soros theory of reflexivity

And since tech companies sell some of their products to other tech companies, these capital inflows actually create better fundamentals for the overall industry. As long as there’s more software worth writing, more chips worth designing, more gadgets worth inventing, etc., the investment case for the industry can get better as more money flows in. This theory, that fundamentals are what inform stock prices, makes enough sense that it’s hard to imagine any alternative—but that’s exactly what George Soros did, and it’s how he made his very large pile of money. We conclude that when the destabilizing forces that caused the current bear market and economic recession finally abate, the U.S. will not be confronted with a so-called L-shaped recovery. In contrast, based on examples from history, stock market reversals in similar environments were V-shaped over a one-year timeframe.

To Soros, competitive equilibrium in economic theory is “an extreme case of negative feedback” and self-correction. It is a “limiting case” because fallibility and reflexivity together can sustain far-from-equilibrium conditions for extended periods of time. The argument above, then, is that the phase transition at the turning point in a cycle occurs when expectations about fundamentals shift relative to expectations about stock prices, rebalancing them toward one another after they had become increasingly “out of balance” in the upswing. At most, depositors are worried about the bank’s stock price as an indicator of the safety of their money. However, the bank run directly affects the bank’s fundamentals, and this then feeds over to and changes investors’ expectations about the bank’s stock price. The dynamic between the two sets of expectations consequently works through how a change in expectations about the bank’s fundamentals influences expectations about its stock price, not the other way around.

The reflexive feedback loops between the objective and subjective aspects of reality create a lace-like pattern, which is superimposed on the direct line leading from one set of facts to the next and deflects it from what it would be if there were no feedback loops. The feedback sometimes brings the subjective and objective aspects closer together and sometimes drives them further apart. The two aspects are aligned, but only loosely – the human uncertainty principle implies that a perfect alignment is the exception rather than the rule. Mehrling gives Soros credit for his stance on imperfect knowledge, and his argument that the deliberate actions we take based on our understanding of the world can actually affect the world outside our window. (Mehrling 2012) Young (2007) also emphasizes a similarity between Soros and Minsky’s model of financial crises. Soros himself has observed that many people regard his theory as nothing more than a common observation that the expectation of people is influenced by their perception.

Bubbles and super bubbles

The fundamental particles of physics, for example, are atoms, electrons, or bosons. The fundamental particles of economics are people, who are made up of trillions of atoms and are capable of free choice. For these reasons, Soros argues that social science should not be held to the same standards as physical science. Not all reflexive phenomena are negative like market bubbles; some can create long-term value.

The housing market in the 1990s and early 2000s exhibited positive feedback processes in both home prices and expansion in household balance sheets beginning in the subprime market and eventually extending to all housing. Whatever caused prices to start rising in the first place, once they did, speculative expectations developed, and this led to increasing lender finance. This improved household fundamentals, and thus favorably changed expectations about households’ capacity to finance more debt, so that speculative expectations led to adjustment in expectations about household fundamentals. The theory that economic agents had, then, was that this was a “new” world in which expanded household balance sheets were secure, because home prices rising at an increasing rate justified household leverage rising at an increasing rate. What was empirically observed, then, provided grounds to hypothesize a new underlying cause-and-effect model of the housing market that replaced the old banking model of traditional household finance that had prevailed previously under conditions of negative feedback.

George Soros, Reflexivity and Market Reversals

Other aspects of fallibility qualify as Knightian uncertainty – for example, probability analysis is not much help in understanding the misconceptions at the heart of the euro crisis. In other words, the presence or absence of reflexivity serves as a criterion of demarcation between social and natural phenomena – a point I will discuss in detail in the next section. When both the cognitive and manipulative functions operate at the same time they may interfere with each other. By depriving each function of the independent variable that would be needed to determine the value of the dependent variable.

  • Central to the whole analysis, in any case, is the paper’s conception of reflexive economic agents seen as adaptive and interactive.
  • Otherwise it would make no sense for them to change what they do in the present in an effort to change how the future plays out.
  • Over time, he’s developed a deeper understanding for what deep-value investing actually means, and refined his philosophy to include any business trading at a wild discount to what he thinks its worth in 3-5 years.
  • The evidence shows persistent fluctuations, whatever length of time is chosen as the period of observation.

He concludes that on account of his theory, which says that markets follow a random walk the performances of the two are rather similar. (Malkiel 2003) From this theory we can extrapolate that stocks already reflect all available information and without adding additional risk unto the portfolio it seems impossible to outperform the markets by looking for undervalued securities. Thus that markets are rational and tend towards equilibrium are important properties of the current paradigm of economic theory. Both the super-bubble and the euro crisis are examples of far-from-equilibrium situations. A core difference between my approach and mainstream economics is that my framework can accommodate and explain such phenomena.

