George Soros cannot understand why the financial authorities have been slow to recognise that the real economy is bound to be affected by the global financial crisis which, he believes, is the worst since the thirties. He is of the view that both financial authorities and market participants harbour misconceptions about the way the markets work which is why the global financial system has been built on false premises. A new paradigm is required, he argues, because the currently prevailing paradigm — that financial markets tend towards equilibrium — is both false and misleading. It has landed us in a mess and failed to give us an explanation of the current state of affairs.
Soros’ new paradigm is based on the theory that misconceptions and misinterpretations play a major role in shaping the course of history. The master trader, who has fifty years of experience in the financial markets, attempted, in an earlier work, to explore his theory of reflexivity: namely, the biased perception of market participants tends to influence not just prices but the fundamentals that those prices are supposed to reflect. The core idea of this theory is that participants don’t just try to understand their situation, they also try to change it. These two functions work in opposing directions and, under certain circumstances, can interfere with each other. This interference Soros calls reflexivity and he is convinced that it is a genuine alternative to the currently prevailing paradigm, though its worth has to be proved. Soros explains that there is a two-way connection between thinking and reality. When this operates simultaneously, it introduces an element of uncertainty in the participants’ thinking and an element of indeterminacy into the course of events. The veteran fund manager says the academics didn’t take this theory seriously—economic theory, he feels, has gone to great lengths to exclude reflexivity from its subject matter. In his latest book, he lays out a conceptual framework to explain the way the markets work and tries to prove that reflexive developments occur and that they are historically significant.
Some of his ideas are drawn from philosophy, his interest in the subject having been kindled in his early teens when he read the classical philosophers. In a candid confession, Soros says he desperately wants to be taken seriously as a philosopher but considers himself a failed philosopher. The Hungary-born chairman of Soros Fund Management also talks about his early life — the experience of being Jewish during the war time, the ‘exhilarating’ experience of living under a false identity which he recounts as ‘an adventure for a fourteen year old’. While working as a swimming pool attendant, and waiting to be admitted to the London School of Economics, Soros read philosopher Karl Popper’s The Open Society and Its Enemies which, he says, influenced him greatly. The theory of perfect competition assumed perfect knowledge and that was in direct conflict with Popper’s contention that our understanding is inherently imperfect. What provoked him to develop the theory of reflexivity, he says, was his interest in the real world rather than mathematical models.
The author has come up with a boom-bust model, which unfolds in eight stages, starting with the first phase in which the trend is not recognised and ends with the stage where there is a crash. A similar pattern, he points out, has been observed in the international banking crisis — a slow start, a gradual acceleration in the boom phase, a moment of truth followed by a twilight period and a catastrophic collapse. Both the huge housing bubble in the US and what he calls the long-term super bubble, which includes other sections of the financial markets, can be partly explained with the help of the model. Interestingly, he notes that the current situation cannot be fully understood without taking into account the economic strength of China and India as also the commodities boom and a host of other factors, especially the increasing unwillingness of the rest of the world to hold dollars. Soros doesn’t come up with any firm policy recommendations—he feels he’s too absorbed in the markets right now to give the matter serious thought. He, however, puts the blame for the excesses of the market on regulators’ failure to exercise proper control.
The book is not an easy read; it’s heavy on theory and aimed at readers who are academically inclined and familiar with concepts of economic theory. Anyone interested in an educated opinion on how the global financial crisis may have come about and a different take on how markets work should spend some time on this work. After all, Soros has spent a lot of time in the financial markets and is, therefore, best placed to marry theory with what happens in the real world.
THE NEW PARADIGM FOR FINANCIAL MARKETS
GEORGE SOROS
Public Affairs
160 pages; $22.95