Soros Lecture On Reflexivity and Its Application To MarketsJacob Wolinsky
2009 – George Soros talks about financial markets here is a nice quote followed by the full informal transcript
A boom bust process is set in motion a trend and that misconception positively reinforce each other. The process is liable to be tested by negative feedback along the way. If the trend is strong enough to survive the test both the trend and the misconception will be for us further reinforced eventually market expectations become so far removed from reality that people are forced to recognize that the misconception is involved a twilight period issues during which doubts grow and more people lose faith. But the prevailing trend is sustained by inertia. As Chuck Prince a former head of Citi Group said We must continue dancing until the music stops. Eventually a point is reached when the trend is reversed.
Soros discusses his general theory of reflexivity and its application to financial markets, providing insights into the recent financial crisis. The third and fourth lectures examine the concept of open society, which has guided Soros's global philanthropy, as well as the potential for conflict between capitalism and open society. The closing lecture focuses on the way ahead, examining the increasingly important economic and political role that China will play in the future.
[00:00:00] The financial markets provide an excellent laboratory for testing the ideas that I put forward in an abstract form yesterday. The course of events is easier to observe than in most other places.
[00:00:17] Many of the facts take a quantitative form and the data are well recorded and well preserved.
[00:00:26] The opportunity for testing occurs because my interpretation of financial markets directly contradicts the official market hypothesis which has been the prevailing theory about financial markets. That theory claims that markets tend towards equilibrium deviations occur in a random fashion and can be attributed to extraneous shocks. If that theory is valid mine is false and vice versa. Let me state the two cardinal principles of my conceptual framework as it applies to the financial markets.
[00:01:13] First market prices always distort the underlying fundamentals the degree of distortions may vary from the negligible to the significant. This is in direct contradiction to the efficient market hypothesis which maintains that market prices accurately reflect all the available information. Second instead of playing a purely passive role in reflecting an underlying reality. Financial markets also have an active role. They can affect the so-called fundamentals that they are supposed to reflect.
[00:01:55] There are various pathways by which the mispricing of financial assets can occur. The most vitally travelled are those which involve the use of leverage both the debt and equity leveraging.
[00:02:13] The various feedback loops may give the impression that markets are often right but the mechanism at work is very different from the one proposed by the prevailing paradigm. I claim that financial markets have ways of altering the fundamentals and that may bring about a closer correspondence between market prices and the underlying fundamentals. Contrast that with the efficient market hypothesis which claims that markets are always accurately reflecting reality and automatically tend towards equilibrium.
[00:02:58] My two propositions focus attention on the flaccid feedback loops that characterize financial markets. There are two kinds of feedback negative and positive. Negative feedback is self-correcting. Positive feedback is self freeing forcing does negative feedback sets up a tendency towards that Librium while positive feedback produces dynamic disagree Librium. Positive feedback loops are more interesting because they can bring about big moves both in market prices and in the underlying fundamentals. Positive feedback process runs its full course is initially suffering forcing but eventually it is liable to reach a climax or reversal point after which it becomes self free forcing in the opposite direction. But the feedback processes don't necessarily run their full course. They may be aborted at any time by negative feedback. I've developed a theory about Busse processes or bubbles along these lines every bubble has two components an underlying trend that prevails in reality and misconception relating to that trend. A boom bust process is set in motion a trend and that misconception positively reinforce each other. The process is liable to be tested by negative feedback along the way. If the trend is strong enough to survive the test both the trend and the misconception will be for us further reinforced eventually market expectations become so far removed from reality that people are forced to recognize that the misconception is involved a twilight period issues during which doubts grow and more people lose faith. But the prevailing trend is sustained by inertia. As Chuck Prince a former head of citi Group said We must continue dancing until the music stops. Eventually a point is reached when the trend is reversed.
[00:05:37] It then becomes self reinforcing in the opposite direction. Let me go back to the example I used when I originally proposed my theory in 1987. The conglomerate boom of the late 1960s. The underlying trend is represented by earnings per share. The expectations relating to the end to that trend by stock prices. So here you have the earnings per share and the stock prices.
[00:06:23] Conglomerates improve their share their earnings per share by acquiring other companies inflated expectations allowed them to improve their earnings performance.
[00:06:36] But eventually reality could not keep up with expectations. After a twilight period the price trend was reversed. All the problems that had been swept under the carpet surfaced and earnings collapsed as the president of one of the conglomerates Ogden Corp. told me at the time I have no audience to play to.
