New Paradigm for Financial Markets, Appunti di Economia Finanziaria

Scarica New Paradigm for Financial Markets e più Appunti in PDF di Economia Finanziaria solo su Docsity! THE NEW PARADIGM FOR FINANCIAL MARKETS SOROS THE CREDIT CRISIS OF 2008 AND WHAT IT MEANS The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page i Copyright © 2008 by George Soros. Published in the United States by PublicAffairs™, a member of the Perseus Books Group. All rights reserved. Printed in the United States of America. No part of this book may be reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and re- views. For information, address PublicAffairs, 250 West 57th Street, Suite 1321, New York, NY 10107. PublicAffairs books are available at special discounts for bulk purchases in the U.S. by corporations, institutions, and other organizations. For more information, please contact the Special Markets Department at the Perseus Books Group, 2300 Chestnut Street, Suite 200, Philadelphia, PA 19103, call (800) 810-4145, x5000, or email special.markets@perseusbooks.com. text set in janson text Cataloging-in-Publication Data is available from the Library of Congress. ISBN 978-1-58648-683-9 (hardback) ISBN 978-1-58648-684-6 (e-book) first edition 1 3 5 7 9 10 8 6 4 2 Soros.qxd 3/28/08 10:22 AM Page iv Contents Introduction vii Setting the Stage xiii Part One: Perspective 1. The Core Idea 3 2. Autobiography of a Failed Philosopher 12 3. The Theory of Reflexivity 25 4. Reflexivity in Financial Markets 51 Part Two: The Current Crisis and Beyond 5. The Super-Bubble Hypothesis 81 6. Autobiography of a Successful Speculator 106 7. My Outlook for 2008 122 8. Some Policy Recommendations 142 Conclusion 153 Acknowledgments 161 About the Author 163 Soros.qxd 3/28/08 10:22 AM Page v Soros.qxd 3/28/08 10:22 AM Page vi When the financial crisis erupted, I had retired from ac- tively managing my fund, having previously changed its sta- tus from an aggressive hedge fund to a more sedate endowment fund. The crisis forced me, however, to refocus my attention on the financial markets, and I became more ac- tively engaged in making investment decisions. Then, to- wards the end of 2007, I decided to write a book analyzing and explaining the current situation. I was motivated by three considerations. First, a new paradigm was urgently needed for a better understanding of what is going on. Sec- ond, engaging in a serious study could help me in my invest- ment decisions. Third, by providing a timely insight into the financial markets, I would ensure that the theory of reflexiv- ity would finally receive serious consideration. It is difficult to gain attention for an abstract theory, but people are in- tensely interested in the financial markets, especially when they are in turmoil. I have already used the financial markets as a laboratory for testing the theory of reflexivity in The Alchemy of Finance; the current situation provides an excellent opportunity to demonstrate its relevance and importance. Of the three considerations, the third weighed most heavily in my decision to publish this book. The fact that I had more than one objective in writing it makes the book more complicated than it would be if it were focused solely on the unfolding financial crisis. Let me ex- plain briefly how the theory of reflexivity applies to the crisis. Contrary to classical economic theory, which assumes per- fect knowledge, neither market participants nor the mone- tary and fiscal authorities can base their decisions purely on knowledge. Their misjudgments and misconceptions affect market prices, and, more importantly, market prices affect Introduction ix Soros.qxd 3/28/08 10:22 AM Page ix the so-called fundamentals that they are supposed to reflect. Market prices do not deviate from a theoretical equilibrium in a random manner, as the current paradigm holds. Partici- pants’ and regulators’ views never correspond to the actual state of affairs; that is to say, markets never reach the equilib- rium postulated by economic theory. There is a two-way reflexive connection between perception and reality which can give rise to initially self-reinforcing but eventually self- defeating boom-bust processes, or bubbles. Every bubble consists of a trend and a misconception that interact in a re- flexive manner. There has been a bubble in the U.S. housing market, but the current crisis is not merely the bursting of the housing bubble. It is bigger than the periodic financial crises we have experienced in our lifetime. All those crises are part of what I call a super-bubble—a long-term reflexive pro- cess which has evolved over the last twenty-five years or so. It consists of a prevailing trend, credit expansion, and a prevailing misconception, market fundamentalism (aka laissez-faire in the nineteenth century), which holds that markets should be given free rein. The previous crises served as successful tests which reinforced the prevailing trend and the prevailing mis- conception. The current crisis constitutes the turning point when both the trend and the misconception have become unsustainable. All this needs a lot more explanation. After setting the stage, I devote the first part of this book to the theory of re- flexivity, which goes well beyond the financial markets. Peo- ple interested solely in the current crisis will find it hard going, but those who make the effort will, I hope, find it re- warding. It constitutes my main interest, my life’s work. Readers of my previous books will note that I have repeated x Introduction Soros.qxd 3/28/08 10:22 AM Page x some passages from them because the points I am making re- main the same. Part 2 draws both on the conceptual frame- work and on my practical experience as a hedge fund manager to illuminate the current situation. Introduction xi Soros.qxd 3/28/08 10:22 AM Page xi • On August 10, the European Central Bank provided an extra 61 billion euros of funds for banks. The U.S. Federal Reserve said it would provide as much overnight money as would be needed to combat the credit crunch. • On August 13, the European Central Bank pumped 47.7 billion euros into the money markets, its third cash injec- tion in as many working days. Central banks in the United States and Japan also topped up earlier injections. Gold- man Sachs said it would pump 3 billion dollars into a hedge fund hit by the credit crunch to shore up its value. • On August 16, Countrywide Financial, the largest U.S. mortgage originator, drew down its entire 11.5 billion dollar credit line. Australian mortgage lender Rams also admitted liquidity problems. • On August 17, the U.S. Federal Reserve cut the discount rate (the interest rate at which it lends to banks) by a half a percentage point to help banks deal with credit problems. (But it did not help. Subsequently the central banks of the developed world ended up injecting funds on a larger scale for longer periods and accepting a wider range of securi- ties as collateral than ever before in history.) • On September 13, it was disclosed that Northern Rock (the largest British mortgage banker) was bordering on in- solvency (which triggered an old-fashioned bank run—for the first time in Britain in a hundred years). The crisis was slow in coming, but it could have been an- ticipated several years in advance. It had its origins in the bursting of the Internet bubble in late 2000. The Fed re- sponded by cutting the federal funds rate from 6.5 percent to xiv Setting the Stage Soros.qxd 3/28/08 10:22 AM Page xiv 3.5 percent within the space of just a few months. Then came the terrorist attack of September 11, 2001. To counteract the disruption of the economy, the Fed continued to lower rates—all the way down to 1 percent by July 2003, the lowest rate in half a century, where it stayed for a full year. For thirty-one consecutive months the base inflation-adjusted short-term interest rate was negative. Cheap money engendered a housing bubble, an explosion of leveraged buyouts, and other excesses. When money is free, the rational lender will keep on lending until there is no one else to lend to. Mortgage lenders relaxed their standards and invented new ways to stimulate business and generate fees. Investment banks on Wall Street developed a variety of new techniques to hive credit risk off to other investors, like pension funds and mutual funds, which were hungry for yield. They also created structured investment vehicles (SIVs) to keep their own positions off their balance sheets. From 2000 until mid-2005, the market value of existing homes grew by more than 50 percent, and there was a frenzy of new construction. Merrill Lynch estimated that about half of all American GDP growth in the first half of 2005 was housing related, either directly, through home building and housing-related purchases like new furniture, or indirectly, by spending the cash generated from the refinancing of mortgages. Martin Feldstein, a former chairman of the Council of Economic Advisers, estimated that from 1997 through 2006, consumers drew more than $9 trillion in cash out of their home equity. A 2005 study led by Alan Green- span estimated that in the 2000s, home equity withdrawals were financing 3 percent of all personal consumption. By the Setting the Stage xv Soros.qxd 3/28/08 10:22 AM Page xv first quarter of 2006, home equity extraction made up nearly 10 percent of disposable personal income.* Double-digit price increases in house prices engendered speculation. When the value of property is expected to rise more than the cost of borrowing, it makes sense to own more property than one wants to occupy. By 2005, 40 percent of all homes purchased were not meant to serve as permanent resi- dences but as investments or second homes.