Here are some comments I wrote for a small workshop discussing the Special Issue in the Journal of Economic Methodology on George Soros’ theory of reflexivity in financial markets.
The Unobserved Political Economy in George Soros’ Theory of Human Uncertainty
Some comments on the Special Issue in the Journal of Economic Methodology
Who in this world has not some lack or need?
One this, one that – here it is cash. Indeed,
There is no gathering it off the pavement;
Yet wisdom taps its most profound encavement
In lodes and masonwork, where gold unstinted
Waits underground, both minted and unminted;
And who can raise it to the light of day?
Man’s gift of Nature and of Mind, I say.
(Mephistopheles in Goethe, Faust II, 4889 – 4896)
1. Introduction: Reflexivity and Partiality
In his book Alchemy of Finance (1987) and more recently in the special issue of the Journal of Economic Methodology (2013), George Soros presents an impressive account of the theoretical blinders in mainstream economic theories. Social theorists would call his theory of reflexivity a second-order observation, i.e. an observation how observers observe (Rasch, 2000). This type of observation is well-suited to reveal blind spots and unobserved partiality and bias in first-order observations such as standard economic theories.
Good practice in reflexivity should start with self-reflexivity and an acknowledgement of my own partiality. So let me start this essay with a confession: I am not a close follower of the practice and economic theory of finance. As a student I did read with genuine interest the Alchemy of Finance. At the time I was very much interested in the kind of social constructivism dominant in International Relations Theory and I applied reflexive thinking to the case of international banking regulation. This is quite long ago, and I specialize on other topics now. Nonetheless, I have read the article in the Journal of Economic Methodology with a lot of sympathy and noted myself mentally nodding many times.
If, in the following, I will criticize something, it comes out of the unavoidable partially biased position of a political economist who is perhaps sometimes too readily critical of mainstream economics. Maybe there is also a deeper psychological issue of many political economists that ‘real economists’ don’t give them enough credit for their work.
With these disclaimers in mind, I have three types of question dealing with George Soros’ theory of reflexivity. Let me start from the deeper levels of theory and then proceed to the more practical issues.
2. How deep does the rabbit hole go?
Observing George Soros’ account it strikes me as odd that his account consists of a very inspiring epistemology, whereas its ontology is more difficult to understand. On the one hand, the account is very critical of treating reality as a given. Instead, the principle of reflexivity implies that the world is full of self-fulfilling or self-defeating prophecies. Take the sentence in his book on p. 7:
“My point is that there are occasions when the bias affects not only market prices but also the so-called fundamentals. This is when reflexivity becomes important. … The recursive relationship renders the evolution of prices indeterminate and the so-called equilibrium price irrelevant.”
This reads like a statement of a radical constructivist: There is nothing in this world beyond language and communication. The world of ‘social facts’ is very different from ‘brute facts’ (Searle, 1995). Some scholars argue that it is this distinction which causes a divide between social science and other types of sciences.
However, in the conceptual world of George Soros the ‘objective reality’ has a very prominent place. Dealing with boom and bust cycles, Soros (2013: 323) states: “Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved.” Several other contributors to the special issue allude to such distinctions between ‘actual’ and ‘natural’ prices (e.g. Shaikh, 2013). What is the ‘(natural) reality’ in this sentence? A type of objective reality akin to brute facts? A type of new, cataclysmic change in the intersubjective understanding of a price for an asset? Or something completely differently? To me it seems that George Soros’ account of reflexivity starts a revolutionary social constructivist onslaught on rationalist economics, but eschews the radical ontological consequences of this project: there is no such thing as objective reality in the realm of social facts. At least not for radical social constructivists.
Now, I can see that George Soros’ theory wants to occupy a pragmatic position, in which reflexivity only matters under certain circumstances. This is an interesting project with obviously appealing qualities for investors seeking advice. But the ambivalent stance on ‘reality’ remains an intellectual challenge. It seems to sway between radicalism and pragmatism and is vulnerable against both. If one lets the constructivist relativist ‘Genie’ out of the bottle, it is hard to contain it again.