[00:07:04] This. This is a model of of the conglomerate bubble that at the time of actual conglomerates like Ogden Corp. closely resembles this chart bubbles that conform to this pattern go through distinct stages there is the inception then a period of acceleration reinforced by okay by successful tests when the price declines but the still the trend reenforces is strong enough to reenforces itself.
[00:07:56] Then a twilight period ensues and a reversal point or climax is reached followed by an acceleration on the the downside culminating in a financial crisis.
[00:08:16] The length and strength of each stage is unpredictable. But there is an internal logic in the sequence of stages so the sequence is predictable but even that can be terminated by government intervention or some other form of negative feedback. In
[00:08:37] the case of a conglomerate boom it was the defeat of Leasecorp in its attempt to acquire Manufacturers Hanover Trust that constituted the timeless climax or reversal point. Typically.
[00:08:53] Bubbles have an asymmetric shape. The boom is long and drawn out slow to start. It accelerates gradually until it flattens out during the twilight period. The bust is short and steep because it's reinforced by the forced liquidation of unsound positions disillusionment turns into panic.
[00:09:19] Reaching its climax in a financial crisis the simplest case is a real estate boom. The trend that precipitated is that it credit becomes cheaper and more easily available.
[00:09:37] The misconception is that the value of the collateral is independent of the availability of credit. As a matter of fact the relationship between the availability of credit and the value of the collateral is reflexive. When credit becomes cheaper and more easily available activity picks up and real estate values arise. There are fewer defaults credit performance improves and lending standards are relaxed. So at the height of the boom the amount of credit involved is at its maximum and a reversal precipitates forced liquidation depressing real estate prices. Yet this misconception continues to occur in various guises.
[00:10:30] For instance the international banking crisis of 1982 revolved around sovereign debt where no collateral is involved. The credit worthiness of the smaller sovereign borders was measured by various debt ratios like debt to GDP and debt service to exports. These ratios were considered objective criteria while in fact they were reflexive when recycling of petrodollars in the 1970s increased the flow of credit to countries like Brazil. Their debt ratios improved encouraging further inflows and starting a Poppo not all bubbles involve the extension of credit. Some are based on equity leveraging.
[00:11:25] The best examples are the conglomerates boom of the 1960s and the Internet bubble of the late 1990s. When Alan Greenspan spoke about irrational exuberance in 1996 6 it misrepresented bubbles. But I see a bubble forming or rushing to buy adding fuel to the fire. That's not irrational and that's why we need regulators to counteract the market. When a bubble is threatening to grow too big because we can't rely on market participants however well-informed and rational they are. Bubbles. Are not the only form in which reflexivity manifests itself. If they are only the most dramatic and the most directly opposed to the efficient markets hypothesis therefore they deserve special attention. But reflexivity can take many other forms in currency markets for instance. The upside 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 and the most important and most interesting reflexive interaction takes place between the financial authorities and financial markets because markets don't tend towards the broom they are prone to produce periodic crises financial crises lead to regulatory reforms. That's how central banking and the regulation of financial markets have evolved. Both the financial authorities and market participants acted on the basis of imperfect understanding and that makes the interaction between them reflexive and unpredictable. While bubbles only occurred intermittently the interplay between authorities and markets is an ongoing process. Misunderstandings by either side usually stay within reasonable bounds because markets reactions provide useful feedback to the authorities allowing them to correct their mistakes.
[00:14:10] But occasionally these mistakes prove to be self validating Sandy setting in motion vicious or virtuous circles. Such feedback loops resemble bubbles in the sense that they are initially self reinforcing but eventually self-defeating. But otherwise they take quite a different shape. It's important to realize that not all price distortions are due to reflexivity market participants can possibly base their decisions on knowledge.
[00:14:47] They have to anticipate the future and the future is contingent on the decisions that people have not yet made. What made those decisions are going to be and what effect they will have.
[00:15:02] Can't be accurately anticipated. Nevertheless people are forced to make decisions to guess correctly.
[00:15:12] People would have to know the decisions of all of the other participants and their consequences.
[00:15:18] But that's impossible.