† Since growth in real median income was anemic in the 2000s, lenders strained ingenuity to make houses appear affordable. The most popular devices were adjustable rate mortgages (ARMs) with “teaser,” below-market initial rates for an ini- tial two-year period. It was assumed that after two years, when the higher rate kicked in, the mortgage would be refi- nanced, taking advantage of the higher prices and generating a new set of fees for the lenders. Credit standards collapsed, and mortgages were made widely available to people with low credit ratings (called subprime mortgages), many of whom were well-to-do. “Alt-A” (or liar loans), with low or no documentation, were common, including, at the extreme, “ninja” loans (no job, no income, no assets), frequently with the active connivance of the mortgage brokers and mortgage lenders. xvi Setting the Stage *Economist, September 10, 2005; Martin Feldstein, “Housing, Credit Markets and the Business Cycle,” National Bureau of Economic Research working paper 13,471, October 2007; Alan Greenspan and James Kennedy, “Estimates of Home Mortgage Origination, Repayments, and Debts on One- to Four-Family Residences,” Federal Reserve staff working paper 2005–41 (data updated through 2007 by Dr. Kennedy and furnished to the author). †Joseph R. Mason and Joshua Rosner, “How Resilient Are Mortgage Backed Se- curities to Collateralized Debt Obligation Market Disruption?” paper pre- sented at the Hudson Institute, Washington, D.C., February 15, 2007, 11. Soros.qxd 3/28/08 10:22 AM Page xvi ket grew exponentially until it came to overshadow all other markets in nominal terms. The estimated nominal value of CDS contracts outstanding is $42.6 trillion. To put matters in perspective, this is equal to almost the entire household wealth of the United States. The capitalization of the U.S. stock market is $18.5 trillion, and the U.S. treasuries market is only $4.5 trillion. The securitization mania led to an enormous increase in the use of leverage. To hold ordinary bonds requires a mar- gin of 10 percent; synthetic bonds created by credit default swaps can be traded on a margin of 1.5 percent. This allowed hedge funds to show good profits by exploiting risk differen- tials on a leveraged basis, driving down risk premiums. It was bound to end badly. There was a precedent to go by. The market in collateralized mortgage obligations (CMOs) started to develop in the 1980s. In 1994, the market in the lowest-rated tranches—or “toxic waste,” as they were known—blew up when a $2 billion hedge fund could not meet a margin call, leading to the demise of Kidder Peabody and total losses of about $55 billion. But no regulatory action was taken. Former Federal Reserve governor Edward M. Gramlich privately warned Federal Reserve Chairman Alan Greenspan about abusive behavior in the subprime mortgage markets in 2000, but the warning was swept aside. Gramlich went public with his worries in 2007 and published a book on the subprime bubble just before the crisis first broke. Charles Kindleberger, an expert on bubbles, warned of the housing bubble in 2002. Martin Feldstein, Paul Volcker (former chairman of the Federal Reserve), and Bill Rhodes (a senior official of Citibank) all made bearish warnings. Nouriel Roubini predicted that the housing bubble would lead to a Setting the Stage xix Soros.qxd 3/28/08 10:22 AM Page xix recession in 2006. But no one, including myself, anticipated how big the bubble could grow and how long it could last. As the Wall Street Journal recently noted, there were many hedge funds taking a bearish stance on housing, but “they suffered such painful losses waiting for a collapse” that most eventually gave up their positions.* Signs of trouble started to multiply early in 2007. On Feb- ruary 22, HSBC fired the head of its U.S. mortgage lending business, recognizing losses reaching $10.8 billion. On March 9, DR Horton, the biggest U.S. homebuilder, warned of losses from subprime mortgages. On March 12, New Century Financial, one of the biggest subprime lenders, had its shares suspended from trading amid fears that the com- pany was headed for bankruptcy. On March 13, it was reported that late payments on mortgages and home fore- closures rose to new highs. On March 16, Accredited Home Lenders Holding put up $2.7 billion of its subprime loan book for sale at a heavy discount to generate cash for busi- ness operations. On April 2, New Century Financial filed for Chapter 11 bankruptcy protection after it was forced to re- purchase billions of dollars worth of bad loans.† On June 15, 2007, Bear Stearns announced that two large mortgage hedge funds were having trouble meeting margin calls. Bear grudgingly created a $3.2 billion credit line to bail out one fund and let the other collapse. Investors’ equity of $1.5 billion was mostly wiped out. xx Setting the Stage *Wall Street Journal, February 27, 2008, and January 15, 2008; New York Times, October 26, 2007. †“Bleak Housing Outlook for US Firm,” BBC News, March 8, 2007, http:// news.bbc.co.uk/2/hi/business/6429815.stm. Soros.qxd 3/28/08 10:22 AM Page xx The failure of the two Bear Stearns mortgage hedge funds in June badly rattled the markets, but U.S. Federal Reserve Chairman Ben Bernanke and other senior officials reassured the public that the subprime problem was an isolated phe- nomenon. Prices stabilized, although the flow of bad news continued unabated. As late as July 20, Bernanke still esti- mated subprime losses at only about $100 billion. When Merrill Lynch and Citigroup took big write-downs on in- house collateralized debt obligations, the markets actually staged a relief rally. The S&P 500 hit a new high in mid-July. It was only at the beginning of August that financial mar- kets really took fright. It came as a shock when Bear Stearns filed for bankruptcy protection for two hedge funds exposed to subprime loans and stopped clients from withdrawing cash from a third fund. As mentioned, Bear Stearns had tried to save these entities by providing $3.2 billion of additional funding. Once the crisis erupted, financial markets unraveled with remarkable rapidity. Everything that could go wrong did. A surprisingly large number of weaknesses were revealed in a remarkably short period of time. What started with low- grade subprime mortgages soon spread to CDOs, particularly those synthetic ones that were constructed out of the top slice of subprime mortgages. The CDOs themselves were not readily tradable, but there were tradable indexes representing the various branches. Investors looking for cover and short sellers looking for profits rushed to sell these indexes, and they de- clined precipitously, bringing the value of the various branches of CDOs that they were supposed to represent into question. Investment banks carried large positions of CDOs off balance sheet in so-called structured investment vehicles Setting the Stage xxi Soros.qxd 3/28/08 10:22 AM Page xxi Over the past several decades the United States has weath- ered several major financial crises, like the international lending crisis of the 1980s and the savings and loan crisis of the early 1990s. But the current crisis is of an entirely different character. It has spread from one segment of the market to others, par- ticularly those which employ newly created structured and synthetic instruments. Both the exposure and the capital base of the major financial institutions have been brought into question, and the uncertainties are likely to remain unre- solved for an extended period of time. This is impeding the normal functioning of the financial system and is liable to have far-reaching consequences for the real economy. Both the financial markets and the financial authorities have been very slow to recognize that the real economy is bound to be affected. It is hard to understand why this should be so. The real economy was stimulated by credit expansion. Why should it not be negatively affected by credit contrac- tion? One cannot escape the conclusion that both the finan- cial authorities and market participants harbor fundamental misconceptions about the way financial markets function. These misconceptions have manifested themselves not only in a failure to understand what is going on; they have given rise to the excesses which are at the root of the current mar- ket turmoil. In Part 1, I shall lay out the conceptual framework in terms of which the functioning of financial markets can be understood. In Part 2, I shall apply that framework to the present moment in history. xxiv Setting the Stage Soros.qxd 3/28/08 10:22 AM Page xxiv The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page xxv Soros.qxd 3/28/08 10:22 AM Page xxvi c h a p t e r 1 The Core Idea My starting point is that our understanding of the world in which we live is inherently imperfect because we are part of the world we seek to understand. There may be other fac- tors that interfere with our ability to acquire knowledge of the natural world, but the fact that we are part of the world poses a formidable obstacle to the understanding of human affairs. Understanding a situation and participating in it involves two different functions. On the one hand people seek to un- derstand the world in which they live. I call this the cognitive function. On the other, people seek to make an impact on the world and change it to their advantage. I used to call this the participating function, but now I consider it more appropri- ate to call it the manipulative function.* If the two functions were isolated from each other they could serve their purpose perfectly well: the participants’ understanding could qualify as knowledge, and their actions could have the desired *Cognitive scientists call it the executive function. Aristotle called it practical reason to distinguish it from theoretical reason, which is the equivalent of the cognitive function. Soros.qxd 3/28/08 10:22 AM Page 3 results. For this reason it is tempting to postulate that the functions do in fact operate in isolation. Indeed, that as- sumption has been made, most notably in economic theory. But the assumption is not justified, except in very exceptional circumstances where the participants make a special effort to keep the two functions separate. That may be the case with social scientists who are single-mindedly devoted to the pursuit of knowledge; but it is not true of the participants in the events that social scientists study. For reasons I shall explore later, social scientists, particularly economists, tend to ignore this fact. When both functions are in operation at the same time they may interfere with each other. For the cognitive function to produce knowledge it must take social phenomena as inde- pendently given; only then will the phenomena qualify as facts to which the observer’s statements may correspond. Similarly, decisions need to be based on knowledge to pro- duce the desired results. But when both functions operate si- multaneously, the phenomena do not consist only of facts but also of intentions and expectations about the future. The past may be uniquely determined, but the future is contingent on the participants’ decisions. Consequently the participants cannot base their decisions on knowledge because they have to deal not only with present and past facts but also with con- tingencies concerning the future. The role that intentions and expectations about the future play in social situations sets up a two-way connection between the participants’ thinking and the situation in which they participate, which has a dele- terious effect on both: it introduces an element of contin- gency or uncertainty into the course of events, and it prevents the participants’ views from qualifying as knowledge. 