Journal of Economic Methodology je objavil posebno izdajo z razpravami na temo “Reflexivity and Economics: George Soros’s Theory of Reflexivity and the Methodology of Economic Science“. Journal je povabil nekaj akademikov, da bi podali svoje mnenje o razmišljanju finančnega guruja Georgea Sorosa o neracionalnosti trgov oziroma natančneje: o refleksivnosti in zmotnosti trgov.

Razpravo Sorosa in akademske odzive nanjo se splača prebrati. Kajti če kdo pozna obnašanje (finančih) trgov ter človeških akterjev na njih, je to prav gotovo Soros. In vpašanje časa je, kdaj bo tudi ekonomija človeško negotovost (neracionalnost) vgradila v ekonomske teorije. Spodaj je nekaj odlomkov iz Sorosove razprave.

Soros izhaja iz filozofskega koncepta človeške negotovosti (human uncertainty principle), katerega sestavna dela sta načelo zmotnosti in načelo refleksivnosti. Prvo načelo, načelo zmotnosti (principle of fallibility) izhaja iz tega, da se človeški pogledi na svet nikoli ne ujemajo z realnostjo, pač pa so nujno pristranski ali nekonsistentni. Načelo refleksivnosti (principle of reflexivity) pa govori o tem, da “nepopolni” pogledi na svet skozi dejavnost posameznika vplivajo tudi na dejansko dogajanje, spreminjajo realnost samo.

Of course I did not discover reflexivity. Earlier observers recognized it, or at least aspects of it, often under a different name. Knight (1921) explored the difference between risk and uncertainty. Keynes (1936, Chapter 12) compared financial markets to a beauty contest where the participants had to guess who would be the most popular choice. The sociologist Merton (1949) wrote about self-fulfilling prophecies, unintended consequences, and the bandwagon effect. Popper spoke of the ‘Oedipus effect’ in the Poverty of Historicism (1957, Chapter 5).

My own conceptual framework has its origins in my time as a student at the London School of Economics in the late 1950s. I took my final exams one year early, so I had a year to fill before I was qualified to receive my degree. I could choose my tutor, and I chose Popper whose book TheOpen Society and Its Enemies (1945) had made a profound impression on me.

In Popper’s other great work Logik der Forschung (1935), which was published in English as The Logic of Scientific Discovery (1959), he argued that the empirical truth cannot be known with absolute certainty. Even scientific laws cannot be verified beyond a shadow of a doubt: they can only be falsified by testing. One failed test is enough to falsify, but no amount of conforming instances is sufficient to verify. Scientific laws are always hypothetical in character, and their validity remains open to falsification.

While I was reading Popper I was also studying economic theory, and I was struck by the contradiction between Popper’s emphasis on imperfect understanding and the theory of perfect competition in economics, which postulated perfect knowledge. This led me to start questioning the assumptions of economic theory. I replaced the postulates of rational expectations and efficient markets with my own principles of fallibility and reflexivity.

After college, I started working in the financial markets where I had not much use for the economic theories I had studied in college. Strangely enough, the conceptual framework I had developed under Popper’s influence provided me with much more valuable insights. And while I was engaged in making money I did not lose my interest in philosophy.

I published my first book, The Alchemy of Finance, in 1987. In that book, I tried to explain the philosophical underpinnings of my approach to financial markets. The book attracted a certain amount of attention. It has been read by many people in the hedge fund industry, and it is taught in business schools. But the philosophical arguments in that book and subsequent books (Soros, 1998, 2000) did not make much of an impression on the economics departments of universities. My framework was largely dismissed as the conceit of a man who has been successful in business and therefore fancies himself as a philosopher. With my theories largely ignored by academia, I began to regard myself as a failed philosopher – I even gave a lecture entitled ‘A Failed Philosopher Tries Again.’

All that changed as a result of the financial crisis of 2008. My understanding of reflexivity enabled me both to anticipate the crisis and to deal with it when it finally struck (Soros, 2008, 2009). When the fallout of the crisis spread from the USA to Europe and around the world it enabled me to explain and predict events better than most others (Soros, 2012). The crisis put in stark relief the failings of orthodox economic theory (Soros, 2010). As people have realized how badly traditional economics has failed, interest in reflexivity has grown.

Thus, this issue of the Journal of Economic Methodology is timely. Economics is in a period of intellectual flux and while some economists will cling to ideas of market efficiency and rationality to their final days, many others are eager to pursue alternative approaches.

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The two principles are tied together like Siamese twins, but fallibility is the firstborn: without fallibility there would be no reflexivity. Both principles can be observed operating in the real world. So when my critics say that I am merely stating the obvious, they are right – but only up to a point. What makes my propositions interesting is that they contradict some of the basic tenets of economic theory. My conceptual framework deserves attention not because it constitutes a new discovery, but because something as commonsensical as reflexivity has been so studiously ignored by economists. The field of economics has gone to great lengths to eliminate the uncertainty associated with reflexivity in order to formulate universally valid laws similar to Newtonian physics. In doing so, economists set themselves an impossible task. The uncertainty associated with fallibility and reflexivity is inherent in the human condition. To make this point, I lump together the two concepts as the human uncertainty principle.

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Financial markets

Financial markets provide an excellent laboratory for testing the ideas I have put forward in the previous sections. The course of events is easier to observe than in most other areas. Many of the facts take a quantitative form, and the data are well recorded and well preserved. The opportunity for testing occurs because my interpretation of financial markets directly contradicts the efficient market hypothesis, which has been the prevailing paradigm.

