Reflexivity, Financial Instability and Monetary Policy: A ‘Convention-Based’ Approach.

ABSTRACT The aim of this paper is to provide a theoretical analysis of the role of social conventions as emergent phenomena in financial markets, the latter being thought of as dynamically complex systems. Combining complexity and reflexivity with Keynes’s view of financial markets, we develop a ‘convention-based’ approach which shows how conventions can only temporarily stabilize the system, inevitably leading to financial instability and crises. Then, we adopt this framework to investigate a central banking agenda to act ‘against the tide’ (i.e., the prevailing convention) in the build-up of a speculative bubble, which calls for macroprudential policy and financial regulation. In this respect, we analyze the moral suasion channel that allows the central monetary authority to ‘talk down’ the market through asset-price management and the unconventional monetary policy toolkit.