4 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 4 For a function to be uniquely determined, it needs an in- dependent variable which determines the value of the depen- dent variable. In the cognitive function the actual state of affairs is supposed to be the independent variable, and the participants’ views the dependent one; in the manipulative function it is the other way round. In reflexive situations each function deprives the other of the independent variable which it would need to produce determinate results. I have given the two-way interference a name: reflexivity. Reflexive situations are characterized by a lack of correspondence between the participants’ views and the actual state of affairs. Take the stock market, for example. People buy and sell stocks in an- ticipation of future stock prices, but those prices are contin- gent on the investors’ expectations. The expectations cannot qualify as knowledge. In the absence of knowledge, partici- pants must introduce an element of judgment or bias into their decision making. As a result, outcomes are liable to di- verge from expectations. Economic theory has gone to great lengths to exclude re- flexivity from its subject matter. At first, classical economists simply assumed that market participants base their decisions on perfect knowledge: one of the postulates on which the theory of perfect competition was based was perfect knowl- edge. Building on those postulates, economists constructed demand curves and supply curves and claimed that those curves governed the participants’ decisions. When the con- struct came under attack, they took refuge behind a method- ological convention. Lionel Robbins, who was my professor at the London School of Economics, argued that economics is concerned only with the relationship between demand and supply; what goes into constituting demand and supply is The Core Idea 5 Soros.qxd 3/28/08 10:22 AM Page 5 in a somewhat different sense to describe a two-way connec- tion between the participants’ thinking and the situation in which they participate. Knowledge is represented by true statements. A statement is true if and only if it corresponds to the facts. That is what the correspondence theory of truth tells us. To establish cor- respondence the facts and the statements which refer to them must be independent of each other. It is this require- ment that cannot be fulfilled when we are part of the world we seek to understand. That is why participants cannot base their decisions on knowledge. What they lack in knowledge they have to make up for with guesswork based on experi- ence, instinct, emotion, ritual, or other misconceptions. It is the participants’ biased views and misconceptions that intro- duce an element of uncertainty into the course of events. All this makes eminent sense. The puzzle is why the con- cept of reflexivity has not been generally recognized. In the case of the financial markets I know the answer: reflexivity prevents economists from producing theories that would ex- plain and predict the behavior of financial markets in the same way that natural scientists can explain and predict natural phenomena. In order to establish and protect the status of economics as a science, economists have gone to great lengths to eliminate reflexivity from their subject matter. When it comes to other realms of reality, I am on less certain ground because I am less well grounded in philosophy. My impression is that philosophers have grappled with the prob- lem in various ways. Aristotle, for instance, distinguished be- tween theoretical reason (i.e., the cognitive function) and practical reason (i.e., the manipulative function). Being philosophers, however, they were so preoccupied with the 8 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 8 cognitive function that they did not give sufficient weight to the manipulative function. Philosophers recognized and explored the cognitive un- certainty associated with self-referent statements. The prob- lem was first stated by the Cretan philosopher Epimenides when he said that Cretans always lie. The paradox of the liar eventually led Bertrand Russell to distinguish between state- ments that refer to themselves and those that do not. Analyti- cal philosophers also studied the problems associated with speech acts, statements that make an impact on the situation to which they refer, but their interest was mainly focused on the cognitive aspect of the problem. The fact that social events have a different structure from natural phenomena did not receive widespread recognition. On the contrary, Karl Popper, who has been a major source of inspiration for me, declared the doctrine of the unity of method, that is to say, the same methods and criteria ought to apply to the study of natural events and social events. Of course, that is not the only point of view that has been put forward, but it is the prevailing view among social scientists who aspire to the same status as natural scientists. Not all social scientists do so. Anthropologists and most sociologists do not even try to imitate the natural sciences. But they are less influential than those who try. The theory of reflexivity seeks to illuminate the relation- ship between thinking and reality. It applies to only a rela- tively narrow segment of reality. In the realm of natural phenomena, events occur independently of what anybody thinks; therefore, natural science can explain and predict the course of events with reasonable certainty. Reflexivity is con- fined to social phenomena—more specifically, those situa- The Core Idea 9 Soros.qxd 3/28/08 10:22 AM Page 9 tions in which participants cannot base their decisions on knowledge—and it creates difficulties for the social sciences from which the natural sciences are exempt. Reflexivity can be interpreted as a circularity, or two-way feedback loop, between the participants’ views and the actual state of affairs. People base their decisions not on the actual situation that confronts them but on their perception or in- terpretation of that situation. Their decisions make an im- pact on the situation (the manipulative function), and changes in the situation are liable to change their percep- tions (the cognitive function). The two functions operate concurrently, not sequentially. If the feedback were sequen- tial, it would produce a uniquely determined sequence lead- ing from facts to perceptions to new facts and then new perceptions, and so on. It is the fact that the two processes occur simultaneously that creates an indeterminacy in both the participants’ perceptions and the actual course of events. This way of looking at reflexivity will be particularly useful, as we shall see, in understanding the behavior of financial markets. Whether we speak of a circularity, or a feedback mechanism, is a matter of interpretation; but the two-way in- teraction is real. The circularity is not an error of interpreta- tion; on the contrary, it is the denial of a circularity that is the error. The theory of reflexivity seeks to correct that error. The difficulties of the social sciences are only pale, sec- ond-hand reflections of the predicament in which the partici- pants find themselves. They can affect the course of events—the future is influenced by their decisions—but they cannot base their decisions on knowledge. They are obliged to form a view of the world, but that view cannot possibly correspond to the actual state of affairs. Whether they recog- 10 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 10 formative experience of his life. Until then he had been an ambitious young man. When World War I broke out, he vol- unteered to serve in the Austro-Hungarian army. He was captured by the Russians and taken as a prisoner of war to Siberia. Being ambitious, he became the editor of a newspa- per produced by the prisoners. The paper was called The Plank because handwritten articles were posted on a plank; the authors hid behind the plank and listened to the com- ments made by the readers. My father became so popular that he was elected the prisoners’ representative. When some soldiers escaped from a neighboring camp, their pris- oners’ representative was shot in retaliation. Instead of wait- ing for the same thing to happen in his camp, my father organized a group and led the breakout. His plan was to build a raft and sail down to the ocean, but his knowledge of geography was deficient; he did not know that all the rivers in Siberia flow into the Arctic Sea. They drifted for several weeks before they realized that they were heading to the Arc- tic, and it took them several months to make their way back to civilization across the taiga. In the meantime, the Russian Revolution broke out, and they became caught up in it. Only after a variety of adventures did my father manage to find his way back to Hungary; had he remained in the camp, he would have arrived home much sooner. My father came home a changed man. His experiences during the Russian Revolution affected him profoundly. He lost his ambition and wanted nothing more from life than to enjoy it. He imparted to his children values that were very different from those of the milieu in which we lived. He had no desire to amass wealth or become socially prominent. On the contrary, he worked only as much as was necessary to Autobiography of a Failed Philosopher 13 Soros.qxd 3/28/08 10:22 AM Page 13 make ends meet. I remember being sent to his main client to borrow some money before we went on a ski vacation; my fa- ther was grouchy for a few weeks afterwards because he had to pay it back. Although we were reasonably prosperous, we were not the typical bourgeois family, and we were proud of being different. When the Germans occupied Hungary on March 19, 1944, my father knew these were not normal times and the normal rules did not apply. He arranged false identities for his family and a number of others. The clients paid; others received his help for free. Most of them survived. That was his finest hour. Living with a false identity turned out to be an exhilarat- ing experience for me. We were confronted by mortal dan- ger, and people perished all around us, but we managed not only to survive but to emerge victorious because we were able to help so many others. We were on the side of the an- gels, and we triumphed against overwhelming odds. I was aware of the dangers, but I did not think they could touch me. It was high adventure, like living through Raiders of the Lost Ark. What more could a fourteen-year-old ask for? After the heady adventures of the Nazi persecution, the situation began to deteriorate during the Soviet occupation. At first, the adventures continued, and we were able to ma- neuver successfully through perilous situations. The Swiss consulate employed my father to act as the liaison officer with the Russian occupying forces. The Swiss were looking after the Allied interests at the time, so this was a key posi- tion. When the Allied Powers established their own repre- sentative offices, my father retired because he felt that if he worked for the Allies he would be too exposed. It was a wise 14 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 14 decision—he avoided later persecution. But the situation was becoming drab and oppressive for a youth who had become accustomed to adventure. I also thought that it was un- healthy for a young man of fifteen to think exactly like his fifty-year-old father. I told my father that I wanted to get away. “Where would you like to go?” he asked. “To Moscow, to find out about communism, or to London because of