[00:15:22] Rational expectations theory sought to circumvent this impossibility by postulating that there is a single correct set of expectations and people's views will converge around it that postulate has no resemblance to reality. But it is the basis of financial economics as it's currently taught in universities. In practice participants are obliged to make the decisions in conditions of uncertainty that decisions are bound to be tentative and biased. That's the general generic cause of price distortions. Occasionally the price distortions set in motion a boom bust process. More often they are corrected by negative feedback. In these cases market fluctuations have a random character I compare them to the waves sloshing around in a swimming pool as opposed to a tidal wave. Obviously the lack of the latter are more significant. But the former are more ubiquitous due two kinds of Franz distortions intermingle so that in reality bust processes rarely follow the exact course of my model bubbles that follow the pattern I described in my model occur only in those rare occasions when they are so powerful that they overshadow all the other processes going on at the same time.
[00:17:13] It will be useful to distinguish between near equilibrium and far from that very grim conditions the near equilibrium conditions are characterized by random fluctuations and the Far from it will improve situations. Are those in which bubble predominates Mirak really is characterized by humdrum everyday events which are repetitive and lend themselves to statistical generalizations. Far from equilibrium conditions give rise to unique historical events where outcomes are generally uncertain but have the capacity to disrupt the statistical general these generalizations based on everyday events. The rules that can guide decisions in near accurately boom conditions don't apply in form from record abuse situations. The recent financial crisis is a case in point. All the risk management tools and synthetic financial products that were based on the assumption that prized deviations from a putek putative equilibrium occur in random fashion broke down and people who relied on mathematical models which had served them well in near equilibrium conditions got badly hurt I have gained some new insights into far from equilibrium conditions during the recent financial crisis.
[00:19:04] As a participant I had to act under immense time pressure and I couldn't gather all the information that would have been available and the same applied to the regulatory authorities in charge. That's how far from a very blue situations can spin out of control and this is not confined to financial markets.
[00:19:30] I experienced it for instance during the collapse of the Soviet Union. The fact that the participants thinking is time bound instead of time less is left out of account by rational expectations theory. I was aware of the uncertainty associated with reflexivity but even I was taken in by as was taken by surprise by the extent of the uncertainty in 2008 it cost me dearly. I got the general direction of the markets right. But they didn't allow for the volatility. As a consequence I took on positions that were too big to withstand the swings caused by volatility and several times I was forced to reduce my positions at the wrong time in order to limit my risk. I would have done much better if I take smaller positions and stuck with them. I learned the hard way that the range of uncertainty is also uncertain and at times it can become practically infinite.
[00:20:46] Uncertainty finds expression in volatility increased volatility requires a reduction in risk risk exposure. This leads to what Keynes called increased liquidity preference. This is an additional factor in the forced liquidation of positions that characterize financial crises.
[00:21:14] When the crisis abates and the range of uncertainty is reduced it leads to an almost automatic rebound in the stock market as the liquidity preference stops arising and eventually falls.
[00:21:30] That's another lesson that I have learned recently.
[00:21:36] I also need to point out that the distinction between here and there Librium and near and far from equilibrium conditions that I've mentioned was introduced by me while trying to make some sense out of a confusing reality. And it doesn't accurately reflect the reality is always more complicated than the dichotomies we introduce into it. The recent crisis is comparable to a hundred year storm. We have had a number of crises leading up to it. These are comparable to five or 10 year storms.
[00:22:22] Regulators who had successfully dealt with the smallest storms were less successful when they applied the same methods to the hundred year storms these are general remarks prepare the ground for a specific hypothesis put forward or have put forward to explain the recent financial crisis. It's not derived from my theory of bubbles by deductive logic.
[00:22:59] Nevertheless the two of them stand or fall together. So here it goes.
[00:23:07] I contend that the puncturing of the subprime bubble in 2007 set off the explosion of a super bubble much as an ordinary bomb sets off a nuclear explosion. The housing bubble in the United States was the most common kind.
[00:23:31] It distinguished only by the widespread use of collateralized debt obligations and other synthetic instruments. Behind this ordinary bubble there was a much larger super bubble growing over a longer period of time which was much more peculiar. The prevailing trend in this super bubble was the ever increasing use of credit and leverage. The prevailing misconception was the belief that financial markets are self-correcting and should be left to their own devices. President Reagan called it the magic of the marketplace and I call it market fundamentalism. It became the dominant creed in the 1980s when Ronald Reagan was president of the United States and Margaret Thatcher was prime minister of the United Kingdom. What made the super bubble so peculiar was the role that financial crises played in making it grow. Since the belief that markets could be safely left to their own devices was false. The super bubble gave rise to a series of financial crises the first and most serious was the international banking crisis of 1982.
[00:25:02] This was followed by many other crises. The most notable being the portfolio insurance debacle in October 1987 the savings and loan crisis that unfolded in various episodes between 1989 and 1994. The emerging market crisis of 1997 98 and the bursting of the Internet bubble in 2008.
