The Crash of 2008 and What it Means

    ‘How could the propaganda techniques described in Orwell’s 1984 be so successful in contemporary America? After all, in 1984 Big Brother was watching you; there was a Ministry of Truth and an apparatus of repression to take care of dissidents. In contemporary America there is freedom of thought and pluralistic media. Yet the Bush administration managed to mislead the people by using Orwellian Newspeak. Suddenly it dawned on me that the concept of reflexivity can shed new light on the question.’ Taken from The Crash of 2008 and What it Means by George Soros

    Excerpt from The Crash of 2008 and What it Means: The New Paradigm for Financial Markets, by George Soros (Public Affairs, 2008). Reprinted with permission from the author.

    From Chapter 2: Autobiography of a Failed Philosopher

    I was greatly influenced by Popper’s philosophy, but of course I read many other books as well, and I did not accept all of Popper’s positions uncritically. In particular, I disagreed with what he called the doctrine of the unity of method—that is to say that the same methods and criteria apply both in the natural and the social sciences. I maintain that there is a fundamental difference between the two, namely that the social sciences deal with events that have thinking participants. These participants base their decisions on their imperfect understanding. Their fallibility creates a difficulty for the understanding of social situations, which is absent in the case of natural phenomena. For that reason the social sciences need to use somewhat different methods and standards from the natural sciences. It may not be possible to draw a hard and fast dividing line between the two—for instance, where does evolutionary psychology or medicine belong? Nevertheless, as I explained in the previous chapter, the difference between natural and social phenomena plays a key role in my view of the world.

    My philosophy evolved over the years, but I started forming it already as an undergraduate student at the LSE. I studied economic theory. I was not very good at math, and that led me to question the assumptions on which the mathematical models of economists were based. The theory of perfect competition assumed perfect knowledge, and that assumption was in direct conflict with Popper’s contention that our understanding is inherently imperfect. In the course of its development, economic theory was forced to abandon the assumption of perfect knowledge, but it replaced that assumption with others that allowed economic theory to produce universally valid generalizations that were comparable to those of Isaac Newton in physics. The assumptions became increasingly convoluted and gave rise to an imaginary world that reflected only some aspects of reality but not others. That was the world of mathematical models describing a putative market equilibrium. I was more interested in the real world than in mathematical models, and that is what led me to develop the concept of reflexivity.

    The theory of reflexivity does not yield determinate results comparable to Newtonian physics; rather, it identifies an element of indeterminacy which is inherent in situations that have participants who operate on the basis of imperfect understanding. Instead of a universal tendency towards equilibrium, financial markets follow a specific one-directional course. There may be patterns that tend to repeat themselves, 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 scientific because it does not provide deterministic explanations and predictions. It is merely a conceptual framework for understanding events that have human participants. Nevertheless, it served me well later when I became a market participant. Much later, when my success in the financial markets allowed me to set up a foundation, my theory of history 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 Kalamazoo, 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 eventually my college education came in very useful. In particular, 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-equilibrium situations with good results. This led to my first published book, The Alchemy of Finance (1987), in which I expounded my approach. I called it alchemy to emphasize that my theory does not meet the currently prevailing requirements of scientific method.

    To what extent my financial success was due to my philosophy is a moot question because the salient feature of my theory 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 understand what I had written the night before. As I have often recounted 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 published 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 hall, looking down on the audience from a cathedra that towered high above the auditorium. I felt inspired by the setting to make an ex cathedra statement, and on the spur of the moment I announced the doctrine of fallibility. It was the best part of my lecture.

    Some of the difficulties in formulating my ideas were inherent in the concepts of fallibility and reflexivity; others were self-inflicted. In retrospect, it is clear that I was not precise enough in my formulations and tended to overstate my case. As a result, the professionals whose positions I challenged 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 rhetoric 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 reason 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 bullshit. I mean, you know the reason he changes his position on the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s this early warning sign.

    If you’re around him a long time, you realize that to a large extent he is driven by temperament. But he is always trying to rationalize what are basically his emotions. And he is living in a constant state of not exactly denial, but rationalization of his emotional state. And it’s very funny.

    I harbored grave doubts myself. Although I took my philosophy very seriously, I was not at all certain that what I had to say deserved to be taken seriously by others. I knew that it was significant for me subjectively, but I was uncertain about its objective worth for others. The theory of reflexivity deals with a subject—the relationship between thinking and reality—that philosophers had been discussing for ages. Is it possible to say something new and original about it? After all, both the cognitive function and the participating function can be observed in real life; what can be so original in the concept of reflexivity? It must have been around under some other names. The fact that I am not well versed in the literature made it all the more difficult for me to reach a firm conclusion. Yet I desperately wanted to be taken seriously as a philosopher, and that very ambition turned into my greatest obstacle. I felt obliged to keep on explaining my philosophy because I felt it was not properly understood. All my books followed the same pattern. They recited my theory of history—usually at the end so as not to discourage the readers—and applied the theory to the present moment in history. With the passage of time, I overcame my reluctance to part with the concept of reflexivity, and the capsule versions of my philosophy became shorter and, I hope, clearer. In my last book, The Age of Fallibility, I put the philosophy up front. I resolved to make it the last presentation, for better or worse, but I was still not sure whether my philosophy deserved to be taken seriously.

    Then something happened to change my mind. I was trying to answer the question, how could the propaganda techniques described in Orwell’s 1984 be so successful in contemporary America? After all, in 1984 Big Brother was watching you; there was a Ministry of Truth and an apparatus of repression to take care of dissidents. In contemporary America there is freedom of thought and pluralistic media. Yet the Bush administration managed to mislead the people by using Orwellian Newspeak. Suddenly it dawned on me that the concept of reflexivity can shed new light on the question. Until then I had taken it for granted that Orwellian Newspeak could prevail only in a closed society like Orwell’s 1984. In doing so I was slavishly following Karl Popper’s argument in favor of the open society, namely, that freedom of thought and expression is liable to lead to a better understanding of reality. His argument hinged on the unspoken assumption that political discourse aims at a better understanding of reality. But the concept of reflexivity asserts that there is such a thing as the manipulative (formerly participating) function, and political discourse can be successfully used to manipulate reality. Why, then, should politicians give preference to the cognitive over the manipulative function? That is appropriate for a social scientist whose aim is the acquisition of knowledge but not for a politician whose primary 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 uncritically. 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 reflexivity 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 identify and refute widespread and influential misconceptions. One of those misconceptions is what I call the Enlightenment 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 Enlightenment 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 concept of reflexivity I was asserting the importance of the manipulative 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 system and threatens to engulf the economy. It is a vivid demonstration 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 equilibrium is false, and vice versa.

    I am now ready to submit my conceptual framework to public consideration in the firm conviction that it deserves attention. I am aware of the various shortcomings in my previous presentations, which I hope to have overcome, and I believe that it will be worth the reader’s while to make the effort 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?

    Excerpted from The Crash of 2008 and What it Means by George Soros. Copyright © George Soros, 2008. All rights reserved.

    George Soros has been a prominent international supporter of democratic ideals and causes for more than 30 years. His philanthropic organization, the Open Society Foundations, supports democracy and human rights in over 70 countries. Born in Budapest in 1930, Soros is Chairman of Soros Fund Management, LLC. As one of history’s most successful financiers, his views on investing and economic issues are widely followed. He is the author of several previous bestselling books including The Bubble of American Supremacy, Underwriting Democracy, and The Age of Fallibility.

    George Soros – Theory of Reflexivity (Bloomberg)

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