the BBC,” I replied. “I know the Soviet Union intimately and I can tell you all about it,” my father said. That left London. It was not easy to get there, but I arrived in September 1947. Living in London was a comedown. I had no money and no friends. After my adventurous life, I was full of myself, but the people in London were not interested. I was an outsider looking in, and I discovered loneliness. There was a moment when I ran out of money. I was having a snack at a Lyons Corner House, and after paying for my food I had no money left. “I have touched bottom,” I told myself, “and I am bound to rise. This will be a valuable experience.” I read and thought a lot while working as a swimming pool attendant in Brentford, waiting to be admitted to the Lon- don School of Economics (LSE). One of the books I read was Karl Popper’s The Open Society and Its Enemies. That book struck me with the force of revelation. Popper argued that the Nazi and Communist ideologies have something in com- mon—they both claim to be in possession of the ultimate truth. Since the ultimate truth is beyond human reach, both ideologies had to be based on a biased and distorted interpre- tation of reality; consequently, they could be imposed on so- ciety only by the use of repressive methods. He juxtaposed a different principle of social organization, one that is based on the recognition that the ultimate truth is beyond our reach Autobiography of a Failed Philosopher 15 Soros.qxd 3/28/08 10:22 AM Page 15 selves, but the actual course is indeterminate and unique. Thus, the theory of reflexivity constitutes a theory of history. However, the theory emphatically does not qualify as scien- tific because it does not provide deterministic explanations and predictions. It is merely a conceptual framework for understanding events that have human participants. Never- theless, it served me well later when I became a market par- ticipant. Much later, when my success in the financial markets allowed me to set up a foundation, my theory of his- tory guided me in my philanthropy. My philosophical explorations did not help me much as a student. I barely passed my exams. I would have preferred to stay within the safe walls of academe—I even had a teaching assistant job prospect at the University of Michigan in Kala- mazoo, but my grades were not good enough, and I was forced to go out into the real world. After several false starts, I ended up working as an arbitrage trader, first in London and then in New York.* At first I had to forget everything I had learned as a student in order to hold down my job, but even- tually my college education came in very useful. In particu- lar, I could apply my theory of reflexivity to establish a disequilibrium scenario or boom-bust pattern for financial markets. The rewarding part came when markets entered what I called far-from-equilibrium territory because that is when the generally accepted equilibrium models broke down. I specialized in detecting and playing far-from-equi- librium situations with good results. This led to my first pub- 18 The New Paradigm for Financial Markets *Arbitrage trading involves exploiting price discrepancies between interrelated markets. The discrepancies may occur between different locations, like Tokyo or Johannesburg versus New York, or different securities, like convertible bonds or warrants versus common stock. Soros.qxd 3/28/08 10:22 AM Page 18 lished book, The Alchemy of Finance (1987), in which I ex- pounded my approach. I called it alchemy to emphasize that my theory does not meet the currently prevailing require- ments of scientific method. To what extent my financial success was due to my philoso- phy is a moot question because the salient feature of my the- ory is that it does not yield any firm predictions. Running a hedge fund involves the constant exercise of judgment in a risky environment, and that can be very stressful. I used to suffer from backaches and other psychosomatic ailments, and I received as many useful signals from my backaches as from my theory. Nevertheless, I attributed great importance to my philosophy and particularly my theory of reflexivity. Indeed, I considered it so significant, treasured it so much, that I found it difficult to part with it by putting it in writing and publishing it. No formulation was good enough. To express my ideas in a few sentences, as I have done here, would have seemed sacrilegious. It had to be a book. As I belabored the points, my arguments became more and more convoluted until I reached a point when I could not under- stand what I had written the night before. As I have often re- counted it, that is when I abandoned my philosophical explorations, returned to the land of the living, and started making money in earnest. But that, too, had its downside. When I resumed my philosophical investigations and pub- lished the results in The Alchemy of Finance, the philosophical part was dismissed by many critics as the self-indulgence of a successful speculator. That is how I came to consider myself a failed philosopher. Nevertheless, I kept on trying. Once I gave a lecture at the University of Vienna with the title “A Failed Philosopher Tries Again.” I found myself in a large Autobiography of a Failed Philosopher 19 Soros.qxd 3/28/08 10:22 AM Page 19 hall, looking down on the audience from a cathedra that tow- ered high above the auditorium. I felt inspired by the setting to make an ex cathedra statement, and on the spur of the mo- ment I announced the doctrine of fallibility. It was the best part of my lecture. Some of the difficulties in formulating my ideas were in- herent in the concepts of fallibility and reflexivity; others were self-inflicted. In retrospect, it is clear that I was not pre- cise enough in my formulations and tended to overstate my case. As a result, the professionals whose positions I chal- lenged could dismiss or ignore my arguments on technical grounds without giving them any real consideration. At the same time, some readers could look through my faulty rheto- ric and appreciate the ideas that lay behind them. That was particularly true for people engaged in the financial markets, where my demonstrated success led them to look for the rea- son behind it, and the obscurity of my formulations added to their fascination. My publisher anticipated this and refrained from editing my manuscript. He wanted the book to be the subject of a cult. To this day The Alchemy of Finance is read by market participants, taught in business schools, but totally ignored in departments of economics. Unfortunately, the idea that I was a failed philosopher came to be accepted by those who wrote about me, including my biographer, Michael Kaufman. He quoted my son Robert: My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bull- shit. I mean, you know the reason he changes his posi- tion on the market or whatever is because his back starts 20 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 20 quisition of knowledge but not for a politician whose pri- mary purpose is to get elected and stay in power. This insight forced me to reconsider the concept of open society, which I had adopted from Karl Popper rather uncrit- ically. But the insight also did something else. It convinced me that my conceptual framework has an objective value that goes beyond my personal predilection. The concepts of re- flexivity and fallibility make an important contribution to our understanding, not because they are something novel or original by themselves but because they can be used to iden- tify and refute widespread and influential misconceptions. One of those misconceptions is what I call the Enlighten- ment fallacy, which assumes that the purpose of reason is to produce knowledge. I call it a fallacy because it ignores the manipulative function. How deeply rooted the Enlighten- ment tradition is can be seen from my own experience. By embracing the concept of open society I subscribed to the Enlightenment fallacy even though by developing the con- cept of reflexivity I was asserting the importance of the ma- nipulative function. This conclusion removed the doubts I used to entertain about the objective value of my philosophy. Then came the financial crisis which is playing havoc with the financial sys- tem and threatens to engulf the economy. It is a vivid demon- stration of how much damage misconceptions can cause. The theory of reflexivity offers a genuine alternative to the currently prevailing paradigm. If the theory of reflexivity is valid, the belief that financial markets tend towards equilib- rium is false, and vice versa. I am now ready to submit my conceptual framework to public consideration in the firm conviction that it deserves Autobiography of a Failed Philosopher 23 Soros.qxd 3/28/08 10:22 AM Page 23 attention. I am aware of the various shortcomings in my pre- vious presentations, which I hope to have overcome, and I believe that it will be worth the reader’s while to make the ef- fort required to understand my philosophy. Needless to say, this makes me very happy. I have been fortunate in making a lot of money and spending it well. But I have always wanted to be a philosopher, and finally I may have become one. What more can one ask for from one life? 24 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 24 c h a p t e r 3 The Theory of Reflexivity Some readers may find this chapter hard going. Those who are only interested in the financial markets may skip it or return to it after they have found my interpretation of the current situation convincing. From the author’s perspective it remains indispensa- ble—more important than the correct interpretation of the finan- cial crisis. Fallibility Having established the significance of my conceptual framework I can now dwell on some of the complexities I swept under the carpet in my summary presentation. I la- bored on my philosophy over many years. I shall now briefly recount the difficulties I encountered and summarize the conclusions I reached. I did not make the relationship between fallibility and re- flexivity sufficiently clear. People are participants, not just ob- servers, and the knowledge they can acquire is not sufficient Soros.qxd 3/28/08 10:22 AM Page 25 thinking is part of reality. I found myself talking about a two- way connection between the course of events and the partici- pants’ thinking. That left out a two-way connection between the thinking of the various participants. To take that connec- tion into account I found myself obliged to distinguish be- tween the objective and subjective aspects of reality. The former refers to the course of events, the latter to the partici- pants’ thinking. There is only one objective aspect, but there are as many subjective aspects as there are participants. The direct interpersonal relations among participants are more likely to be reflexive than the interaction between percep- tions and events because events take longer to unfold. Once we distinguish between objective and subjective as- pects we must also distinguish between reflexive processes and reflexive statements. Reflexive statements belong to the realm of direct interpersonal relations, and those relations are more likely to be reflexive than the course of events. Consider a statement about the objective aspect: “It is raining.” That is either true or false; it is not reflexive. But take a statement like: “You are my enemy.” That may be true or false, depending on how you react to it. That is reflexive. Re- flexive statements resemble self-referent statements, but the indeterminacy is inherent not in their meaning but in the im- pact they make. The most famous self-referent statement is the paradox of the liar: “Cretans always lie,” said Epimenides. If this statement is true, the Cretan philosopher was not lying, and therefore the statement is false. The ambivalence has nothing to do with the impact of the statement. By con- trast, in “You are my enemy” the truth value of the statement depends on your reaction. 