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Reflexivity and bubble trouble

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Tuesday, Nov 11, 2008

In the New York Review of Books, George Soros pushes his “reflexivity” thesis, which as far as I can understand—I haven’t read any of his several books on the topic—is simply a refutation of the idea that we can’t argue with the equilibrium points markets move toward.

As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.

Whenever someone proposes an “alternative paradigm,” you have to wonder if that person is a crank, and certainly Soros has been accused of that, despite the fortune he made in the 1990s in currency trading. And the nebulousness of the new paradigm here doesn’t help. It’s hedged and abstracted to the point where it doesn’t seem to argue for anything that anyone would disagree with. Yes, there are market failures; yes, bubbles form when investors misread the economic tea leaves. Yes, markets work dialectically—they are always in the process of aggregating the decisions of investors and so are never in a static state from which absolutely reliable conclusions can be drawn. Information is always in the process of being priced in, but there are lags, asymmetries, criminal manipulations all affecting what prices can signal, not to mention the fact that prices must be considered in relation to other prices, each with its own host of distortions. Investors are obviously forced to make decisions with imperfect information, because no one can adequately process all the information that is now accessible, let alone take into account the known unknowns. And markets may move toward equilibria, but they never quite achieve it, because inputs into the system are always in the process of changing. (Mark Thoma links to this paper, which deals with the same problem and champions Imperfect Knowledge Economics—perhaps a successor to behavioral economics in garnering future buzz?—as a way of accommodating policy to asset-price swings.)

Soros seems to be arguing for an inherent momentum in false perceptions, a feedback loop that compounds erroneous assumptions. His ponderous way of putting this: “occasionally there is a misconception or misinterpretation that finds a way to reinforce a trend that is already present in reality and by doing so it also reinforces itself. Such self-reinforcing processes may carry markets into far-from-equilibrium territory.” This continues until some unspecified magic moment when everybody all of a sudden recognizes that everything is out of whack (Soros: “it may persist until the misconception becomes so glaring that it has to be recognized as such”). But the imprecision about what prompts this sudden recognition is frustratingly vague. Why doesn’t it happen sooner? Do certain parties actively prevent such recognition? Is it a tipping-point phenomenon? Aren’t there already a plethora of opinions that the market is already aggregating? Are there investor opinions that don’t get factored into market-moving decisions until some later consensus is achieved? What is the mechanism here? Soros blames reflexivity on the “distorted view of reality” of market participants, but that seems to misrepresent the nature of financial reality. Not to go all postmodern here, but how can anyone presume to know what the underlying reality is to ascertain that it has been misperceived? Financial reality is not some given thing; it’s constructed by the market’s participants and is always in the process of being shaped. It’s not just there, waiting to be misunderstood by certain foolish investors. The difficulty in pinning down what “reality” is makes it hard to identify and prick bubbles, because for every benchmark one can cite to show that asset prices are misbehaving, one can also bring up some reason why this time it’s different.

Also, in trying to grasp the nature of economic reality, we confront the quantum problem: we affect what we are trying to observe. This is especially true of, say, Fed governors, whose comments profoundly affect markets.

Often in financial commentary, a dichotomy is set up between investing based on “fundamentals” and rampant speculation—trading on noise. Soros’s theory would seem to fit in to this: the reality is dictated by fundamentals—the raw data about capital flows—but the market moves according to the distorted interpretations of those fundamentals. But you don’t need to be in a post-structuralism seminar to be wary of this particular dyad. One can’t act on the fundamentals without interpreting them in some way, and once in the realm of interpretations, the nature of the fundamentals themselves becomes superfluous. In other words, fundamentals alone don’t dictate market activity. The interpretations are all that there is. Trying to present your own investment decisions as being based on fundamentals is just an appeal to the ineffable authority those fundamentals are supposed to give, but fundamentals are like the “master signifier,” unknowable in and of itself and without any essential meaning, though its theoretical existence supplies the rationale for all the meanings encrusted around it. We can collect all the data we want, but we can’t “know” the fundamentals. To paraphrase Lebowski, we just have, like, our opinion, man. Everyone is ultimately trading on noise. Often, as a result, amateurs are urged to “buy and hold” because we collectively have faith that we will produce more and not less going forward, so the sum total GDP in the future will be bigger. That’s about as fundamental as it gets.

One useful thing about Soros’s article is how he frames the events of September not as a catastrophe narrowly averted, as if often done in recounting the Fed and the Treasury Department’s heroic efforts to save the banking system, but as the catastrophe itself.

the inconceivable occurred: the financial system actually melted down. A large money market fund that had invested in commercial paper issued by Lehman Brothers “broke the buck,” i.e., its asset value fell below the dollar amount deposited, breaking an implicit promise that deposits in such funds are totally safe and liquid. This started a run on money market funds and the funds stopped buying commercial paper. Since they were the largest buyers, the commercial paper market ceased to function. The issuers of commercial paper were forced to draw down their credit lines, bringing interbank lending to a standstill. Credit spreads—i.e., the risk premium over and above the riskless rate of interest—widened to unprecedented levels and eventually the stock market was also overwhelmed by panic. All this happened in the space of a week.

It reminds us that we don’t have to wonder what disaster would have looked like; we saw it. And when we think of potential disasters to come, we can remember what that week in September felt like as a gauge of what happens int he midst of a panic, and how there is always some larger crisis that we are rushing heroically to prevent. When the house is on fire, politicians will tell us how effective they’ve been in saving the city from burning down.

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