The news that George Soros, among others, testified before Congress today about the doings in the market reminds me that he has been banging the drum for years about his theory of Reflexivity. From today’s WSJ . . .
Billionaire investor George Soros presented a blow-by-blow account of the financial crisis and offered a bleak outlook for the economy. “A deep recession is inevitable and the possibility of a depression cannot be ruled out,” he said. Mr. Soros argued that the events of recent months undercut what he called the prevailing theory of markets — that they always return to equilibrium and that deviations are caused by random, external events.
Mr. Soros said the current crisis wasn’t caused by an outside shock, such as a surge in energy prices, but by the financial system itself. He argued that a flawed theory of markets had been used to justify unbridled free-market capitalism and deregulation. He described his own theory, dubbed reflexivity. It says that financial markets present a distorted view of underlying reality, which affects market prices.
After decrying the lack of attention his theories have gotten at a speech he made to the MIT Department of Economics in 1994, he quoted himself in testimony he made to Congress back then.
“I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy.”
The core of his thesis is that classical economics theory is fundamentally flawed because it discounts the actions and effects of the thinker/observer with two grand, hugely flawed assumptions:
- That the actors are completely rational.
- That they have perfect knowledge.
In this way, he is plowing the same field that behavioral economists are. Here’s what Soros has to say on that (lengthy but worth reading).
The theory holds, in the most general terms, that the way philosophy and natural science have taught us to look at the world is basically inappropriate when we are considering events which have thinking participants. Both philosophy and natural science have gone to great lengths to separate events from the observations which relate to them. Events are facts and observations are true or false, depending on whether or not they correspond to the facts.
This way of looking at things can be very productive. The achievements of natural science are truly awesome, and the separation between fact and statement provides a very reliable criterion of truth. So I am in no way critical of this approach. The separation between fact and statement was probably a greater advance in the field of thinking than the invention of the wheel in the field of transportation.
But exactly because the approach has been so successful, it has been carried too far. Applied to events which have thinking participants, it provides a distorted picture of reality. The key feature of these events is that the participants’ thinking affects the situation to which it refers. Facts and thoughts cannot be separated in the same way as they are in natural science or, more exactly, by separating them we introduce a distortion which is not present in natural science, because in natural science thoughts and statements are outside the subject matter, whereas in the social sciences they constitute part of the subject matter. If the study of events is confined to the study of facts, an important element, namely, the participants’ thinking, is left out of account. Strange as it may seem, that is exactly what has happened, particularly in economics, which is the most scientific of the social sciences.
Classical economics was modeled on Newtonian physics. It sought to establish the equilibrium position and it used differential equations to do so. To make this intellectual feat possible, economic theory assumed perfect knowledge on the part of the participants. Perfect knowledge meant that the participants’ thinking corresponded to the facts and therefore it could be ignored. Unfortunately, reality never quite conformed to the theory. Up to a point, the discrepancies could be dismissed by saying that the equilibrium situation represented the final outcome and the divergence from equilibrium represented temporary noise. But, eventually, the assumption of perfect knowledge became untenable and it was replaced by a methodological device which was invented by my professor at the London School of Economics, Lionel Robbins, who asserted that the task of economics is to study the relationship between supply and demand; therefore it must take supply and demand as given. This methodological device has managed to protect equilibrium theory from the onslaught of reality down to the present day.
I don’t know too much about the prevailing theory about financial markets but, from what little I know, it continues to maintain the approach established by classical economics. This means that financial markets are envisaged as playing an essentially passive role; they discount the future and they do so with remarkable accuracy. There is some kind of magic involved and that is, of course, the magic of the marketplace where all the participants, taken together, are endowed with an intelligence far superior to that which could be attained by any particular individual. I think this interpretation of the way financial markets operate is severely distorted. That is why I have not bothered to familiarize myself with efficient market theory and modern portfolio theory, and that is why I take such a jaundiced view of derivative instruments which are based on what I consider a fundamentally flawed principle. Another reason is that I am rather poor in mathematics.