[00:25:31] Each time a financial crisis occurred the author and the authorities intervened merged the way or otherwise took care of the fall of failing financial institutions and applied monetary and fiscal stimulus to protect the economy. These measures reinforced the prevailing trend of ever increasing credit and leverage. But as long as they worked they also reinforced the prevailing misconception that markets can't be safely left to their own devices. That was a misconception because it was the intervention of the authorities that saved the system. Nevertheless these crises serve as successful tests of false belief and as such they inflated the super bubble even further.
[00:26:30] Eventually the credit expansion became unsustainable and the super bubble exploded.
[00:26:38] The collapse of the subprime mortgage market led to the collapse of one market after another in quick succession because they were all interconnected. The firewall was having been removed by deregulation. That's what distinguished this financial crisis from all those that preceded it. Those were successful tests that reinforced the process. The subprime crisis of 2007 constituted the turning point the collapse then this climax with the bankruptcy of Lehman Brothers which precipitated the large scale intervention of the financial authorities. It's characteristic of my boom bust model that we can predict in advance whether a test will be successful or not.
[00:27:35] This holds for ordinary bubbles as well as the super bubble.
[00:27:41] I personally thought that the emerging market crisis of 1997 98 would constitute the turning point for the super bubble but I was wrong. The authorities managed to save the system and a super bubble continued growing that made the bust that eventually came in 2008.
[00:28:06] All the more devastating after the bankruptcy of Lehman Brothers on September 15 2008 the the financial markets had to be put on artificial life support this was a shock not only for the financial sector but also for the real economy. International trade was particularly badly hit but the artificial life support worked and financial markets stabilized the economy gradually revived. A year later the whole episode feels like a bad dream and people would like to forget it. There is a widespread desire to treat the crisis as just another crisis and return to business as usual but the reality is likely to oblige. The system is actually broken and needs to be fixed.
[00:29:11] My analysis offers some worthwhile clues to the kind of regulatory reform that's needed. First and foremost since markets are bubble prone the financial authorities have to accept responsibility for preventing bubbles from growing too big. Alan Greenspan and others have expressly refused to accept that responsibility. If markets can't recognize Bubbles Greenspan asserted. Neither can regulators and he was right. Nevertheless the financial or authorities have to accept the assignment knowing full well that they will not be able to meet it without making mistakes. They will however have the benefit of receiving feedback from the markets which will tell them whether they have done too much or too little. They can then correct their mistakes Second in order to control asset bubbles is not enough to control the money supply. You must also control the availability of credit. This can be done by using only monetary tools. We must also use credit controls the best known tools our margin requirements and minimum capital requirements currently if they are fixed irrespective of the market mood because markets are not supposed to have rules. Yet they do and the financial authorities need to very margin and minimum capital requirements in order to control asset bubbles. Regulators may also have to invent new tools or revised ones that have fallen into disuse. For instance in my early days in finance many years ago central banks used to instruct commercial banks to limit their lending to a particular sector of the economy such as real estate or consumer loans because they felt that the sector was overheating. Market fundamentalists consider that crass interference with the market mechanism but they are wrong now.
[00:31:44] Central banks used to do it. We had no financial crises to speak of.
[00:31:50] The Chinese authorities do it today and they have much better control over the banking system than we do the deposits that commercial banks have to maintain at the Central Bank were increased 17 times in China during the boom and when the authorities reversed course the banks obeyed them with alacrity or consider the Internet boom.
[00:32:21] Alan Greenspan recognized it quite early when he spoke about irrational exuberance in 1996 but far from his famous speech he did nothing to avert it. He felt that reducing the money supply would have been too blunt instrument to use. And he was right. But he could have asked the S.E.C. to put a freeze on new share issues because the Internet boom was fueled by equity leveraging. He didn't because that would have violated his market fundamentalist principles.
[00:33:02] Since markets are potentially unstable there are systemic risks in addition to the risks affecting individual market participants.
[00:33:14] Participants may ignore the systemic risks in the belief that they can always dispose of their positions to someone else. But regulators can't ignore them because if too many participants are on the same side the positions can be liquidated without creating a discontinuity or a collapse or a collapse. They have to monitor the positions of the participants in order to detect potential imbalances. That means that the positions of all major participants including hedge funds and sovereign wealth funds need to be monitored. Certain derivatives like credit default swaps and knockout options are particularly prone to creating hidden imbalances. Therefore
[00:34:12] they must be regulated and if appropriate restricted or forbidden the issuing of synthetic securities needs to be subject to regulatory approval just as ordinary securities are fourth.
