Delivered April 26, 1994 to the MIT Department of Economics World Economy
Laboratory Conference Washington, D.C.

    When Rudi Dornbusch invited me to speak at this conference, he gave me a
totally free hand in deciding what I wanted to talk about.  Well, I want
to discuss a subject which fascinates me but doesn’t seem to interest
others very much.  That is my theory of reflexivity which has guided me
both in making money and in giving money away, but has received very
little serious consideration from anybody else. It is really a very
curious situation.  I am taken very seriously; indeed, a bit too
seriously.  But the theory that I take seriously and, in fact, rely on in
my decision-making process is pretty completely ignored.  I have written a
book about it which was first published in 1987 under the title The
Alchemy of Finance; but it received practically no critical examination.
It has been out of print for the last several years but demand has been
building up as a result of my increased visibility, not to say notoriety,
and now the book is being re-issued.  I think this is a good time to get
the theory seriously considered.

I was invited to testify before Congress last week and this is how I
started my testimony.  I quote: “I must state at the outset that I am in
fundamental disagreement with the prevailing wisdom.  The generally
accepted theory is that financial markets tend towards equilibrium, and on
the whole, discount the future correctly.  I operate using a different
theory, according to which financial markets cannot possibly discount the
future correctly because they do not merely discount the future; they help
to shape it.  In certain circumstances, financial markets can affect the
so-called fundamentals which they are supposed to reflect.  When that
happens, markets enter into a state of dynamic disequilibrium and behave
quite differently from what would be considered normal by the theory of
efficient markets.  Such boom/bust sequences do not arise very often, but
when they do, they can be very disruptive, exactly because they affect the
fundamentals of the economy.” I did not have time to expound my theory
before Congress, so I am taking advantage of my captive audience to do so
now.  My apologies for inflicting a very theoretical discussion on you.

The theory holds, in the most general terms, that the way philosophy and
natural science have taught us to look at the world is basically
inappropriate when we are considering events which have thinking
participants.  Both philosophy and natural science have gone to great
lengths to separate events from the observations which relate to them.
Events are facts and observations are true or false, depending on whether
or not they correspond to the facts.

This way of looking at things can be very productive.  The achievements of
natural science are truly awesome, and the separation between fact and
statement provides a very reliable criterion of truth. So I am in no way
critical of this approach.  The separation between fact and statement was
probably a greater advance in the field of thinking than the invention of
the wheel in the field of transportation.

But exactly because the approach has been so successful, it has been
carried too far.  Applied to events which have thinking participants, it
provides a distorted picture of reality.  The key feature of these events
is that the participants’ thinking affects the situation to which it
refers.  Facts and thoughts cannot be separated in the same way as they
are in natural science or, more exactly, by separating them we introduce a
distortion which is not present in natural science, because in natural
science thoughts and statements are outside the subject matter, whereas in
the social sciences they constitute part of the subject matter.  If the
study of events is confined to the study of facts, an important element,
namely, the participants’ thinking, is left out of account.  Strange as it
may seem, that is exactly what has happened, particularly in economics,
which is the most scientific of the social sciences.

Classical economics was modeled on Newtonian physics.  It sought to
establish the equilibrium position and it used differential equations to
do so.  To make this intellectual feat possible, economic theory assumed
perfect knowledge on the part of the participants.  Perfect knowledge
meant that the participants’ thinking corresponded to the facts and
therefore it could be ignored. Unfortunately, reality never quite
conformed to the theory.  Up to a point, the discrepancies could be
dismissed by saying that the equilibrium situation represented the final
outcome and the divergence from equilibrium represented temporary noise.
But, eventually, the assumption of perfect knowledge became untenable and
it was replaced by a methodological device which was invented by my
professor at the London School of Economics, Lionel Robbins, who asserted
that the task of economics is to study the relationship between supply and
demand; therefore it must take supply and demand as given.  This
methodological device has managed to protect equilibrium theory from the
onslaught of reality down to the present day.

I don't know too much about the prevailing theory about financial markets
but, from what little I know, it continues to maintain the approach
established by classical economics.  This means that financial markets are
envisaged as playing an essentially passive role;  they discount the
future and they do so with remarkable accuracy.  There is some kind of
magic involved and that is, of course, the magic of the marketplace where
all the participants, taken together, are endowed with an intelligence far
superior to that which could be attained by any particular individual.  I
think this interpretation of the way financial markets operate is severely
distorted.  That is why I have not bothered to familiarize myself with
efficient market theory and modern portfolio theory, and that is why I
take such a jaundiced view of derivative instruments which are based on
what I consider a fundamentally flawed principle.  Another reason is that
I am rather poor in mathematics.

It may seem strange that a patently false theory should gain such
widespread acceptance, except for one consideration; that is, that all our
theories about social events are distorted in some way or another.  And
that is the starting point of my theory, the theory of reflexivity, which
holds that our thinking is inherently biased. Thinking participants cannot
act on the basis of knowledge.  Knowledge presupposes facts which occur
independently of the statements which refer to them; but being a
participant implies that one’s decisions influence the outcome.
Therefore, the situation participants have to deal with does not consist
of facts independently given but facts which will be shaped by the
decision of the participants.  There is an active relationship between
thinking and reality, as well as the passive one which is the only one
recognized by natural science and, by way of a false analogy, also by
economic theory.

