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Wednesday, 2 March 2011

Soros' Economic Reflexivity

Feedback in Cause and Effect

Social Psychology 101 stresses the interconnectedness of cause and effect in human mediated systems. It’s not just that cause begets effect but effect then begets cause which begets effect which … yeah, well, you get the idea.

The investor George Soros has taken this idea and used it to become mindbogglingly rich. He sees behavioral economics as only one part of a better description of our financial system: it explains how causes create effects but not how they feedback on each other. To explain that we need to look at what he calls economic reflexivity.

Volcanic Behavior
“Reflexivity is the favourite candidate for the property which makes the human sciences unique. Reflexivity is the property of the objects of a scientific inquiry also being the subjects who carry out the inquiry”.
Thus spake Owen Flanagan, but the problem might be summed up thus: people think for themselves and this gets them into lots of trouble because they often don’t do it very well. Potentially we end up with self-fulfilling prophesies, which we considered in Is Self-Interest Self-Fulfilling? Here's Flanagan, again:
“When scientists predicted that Mount Saint Helens would erupt they did not worry that the prediction would affect the volcano’s behaviour by causing it to erupt when it would not have because it preferred to do what geologists said it would do; or by causing it to stop an incipient eruption because it preferred to be disobedient. However, when we predict, based on our observations of some community of people studied as objects, that the rate of inflation will rise because of people’s negative attitudes towards saving money, we generate information which these very people can use in their role as economically self-interested subjects.”
So in this model it is the expectation of future inflation that generates inflation, as people demand wage rises to counter this: the so-called expectations theory of inflation. Anticipation of price rises leads people to spend more, save less and demand inflation-busting pay rises. Breaking the circle of expectation is the key to bringing inflation under control.

Thomas and Merton

Reflexivity as an idea in the social sciences dates back to the 1920’s and the so-called Thomas theorem, but is more closely associated with Robert Merton who came up with the associated concept of a self-fulfilling prophesy. Merton’s ideas as applied to the social sciences were picked up by the philosopher of science, Karl Popper, under whom Soros studied at London.

By the time he reached London Soros had already had an extraordinary life. As a child he survived the Nazis takeover of his native Hungary and then escaped the country after the Soviets took over. Eventually he went on to gain notoriety by making huge amounts of money betting on the currencies of various countries whose leaders were under the misapprehension that their bullshit economics was enough to fool hard nosed financiers: something that Eurozone politicians have been rediscovering the hard way more recently.

Popper’s Oedipus Effect

One of the major influences on Soros’ thinking was Popper, who developed the idea of reflexivity as applied to science, naming it the “Oedipus Effect”, in honour of the unfortunate Greek King of Thebes who fulfilled the prophesy that he would kill his father and marry his mother because of his attempts to avoid that very fate.

Soros has developed this idea and turned it back to the social sciences, with particular import for economics. He particularly regards the idea of economic equilibrium with opprobrium. Equilibrium is, as we saw in T√Ętonnement, Groping for Stock Equilibrium, the expected outcome of the economic principle of supply and demand.

So if a security falls in price below its fundamental value then traders will purchase it and bid its price up until it reaches the equilibrium point again. With economic reflexivity this may not happen: if traders believe markets are about to fall they’ll sell – and markets will fall. Sometimes lots of traders will do this, become convinced they're right and carry on selling (or buying). Standard economics calls this irrational, Soros thinks it's reflexivity in action because the act of selling, or buying, changes the mental expectations of people. We've seen an example of how this can happen in Abritraging Embeddedness.

The General Theory of Reflexivity

This is how George Soros explains the idea in The General Theory of Reflexivity:
“I can state the core idea in two relatively simple propositions. One is that in situations that have thinking participants, the participants' view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity. For instance, treating drug addicts as criminals creates criminal behavior. It misconstrues the problem and interferes with the proper treatment of addicts. As another example, declaring that government is bad tends to make for bad government.”
Basically there can be no certainty in anything because we’re fallible and our fallibility translates into actions which impact the very situations we’re trying to analyse. In this feedback Soros discerns a problem in behavioral finance:
“Instead of playing a purely passive role in reflecting an underlying reality, financial markets also have an active role: they can affect the so-called fundamentals they are supposed to reflect. That is the point that behavioral economics is missing. It focuses only on one half of a reflexive process: the mispricing of financial assets; it does not concern itself with the impact of the mispricing on the so-called fundamentals.”
The Flaw in the Behavioral Approach

What Soros is pointing out, albeit in different terms, is the same problem other commentators have raised with behavioral economics: it plays by the same rules as the traditional version, with a bit of psychology thrown in to pacify the unruly masses. If you add reflexivity to the equation you have a different sort of problem, because it implies that the standard models can’t apply and all that behavioural finance is explaining are the limits to human cognition, not their affects on economic behaviour.

Equilibrium is only possible in a world without reflexivity: in a world with it then prices can be driven to insane levels simply because of people behaving like people. If enough investors believe that a price change is indicative of something important and follow the trend then the trend can take on a life of its own and equilibrium be damned.

Reflexivity in Action

The fact is we don’t just observe markets, we don’t just participate in the markets: we are the markets. Taking account of that is beyond our current abilities, although it’s one of the principles that’s led Soros to his current state of being wealthy beyond the dreams of average avarice. Such a state means that he can indulge himself by pursuing his ideas and to this end he’s set up The Institute for New Economic Thinking, which:
“Recognizes problems and inadequacies within our current economic system and the modes of thought used to comprehend recent and past catastrophic developments in the world economy. The Institute embraces the professional responsibility to think beyond these inadequate methods and models and will support the emergence of new paradigms in the understanding of economic processes.”
Well, we’ll see.

Related articles: Time for Shiva and Schumpeter, Arbitraging Embededdness, Holes in Black-Scholes


Denise Shull said...

"Taking account of that is beyond our current abilities" ... is that really true?

Why can't we teach ourselves to enhance our powers of self-observation? Why can't we learn to read markets through our facilities for theory of mind?

I sound rhetorical but I am not really. I teach traders to do this everyday - some trade a billion dollars, some trade on desks of banks we love to hate and some trade their own capital.

You and Soros are of course right - we are the markets. But people tend to feel as if the market is some force of nature like the solar system. Once they realize that it is only the collective results of human beings that for practical purposes are JUST like themselves, they are much better able to read them. .... just as the theory of mind science would predict.

timarr said...

Hi Denise

It would probably have been better had I said that "taking account of this is beyond the current abilities of most of us".

But is it true that the markets are "only the collective results of human beings"? Surely these results are only the outcome of people reacting to events in the world around us, some of which are not under our control: Icelandic volcanoes and suchlike?

For me one of the most interesting things about Soros is that, apparently, he loses on most of his trades. It's just that when he wins, he wins big. Which may be the key to successfully trading reflexively: I'm afraid I wouldn't know :)