28 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 28 In the case of reflexive processes the indeterminacy is in- troduced by a lack of correspondence between the objective and subjective aspects of a situation. A situation may be re- flexive even if the cognitive and manipulative functions oper- ate sequentially and not simultaneously. The process then evolves over a period of time, but it qualifies as reflexive as long as neither the participants’ thinking nor the actual state of affairs remains the same at the end of the process as it was at the beginning, and the changes occur as a result of some misconception or misinterpretation by the participants, in- troducing an element of genuine indeterminacy into the course of events. This renders the situation unpredictable on the basis of scientific laws. Reflexivity is best demonstrated and studied in the finan- cial markets because financial markets are supposed to be governed by such laws. In other areas the science is less well developed. Even in the financial markets demonstrably re- flexive processes occur only intermittently. On a day-by-day basis markets seem to follow certain statistical rules, but occa- sionally those rules are broken. We may therefore distinguish between humdrum, everyday events that are predictable, and reflexive processes that are not. The latter are of great signifi- cance because they alter the course of history. This considera- tion led me to argue that historic developments are distinguished from everyday events by their reflexivity. But that argument is false. There are many historic events, such as earthquakes, that are not reflexive. The distinction between humdrum and reflexive turns out to be tautological: reflexive developments leave neither the objective nor the subjective aspects of reality unaltered, by definition. The Theory of Reflexivity 29 Soros.qxd 3/28/08 10:22 AM Page 29 Now that cognitive science and the study of languages have made such progress the concept of reflexivity has been to some extent superseded. Reflexivity distinguishes only two functions: the cognitive and the manipulative. This is a rather crude classification compared to the much more nu- anced and detailed analyses of brain and language functions that have become available in recent years. Nevertheless, the concept has not lost its relevance. It pinpoints a distortion in the way philosophers and scientists tend to look at the world. Their primary concern is the cognitive function; insofar as the manipulative function interferes with the proper func- tioning of cognition, they are inclined to ignore it or to de- liberately eliminate it from consideration. Economic theory provides the best example. The theory of perfect competi- tion was built on the assumption of perfect knowledge. When the assumption proved untenable, economists went through ever more elaborate contortions in order to protect the edifice they have erected against the nefarious effects of reflexivity. That is how the assumption of perfect knowledge morphed into the theory of rational expectations—a make- believe world that bears no resemblance to reality. More on that in the next chapter. The Human Uncertainty Principle The distinguishing feature of reflexivity is that it intro- duces an element of uncertainty into the participants’ think- ing and an element of indeterminacy into the situation in which they participate. Reflexivity bears some resemblance to Werner Heisenberg’s uncertainty principle in quantum 30 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 30 relationships among them was richly rewarding. Knowledge was being acquired in so many different ways and from so many different directions that the possibilities seemed un- limited. Reason was sweeping away centuries of superstition and generating in its place a triumphant sense of progress. The Enlightenment, as it came to be understood, recog- nized no limit to the acquisition of knowledge. Having identi- fied only a one-way connection between thinking and reality, it treated reality as something independently given that could be fully understood by making statements that corresponded to the facts. This point of view—Popper called it compre- hensive rationality—reached its apogee in logical positivism, a philosophy that flourished at the beginning of the twenti- eth century, primarily in Vienna. Logical positivism held that only empirical statements that could be verified were mean- ingful, and metaphysical discussions were meaningless.* Logical positivists treated facts and statements as if they be- longed to separate universes. The only connection between the two universes was that true statements corresponded to the facts and false statements did not. In these circumstances the facts served as a reliable criterion of truth. This was the foundation of the correspondence theory of truth. The pos- sibility that statements also constituted facts was largely, but not entirely, ignored. A lot of attention was paid to the para- dox of the liar. Bertrand Russell, the British philosopher who was re- sponsible for bringing Ludwig Wittgenstein to Cambridge from Vienna, offered a solution to the paradox of the liar. The Theory of Reflexivity 33 *Logical positivists made an exception for analytic statements such as “bachelors are unmarried males,” which they considered meaningful. This cleared the way to analytical philosophy. Soros.qxd 3/28/08 10:22 AM Page 33 Russell drew a distinction between two classes of statements: self-referential statements and non-self-referential ones. Since the truth value of self-referent statements could not be unequivocally determined, he proposed that they should be excluded from the universe of meaningful statements. This solution might have served to preserve the pristine separa- tion between facts and statements, but it would have pre- vented people from thinking about issues that concerned them, or even from being conscious of themselves. The ab- surdity of this position was highlighted by Wittgenstein, who concluded his Tractatus Logico-Philosophicus by stating that those who understood the book had to realize that it was meaningless. Shortly thereafter, Wittgenstein abandoned the pursuit of an ideal logical language and replaced it with a study of the workings of ordinary language. Fertile Fallacies While the Enlightenment’s faith in reason was not fully justified, it produced truly impressive results, which were sufficient to sustain the Enlightenment for two centuries. I call flawed ideas that produce positive results fertile fallacies. I call the separation of thinking and reality a fertile fallacy. It is not the only one. Fertile fallacies abound in history. I con- tend that all cultures are built on fertile fallacies. They are fertile because they flourish and produce positive results be- fore their deficiencies are discovered; they are fallacies be- cause our understanding of reality is inherently imperfect. We are, of course, capable of acquiring knowledge; but if that knowledge proves useful we are liable to overexploit it and 34 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 34 extend it to areas where it no longer applies. That is when it becomes a fallacy. That is what happened to the Enlighten- ment. The ideas of the Enlightenment have become deeply ingrained in our Western civilization, and are difficult to shake. They permeate the writings even of those who are critical of some aspects of the Enlightenment tradition, in- cluding myself. Popper’s Scheme of Scientific Method Karl Popper, a non-card-carrying member of the Vienna Circle, was critical of Wittgenstein and disagreed with com- prehensive rationality. He maintained that reason is not ca- pable of establishing the truth of generalizations beyond doubt. Even scientific laws cannot be verified because it is impossible to derive universally valid generalizations from individual observations, however numerous, by deductive logic. Scientific method works best by adopting an attitude of comprehensive skepticism: Scientific laws should be treated as hypotheses which are provisionally valid unless and until they are falsified. Popper constructed a beautifully simple and elegant scheme of scientific method consisting of three elements and three operations. The three elements are the initial condi- tions, the final conditions, and the generalizations of univer- sal validity, or scientific laws. The three operations are prediction, explanation, and testing. When the initial condi- tions are combined with scientific laws they provide a predic- tion. When the final conditions are combined with those The Theory of Reflexivity 35 Soros.qxd 3/28/08 10:22 AM Page 35 cept of reflexivity. The concept of self-reference had already been extensively analyzed by Russell and others. But self- reference pertains exclusively to the realm of statements. If the separation between the universe of statements and the universe of facts is a distortion of reality, then there has to be a similar effect in the realm of facts. That is the relationship that the concept of reflexivity seeks to express. To some ex- tent the concept was explored by J. L. Austin and John Searle in their work on speech acts, but I see it in a much wider con- text. Reflexivity is a two-way feedback mechanism that af- fects not only statements (by rendering their truth value indeterminate) but also facts (by introducing an element of indeterminacy into the course of events). Yet, in spite of my preoccupation with the concept of re- flexivity, I failed to recognize a flaw in Popper’s concept of open society: that political discourse is not necessarily di- rected at the pursuit of truth. I believe both Popper and I made these mistakes because of our preoccupation with the pursuit of truth. Fortunately, these errors are not fatal be- cause the case for critical thinking remains unimpaired and the mistakes can be corrected: we can recognize a difference between the natural and social sciences, and we can introduce the pursuit of truth