Sunday, November 20, 2011

George Soros and Economics

George Soros is one of the more polarizing figures in the world.  He has backed pro-democracy movements throughout the world, and other politically aimed organizations primarily through his Open Society Institute.  Because of his political support, he has been criticized severely and has been made the subject of many conspiracy theories.  Glenn Beck and other American right wing pundits have especially made pointed remarks about George Soros.

One of the paradoxes of American right wing distaste for Soros is how much Soros' philosophy is similar to theirs.  Soros has been a lifelong capitalist and promoter of free societies.  He studied philosophy at the London School of Economics under Karl Popper.  Popper made an enormous impact on Soros and his book, The Open Society and its Enemies.  In some aspects, Soros is a classical liberal, but he clearly has different ideas about the role of government than typical Austrian economists and philosophers.

George Soros (photo: World Economic Forum)

One of George Soros ideas that has gained little, if any, traction is his Theory of Reflexivity.  For economics, this is an enormous idea that if it were accepted, would be as revolutionary as marginalism.  The idea for reflexivity is grounded in logic rather than mathematics, but it seeks to replace the equilibrium as central point of analysis for economics.

Soros writes that "there is a two way interaction between the participants' thinking and the situation in which they participate.  One the one hand, participants seek to understand reality ( f ); on the other, they seek to bring about a desired outcome ( φ ).  The two functions work in opposite directions: in the cognitive function reality is the given; in the participating function, the participants' understanding is the constant.  The two functions can interfere with each other by rendering what is supposed to be given, contingent."

His set of equations looked like this:
f (x) = y ,
φ (y) = x .

Soros criticizes the concept of equilibrium as being illogical because it attempts to use a dependent variable to influence a respondent variable when the dependent variable is also a respondent variable.  Soros admits that this is a bit of circular logic, an aspect which he calls a feedback loop.

Soros gives several stock and currency market examples of his theory in action in his book, The Alchemy of Finance.  He criticizes the concept of economic equilibrium and attempts to shake it to its core, but he does not replace it with any robust mathematical concepts, instead merely simple logic and life experience.  Surely, all of us find the concept of equilibrium to be very abstract when applied to our daily lives, because equilibriums are not always intended for real life.  They are models based on assumptions to help us understand difficult but widely observed truths like the relationship between supply and demand.  In real life, we often depart from these concepts on the individual scale, and it is often not until we reach populations that noticeable trends emerge.

The concept of perfect information is used to make our supply and demand lines straight rather than a blur of individual dots that trend in those lines.  Similarly, on supply demand graphs with equilibriums, we generally use static time, which is not realistic either.  Transactions are constant and as Soros describes, the market's actions affect the market's information about future actions.  He is correct that there not actually any constant variables and that everything is actually respondent.

Soros actually borrows this idea from his mentor Karl Popper who wrote about it in, The Poverty of Historicism.  Popper defines it as "the influence of the prediction upon the predicted event," which he was using to refute what he called historical prophecy.  Popper is such a famous philosopher, and one that the progressive movement has not warmed to.  Like the flip side of a coin, Soros is probably an even more famous currency trader and philanthropist, and one that classically liberal and conservative movements have not warmed to either.  Yet the connections between Soros and Popper are very strong.

While many have accused George Soros of various conspiracies, most of these accusations are rather groundless.  He would like to replace the concept of equilibrium with the theory of reflexivity, while it may not be a sinister conspiracy involving dark alley ways and secret handshakes, it is something.  It seems to me that his main argument against it is that it is static, but it is measuring elements which are dependent upon one another and are never actually static.  He would prefer a different, reflexive point which would be dynamic and more realistic.  G.L.S. Shackle writes of this issue in economics, "We cannot, then, regard the 'present moment,' or the moment-in-being, as strictly a still platform from which the 'rest of time' can be surveyed."

Many others have written about how future events or our expectations affect our decision making and even that a certain awareness of our own impact could enter into these rational expectations.  These writings do not scrap the notion of equilibrium, and nor would I.  I do not think that Soros' theories have risen to level of rewriting our understanding of economics, but that does not necessarily mean that they are not worthwhile ideas either.  For a more detailed, mathematical understanding of reflexivity, read the paper by C.P. Kwong, or read it in its original form in The Alchemy of Finance.


Kwong, C.P.  "Mathematical Analysis of Soros' Theory of Reflexivity."  Cornell University.  2008.  Web.
Popper, Karl.  The Poverty of Historicism.  London: Routledge & Kegan Hall.  1957.  Print.
Shackle, G.L.S.  Time in Economics.  Amsterdam: North Holland Publishing.  1957.  Print.
Soros, George.  The Alchemy of Finance.  Hoboken, NJ: John Wiley & Sons.  2003.  Print.  (originally published in 1987)

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