3.) Reflexivity or more primitive political economy?
Let’s step down in the ladder of abstraction from questions of meta-theory towards questions of theory. In this realm, I wonder why the reflexive theory is so cautious about heterogeneity of agency, especially in relation to the manipulative function of reflexivity.
For me as a political economist, economic theory always has one extremely bewildering aspect: the readiness to assume a representative agent, such as a representative household or consumer. Most sociology and political science start from exactly the opposite position, i.e. societies are inherently heterogeneous, with the potential of conflict and contradictions. In a nutshell, this seems to me the most striking contrast between economics and most of the other social sciences.
Of course, this is not the only problematic assumption in the axiomatic world of economic theory. And yet, positive and normative economic theory become fundamentally more complex with more than one type of economic agents (see in the special issue Hommes, 2013; also Keen, 2002). My favourite example is the doyen of mainstream economics instruction, Gregory Mankiw. While he gives straightforward ‘cooking-book’ style recommendations on macroeconomic policy in his text books, he himself acknowledges that just allowing for two types of agents challenges most of these traditional policy recommendations (Mankiw, 2000).
Of course, Soros’ theory of reflexivity openly acknowledges human diversity, none the least where he discusses human fallibility. But what type of diversity? It is the plight of academic theory that if the number of types of agents in a society cannot be one, it cannot be infinity either. What is a model of heterogeneity in the theory of reflexivity? Some contributions in the special issue give some answers to this question, but I think this is only the beginning.
For instance, there is little role in the theory for classic political economy. However, this classic literature deals with many interesting and important types of heterogeneity: e.g. asymmetries in market power and income or class position. How does a theory of reflexivity look like, if there is market power in the system? Do we even need reflexivity in this case?
George Soros finds corroboration of his theory in his own success and failure in financial markets (1987; , 2013: 327/8). He is remarkably open and self-reflective about ‘testing’ his ideas. Nonetheless, I wonder what a naive model of market power would deliver in terms of prediction. Large investors could move prices along the same lines a beauty contest would predict, but without the conceptual complexity that burdens the latter. Now, I do not want to create the impression that the asset markets of this world are determined by a handful of individuals or companies. I know that even large traders get it wrong sometimes, and that they cannot move the market at their will. Nonetheless, I would like to see this side of the story included in the theory. What part is due to reflexivity of infinitesimally small agents moving like herds, and what part is due to power asymmetries in the market?
4.) The Alchemy of Policy Advice and Moving the Minds of Economists
The special issue deals very often with the question whether social sciences (should or do) have a different scientific methodology than the natural sciences. In my mind, if anything, economics seems to be modelled more after a sterile form of math than physics (Farmer, 2013; Keen, 2002). Interpretative social science does not seem to be very important in this debate. The interpretative fields in social science are much closer to humanities and hermeneutics. My feeling is that here is a major dividing line to which a theory of reflexivity, in as much as it wants to talk about ‘thinking objects’ would need to position itself.
Much more fundamental though is the issue I sketched in the previous section. Assumptions about how to model human diversity directly map into the readiness with which sciences jump to normative assessments and policy conclusions. The fact that much of sociology and political science is about differences and conflict directly maps onto what social science is about, both in terms of how it is done, and what it is good for. Again, there is a remarkable difference to economics, which has a relatively impoverished normative theory – very often not more than some sort of Pareto or Utilitarian criteria. Yet, economics is very quick in sketching policy recommendations on basis of these simplistic normative assessments. Political or social science takes normative conflicts and tradeoffs much more seriously, and is therefore much more cautious to jump to conclusions. To exaggerate, they emulate more Hume than Mills.
I would be very curious what a theory of reflexivity can contribute to the problem of normative claims. From my point of view, there is a relative strong rupture between the analytical and prescriptive parts of The Alchemy of Finance (parts I-IV and V respectively). As a reflexivist I think one has to acknowledge that due to the very partiality of each observation, policy advice is always political.