as a requirement for an open society. The postmodern attitude towards reality is much more dangerous. While it has stolen a march on the Enlightenment by discovering that reality can be manipulated, it does not rec- ognize the pursuit of truth as a requirement. Consequently, it allows the manipulation of reality to go unhindered. Why is that so dangerous? Because in the absence of proper under- standing the results of the manipulation are liable to be radi- cally different from the expectations of the manipulators. One 38 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 38 of the most successful instances of manipulation was when President George W. Bush declared a War on Terror and used it to invade Iraq on false pretenses. The outcome was the exact opposite of what he intended: He wanted to demonstrate American supremacy and garner political support in the pro- cess; but he caused a precipitous decline in American power and influence and lost political support in the process. To guard against the dangers of manipulation, the concept of open society originally formulated by Karl Popper needs to be modified in an important respect. What Popper took for granted needs to be introduced as an explicit require- ment. Popper assumed that the purpose of critical thinking is to gain a better understanding of reality. That is true in sci- ence but not in politics. The primary purpose of political dis- course is to gain power and to stay in power. Those who fail to recognize this are unlikely to be in power. The only way in which politicians can be persuaded to pay more respect to re- ality is by the electorate insisting on it, rewarding those whom it considers truthful and insightful, and punishing those who engage in deliberate deception. In other words, the electorate needs to be more committed to the pursuit of truth than it is at present. Without such a commitment, democratic politics will not produce the desired results. An open society can be only as virtuous as the people living in it. The Pursuit of Truth Now that we know reality can be manipulated, it is much more difficult to make a commitment to the pursuit of truth than it was at the time of the Enlightenment. For one thing, The Theory of Reflexivity 39 Soros.qxd 3/28/08 10:22 AM Page 39 it is more difficult to establish what the truth is. The Enlight- enment regarded reality as something independently given and therefore knowable; but when the course of events is contingent on the biased beliefs and misconceptions of the participants, reality turns into a moving target. For another, it is not at all self-evident why the pursuit of truth should take precedence over the pursuit of power. And even if the electorate were convinced of it, how can the politicians be kept honest? Reflexivity provides part of the answer, even if it leaves the problem of keeping politicians honest unresolved. It teaches us that the pursuit of truth is important exactly because mis- conceptions are liable to lead to unintended adverse conse- quences. Unfortunately the concept of reflexivity is not properly understood. That can be seen from the far-reaching influence that the Enlightenment tradition and, more re- cently, the postmodern idiom have exerted over people’s view of the world. Both interpretations of the relationship between thinking and reality are distorted. The Enlighten- ment ignores the manipulative function. The postmodern approach goes to the other extreme: By treating reality as a collection of often conflicting narratives, it fails to give suffi- cient weight to the objective aspect of reality. The concept of reflexivity helps to identify what is missing from each. That said, reflexivity is far from a perfect representation of a very complex reality. The main problem with the concept is that it seeks to describe the relationship between thinking and reality as separate entities when in reality thinking is part of reality. I have gained a healthy respect for the objective aspect of reality both by having lived under Nazi and Communist regimes and by speculating in the financial markets. The 40 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 40 nipulation of truth as a superior approach. This interferes di- rectly with the pursuit of truth both by declaring it futile and by making the task more difficult through constant manipu- lation. Moreover, Rove’s approach led to the restriction of liberties by using the manipulation of public opinion to en- hance the powers and prerogatives of the president. That is what the Bush administration wrought by declaring the War on Terror. I believe the War on Terror provides an excellent illustra- tion of the dangers inherent in Rove’s ideology. The Bush administration used the War on Terror to invade Iraq. This was one of the most successful instances of manipulation, yet its consequences for the United States and the Bush adminis- tration itself were nothing short of disastrous. The public is now awakening, as if from a bad dream. What can it learn from the experience? That reality is a hard task master, and we manipulate it at our peril: The conse- quences of our actions are liable to diverge from our expecta- tions. However powerful we are, we cannot impose our will on the world: we need to understand the way the world works. Perfect knowledge is not within our reach; but we must try to come as close to it as we can. Reality is a moving target, yet we need to pursue it. In short, understanding reality ought to take precedence over manipulating it. As things stand now, the pursuit of power tends to take precedence over the pursuit of truth. Popper and his follow- ers—including me—made a mistake when we took the pur- suit of truth for granted. Recognizing the mistake should not lead us to abandon the concept of open society. On the con- trary, the experience with the Bush administration ought to reinforce our commitment to open society as a desirable The Theory of Reflexivity 43 Soros.qxd 3/28/08 10:22 AM Page 43 form of social organization. We must alter, however, our defi- nition of what an open society entails. In addition to the familiar attributes of a liberal democracy—free elections, in- dividual liberties, division of powers, the rule of law, etc.—it also entails an electorate that insists on certain standards of honesty and truthfulness. What these standards are need to be first carefully elaborated and then generally accepted. Standards of Political Discourse Karl Popper, who was first and foremost a philosopher of science, elaborated such standards for scientific discourse and experimentation. To give just one example, laws need to be falsifiable, and experiments need to be replicable to qual- ify as scientific. The standards of scientific method cannot be applied to politics directly; nevertheless, they serve as an ex- ample of the kind of rules that need to be established. We have identified two crucial differences between sci- ence and politics. One is that politics is more concerned with the pursuit of power than the pursuit of truth. The other is that in science there is an independent criterion, namely the facts, by which the truth or validity of statements can be judged. In politics, the facts are often contingent on the par- ticipants’ decisions. Reflexivity throws a monkey wrench into Popper’s model of scientific method. In The Alchemy of Finance, I took issue with Popper’s doc- trine of the unity of method. I argued that reflexivity pre- vents the social sciences from meeting the standards of natural science. How could scientific method be expected to produce generalizations which reversibly provide determi- 44 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 44 nate predictions and explanations, when the course of events is inherently indeterminate? We must be content with hunches and alternative scenarios instead of determinate predictions. In retrospect, I probably spent too much time on examining the role of the social scientists and not enough on the participants in social situations. That is why I failed to recognize a flaw in Popper’s concept of open society, namely, that politics is more concerned with the pursuit of power than the pursuit of truth. I am now correcting the error by introducing truthfulness and respect for reality as explicit re- quirements for an open society. Unfortunately I do not have any clear-cut formula for how that requirement could be met; I can only identify it as an un- solved problem. That is not surprising. The problem is not one that an individual can solve; it requires a change in the attitude of the public.* I believe political discourse used to abide by much higher standards of truthfulness and respect for the opponents’ opinions in the first two hundred years of democracy in America than it does today. I realize that old men usually see the past in rosier colors than the present, but in this case I be- lieve I can justify my claim by invoking the Enlightenment fallacy. As long as people believed in the power of reason they also believed in the pursuit of truth. Now that we have discovered that reality can be manipulated, that belief has been shaken. This leads to the paradoxical conclusion that the higher standards in politics were based on an illusion, and they were The Theory of Reflexivity 45 *Bernard Williams has a valuable discussion of the point in his book Truth and Truthfulness: An Essay in Genealogy (Princeton: Princeton University Press, 2004). Soros.qxd 3/28/08 10:22 AM Page 45 understood. Confronted by this moving target, we are liable to overburden whatever knowledge we have acquired by ex- tending it to areas where it is no longer applicable. In this way, even valid interpretations of reality are bound to give rise to distorted ones. This argument is similar to the Peter Principle, which holds that competent employees are pro- moted until they reach their level of incompetence. I find my position buttressed by the findings of cognitive linguistics. George Lakoff, among others, has shown that language employs metaphors rather than strict logic. Meta- phors work by transferring observations or attributes from one set of circumstances to another, and it is almost in- evitable that the process will be carried too far. This can be best seen in the case of scientific method. Science is a highly successful method for acquiring knowledge. As such, it seems to contradict the postulate of radical fallibility, namely, that we are bound to be wrong. But the process has been carried too far. Because of the success of natural science, social scien- tists have gone to great lengths to imitate natural science. Consider classical economic theory. In its use of the con- cept of equilibrium, it is imitating Newtonian physics. But in financial markets, where expectations play an important role, the contention that markets tend towards equilibrium does not correspond to reality. Rational expectations theory has gone through great contortions to create an artificial world in which equilibrium prevails, but in that