Principle of Reflexivity George Soros on feedback loops & super bubbles

soros theory of reflexivity

By taking the prevailing values and methods of production as given he eliminated reflexivity as a possible subject of study for economics. Subsequently, this approach reached its apex with the rational expectations and efficient market hypotheses in the 1960s and 1970s. In natural science, the outside observer is engaged only in the cognitive function, and the facts provide a reliable criterion by which the truth of the observers’ theories can be judged.

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In George Soros’ book about the 2008 credit crisis, The New Paradigm for Financial Markets, his theory of “reflexivity”is central. Essentially, this theory relates to how observations about the economy affect investor behavior which in turn affect the economy. Still, for anyone who’s listened to some of the gloomier economic prophets, such as economist Nouriel Roubini or The Trillion-Dollar Meltdown author Charles Morris, Soros’ analysis of the financial crisis itself is unremarkable. Like others, he blames a failure of regulators, including Alan Greenspan’s Federal Reserve, to keep a tight enough rein on Wall Street. He anticipates further sharp declines in housing prices and says, when pressed, that Americans ultimately won’t escape this episode without suffering a noticeable decline in their standard of living.

George Soros

These two characteristics contrast with the mainstream atomistic agent view that rejects both characteristics. Not surprisingly, mainstream economics itself is neither complex nor evolutionary. Not surprisingly, the mainstream framework fails to explain recurring crises and financial fragility that are so disruptive and costly to people’s lives. Thus, one motivation for this paper’s argument is its assumption that adequate explanations of capitalist market economies depend on first having adequate conceptions of economic agents who inhabit such economies. This paper makes one step in that direction in connection with its analysis of boom-bust cycles. Here, I explain how expectations about stock prices and expectations about fundamentals change in relation to one another at turning points in boom-bust cycles when they are the most “out of balance” in order to explain turning points as phase transitions as widespread belief reversals.

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Second, one about how these two sets of expectations interact in the upswing of a boom leading up to that turning point. Increasing order backlogs encouraged higher earnings estimates from Wall Street analysts, which led to a rising stock price, more fear of shortages, more double ordering, etc. We start with an analogy from the physical world, then apply the idea to the financial arena. Imagine a small round marble sitting inside of a cereal bowl, as shown in Figure 1.

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In general, supply and demand usually move towards an equilibrium that creates a market clearing price. Reflexivity suggests that, sometimes, markets are unstable… the marble rolls away. In this paper, we examine the ideas behind reflexivity and discuss how they result in parabolic price patterns. The belief that markets simply tend to overshoot in search for equilibrium is inadequate.

In my articles, I put forward a series of practical proposals that could have worked at the time but became inadequate soon thereafter. Conversely, had the authorities adopted earlier some measures that they were willing to adopt later, they could have arrested the downtrend and then reversed it by adopting further measures. As it is, they have managed to calm the crisis, but failed to reverse the trend. I have been following the euro crisis closely ever since its inception. I have written numerous articles that have been collected in a book (Soros, 2012). It would be impossible to summarize all my arguments for this essay; therefore, I shall focus only on the reflexive interaction between markets and authorities.

Belief reversals as phase transitions and economic fragility: a complexity theory of financial cycles with reflexive agents

Reflexivity is the theory that a two-way feedback loop exists in which investors’ perceptions affect that environment, which in turn changes investor perceptions. Despite George Soros’s main theory — his theory of reflexivity — being a bit complicated, I will try and simplify it here with some help from a couple of passages from his book. Soros tells a story about how his youthful embrace of Popper’s The Open Society and its Enemies (published in 1945) was too unsophisticated, and he later amended his interpretation of it.

  • Imagine a small round marble sitting inside of a cereal bowl, as shown in Figure 1.
  • Given that the social sciences, such as economics, have more explanatory than predictive power, it is unclear how to prevent bubbles ahead of time.
  • Disturbing the marble causes it to roll away and fall to the side, never again to return to its perch on top of the bowl.
  • My own conceptual framework has its origins in my time as a student at the London School of Economics in the late 1950s.
  • Soros said it wouldn’t have come as a surprise to anyone who believed in reflexivity.

Up until the crisis, most speculators and investors regarded the banks as solvent, and dissenters were thought to be wrong by most analysts in the financial community, as well-described by Michael Lewis (Lewis 2010). Yet, the dissenters eventually influenced some investors who began to be more cautious. Inter-bank lending then began to decline; banks found they were no longer able to finance themselves on overnight markets, and were then illiquid and in some cases insolvent, fulfilling the dissenters’ “false” prophecy. As in Merton’s example, then, it was a reversal in beliefs about the banks’ fundamentals, not beliefs about bank stock market values, which led to a reversal in beliefs about the value of the banks and brought about the downswing.

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For this reason, we suggest the key to identifying extremes lies in the prices themselves. A study of historical stock market patterns during reflexive price movements can help us anticipate the turning point. And he was right about the Japanese stock market being one of the landmarks of contemporary history.

  • The influence is continuous and circular; that is what turns it into a feedback loop.
  • Both claimed scientific status for their theories but Popper rightly argued that their theories could not be falsified by testing.
  • That begs the question of what constitutes a ‘thinking participant.’ One might reasonably ask whether a chimpanzee, a dolphin, or a computerized stock-trading program is a thinking participant.
  • This invests change with an ontological status and means that the underlying relationships we investigate cannot always be in a settled state.

It might seem that the turning point is the analyst’s judgment about the bank’s stock price, and that investors are in the lead. Indeed, the advantage of Merton’s example is that it specifically rules this out in that the bank analyst makes what is generally regarded as a false judgment about the bank according to the standards of the financial community, which had instead judged the bank to be solvent. It is only after the bank run and change in depositor expectations that investors judge the bank stock price to be too high.

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