The Soros Lectures
George Soros is well known among the financial elite as one of the most successful hedge fund managers in recent history. In October 2009, he began a series of lectures at Central European University that would explain his perceived conceptual framework as it relates to the behavior of people in the financial markets.
Lecture One: The Human Uncertainty Principle
As a student at the London School of Economics, Gorge Soros began philosophizing about his idea of behavior in the financial markets. His initial framework, influenced greatly by Karl Popper’s The Open Society and Its Enemies, was centered around an open society: a society in which people are free to hold divergent opinions and the rule of law allows people with different views and interests to live together in peace. This struck him as odd as he was concurrently learning economic theory. Karl Popper’s theories were based around abstracts and uncertain information; whereas, economic theory assumed perfect competition which postulates perfect knowledge. This perplexing idea, coupled with many life experiences brought Soros to the concepts that he would eventually model his investing principles after: fallibility and reflexivity.
Fallibility is clearly defined by the fact that in any situation where there are thinking participants, the participants’ view of the world is always partial and distorted. Then, these distorted views can influence the situation to which they relate because false views lead to inappropriate action. That is reflexivity. For example: Treating drug addicts as criminals creates criminal behavior. This misconstrues the problem and interferes with the proper treatment of addicts. Fallibility is far less controversial than reflexivity. Almost everyone would agree that the world we live in is much more complex than we could comprehend.
Reflexivity can be broken down into two diverging sections. One, cognitive function, is the understanding of the world we live in. The second, the manipulative function, is how we change the situation to our advantage. Because each of these are happening at the same time, it robs each of the truly independent variable, or knowledge as Soros explains, we need to perceive the correct decision or action to take. This being the case, the two are linked subliminally. Consider this example: the statement “It is raining” is true or false based on whether or not it is truly raining. The statement “This is a revolutionary movement” is reflexive because its value depends on the revolution’s impact.
With reflexivity, any two or more aspects of reality can be connected with feedback loops, of which can be either positive or negative. Negative feedback loops bring the participants’ views and the actual situation closer together; whereas, positive feedback loops drives them further apart. In other words, negative feedback loops are self-correcting and positive feedback loops can go on forever. In this way, bubbles are created by a self-perpetuating positive feedback loop in which reality becomes so distorted that it must revert to a negative feedback.
Reflexivity is not the only source of confusion when dealing with the economic environment. There is also the imperfect knowledge and the inability of people to know what others are thinking at any given moment. This can be seen in economic theory. It started out assuming perfect knowledge, and when that assumption proved untenable it went through more contortions to maintain the fiction of rational behavior. This is how the theory of rational expectations came into existence. It was necessary to let economic theory model itself after Newtonian physics.
Lecture Two: Financial Markets
During this lecture, Soros applied the aforementioned framework to the financial markets. By the preceding definitions, Soros’ view of the financial markets violates the efficient market hypothesis. Firstly, market prices always distort the underlying fundamentals. Secondly, financial markets play an active role in affecting the fundamentals they are supposed to reflect. This is the diverging principle of Soros’ viewpoint and behavioral economics.
Bubbles, or boom-bust process can be explained simply under Soros’ philosophy: Ever bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. A boom-bust process is set in motion when a trend and misconception positively reinforce each other. The process is liable to be tested by negative feedback along the way. If the trend is strong enough, the misconception will be further reinforced.
Bubbles are not the only way that reflexivity is shown in the financial markets. For example, in the currency markets, the upside and downside are symmetrical so that there is no sign of an asymmetry between boom and bust, but there is no sign of equilibrium either. Freely floating exchange rates tend to move in large, multi-year waves.
Soros used this information to “pop” the super bubble of 2007. The housing bubble in the United States was the most common kind, distinguished only by the widespread use of CDOs and other synthetic instruments. Behind the ordinary bubble was a much larger super bubble growing over a larger period of time that was much more peculiar. The prevailing trend in this super bubble was the increasing use of credit and leverage. The administration at the time believed that the markets were efficient, and if left to their own devices, would correct to a mean. This not being the case, as Soros believes in his philosophy, he called the boom-bust process during the market crisis of both 1997–1998 and 2007–2008.
Because markets are bubble prone, Soros offers ways to regulate the economy. First, financial authorities must accept responsibility for preventing bubbles from growing too big. Second, in order to control asset bubbles, it is not enough to control the money supply; you must also control the availability of credit. Third, regulators cannot ignore market risk because too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. Fourth, we must recognize that financial markets evolve in a one- directional, nonreversible manner. Finally, the drafters of the Basal accords made a mistake when they gave securities held by banks substantially lower risk ratings than regular loans, as this was an important factor in aggravating the crisis.