world reality is fit- ted to the theory rather than the other way round. This is a case to which the postulate of radical fallibility applies. Even when they failed to meet the rules and standards of scientific method, social thinkers sought to cloak their theo- ries in scientific guise to gain acceptance. Sigmund Freud 48 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 48 and Karl Marx both asserted that their theories determined the course of events in their respective fields because they were scientific. (At that time, scientific laws were expected to be deterministic.) Popper was successful in unmasking them, particularly Marx, by showing that their theories could not be tested in accordance with his scheme; therefore they were not scientific. But Popper did not go far enough. He did not acknowledge that the study of social phenomena encounters an obstacle that is absent in the natural sciences—reflexivity and the human uncertainty principle. As a consequence, the slavish imitation of natural science does not produce an ade- quate representation of reality. General equilibrium and ra- tional expectations are far removed from reality. They provide examples of how an approach that produces valid re- sults becomes overexploited and overburdened to the point where it is no longer valid. Suppose my objections to the concepts of general equilib- rium and rational expectations were generally upheld, and the theories were abandoned; they would no longer serve as examples of radical fallibility. This shows the fatal flaw in my postulate: It is not necessarily true. Just as Popper did not go far enough, I went too far. We are not bound to be wrong in every situation. Misconceptions can be corrected. Where does that leave my postulate? It qualifies as a fertile fallacy. It cannot possibly be true because if it were true it would fall into the category of the paradox of the liar. If it were a scientific theory it would be proven false because in Popper’s scheme a single instance is sufficient to falsify a the- ory. But the postulate of radical fallibility is not a scientific theory. It is a working hypothesis and, as such, it works re- markably well. It helps to identify initially self-reinforcing The Theory of Reflexivity 49 Soros.qxd 3/28/08 10:22 AM Page 49 but eventually self-defeating sequences because it presup- poses that ideas that work well will be overexploited to the point where they do not work anymore. Indeed, in the course of my investment career I identified many more boom-bust sequences than actually occurred. I discarded most of them by a process of trial and error. The postulate of radical falli- bility emphasizes the divergence between reality and the par- ticipants’ perception of reality, and it focuses attention on misconceptions as a causal factor in history. This leads to a particular interpretation of history that can be illuminating. The present moment is such a time. I regard the War on Ter- ror as a misconception, or false metaphor, that has had a ne- farious effect on America and the world. And the current financial crisis can be directly attributed to a false interpreta- tion of how financial markets function. The postulate of radical fallibility and the idea of fertile fallacies are the hallmarks of my thinking. These concepts sound negative, but they are not. What is imperfect can be improved; radical fallibility leaves infinite room for improve- ment. In my definition, an open society is an imperfect soci- ety that holds itself open to improvement. Open society engenders hope and creativity, although open society is con- stantly endangered, and history is full of disappointments. In spite of the negative-sounding terminology—imperfect un- derstanding, radical fallibility, fertile fallacies—my outlook on life is profoundly optimistic. That is because from time to time my conceptual framework allowed me to bring about improvements in real life. 50 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 50 be used reversibly to explain and predict economic phenom- ena. In particular the theory of perfect competition modeled itself after Newtonian physics by specifying the equilibrium between supply and demand towards which market prices tend. The theory has been constructed as an axiomatic sys- tem like Euclidean geometry: It is based on postulates, and all of its conclusions are derived from them by logical or mathematical calculation. The postulates specify certain ideal conditions, yet the conclusions are supposed to be rele- vant to the real world. The theory holds that under the speci- fied conditions the unrestrained pursuit of self-interest leads to the optimum allocation of resources. The equilibrium point is reached when each firm produces at a level where its marginal cost equals the market price, and each consumer buys an amount whose marginal utility equals the market price. It can be mathematically calculated that the equilib- rium position maximizes the benefit of all participants. It is this line of argument that served as the theoretical underpin- ning for the laissez-faire policies of the nineteenth century, and it is also the basis of the belief in the “magic of the mar- ketplace” that gained widespread acceptance during Ronald Reagan’s presidency. One of the key postulates of the theory as it was originally proposed is perfect knowledge. Other postulates include ho- mogeneous and divisible products and a large enough num- ber of participants so that no individual buyer or seller can influence the market price. The assumption of perfect knowl- edge was in direct conflict not only with reflexivity but also with the idea of imperfect understanding, convincingly ar- gued by Karl Popper. That is what made me question the the- ory as a student. Classical economists used the concept of Reflexivity in Financial Markets 53 Soros.qxd 3/28/08 10:22 AM Page 53 perfect knowledge in exactly that sense in which Popper ob- jected to it. They were laboring under what I now call the En- lightenment fallacy. As the epistemological problems began to surface, exponents of the theory found that they had to use a more modest concept: information. In its modern formula- tion the theory merely postulates perfect information.* Unfortunately this assumption is not quite sufficient to support the conclusions of the theory. To make up for the de- ficiency, modern economists resorted to an ingenious device: they insisted that the demand and supply curves should be taken as independently given. They did not present this as a postulate; rather, they based their claim on methodological grounds. They argued that the task of economics is to study the relationship between supply and demand and not either by itself. Demand may be a suitable subject for psychologists, supply may be the province of engineers or management sci- entists; both are beyond the scope of economics.† Therefore, both must be taken as given. This was the theory I was taught as a student. Yet, if we stop to ask what it means that the conditions of supply and demand are independently given, it becomes clear that an additional assumption has been introduced. Otherwise, where would those curves come from? We are dealing with an assumption disguised as a methodological device. Participants are supposed to choose between alterna- tives in accordance with their scale of preferences. The un- 54 The New Paradigm for Financial Markets *George Stigler, Theory of Price (New York: Macmillan, 1966). †Lionel C. Robbins, An Essay on the Nature and Significance of Economic Science, 3d ed. (New York: New York University Press, 1984). Soros.qxd 3/28/08 10:22 AM Page 54 spoken assumption is that the participants know what those preferences and alternatives are. As I shall try to show, this assumption is untenable. The shape of the supply and demand curves cannot be taken as in- dependently given because both of them incorporate the participants’ expectations about events that are shaped by their own expectations. Nowhere is the role of expectations more clearly visible than in financial markets. Buy and sell decisions are based on expectations about future prices, and future prices, in turn, are contingent on present buy and sell decisions. To speak of supply and demand as if they were determined by forces that are independent of the market participants’ ex- pectations is quite misleading. Demand and supply curves are presented in textbooks as though they were grounded in empirical evidence. But there is scant evidence for independ- ently given demand and supply curves. Anyone who trades in markets where prices are continuously changing knows that participants are very much influenced by market develop- ments. Rising prices often attract buyers and vice versa. How could self-reinforcing trends persist if supply and demand curves were independent of market prices? Yet, even a cur- sory look at commodity, stock, and currency markets con- firms that such trends are the rule rather than the exception. The very idea that events in the marketplace may affect the shape of the demand and supply curves seems incongru- ous to those who have been reared on classical economics. The demand and supply curves are supposed to determine the market price. If they were themselves subject to market influences, prices would cease to be uniquely determined. In- stead of equilibrium, we would be left with fluctuating prices. Reflexivity in Financial Markets 55 Soros.qxd 3/28/08 10:22 AM Page 55 damentals. The illusion that markets manage to be always right is caused by their ability to affect the fundamentals that they are supposed to reflect. The change in the funda- mentals may then reinforce the biased expectations in an initially self-reinforcing but eventually self-defeating pro- cess. Of course such boom-bust sequences do not occur all the time. More often the prevailing bias corrects itself be- fore it can affect the fundamentals. But the fact that they can occur invalidates the theory of rational expectations. When they occur, boom-bust processes can take on historic signifi- cance. That is what happened in the Great Depression, and that is what is unfolding now, although it is taking a very dif- ferent shape. In The Alchemy of Finance I cite many examples of boom- bust processes or bubbles from the financial markets. Each case involves a two-way, reflexive connection between mar- ket valuations and the so-called fundamentals that sets up some kind of short circuit between them whereby valuations affect the fundamentals that they are supposed to reflect. The short circuit may take the form of equity leveraging, that is, the issue of additional shares at inflated prices, but more commonly it involves the leveraging of debt. Most but not all cases involve real estate, commercial or residential, where the willingness to lend influences the value of the col- lateral. In the international banking crisis of the 1980s the short circuit occurred in sovereign borrowing; no collateral was involved, but the banks’ willingness to lend affected the so-called debt ratios which determined the countries’ ability to borrow. 