It may seem strange that a patently false theory should gain such widespread acceptance, except for one consideration; that is, that all our theories about social events are distorted in some way or another. And that is the starting point of my theory, the theory of reflexivity, which holds that our thinking is inherently biased. Thinking participants cannot act on the basis of knowledge. Knowledge presupposes facts which occur independently of the statements which refer to them; but being a participant implies that one’s decisions influence the outcome. Therefore, the situation participants have to deal with does not consist of facts independently given but facts which will be shaped by the decision of the participants. There is an active relationship between thinking and reality, as well as the passive one which is the only one recognized by natural science and, by way of a false analogy, also by economic theory.
I call the passive relationship the “cognitive function” and the active relationship the “participating function,” and the interaction between the two functions I call “reflexivity.” Reflexivity is, in effect, a two-way feedback mechanism in which reality helps shape the participants’ thinking and the participants’ thinking helps shape reality in an unending process in which thinking and reality may come to approach each other but can never become identical. Knowledge implies a correspondence between statements and facts, thoughts and reality, which is not possible in this situation. The key element is the lack of correspondence, the inherent divergence, between the participants’ views and the actual state of affairs. It is this divergence, which I have called the “participant’s bias,” which provides the clue to understanding the course of events. That, in very general terms, is the gist of my theory of reflexivity.
For reasons Soros professes not to comprehend, his thinking along these lines has been roundly ignored and discounted, particularly in the halls of Academia, I’m sure starting with the fact that he doesn’t have a PhD, didn’t climb the tenure ladder and study with all the right people, and most particularly, because of his gauche tendency to make huge sums of money putting his theories into practice.
Further on, he makes one of two critical points. The first is that when reflexivity occurs, the warping effect defies conventional explanations of market behavior. Most importantly, markets do not return to equilibrium. They land someplace else all together . . .
. . . reflexivity is real; it is not merely a different way of looking at events; it is a different way in which events unfold. It doesn’t occur in every case but, when it does, it changes the character of the situation. Instead of a tendency towards some kind of theoretical equilibrium, the participants’ views and the actual state of affairs enter into a process of dynamic disequilibrium which may be mutually self-reinforcing at first, moving both thinking and reality in a certain direction, but is bound to become unsustainable in the long run and engender a move in the opposite direction. The net result is that neither the participants’ views nor the actual state of affairs returns to the condition from which it started.
The second is to point out that reflexivity isn’t a universal theory, but it does come into play in specific circumstances . . .
I have come to distinguish between normal conditions and far-from equilibrium conditions. In normal conditions, there is a tendency for the participants’ views and the actual state of affairs to converge or, at least, there are mechanisms at work to prevent them from drifting too far apart. I call these conditions “normal,” because that is what our intellectual traditions—including philosophy and scientific method —have prepared us for. I contrast them with far-from- equilibrium conditions, where the participants’ views are far removed from the actual state of affairs and there is no tendency for the two of them to come together. I have always found the far-from-equilibrium conditions much more fascinating, and I have studied them both in theory and in practice.
There are two very different kinds of far-from-equilibrium conditions: one is associated with the absence of change, and the other with revolutionary change. These two opposite poles act as “strange attractors”—an expression with which has become familiar since chaos theory has come into vogue.
So we can observe three very different conditions in history: the “normal,” in which the participants’ views and the actual state of affairs tend to converge; and two far-from- equilibrium conditions, one of apparent changelessness, in which thinking and reality are very far apart and show no tendency to converge, and one of revolutionary change in which the actual situation is so novel and unexpected and changing so rapidly that the participants’ views cannot keep up with it.
There are loads of possible lessons here. A couple I take from it are . . .
- Discount and ignore the effect emotions play at your peril. We’re not more Newtonian than organizations or economies are. We’re not econs.
- Any kind of planning model needs to take into account the effects of black swans, reflexivity, or whatever term you want to use to capture the idea of things happening outside the second standard deviation.
- When conditions begin to move away from equilibrium, like they are now, hang on. The ride will not go the way you think it will.
Tags: GeorgeSoros, Reflexivity, Behavioral Economics, back swan