Lecture Three: Open Society
In this lecture, Soros describes the concept of open society. The connection between open society and reflexivity are far from obvious, but they are connected. Their connection, on a conceptual level, is fallibility. It is the definition of fallibility, our distorted view of reality, that often makes us misconstrue societies complexity. It is these misconceptions that inevitably shape our history thus creating reflexivity.
The enlightenment period, focused on seeking and finding truths, gave rise to the ideology of perfect knowledge: all knowledge is available and can be discovered. This led to what is called the Enlightenment fallacy. Soros draws a connection between that and what he calls a fertile fallacy, a fallacy based in truth. A fertile fallacy means that we are capable of acquiring knowledge, but we can never have enough knowledge to allow us to base all our decisions on knowledge.
There is a competing belief to the Enlightenment fallacy and that is called the post- modern worldview. This view is a pragmatic approach to politics. Basically it approaches politics in the following manner: Now that we have discovered that reality can be manipulated, why should the cognitive function be given precedence?
The event that forced Soros to thoroughly divulge into the concept of open society is the reelection of George W. Bush. He states, “Here was the oldest and most successful democracy in the world violating the principles for which it was supposed to stand by engaging in human rights violations in the name of fighting a war on terror and invading Iraq under false pretenses. Yet, he was reelected.” It was this event that led him to believe that our view of the world is deeply rooted in an intellectual tradition that either ignores the manipulative function or treats it as subservient to the cognitive function.
The manipulative techniques have developed over time. They originated in the commercial arena toward the end of the nineteenth century when entrepreneurs discovered that they could improve their profit margins by differentiating their products through branding and advertising. This led to manipulation in the demand curve by advertising, thus giving rise to the manipulative function.
Lecture Four: Capitalism Versus Open Society
In this lecture, Soros discusses the inherent dichotomy between capitalism and open society. The main point of contention is the agency problem. Markets are supposed to be guided by an invisible hand; that is what makes them efficient. In truth, the rules governing the financial markets are decided by the invisible hand of politicians, and in a representative democracy politicians run into an agency problem. This value is perpetuated by the inherent view of democracy and open society. The politician has to please the constituency in order to get reelected, regardless of their beliefs on how the markets, or regions should be governed. This in turn leads to reflexivity as values and social orders are highly subjective.
The only distinguishing feature of the market mechanism, as it relates to capitalism and open society, is that it is amoral; mean every person’s dollar is worth exactly the same as another person’s; irrespective of how she came to possess it.
Capitalism is not directly opposed to open society; nevertheless, it poses some serious threats. Firstly, markets are not equilibrium bound, but instead bubble-prone. Secondly, the agency problem of democracy separates the two beliefs. As a far extreme, lobbying is at the core of the agency problem in America and borders on an ethical dilemma.
Lecture Five: The Way Ahead
In this lecture, George Soros describes where he sees the economy going as it relates to the aforementioned topics. He states, “We are at a moment in history when the range of uncertainty is unusually wide.” He is unusually optimistic about the bailout attempt, but is calling for a double dip in either 2010 or 2011 as we are still in a far from equilibrium situation in the financial markets. To illustrate: Effectively, the international financial system has a two- tier structure: countries that can borrow in their own currency constitute the center, and those whose borrowings are denominated in one of the hard currencies constitute the periphery. If individual countries get into difficulties, the receive assistance, but only under strict conditions. That hold true whether they are from the center of from the periphery. But if the center itself becomes endangered, then preserving the system takes precedence over all other considerations. Thus, he supported and will continue to support a bailout through a double dip.
In addition, he sees the United States losing its seat as the sole super power financially. The likes of China and other emerging markets are seeing a faster rebound, which he believes will propel it to the top of the pack economically. But, with this globalization, Soros calls for greater financial regulation. Without this, he states, financial markets will not be able to remain global.
In summary, the world is facing a choice between two fundamentally different forms of economic organization, international capitalism and state capitalism. The former, represented by the US has failed with the financial crisis. The latter, represented by China, has only begun to grow and will see extensive growth in the near term.
A link to the full book can be found here. The views expressed are, unless expressly stated, the views of the author or the brief writer, not Titans Of Investing as an organization.
Today’s Titans Brief was written by Mark Gibson.
