George Soros on The Future of Europe: Remarks delivered at the Global Economic Symposium, 10/01/13 in Kiel, Germany
October 01, 2013

George Soros

George Soros lecture via http://www.georgesoros.com/

 

I shall take a holistic approach to the future of Europe. I have developed a conceptual framework, which has guided me in my decisions throughout my adult life. The framework is much broader than the financial markets; it deals with the relationship between thinking and reality. What makes that relationship so complicated is that the thoughts and actions of participants are part of the reality they have to think about. Their thinking serves a dual function: on the one hand they try to understand the world in which they live – that is the cognitive function; on the other, they want to influence the events in which they participate – that is the manipulative function. The two functions interfere with each other – I call the interference reflexivity. The cornerstone of my conceptual framework is the human uncertainty principle, which is based on the twin pillars of fallibility and reflexivity.

The human uncertainty principle has far reaching implications for scientific method. It applies only to social phenomena and thereby it separates the social sciences from the natural sciences. Economic theory has sought to imitate the natural sciences, particularly Newtonian physics. Consequently my conceptual framework is in direct conflict with mainstream economic theory.

The differences are especially pronounced in dealing with financial problems in general and the euro crisis in particular. Mainstream economics has pursued timelessly and universally valid laws whose validity can be tested by reference to the facts. I contend that the facts produced by social processes do not constitute a reliable criterion for judging the validity of theories because of the human uncertainty principle. I do not deny the possibility of establishing universally and timelessly valid laws – the human uncertainty principle is one of them – but I consider such laws too vague and general to be of much use in producing specific predictions and explanations.

In any case social phenomena are easier to explain than to predict. The past is uniquely determined while the human uncertainty principle renders the future inherently indeterminate. That is not how Newtonian physics works. Mainstream economics sought to apply the Newtonian approach to social phenomena by introducing the concept of equilibrium. This required elaborate mental gymnastics. It started with the theory of perfect competition, which assumed perfect knowledge and ended with rational expectations and the efficient market hypothesis.

By contrast I emphasize the role of misconceptions, misinterpretations and a sheer lack of understanding in shaping the course of events. I focus on the process of change rather than on the eventual outcome. The process involves reflexive feedback loops between the objective and subjective aspects of reality. Fallibility insures that the two aspects are never identical. That is where my framework differs from mainstream economics.

Feedback can be negative or positive. Negative feedback narrows the divergence between the objective and subjective aspects of reality; positive feedback widens it. Carried to an extreme, negative feedback would lead to equilibrium; positive feedback would result in mayhem. In standard economics equilibrium is the inevitable outcome, in my framework equilibrium is one of two theoretical extremes. Reality ranges from near equilibrium to far from equilibrium conditions, but the distribution of cases does not follow a regular bell curve; it tends to cluster around the two extremes. The extremes act as “strange attractors” because people tend to use dichotomies to simplify matters. A situation can be considered stable or unstable. But people’s opinion can shift quite quickly. This leads to the “fat tails” observed in market volatility- that is inherent in my framework but not in standard economics.

Using this conceptual framework I have developed a boom-bust theory of financial crises, which is the opposite of equilibrium. It consists of a trend that prevails in reality and a misinterpretation or misconception relating to that trend. The trend and the misconception mutually reinforce each other until they grow to such an extent that the misconception becomes increasingly apparent. Eventually an inflection point is reached where the trend is reversed and a positive feedback loop develops in the opposite direction.

Boom bust processes or bubbles are only one manifestation of reflexivity and only occasionally do they grow to a size where they assume macroeconomic importance. There is also a reflexive interaction between the authorities and the markets. Behind the invisible hand of markets lurks the visible hand of politics. Both the markets and the authorities are fallible; that is what makes their interaction reflexive. While bubbles occur only intermittently the interplay between economics and politics is ongoing. We need to study the political economy where every event is unique instead of looking for timelessly valid laws.

My conceptual framework consists of universally valid generalizations; therefore its usefulness in explaining or predicting the political economy is strictly limited. But as a hedge fund manager I have used it to develop specific theories about specific situations and my performance record testifies to their usefulness.

I have followed the euro crisis closely ever since its inception. I have written numerous articles about it that has been collected in a book. I found my conceptual framework particularly helpful because the crisis is the result of a reflexive interaction between financial and political processes and combines historical, cultural, moral and above all legal aspects. That makes it so complicated that it boggles the mind. Misconceptions have played a central role. I shall focus on them instead of presenting a comprehensive analysis.

The design of the common currency had many flaws. Some of them were known at the time the euro was introduced.  Everybody, for example, knew that it was an incomplete currency; it had a central bank, but it didn’t have a common treasury. Other defects were discovered only in the crisis. In retrospect the most important defect was that the euro exposed the government bonds of member countries to the risk of default. In a developed country with its own currency, the risk of default is absent because it can always print money.  But by ceding that right to an independent central bank, the member-states put themselves in the position of third-world countries that borrow in a foreign currency. This fact was not recognized either by the markets or by the authorities prior to the crisis, testifying to the fallibility of both.

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 and the European Central Bank (ECB) accepted all government bonds on equal terms at its 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 rate differentials converged to practically zero.

This convergence in interest rates caused divergences in economic performance.  The weaker countries enjoyed real estate, consumption and investment booms, while Germany, weighed down by the burdens of reunification, had to adopt fiscal austerity and structural reforms. This divergence was not envisioned by the Maastricht Treaty, which assumed that only the public sector produces

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