This week, George Soros is the news. We thought some of his old speeches/ideas before he was super famous would be of interest to readers. We found some material from 2007/08. If you have anything earlier we would LOVE to see it send us a tip (thank you to a reader for sending this one to us). Here is a speech George Soros made in 2010. We will be posting more. sign up for our free newsletter to ensure you do not miss any.

Also see: George Soros On The 2008 Crisis And Reflexivity

George Soros

George Soros Speech on Anatomy of a Crisis

April 09, 2010

Economic theory has modeled itself on theoretical physics. It has sought to establish timelessly valid laws that govern economic behavior and can be used reversibly both to explain and to predict events.  But instead of finding laws capable of being falsified through testing, economics has increasingly turned itself into an axiomatic discipline consisting of assumptions and mathematical deductions – similar to Euclidean geometry.

Rational expectations theory and the efficient market hypothesis are products of this approach.  Unfortunately they proved to be unsound.  To be useful, the axioms must resemble reality.  Euclid’s axioms met that condition; rational expectations theory doesn’t.  It postulates that there is a correct view of the future to which the views of the participants tend to converge.  But the correct view is correct only if it is universally adopted by all the participants — an unlikely prospect.  Indeed, if it is unrealistic to expect all participants to subscribe to the theory of rational expectations, it’s irrational for any participant to adopt it.  Anyhow, rational expectations theory was pretty conclusively falsified by the crash of 2008 which caught most participants and most regulators unawares.  The crash of 2008 also falsified the Efficient Market Hypothesis because it was generated by internal developments within the financial markets, not by external shocks, as the hypothesis postulates.

The failure of these theories brings the entire edifice of economic theory into question.  Can economic phenomena be predicted by universally valid laws?  I contend that they can’t be, because the phenomena studied have a fundamentally different structure from natural phenomena.  The difference lies in the role of thinking.  Economic phenomena have thinking participants, natural phenomena don’t.  The thinking of the participants introduces an element of uncertainty that is absent in natural phenomena.  The uncertainty arises because the participants’ thinking does not accurately represent reality.

In human affairs thinking serves two functions: a cognitive one and a causal one.  The two functions interfere with each other:  the independent variable of one function is the dependent variable of the other.  And when the two functions operate simultaneously, neither function has a truly independent variable.  I call this interference reflexivity.

Reflexivity introduces an element of uncertainty both into the participants’ understanding and into the situation in which they participate.  It renders the situation unpredictable by timelessly valid laws.  Such laws exist, of course, but they don’t determine the course of events.

Economic theory jumped through many hoops trying to eliminate this element of uncertainty.  It started out with the assumption of perfect knowledge.  But as Frank Knight showed in his book, “Risk, Uncertainty, and Profit” published in 1921, in conditions of perfect knowledge there would be no room for profits.

The assumption of perfect knowledge was replaced by the assumption of perfect information.  When that proved insufficient to explain how financial markets anticipate the future, economists developed the theory of rational expectations.  That is when economic theory parted company with reality.  Some great thinkers, including Friedrich Hayek in his Nobel Prize speech, kept reminding economists of the importance of uncertainty but advances in quantitative modeling led to the neglect of this Knightian uncertainty.  That is because quantitative methods cannot take into account uncertainty that cannot be quantified.  Collateralized Debt Obligations and Credit Default Swaps and risk management methods produced by these quantitative approaches played a nefarious role in the crash of 2008.

The meltdown of the financial system in 2008 forces us to go back to the drawing board and look for a more realistic approach.  I believe that we have to start with recognizing a fundamental difference between human and natural phenomena. 

This means that financial markets should not be treated as a physics laboratory but as a form of history.  The course of events is time-bound and one-directional.  Predictions and explanations are not reversible.  Some timelessly valid generalizations can serve to explain events but not to predict them.

I have started to develop a set of generalizations along these lines by introducing the concept of reflexivity.  Reflexivity can be interpreted as a two-way feedback mechanism between the participants’ expectations and the actual course of events.  The feedback may be positive or negative.  Negative feedback serves to correct the participants’ misjudgments and misconceptions and brings their views closer to the actual state of affairs until, in an extreme case, they actually correspond to each other.  In a positive feedback a distortion in the participants’ view causes mispricing in financial markets, which in turn affects the so-called fundamentals in a self-reinforcing fashion, driving the participants’ views and the actual state of affairs ever further apart.  What renders the outcome uncertain is that a positive feedback cannot go on forever, yet the exact point at which it turns negative is inherently unpredictable.  Such initially self-reinforcing but eventually self-defeating, boom-bust processes are just as characteristic of financial markets as the tendency towards equilibrium.

Instead of a universal and timeless tendency towards equilibrium, equilibrium turns out to be an extreme case of negative feedback.  At the other extreme, positive feedback produces bubbles.  Bubbles have two components: a trend that prevails in reality and a misconception relating to that trend.  The trend that most commonly causes a bubble is the easy availability of credit and the most common misconception is that the availability of credit doesn’t affect the value of the collateral.  Of course it does, as we have seen in the recent housing bubble.  But that’s not sufficient to fully explain the course of events.

I have formulated a specific hypothesis for the crash of 2008 which holds that it was the result of a “super-bubble” that started forming in 1980 when Ronald Reagan became President of the United States and Margaret Thatcher was Prime Minister of the United Kingdom. The prevailing trend in the super-bubble was also the ever-increasing use of credit and leverage; but the misconception was different.  It was the belief that markets correct their own excesses.  Reagan called it the “magic of the marketplace”; I call it market fundamentalism.  Since it was a misconception, it gave rise to bubbles.  So the super-bubble was composed of a number of smaller bubbles — and punctuated by a series of financial crises.  Each time the authorities intervened and saved the system by taking care of the failing institutions and injecting more credit when necessary.  So the smaller bubbles served as successful tests of a false belief, helping the super-bubble to grow bigger by reinforcing both credit creation and market fundamentalism.

It should be emphasized that this hypothesis was not sufficient to predict the outcome of individual crises.  For instance, I predicted that the emerging market crisis of 1997

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