skip to main |
skip to sidebar
EXCERPT FROM THE GEORGE SOROS ‘ACT II OF THE DRAMA’ SPEECH, JUNE 2010 (emphasis added)
Let me briefly recapitulate my theory for those who are not familiar
with it. It can be summed up in two propositions. First, financial
markets, far from accurately reflecting all the available knowledge,
always provide a distorted view of reality. This is the principle of
fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced.
When there is a significant divergence between market prices and the
underlying reality I speak of far from equilibrium conditions. That is
where we are now.
Second, financial markets do not play a purely passive role;
they can also affect the so-called fundamentals they are supposed to
reflect. These two functions that financial markets perform
work in opposite directions. In the passive or cognitive function, the
fundamentals are supposed to determine market prices. In the active or
manipulative function market, prices find ways of influencing the
fundamentals. When both functions operate at the same time, they
interfere with each other. The supposedly independent variable of one
function is the dependent variable of the other, so that neither
function has a truly independent variable. As a result, neither
market prices nor the underlying reality is fully determined. Both
suffer from an element of uncertainty that cannot be quantified.
I call the interaction between the two functions reflexivity. Frank
Knight recognized and explicated this element of unquantifiable
uncertainty in a book published in 1921, but the Efficient Market
Hypothesis and Rational Expectation Theory have deliberately ignored it.
That is what made them so misleading.
Reflexivity sets up a feedback loop between market valuations and the
so-called fundamentals which are being valued. The feedback can be
either positive or negative. Negative feedback brings market prices and
the underlying reality closer together. In other words, negative
feedback is self-correcting. It can go on forever, and if the underlying
reality remains unchanged, it may eventually lead to an equilibrium in
which market prices accurately reflect the fundamentals. By
contrast, a positive feedback is self-reinforcing. It cannot go on
forever because eventually, market prices would become so far removed
from reality that market participants would have to recognize them as
unrealistic. When that tipping point is reached, the process
becomes self-reinforcing in the opposite direction. That is how
financial markets produce boom-bust phenomena or bubbles. Bubbles are not the only manifestations of reflexivity, but they are the most spectacular.
In my interpretation equilibrium, which is the central case in economic
theory, turns out to be a limiting case where negative feedback is
carried to its ultimate limit. Positive feedback has been largely
assumed away by the prevailing dogma, and it deserves a lot more
attention.
I have developed a rudimentary theory of bubbles along these lines.
Every bubble has two components: an underlying trend that prevails in
reality and a misconception relating to that trend. When a
positive feedback develops between the trend and the misconception, a
boom-bust process is set in motion. The process is liable to be tested
by negative feedback along the way, and if it is strong enough to
survive these tests, both the trend and the misconception will be
reinforced. Eventually, market expectations become so far
removed from reality that people are forced to recognize that a
misconception is involved. A twilight period ensues during which
doubts grow and more and more people lose faith, but the prevailing
trend is sustained by inertia. As Chuck Prince, former head of
Citigroup, said, “As long as the music is playing, you’ve got to get up
and dance. We are still dancing.” Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.
Typically bubbles have an asymmetric shape. The boom is long and slow
to start. It accelerates gradually until it flattens out again during
the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.