What Are Subjective Realities?

That is why I am so pleased that the Journal of Economic Methodology is publishing this special issue. Everybody, for example, knew that it was an incomplete currency; it had a central bank, but it did not have a common treasury. In retrospect, the most important was that by transferring the right to print to money to an independent central bank, member countries ran the risk of default on their government bonds. In a developed country with its own currency, the risk of default is absent because it can always print money. But by ceding or transferring that right to an independent central bank, which no member state actually controls, the member states put themselves in the position of third-world countries that borrow in a foreign currency. Philosopher Karl Popper says that we cannot know anything with ultimate certitude.

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This fact was not recognized either by the markets or by the authorities prior to the crash of 2008, testifying to their fallibility. When the euro was introduced, the authorities actually declared government bonds to be riskless. Commercial banks were not required to set aside any capital reserves against their holdings of government bonds. The European Central Bank (ECB) accepted all government bonds on equal terms at the discount window. This set up a perverse incentive for commercial banks to buy the debt of the weaker governments in order to earn what eventually became just a few basis points, because interest rates on government bonds converged to practically zero.

Soros sees ‘reflexivity’ theory of economics as life’s work

This essay has shown that my interpretation of financial markets – based on my theory of reflexivity – is radically different from orthodox economics based on efficient markets and rational expectations. Strictly speaking, both interpretations are pseudo-scientific by Popper’s standards. And that is why some proponents of the efficient market hypothesis still defend it in the face of all the evidence. 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.

  • Perhaps that original reading of Popper would have benefited with a read of Machiavelli’s The Prince (published in 1532).
  • Soros retired from full-time investing in 2000 and concentrated on philanthropy through a network of non-profit organizations he had established in the 1980s and his Open Society Institute.
  • Prices reflect market participants’ expectations of future market prices.
  • Thus, this led everyone to miscalculate the risk to the system as a whole.
  • Human beings differ from other natural agents in that they are intentional beings and have a rudimentary understanding of the nature of causality.

Finally Soros admits that reflexivity does not conform to the currently accepted standards of scientific theory. Soros is arguing that we must modify or study financial markets in a nonscientific way — at least occasionally. What this would entail is a restoration of philosophy to its preeminent position. In his words, “my conceptual framework could then serve as the new philosophical paradigm for understanding human affairs in general and financial markets in particular. “ (Soros 2009b, 286) What Soros might then be suggesting is that to understand how financial markets operate we need a more philosophical, and less scientific approach. In Soros’s model we then enter the fourth stage, a period of acceleration, which begins after the test has been successfully survived, the test being marking a new high after surpassing the short-term top.

Understanding Reflexivity

There are no doubt some interesting examples of reflexivity in politics. Also, I imagine that Soros was originally inspired by Popper to start thinking about reflexivity. The value of an Open Society, and the phenomenon of reflexivity are both worthy but distinct subjects, and should be treated as such. With this definition of the three classes of behavior, we can move onto a more precise definition of reflexivity. Let’s start with a purposefully simple illustration of the behavioral functions, a child playing with blocks (Figure 1).

soros theory of reflexivity

Soros credits his investment success to reflexivity, which he uses to identify price extremes. Many economic theories assume markets are dynamically stable, or self-correcting. For example, when profit margins are excessive, new competition will drive down prices. Similarly, rational investors are supposed to allocate capital out of overvalued securities and into the most attractively priced shares causing individual stock valuations to move closer to levels supported by fundamentals.

Reflexivity theory states that investors don’t base their decisions on reality, but rather on their perceptions of reality instead. The actions that result from these perceptions have an impact on reality, or fundamentals, which then affects investors’ perceptions and thus prices. The process is self-reinforcing and tends toward disequilibrium, causing prices to become increasingly detached from reality. Soros views the global financial crisis as an illustration of the theory.

Feedback patterns as repeated reflexivity judgments

They acknowledged that it was a cycle fuelled “not by virtue but by delusion”. Thus, this led everyone to miscalculate the risk to the system as a whole. What Soros sees as the market economy’s inherent tendency to lurch from bubble to bubble and excess to excess makes it all the more essential that those at the economy’s helm embrace reflexivity, he says. Reflexivity cannot provide firm predictions about the future, only a better understanding of the past and an awareness of all that could go wrong, he says.

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In epistemology, and more specifically, the sociology of knowledge, reflexivity refers to circular relationships between cause and effect, especially as embedded in human belief structures. A reflexive relationship is bidirectional with both the cause and the effect affecting one another in a relationship in which neither can be assigned as causes or effects. It was caused by a lack of understanding of an extremely complicated reality.