against a loan falls in price, requiring more collateral, and selling of assets by the borrowing bank to obtain it, causing yet further price falls (Turner 2016 p102). These effects were significant factors in the 2008 crash.
All this wouldn't matter if it only affected the players themselves, but with banks involved and with really serious snowball price falls the players soon can't meet the margin calls, and the banks are left with debts that borrowers can't repay and collateral that no longer covers them. Then the banks are in trouble, and because society depends on banks' ability to make payments for everyone to carry out normal everyday transactions the government can't allow them to fail, so it is the taxpayer who bails them out by taking on the debts that the asset market players can't pay.
Because all the players want to do is gamble, and because direct asset purchase and sale can be costly and often difficult or inconvenient, banks have created derivative products that avoid the need to buy the assets themselves. Instead players buy and sell these derivatives with the bank acting as intermediary in the process. In effect they buy and sell them to bet on future price changes. Contracts for difference (CFDs) and spread betting are two popular forms of derivative for this purpose and offer greater flexibility in that they allow bets to be placed on prices falling. They also offer the ability to play in many different types of market. Leverage is routinely offered for these products.
The fact that people are buying and selling things not because they want them for themselves but to make money means that they don't follow the supply and demand behaviour of consumable products. In fact there are buyers waiting for the price to fall before they buy if they think the price is too high, but other buyers waiting for the price to rise before they buy, hoping for the price rise to signal further price rises, and the same for sellers. It makes for a very complex market. It provides yet more evidence that participants aren't independent, because buyers buying on price rises and sellers selling on price falls depend for success on the herd instinct kicking in to bring about further rises or falls, which it often does. In fact, so commonplace and well known is this phenomenon that it has its own name - 'momentum investing'.[213] The Efficient Markets Hypothesis, not surprisingly, has a hard time trying to explain it.
Buyers who buy more in response to a price rise often give rise to bubbles because their willingness to buy has increased and this inflates the price without there being any increase in underlying value. Bubbles always collapse sooner or later because they only inflate as long as new buyers keep entering the market, and new buyers can't be found indefinitely, so when they run out the price levels off, then falls sharply as sellers stampede to be the first to sell. An odd thing about bubbles is that even when some players recognise them as such they continue to inflate because of the 'greater fool' theory mentioned earlier - I might be a fool to buy this product at this price, but there will be an even greater fool along shortly that I can sell it to and make a nice profit. It can be very disturbing to participants who hold off buying or sell an asset short (i.e. borrow a quantity of the asset from someone else and sell it, with an agreement to buy it back and replace it at a later date when the short seller hopes the price has fallen) in expectation of a price drop, only to watch the price keep on rising. Keynes had a lovely quotation for just this situation:
The market can remain irrational longer than you can remain solvent.
Indeed so!
The positive feedback that characterises financial markets makes them subject to manipulation by big players, who are able to buy in quantity and await the usual herd mentality that kicks in and inflates the price further, then sell at a profit. The same applies for selling. This kind of manipulation works to the advantage of speculators who are both sizeable and quick off the mark, but injects a destabilising effect on the market as a whole. Deliberate market manipulation is illegal, but the rewards are high so it goes on all the time. Insider dealing is also illegal - this is trading on information that is not in the public domain - but occurs because it is so lucrative. Many of the senior managers and directors of companies quoted on stock exchanges are very knowledgeable about impending good and bad news before it is made public, and there are very many of them. In fact people in the know don't just work for the companies themselves, they work for accountancy firms, law firms, banking corporations, consultants and so on, so the opportunities for insider dealing are widespread and the rewards very high indeed.
Perhaps the saddest thing about all this is that so many very talented people are spending all their time gambling against each other, or managing computer programs to do the gambling for them. What a dreadful waste. The argument in favour is that this kind of trading maintains a liquid market for assets, which is desirable as it allows people to buy or sell them easily for reasons other than for gambling. However this reason nowhere near justifies the level of activity or the dangers that we see in these markets. Another of Keynes' quotations is very apt:
When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.
Since the deregulation of finance in the 1980s, after which banks were permitted to offer mortgages on much more profitable terms[214], property has become a very popular form of investment. It is driven by the same mechanisms as drive other tradable assets, though on a longer timescale since there is as yet no immediately available central market for trading property - though it has found its way in the form of property indices into spread betting derivatives. This phenomenon has emerged because banks strongly favour lending on property over businesses because of the immediately available collateral, and have encouraged buying in quantity by existing and new landlords using buy-to-let mortgages. Prices have risen considerably as a result of all this buying activity, and governments like rising property prices because of the feel-good factor for property owners which they hope will be translated into votes. However this development is unfortunate because those who want property to live in have to pay an increasing share of their income in mortgage payments to banks or in rental payments to landlords, which is good for banks and landlords but bad for those individuals and for the economy because there is less of that income available for spending on consumption - it takes money out of the wealth-creating loop - which is what a healthy economy depends on - see chapters 20 (especially section 20.5) and 24.