Nonetheless, I think the political programme of George Soros’ approach is highly laudable. It is an important critique of mainstream arguments about free markets. Why does it then get so little headway into mainstream economics so far? Soros (2013: 320) rightly points out that market fundamentalism generates its own political support of self-interested people. Yet, from a political science perspective it is still questionable why the winners of the system can ‘get away’ with their story.
In the special issue other arguments have been put forth. Bronk (2013), for instance, talks about analytic monocultures and the way they dominate the fields of finance and economics. Indeed there is a large literature on the power and pervasiveness of some economic ideas (Berman, 2002; Hall, 1993). It is very tempting to connect this literature to the psychological literature on framing and perception (Kahneman, 2003). If framing is an important communication strategy, maybe it could also give some hints at how the theory of reflexivity can ‘infiltrate’ mainstream economics.
Looking at the articles in the special issue I felt that there is a lot of negative spin to the message. The main message is essentially what mainstream economics has done wrong in the last 120 years. This will, no doubt evoke a lot of automatic rejection. Such a political strategy would need a lot of energy to form a new coalition of powerful people in the academic networks. Perhaps INET is about this, but the upshot might as well just be a new somewhat bigger, somewhat less marginalized group of heterodox economists falling into the typical stances of a counter elite.
Perhaps a positive frame would gain more access to mainstream economists’ minds. Rather than showing how mainstream economics failed, it would be interesting to see how mainstream economics can be complemented. Much of this is related to the fact that in the heat of the battle innocent bystanders are shot. The use of mathematics is an example. Steve Keen would say: Don’t shoot the piano; it is not responsible for the kind of music you play. Similar things apply to equilibrium analysis (Guala, 2013). Positive frames would avoid this. Such a strategy sounds naive, but we know that framing strategies can work (Thaler & Sunstein, 2009).
For me the most important result of a theory of reflexivity would be that mainstream economists become more self-aware of their own shortcomings and don’t rush too fast to normative conclusions. This would already be a major achievement.
Berman, S. (2002) ‘Review Article: Ideas, Norms, and Culture in Political Analysis’. Comparative Politics 33(2): 231-250.
Bronk, R. (2013) ‘Fallibility, reflexivity, and the human uncertainty principle’. Journal of Economic Methodology 20(4): 343-349.
Farmer, J. D. (2013) ‘Hypotheses non fingo: Problems with the scientific method in economics’. Journal of Economic Methodology 20(4): 377-385.
Guala, F. (2013) ‘Reflexivity and equilibria’. Journal of Economic Methodology 20(4): 397-405.
Hall, P. A. (1993) ‘Policy Paradigms, Social-Learning, and the State – the Case of Economic Policy-Making in Britain’. Comparative Politics 25(3): 275-296.
Hommes, C. (2013) ‘Reflexivity, expectations feedback and almost self-fulfilling equilibria: economic theory, empirical evidence and laboratory experiments’. Journal of Economic Methodology 20(4): 406-419.
Kahneman, D. (2003) ‘Maps of Bounded Rationality: Psychology for Behavioral Economics’. American Economic Review 93(5): 1449-1475.
Keen, S. (2002) Debunking Economics. The Naked Emperor of the Social Sciences. London: Zed Books.
Mankiw, G. (2000) ‘The Savers-Spenders Theory of Fiscal Policy’. Papers and Proceedings of the One Hundred Twelfth Annual Meeting of the American Economic Association: 120-125.
Rasch, W. (2000) Niklas Luhmann’s Modernity. The Paradoxes of Differentiation. Stanford: Stanford UP.
Searle, J. (1995) The Construction of Social Reality. New York: Free Press.
Shaikh, A. (2013) ‘On the role of reflexivity in economic analysis’. Journal of Economic Methodology 20(4): 439-445.
Soros, G. (1987) The Alchemy of Finance. Reading the Mind of the Market (John Wiley and Sons.
Soros, G. (2013) ‘Fallibility, reflexivity, and the human uncertainty principle’. Journal of Economic Methodology 20(4): 309-329.
Thaler, R., & Sunstein, C. R. (2009) Nudge. Improving Decisions About Health, Wealth, and Happiness. Londong et al.: Penguin. Paperback edition.