Sorting Out Soros.

A FEW TRUTHS FROM AN OLD PLUTOCRAT:

(With A Bit of Dissemblance Too.)

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Abstract: George Soros, the major plutocrat, made Remarks at the Festival of Economics, Trento Italy, June 02, 2012. A lot of what he said is pretty good.

Soros eschews the deeper things such as: the divulgation of the injustice of the Fractional Reserve System, what it means to be a state, the Plutocratic effect, the Will To Evil, etc,. which are all major constituents of the deeper fundaments of the present crisis.

And of course, Soros made a billion dollars pushing Britain out of the European Monetary Union, so its compassion vis a vis Europe has got to remind us of that of the fox for the hens he killed. Indeed, the EMU would be stronger, with Britain in, as would have happened if no hedge fund manager such as Soros had ever existed. 

But still, his work is worth commenting upon, it’s much deeper than the usual platitudes.

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A note on Soros: After living under Nazi occupation, and escaping those German monsters by the skin of his teeth, as a Hungarian Jewish child, Soros went to London to study economics (and the philosophy of Popper). Soros made a career as a major financial manipulator, first in the company of Jim Rogers. He was operator of the “Quantum Fund”, one of the earliest, largest and most successful hedge funds.

Soros played a very positive role in the opening of the Iron Curtain, financing Hungarian students.

Soros often talks as if nothing mattered more for him than being viewed as philosopher. He is obsessed by “reflexivity“, a notion he used in his trading. Reflexivity is nothing new for those who reflect reflexively. But Soros is right to insist on its importance. What he means by this, he explains below.

Finance and economics are riddled with non linear feedback loop, entangling subject and object, which often dominate, causing catastrophes. The same is true in politics, sociology, cultures… Such is the human, all too human factor.

As the present German loss of control about Europe demonstrates. Is that one of these famous Hitler’s rages again?

Below I put Soros in italics, my comments are in regular script. I took the freedom of underlining passages of Soros which I find particularly interesting. That generally indicates approbation (and reprobation will be duly expressed, if needed). I cut out one section of Soros’ discourse, for lack of punch. All the rest is there. Let Soros talk:

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Soros: Ever since the Crash of 2008 there has been a widespread recognition, both among economists and the general public, that economic theory has failed. But there is no consensus on the causes and the extent of that failure.

I believe that the failure is more profound than generally recognized. It goes back to the foundations of economic theory. Economics tried to model itself on Newtonian physics. It sought to establish universally and timelessly valid laws governing reality. But economics is a social science and there is a fundamental difference between the natural and social sciences. Social phenomena have thinking participants who base their decisions on imperfect knowledge. That is what economic theory has tried to ignore.

Scientific method needs an independent criterion, by which the truth or validity of its theories can be judged. Natural phenomena constitute such a criterion; social phenomena do not. That is because natural phenomena consist of facts that unfold independently of any statements that relate to them. The facts then serve as objective evidence by which the validity of scientific theories can be judged. That has enabled natural science to produce amazing results.

PA: By the way, that is exactly what fails in Quantum physics: in Quantum physics, facts unfold in dependence with any statements that relate to them. Because the observing act affects the observed. That was Bohr’s great point, and it is the main difficulty with making a Quantum computer.

The Quantum computer can be made, as it is the way the natural world works. But to realize one, in full, I believe, our understanding of Quantum physics will have to progress.

Somehow, Quantum physics replaces local physics, made of points, by the integrated whole. In other words something where all participants participate, be they geometry, potentials, initial conditions, etc. That integrated whole approach is the engine at the heart of biology, and it is the one that allows to circumvent the Second Law of Thermodynamics (you will have heard it here first!). OK, back to Soros:

Soros: Social events, by contrast, have thinking participants who have a will of their own.  They are not detached observers but engaged decision makers whose decisions greatly influence the course of events. Therefore the events do not constitute an independent criterion by which participants can decide whether their views are valid. In the absence of an independent criterion people have to base their decisions not on knowledge but on an inherently biased and to greater or lesser extent distorted interpretation of reality. Their lack of perfect knowledge or fallibility introduces an element of indeterminacy into the course of events that is absent when the events relate to the behavior of inanimate objects. The resulting uncertainty hinders the social sciences in producing laws similar to Newton’s physics.

PA: Quantum computer, here we come!

Soros: Economics, which became the most influential of the social sciences, sought to remove this handicap by taking an axiomatic approach similar to Euclid’s geometry. But Euclid’s axioms closely resembled reality while the theory of rational expectations and the efficient market hypothesis became far removed from it. Up to a point the axiomatic approach worked. For instance, the theory of perfect competition postulated perfect knowledge. But the postulate worked only as long as it was applied to the exchange of physical goods. When it came to production, as distinct from exchange, or to the use of money and credit, the postulate became untenable because the participants’ decisions involved the future and the future cannot be known until it has actually occurred.

