Here is a speech George Soros made in 2007. We will be posting more. sign up for our free newsletter to ensure you do not miss any.
George Soros Theory of Reflexivity MIT Speech
7 August 2007
The MIT Department of Economics World Economy
Laboratory Conference Washington, D.C.
Delivered April 26, 1994
When Rudi Dornbusch invited me to speak at this conference, he gave me a totally free hand in deciding what I wanted to talk about. Well, I want to discuss a subject which fascinates me but doesn’t seem to interest others very much. That is my theory of reflexivity which has guided me both in making money and in giving money away, but has received very little sdeerious consideration from anybody else. It is really a very curious situation. I am taken very seriously; indeed, a bit too seriously. But the theory that I take seriously and, in fact, rely on in my decision-making process is pretty completely ignored. I have written a book about it which was first published in 1987 under the title The Alchemy of Finance; but it received practically no critical examination. It has been out of print for the last several years but demand has been building up as a result of my increased visibility, not to say notoriety, and now the book is being re issued. I think this is a good time to get the theory seriously considered.
I was invited to testify before Congress last week and this is how I started my testimony. I quote: “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.” I did not have time to expound my theory before Congress, so I am taking advantage of my captive audience to do so now. My apologies for inflicting a very theoretical discussion on you.
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,