[As a reminder, please take off-topic discussions to the previous thread – bev]
The Crash of 2008, by George Soros.
It must be really quite frustrating for George Soros to see the academic reception given to Nassim Nicholas Taleb. After spending the thirty years since the publication of "The Alchemy of Finance" trying, respectfully and politely, to get academic economists and philosophers to take his ideas seriously to no avail, the success of "The Black Swan" indicates that he had the wrong approach all along. As Taleb has shown, academics are fundamentally masochists and the way to get their attention is to roundly abuse them, and tell them they’re idiots who don’t know what they’re talking about.
"The Crash of 2008" is for the most part still far too polite to mainstream economics (apart from a couple of deliciously acid remarks about the status-insecurity of social science academics), but by the end of it, the evidence assembled about insights missed, predictions screwed up and disaster which could and should have been averted but weren’t, is just as damning as Taleb’s findings about financial risk management.
Now that we’re half way through 2009, the specific predictions and analyses contained in the book are perhaps not the most interesting and important part of it, albeit that it is rather impressive given the dates of publication of the original and revised editions that Soros got so much right so early on. Future historians will presumably note that all of the major features of 2008 – massive seizure of financial markets, recession in G8 but not China, etc – were foreseeable from early March, and also that most of Soros’ policy suggestions (particularly the use of TARP to inject equity capital into banks) ended up being adopted, usually after all the more palatable alternatives had been tried and failed. I think the book is sometimes a bit unfair in suggesting that "economists" as a group missed these predictions – many people did actually make roughly the same predictions as Soros, from Robert Shiller to Paul Krugman – but it is true that those who got it right did so out of a mixture of rough-hewn Keynesianism and ad hoc institutional knowledge rather than anything you find in the textbooks. And perhaps more importantly, those who got it wrong, almost to a man, did so because they were in the grip of "market fundamentalism" – an ideology which is still around and still doing plenty of damage, as any regular reader of Paul Krugman’s blog will be aware.
The meat of the book, though, is that it contains the final and definitive statement of Soros’ theory of "reflexivity", which it’s probably worth setting out in a couple of paragraphs. It is actually possible to locate this idea in a particular tradition of heterodox economics – Jerome Levy in the 1930s, and British "cybernetician" and management theorist Anthony Stafford Beer both come to mind as having perhaps more detailed and thorough models of the economy as a feedback loop – and at times it does get frustrating to see so many wheels reinvented. I practically drove my pencil through the page, for example, on seeing Soros introduce the concept of "the manipulative function" of social science with a quotation from Karl Rove on "making
our own reality" rather than Karl Marx’s line about philosophers interpreting the world when the point is to change it. Even the general principle of feedback from fundamentals to perceptions to altered fundamentals is by no means wholly original – it’s actually the central concept of rational expectations macroeconomics, except that the Chicago School, for largely ideological reasons, presumes that this feedback will always take a specific form of stabilised convergence on a theoretical equilibrium.
However, the wheels are reinvented in pretty interesting ways, and the overall framework is quite attractive. In most general terms, Soros’ principle of reflexivity is an assumption that social systems form anopen feedback loop with no general tendency to be stable, as human actors’ perception of the facts has the effect of changing the (social) reality with which they interact. This happens either through the importance of mutual expectations of social behaviour, or by conscious manipulation of mass politics by people like the two Karls, Marx and Rove. In the particular context of financial markets, this feedback loop shows up as a preponderance of boom and bust cycles.
Naturally, the reflexive theory of financial bubbles is the most detailed example of the general theory. For Soros, two things are needed to create a bubble – some form of financial leverage, and an underlying misconception (a "fertile fallacy") which stops people from realising that the leverage they have taken on is excessive. Plenty of examples are given in the book, from the conglomerate boom of the 1960s to the ERM crisis of 1992 to the LTCM crisis of 1998, all of them, not coincidentally, also being occasions upon which a lot of money made its way in the direction of George Soros. But the Big One here is the "Super Bubble" thesis – that the entire market fundamentalist ideology which came in with Thatcher and Reagan in the
1980s was a massive fertile fallacy, and that the current bust represents the unwind of a leveraging-up process which was nearly thirty years in the making. If this is right, we’ve got a lot more problems in store …
The thing that interests me, though, is that it seems very important to Mr Soros that reflexivity is taken not just as a way of trading the stock market, but as a broader philosophical theory about social science – effectively, a theory of history every bit as universal in scope as dialectical materialism. Which raises the question that’s always bugged me since I first read "Alchemy of Finance"; where’s the falsification in this? Karl Popper’s philosophy of science is clearly fundamental to Soros’ theory, and in the context of stock markets he’s always very clear about the way in which his theses are "tested" by making or losing money. What’s the analogy to a stop-loss order in the political system? Why should we necessarily regard the Bush
administration as the political equivalent of a subprime CDO? That’s what I’m hoping to find out in this book event.