The efficient market hypothesis claims that markets tend toward equilibrium and that deviations occur in a random fashion and can be attributed to exogenous shocks. It is then a testable proposition whether the efficient market hypothesis or my theory of reflexivity is better at explaining and predicting events. I contend that my theory of reflexivity is superior, even in its current rudimentary stage of development for explaining and predicting financial markets in general, and historical events like the financial crisis of 2007–2008 and the subsequent euro crisis in particular.

My conceptual framework

Let me state the three key concepts of my approach, fallibility, reflexivity, and the human uncertainty principle as they apply to the financial markets. First, fallibility. Market prices of financial assets do not accurately reflect their fundamental value because they do not even aim to do so. Prices reflect market participants’ expectations of future market prices. Moreover, market participants are subject to fallibility; consequently, their expectations about the discounted present value of future earnings flows are likely to diverge from reality. The divergence may range from the negligible to the significant. This is in direct contradiction of the efficient market hypothesis, which does not admit fallibility.

Second, reflexivity. Instead of playing a purely passive role in reflecting an underlying reality, financial markets also have an active role: they can affect the future earnings flows they are supposed to reflect. That is the point that behavioral economists have missed. Behavioral economics focuses on only half of the reflexive process: cognitive fallibility leading to the mispricing of assets; they do not concern themselves with the effects that mispricing can have on the fundamentals.

There are various pathways by which the mispricing of financial assets can affect the so-called fundamentals. The most widely used are those that involve the use of leverage – both debt and equity leveraging. For instance, companies can improve their earnings per-share by issuing shares at inflated prices – at least for a while. Markets may give the impression that they are always right, but the mechanism at work is very different from that implied by the prevailing paradigm.

Third, the human uncertainty principle turns what economic theory treats as timeless generalizations into a time-bound historical process. If agents act on the basis of their perfect understanding, equilibrium is far from a universally and timelessly prevailing condition of financial markets. Markets may just as easily tend away from a putative equilibrium as toward it. Instead of universally and timelessly prevailing, equilibrium becomes an extreme condition in which subjective market expectations correspond to objective reality. Theoretically such a correspondence could be brought about by either the cognitive or the manipulative function by itself – either perceptions can change to match reality or perceptions can lead to actions which change reality to match perceptions. But in practice such a correspondence is more likely to be the product of a reflexive interaction between the two functions. Whereas economics views equilibrium as the normal, indeed necessary state of affairs, I view such periods of stability as exceptional. Rather I focus on the reflexive feedback loops that characterize financial markets and cause them to be changing over time.

Negative versus positive feedback loops

Reflexive feedback loops can be either negative or positive. Negative feedback brings the participants’ views and the actual situation closer together; positive feedback drives them further apart. In other words, a negative feedback process is self-correcting. It can go on forever and if there are no significant changes in external reality, it may eventually lead to an equilibrium in which the participants’ views come to correspond to the actual state of affairs.

That is what rational expectations theory expects to happen in financial markets. It postulates that there is a single correct set of expectations that people’s views will converge around and deviations are random – there are no systematic errors between participants’ forecasts and what comes to pass. That postulate has no resemblance to reality, but it is a core tenet of economics as it is currently taught in universities and even used in the models of central banks. In practice, market participants’ expectations diverge from reality to a greater or lesser extent and their errors may be correlated and significantly biased. That is the generic cause of price distortions. So equilibrium, which is the central case in mainstream economic theory, turns out to be an extreme case of negative feedback, a limiting case in my conceptual framework. Since equilibrium is so extreme that it is unlikely to prevail in reality, I prefer to speak of near-equilibrium conditions.

By contrast, a positive feedback process is self-reinforcing. It cannot go on forever because eventually the participants’ views would become so far removed from objective reality that the participants would have to recognize them as unrealistic. Nor can the iterative process occur without any change in the actual state of affairs, because positive feedback reinforces whatever tendency prevails in the real world. Instead of equilibrium, we are faced with a dynamic disequilibrium, or what may be described as far-from-equilibrium situations.

There are myriad feedback loops at work in financial markets at any point of time. Some of them are positive, others negative. As long as they are more or less in balance they cancel out each other and market fluctuations do not have a definite direction. I compare these swings to the waves sloshing around in a swimming pool as opposed to the tides and currents that may prevail when positive feedbacks preponderate. Since positive feedbacks are self-reinforcing occasionally they may become so big that they overshadow all other happenings in the market.

Negative feedback loops tend to be more ubiquitous but positive feedback loops are more interesting because they can cause big moves both in market prices and in the underlying fundamentals. A positive feedback process that runs its full course is initially self-reinforcing in one direction, but eventually it is liable to reach a climax or reversal point, after which it becomes self-reinforcing in the opposite direction. But positive feedback processes do not necessarily run their full course; they may be aborted at any time by negative feedback.

Boom–bust processes

Building on these ideas, I have developed a theory about boom–bust processes, or bubbles (Soros, 1987, 2008). Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend (see Figure 4). A boom–bust process is set in motion when a trend and a misconception positively reinforce each other. The process is liable to be tested by negative feedback along the way, giving rise to climaxes which may or may not turn out to be genuine. If a trend is strong enough to survive the test, both the trend and the misconception will be further reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup said during the twilight of the super bubble: ‘As long as the music is playing, you’ve got to get up and dance. We’re still dancing.’ Eventually, a point is reached when the trend is reversed, it then becomes self-reinforcing in the opposite direction. Boom–bust processes tend to be asymmetrical: booms are slow to develop and take a long time to become unsustainable, busts tend to be more abrupt, due to forced liquidation of unsustainable positions and the asymmetries introduced by leverage.

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