[00:34:31] We must recognize that financial markets evolve in a one directional non reversible manner. The financial authorities in carrying out their duty of preventing the system from collapsing have extended an implicit guarantee to all institutions that are too big to fail. Now they can't withdraw that guarantee as long as there are institutions that are too big to fail therefore they must impose regulations that will ensure that the guarantee will not be invoked.
[00:35:12] Too Big To Fail banks must use less leverage and accept various restrictions on how they invest the depositors money the Paz's should not be used to finance proprietary trading. But the regulators have to go even further they must regulate the compensation packages of proprietary traders to ensure that the risks and rewards are properly aligned. This may push proprietary traders out of banks into hedge funds where they properly belong.
[00:35:50] Just as oil tankers are compartmentalized in order to keep them stable that ought to be firewalls between different markets.
[00:35:59] It's probably impractical to separate investment banking from commercial banking as the Glass Steagall that of 1930s prevented. But there have to be internal compartments keeping proprietary trading in various markets separate from each other as each other in order to prevent contagion.
[00:36:24] Some banks that have come to occupy Cui's I'm on their policy positions may have to be broken up finally. The Basel accords made a mistake when they gave securities held by banks substantially lower risk gratings than regular loans. They ignored the systemic risks attached to concentrated positions in securities. This was an important factor aggravating the crisis. It has to be corrected by raising the risk ratings of securities held by banks that will probably discourage the securitization of loans.
[00:37:11] All these measures will reduce the profitability and leverage of banks. This raises an interesting question as to timing. This is not the right time to enact permanent reforms. The financial system and the economy are very far from equilibrium and they can be brought back to near equilibrium conditions by a straightforward corrective move just as when a car is skidding.
[00:37:43] You must first turn the wheel in the direction of the skid before you correct the car. What makes what needs to be done in the short term was exactly the opposite of what is needed in the long term. First the credit that evaporated had to be replaced by using the only source of credit that the main credible namely the state.
[00:38:16] That meant increasing the national debt and extending the base as the economy stabilizes. You must then shrink the monetary base as fast as it revise. Otherwise deflation will be replaced by the specter of inflation. We are still in the first phase of this delicate maneuver. The banks are in the process of earning their way out of a hole to reduce their profitability. Now would be directly counterproductive. Regulatory reform has to await the second phase when the money supply needs to be brought under control and it needs to be carefully phased in so as not to disrupt the recovery. But we can't afford to forget about it. You have seen that my interpretation of financial markets call it the theory of reflexivity is very different from the efficient market hypothesis. Strictly speaking neither theory is falsifiable by Popper's standards. I predicted the bursting of the super bubble in 1998. I was wrong then so am I right now and some proponents of the Efficient Markets Hypothesis are still defending it in the face of all the evidence. Still there is a widespread feeling that we need a new paradigm. And I contend that my theory provides a better explanation than the available alternatives. Behavioral economics which is gaining increased recognition deals that only one half of reflexivity the misinterpretations of reality. But doesn't study the pathways by which mispricing can change the fundamentals. I realize that my theory of financial markets is still very rudimentary and needs a lot more development. The pathways by which the risk mispricing can affect the fundamentals need a lot more study.
[00:40:48] Obviously I can't do it on my own so I may have been premature in putting forward my theory as a new paradigm but the efficient market hypothesis has certainly proved inadequate. That has been the entire edifice of global financial markets that has been erected on the false premise that markets can be left to their own devices has to be built from the ground up and that concludes today's lecture. But I would like to also want to use this occasion to make an announcement. I have decided to sponsor an Institute for New Economic Thinking. I know that for short it will be a major execution fostering research workshops and curricula that will develop an alternative to the prevailing paradigm. I have committed 50 million dollars over 10 years and I hope other others will join. I also hope that reflexivity will run off will be one of the concepts that will be explored but clearly it should not be the only one. I recognize the potential conflict between being a protagonist and a financial sponsor. At the same time to protect against it I want to erect a Chinese wall between me and these dudes to this and I will extend my financial support through the Central European University and I will not personally participate in that duty. It will be expressly instructed to encourage other alternatives behind besides the theory of reflexivity. The plan is to launch that at a workshop on the lessons of the financial crisis at King's College Cambridge on April 10th and 11th. And I hope that the New Economic Thinking will find a home here at the sea. Thank you very much.