58 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 58 The Conglomerate Boom of the 1960s One of my early successes as a hedge fund manager was in exploiting the conglomerate boom that unfolded in the late 1960s. It started when the managements of some high-tech- nology companies specializing in defense recognized that the prevailing growth rate their companies enjoyed could not be sustained in the aftermath of the Vietnam War. Companies such as Textron, LTV, and Teledyne started to use their rela- tively high-priced stock to acquire more mundane compa- nies, and, as their per-share earnings growth accelerated, their price-earnings multiples, instead of contracting, ex- panded. They were the path breakers. The success of these companies attracted imitators; later on, even the most hum- drum company could attain a higher multiple simply by go- ing on an acquisition spree. Eventually, a company could achieve a higher multiple just by promising to put it to good use by making acquisitions. Managements developed special accounting techniques that enhanced the beneficial impact of acquisitions. They also introduced changes in the acquired companies: They streamlined operations, disposed of assets, and generally focused on the bottom line, but these changes were less sig- nificant than the impact on per-share earnings of the acquisi- tions themselves. Investors responded like pigs at the tough. At first, the record of each company was judged on its own merit, but gradually conglomerates became recognized as a group. A new breed of investors emerged: the early hedge fund man- Reflexivity in Financial Markets 59 Soros.qxd 3/28/08 10:22 AM Page 59 agers, or gunslingers. They developed direct lines of com- munication with the managements of conglomerates, and conglomerates placed so-called letter stock directly with fund managers. The placement price was at a discount to the market price, but the stock could not be resold for a fixed pe- riod. Gradually, conglomerates learned to manage their stock prices as well as their earnings. The misconception on which the conglomerate boom rested was the belief that companies should be valued ac- cording to the growth of their reported per-share earnings no matter how the growth was achieved. The misconception was exploited by managers who used their overvalued stock to buy companies on advantageous terms, thereby inflating the value of their stock even further. Analytically, the mis- conception could not have arisen if investors had understood reflexivity and realized that equity leveraging, that is, selling stock at inflated valuations, can generate earnings growth. Multiples expanded, and eventually reality could not sus- tain expectations. More and more people became aware of the misconception on which the boom rested even as they continued to play the game. To maintain the momentum of earnings growth, acquisitions had to be larger and larger, and eventually conglomerates ran into the limits of size. The turning point came when Saul Steinberg of the Reliance Group sought to acquire Chemical Bank: It was fought and defeated by the white shoe establishment of the time. When stock prices started to fall, the decline fed on itself. As the overvaluation diminished, it became impractical to make new acquisitions. The internal problems that had been swept under the carpet during the period of rapid external 60 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 60 almost as rapidly as they had risen. Obviously the readers of my report had failed to take into account the ease of entry, and their mistake was corrected in short order. Nevertheless, their initial enthusiasm helped to get the self-reinforcing process described in the report under way. Subsequent events took the course outlined in the report. Mortgage trusts enjoyed a boom that was not as violent as the one that came after the publication of my report, but it turned out to be more enduring. I had invested heavily in mortgage trusts at the time I wrote my report and took some profits when the reception of my study exceeded my expectations. But I was sufficiently carried away by my own success to be caught holding an in- ventory of shares when the downdraft came. I hung on, and I even increased my positions. I continued to follow the industry closely for a year or so and eventually sold my holdings, real- izing good profits. Then I lost touch with the group until a few years later when the problems began to surface. When I became aware of them I was tempted to establish short posi- tions, but I was handicapped because I was no longer familiar with the companies. Nevertheless, when I reread the report I had written several years earlier, I found it so convincing that I decided to sell the group short more or less indiscriminately. Moreover as the shares fell I maintained the same level of ex- posure by selling additional shares short. My original predic- tion was fulfilled, and most mortgage trusts went broke. The result was that I reaped more than 100 percent profit on my short positions—a seeming impossibility since the maximum profit on a short position is 100 percent. (The explanation is that I kept on selling additional shares.) Reflexivity in Financial Markets 63 Soros.qxd 3/28/08 10:22 AM Page 63 The International Banking Crisis of the 1980s All boom-bust processes contain an element of misunder- standing or misconception. In the two cases I have described, the process took the form of equity leveraging, that is, issu- ing shares at inflated prices, which was made possible by a misconception about earnings growth: Growth achieved by issuing additional shares at inflated prices was accorded the same premium as growth achieved by other means. Boom- bust processes, or bubbles, are more commonly associated with leveraging of debt rather than equity leveraging, but I analyzed only one instance in The Alchemy of Finance: the in- ternational banking crisis of the 1980s, which arose out of ex- cessive lending to developing countries in the 1970s. After the oil shock of 1973, caused by the formation of OPEC (Organization of the Petroleum Exporting Coun- tries), the large money center banks were flooded with deposits from the oil producing countries, and they rechan- neled them mainly to oil-importing countries that had to finance their balance of payments deficits. Banks used so- called debt ratios to evaluate the creditworthiness of the bor- rowing countries, but they failed to realize that the debt ratios were affected by their own lending activities, until it was too late. In cases of debt leveraging the misconception consists in a failure to recognize a reflexive, two-way connection between the creditworthiness of the borrowers and the willingness of the creditors to lend: Usually there is a collateral involved, and the most common form of collateral is real estate. Bub- bles arise when banks treat the value of the real estate as if it 64 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 64 were independent of the banks’ willingness to lend against it. The international banking crisis of the 1980s was somewhat different. The debtors were sovereign countries, and they pledged no collateral. Their creditworthiness was measured by the debt ratios, which turned out to be reflexive: Instead of being independently given, the debt ratios of borrowing countries were inflated during the 1970s by the banks’ will- ingness to lend to them and an associated boom in commodity prices. The first country to run into severe difficulties was Mexico, which was an oil producing country. (Hungary pre- ceded it but the problem was contained.) Since the interna- tional banking crisis of the 1980s I have witnessed several real estate bubbles in Japan, Britain, and the United States. The misconception can manifest itself in different guises, but the principle is always the same. What is amazing is that it keeps recurring. The Boom-Bust Model Using the conglomerate boom as my model, I devised a typical boom-bust sequence. The drama unfolds in eight stages. It starts with a prevailing bias and a prevailing trend. In the case of the conglomerate boom, the prevailing bias was a preference for rapid earnings growth per share without much attention to how it was brought about; the prevailing trend was the ability of companies to generate high earnings growth per share by using their stock to acquire other com- panies selling at a lower multiple of earnings. In the initial stage (1) the trend is not yet recognized. Then comes the pe- riod of acceleration (2), when the trend is recognized and Reflexivity in Financial Markets 65 Soros.qxd 3/28/08 10:22 AM Page 65 Exactly the same sequence could be observed in the inter- national banking crisis. It followed the same asymmetric pat- tern—slow start, gradual acceleration in the boom phase, a moment of truth followed by a twilight period, and a cata- strophic collapse. The reason I did not use it as my paradigm was that it did not lend itself to a graphic presentation. In the 68 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 68 conglomerate boom, I could draw a chart showing stock prices and earnings per share; in the international banking crisis I could not create a similar graph. Reflexivity in Financial Markets 69 Soros.qxd 3/28/08 10:22 AM Page 69 Other Forms of Reflexivity It would be a mistake to think, however, that reflexive processes always manifest themselves in the form of a bub- ble. They can take many other forms. In freely floating ex- change rate regimes, for instance, the reflexive relationship between market valuations and the so-called fundamentals tends to generate large multi-year waves. There is no differ- ence between up and down, except in the case of runaway inflation, and there is no sign of the asymmetry that charac- terizes bubbles; there is even less evidence of a tendency to- wards equilibrium. It is important to realize that two-way, reflexive connec- tions are much more common in financial markets than boom-bust sequences. Market participants act on the basis of imperfect understanding at all times. Consequently market prices usually express a prevailing bias rather than the correct valuation. In the majority of cases, the valua- tions are proven wrong by subsequent evidence, and the bias is corrected, only to be replaced by a different bias. Only once in a blue moon does a prevailing bias set in motion an initially self-reinforcing but eventually self- defeating process. It happens only when the prevailing bias finds some kind of short circuit that allows it to affect the fundamentals. This is usually associated with a misunder- standing or misconception. Both market prices and eco- nomic conditions may then move far beyond anything that would be possible in the absence of a short circuit, and the correction, when it comes, may have catastrophic conse- quences. 70 The New Paradigm for Financial Markets Soros.qxd 3/28/08 10:22 AM Page 70