PA: By the way, Euclidean, and Non-Euclidean geometries, are COMMUTATIVE geometries. Instead…

Quantum physics uses NON COMMUTATIVE geometry (what it consists of exactly is a matter of debate among mathematicians). Basically, the order of events matter, just as the order of rotations in space matter, or just as the order in which what happens to social participants matter.

Soros: I am not well qualified to criticize the theory of rational expectations and the efficient market hypothesis because as a market participant I considered them so unrealistic that I never bothered to study them. That is an indictment in itself but I shall leave a detailed critique of these theories to others.

Instead, I should like to put before you a radically different approach to financial markets. It was inspired by Karl Popper who taught me that people’s interpretation of reality never quite corresponds to reality itself. This led me to study the relationship between the two. I found a two-way connection between the participants’ thinking and the situations in which they participate. On the one hand people seek to understand the situation; that is the cognitive function. On the other, they seek to make an impact on the situation; I call that the causative or manipulative function. The two functions connect the thinking agents and the situations in which they participate in opposite directions. In the cognitive function the situation is supposed to determine the participants’ views; in the causative function the participants’ views are supposed to determine the outcome. When both functions are at work at the same time they interfere with each other. The two functions form a circular relationship or feedback loop. I call that feedback loop reflexivity. In a reflexive situation the participants’ views cannot correspond to reality because reality is not something independently given; it is contingent on the participants’ views and decisions. The decisions, in turn, cannot be based on knowledge alone; they must contain some bias or guess work about the future because the future is contingent on the participants’ decisions.

[…] Bubbles are usually asymmetric in shape: booms develop slowly but the bust tends to be sudden and devastating. That is due to the use of leverage: price declines precipitate the forced liquidation of leveraged positions.

PA: Busts are also caused by panic. An animal generally approaches a threat with more caution that it puts in flight. Panic insures survival, the most important instinct, most of the time. Whereas greed is a luxury, and, if there is an instinct for it, it’s much less developed. Carnivores have been known to kill, for killing’s sake (a form of greed). But if they experience the slightest fear, they won’t engage in it, and will spend lots of energy putting lots of distance between them and the threat.

Soros: Well-formed financial bubbles always follow this pattern but the magnitude and duration of each phase is unpredictable. Moreover the process can be aborted at any stage so that well-formed financial bubbles occur rather infrequently.

At any moment of time there are myriads of feedback loops at work, some of which are positive, others negative. They interact with each other, producing the irregular price patterns that prevail most of the time; but on the rare occasions that bubbles develop to their full potential they tend to overshadow all other influences.

According to my theory financial markets may just as soon produce bubbles as tend toward equilibrium. Since bubbles disrupt financial markets, history has been punctuated by financial crises. Each crisis provoked a regulatory response. That is how central banking and financial regulations have evolved, in step with the markets themselves. Bubbles occur only intermittently but the interplay between markets and regulators is ongoing. Since both market participants and regulators act on the basis of imperfect knowledge the interplay between them is reflexive. Moreover reflexivity and fallibility are not confined to the financial markets; they also characterize other spheres of social life, particularly politics. Indeed, in light of the ongoing interaction between markets and regulators it is quite misleading to study financial markets in isolation. Behind the invisible hand of the market lies the visible hand of politics. Instead of pursuing timeless laws and models we ought to study events in their time bound context.

My interpretation of financial markets differs from the prevailing paradigm in many ways. I emphasize the role of misunderstandings and misconceptions in shaping the course of history. And I treat bubbles as largely unpredictable. The direction and its eventual reversal are predictable; the magnitude and duration of the various phases is not. I contend that taking fallibility as the starting point makes my conceptual framework more realistic. But at a price: the idea that laws or models of universal validity can predict the future must be abandoned.

Until recently, my interpretation of financial markets was either ignored or dismissed by academic economists. All this has changed since the crash of 2008. Reflexivity became recognized but, with the exception of Imperfect Knowledge Economics, the foundations of economic theory have not been subjected to the profound rethinking that I consider necessary. Reflexivity has been accommodated by speaking of multiple equilibria instead of a single one. But that is not enough. The fallibility of market participants, regulators, and economists must also be recognized.  A truly dynamic situation cannot be understood by studying multiple equilibria.  We need to study the process of change.

The euro crisis is particularly instructive in this regard. It demonstrates the role of misconceptions and a lack of understanding in shaping the course of history. The authorities didn’t understand the nature of the euro crisis; they thought it is a fiscal problem while it is more of a banking problem and a problem of competitiveness.

[To be continued in the next essay, “Boosting Soros On Europe“].

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Patrice Ayme