Social change: feedback loop reflexivity

George Soros "Remarks at the Institute for New Economic Thinking Annual Plenary Conference in Berlin, Germany"

(...) Economics is a social science and there is a fundamental difference between the natural and social sciences. Social phenomena have thinking participants who base their decisions on imperfect knowledge. That is what economic theory has tried to ignore.

(...) Karl Popper taught me that people’s interpretation of reality never quite corresponds to reality itself. This led me to study the relationship between the two. I found a two-way connection between the participants’ thinking and the situations in which they participate:

• On the one hand people seek to understand the situation; that is the cognitive function. 
• On the other, they seek to make an impact on the situation; I call that the causative or manipulative function. 

The two functions connect the thinking agents and the situations in which they participate in opposite directions.
Continúa

In the cognitive function the situation is supposed to determine the participants’ views; in the causative function the participants’ views are supposed to determine the outcome. When both functions are at work at the same time they interfere with each other. The two functions form a circular relationship or feedback loop. I call that feedback loop reflexivity. In a reflexive situation the participants’ views cannot correspond to reality because reality is not something independently given; it is contingent on the participants’ views and decisions. The decisions, in turn, cannot be based on knowledge alone; they must contain some bias or guess work about the future because the future is contingent on the participants’ decisions.

Fallibility and reflexivity are tied together like (...) Without fallibility there would be no reflexivity – although the opposite is not the case: people’s understanding would be imperfect even in the absence of reflexivity. (...) fallibility is the first born. Together, they ensure both a divergence between the participants’ view of reality and the actual state of affairs and a divergence between the participants’ expectations and the actual outcome. Obviously, I did not discover reflexivity.

(...) I focused on a problem area, namely the role of misconceptions and misunderstandings in shaping the course of events that mainstream economics tried to ignore.

(...) According to my theory, financial bubbles have two components: a trend that prevails in reality and a misinterpretation of that trend. A bubble can develop when the feedback is initially positive in the sense that both the trend and its biased interpretation are mutually reinforced. Eventually the gap between the trend and its biased interpretation grows so wide that it becomes unsustainable. After a twilight period both the bias and the trend are reversed and reinforce each other in the opposite direction. Bubbles are usually asymmetric in shape: booms develop slowly but the bust tends to be sudden and devastating. That is due to the use of leverage: price declines precipitate the forced liquidation of leveraged positions.

Well formed financial bubbles always follow this pattern but the magnitude and duration of each phase is unpredictable. Moreover the process can be aborted at any stage so that well formed financial bubbles occur rather infrequently. At any moment of time there are myriads of feedback loops at work, some of which are positive, others negative. They interact with each other, producing the irregular price patterns that prevail most of the time; but on the rare occasions that bubbles develop to their full potential they tend to overshadow all other influences.

According to my theory financial markets may just as soon produce bubbles as tend toward equilibrium. Since bubbles disrupt financial markets, history has been punctuated by financial crises. Each crisis provoked a regulatory response. That is how central banking and financial regulations have evolved, in step with the markets themselves. Bubbles occur only intermittently but the interplay between markets and regulators is ongoing. Since both market participants and regulators act on the basis of imperfect knowledge the interplay between them is reflexive. (...) Indeed, in light of the ongoing interaction between markets and regulators it is quite misleading to study financial markets in isolation.

Behind the invisible hand of the market lies the visible hand of politics. (...) I emphasize the role of misunderstandings and misconceptions in shaping the course of history. And I treat bubbles as largely unpredictable. The direction and its eventual reversal are predictable; the magnitude and duration of the various phases is not. (...) the idea that laws or models of universal validity can predict the future must be abandoned. (...) Reflexivity has been accommodated by speaking of multiple equilibria instead of a single one. (...) The fallibility of market participants, regulators, and economists must also be recognized. A truly dynamic situation cannot be understood by studying multiple equilibria. We need to study the process of change.

The euro crisis is particularly instructive in this regard. It shows that policies that could have worked at one point of time are no longer sufficient at the next. It also demonstrates the role of imperfect understanding and misconceptions in shaping the course of history. (...) the euro crisis is currently exerting an overwhelming influence on the global economy.

(...) The discussion of the euro crisis illustrates how fallibility and reflexivity can provide interesting insights into the process of social change. (...) Since the Crash of 2008 there has been a widespread recognition, both among economists and the general public, that economic theory has failed. But there is no consensus, even among participants in this conference, on the extent of that failure.

(...) I believe that the failure is more profound than generally recognized. It goes back to the foundations of economic theory. Economics tried to model itself on Newtonian physics. It sought to establish universally and timelessly valid laws governing reality.

(...) I believe a solution can be found even at this late stage but it will require a change:

1. First, the rules governing the eurozone have failed and need to be radically revised. Defending a status quo that is unworkable only makes matters worse. 


2. Second, current conditions are far removed from the Maastricht criteria and exceptional measures are needed to restore normalcy. 


3. Finally, the new rules must allow for financial markets’ inherent instability.

I have translated these general principles into a practical proposal which is published in today’s Financial Times but it would take us too long to discuss it here.