I call the passive relationship the “cognitive function” and the active
relationship the “participating function,” and the interaction between the
two functions I call “reflexivity.” Reflexivity is, in effect, a two-way
feedback mechanism in which reality helps shape the participants’ thinking
and the participants’ thinking helps shape reality in an unending process
in which thinking and reality may come to approach each other but can
never become identical.  Knowledge implies a correspondence between
statements and facts, thoughts and reality, which is not possible in this
situation.  The key element is the lack of correspondence, the inherent
divergence, between the participants’ views and the actual state of
affairs.  It is this divergence, which I have called the “participant’s
bias,” which provides the clue to understanding the course of events.
That, in very general terms, is the gist of my theory of reflexivity.

The theory has far-reaching implications. It draws a sharp distinction
between natural science and social science, and it introduces an element
of indeterminacy into social events which is missing in the events studied
by natural science.  It interprets social events as a never-ending
historical process and not as an equilibrium situation.  The process
cannot be explained and predicted with the help of universally valid laws,
in the manner of natural science, because of the element of indeterminacy
introduced by the participants’ bias.  The implications are so
far-reaching that I can’t even begin to enumerate them.  They range from
the inherent instability of financial markets to the concept of an open
society which is based on the recognition that nobody has access to the
ultimate truth.  The theory gives rise to a new morality as well as a new
epistemology.  As you probably know, I am the founder—and the funder—of
the Open Society Foundation.  That is why I feel justified in claiming
that the theory of reflexivity has guided me both in making and in
spending money.

But is it possible to come up with a valid new theory about the
relationship between thinking and reality?  It seems highly unlikely.  The
subject has been so thoroughly explored that probably everything that can
be said has been said.  In my defense, I did not produce the theory in a
vacuum.  The logical indeterminacy of self-referring statements was first
discussed by Epimenides, the Cretan philosopher, who said, “Cretans always
lie,” and the paradox of the liar was the basis of Bertrand Russell's
theory of classes.  But I am claiming more than a logical indeterminacy.
Reflexivity is a two-way feedback mechanism, which is responsible for a
causal indeterminacy as well as a logical one.  The causal indeterminacy
resembles Heisenberg’s uncertainty principle, but there is a major
difference: Heisenberg’s theory deals with observations, whereas
reflexivity deals with the role of thinking in generating observable
phenomena.

I am thrilled by the possibility that I may have reached a profound new
insight, but I am also scared because such claims are usually made by
insane people and there are many more insane people in the world than
there are people who have reached a profound new insight.  I wonder
whether my insight has an objective validity or only a subjective
significance.

That is why I am so eager to submit my ideas to a critical examination and
that is why I find the present situation, where I am taken so seriously
but my theory is not, so frustrating.  As I have said before, the theory
of reflexivity has received practically no serious consideration.  It is
treated as the self-indulgence of a man who made a lot of money in the
stock market.  It is generally summed up by saying that markets are
influenced by psychological factors, and that is pretty trite.  But that
is not what the theory says.  It says that, in certain cases, the
participants’ bias can change the fundamentals which are supposed to
determine market prices.

I ask myself, why did I fail to communicate this point?  The answer I come
up with is that I tried to say too much, too soon.  I tried to propound a
general theory of reflexivity at a time when reflexivity as a phenomenon
is not even recognized.  In retrospect, I think I should have started more
modestly; I should have tried to prove the existence of reflexivity as a
phenomenon before I tried to revise our view of the world based on that
phenomenon.  It can be done relatively easily, and the financial markets
provide an excellent laboratory in which to do it.  And that is what I
should like to do here today.

What I need to do is to demonstrate that there are instances where the
participants’ bias is capable of affecting not only market prices but also
the so-called fundamentals that market prices are supposed to reflect.  I
have collected and analyzed such instances in The Alchemy of Finance, so
all I need to do here is simply to enumerate them.  In the case of stocks,
I have analyzed two particular instances which demonstrate my case
perfectly; one is the conglomerate boom and bust of the late 1960s, and
the other is the boom and bust of real estate investment trusts in the
early 70s.  I cite may other instances, such as the leveraged buyout boom
of the 1980s and the boom/bust sequences engendered by foreign investors.
But these cases are less clear cut.

The common thread in the two instances I have mentioned is so-called
equity leveraging;  that is to say, companies can use inflated
expectations to issue new stock at inflated prices, and the resulting
increase in earnings per share can go a long way to validate the inflated
expectations.  But equity leveraging is only one of many possible
mechanisms for transmitting the participants’ bias to the underlying
fundamentals.  Consider, for instance, the boom in international lending
which occurred in the 1970s and led to the bust of 1982.  In the boom,
banks relied on so-called debt ratios, which they considered as objective
measurements of the ability of the borrowing countries to service their
debt, and it turned out that these debt ratios were themselves influenced
by the lending activity of the banks.

In all these cases, the participants’ bias involved an actual fallacy: in
the case of the conglomerate and mortgage trust booms, the growth in
earnings per share was treated as if it were independent of equity
leveraging; and in the case of the international lending boom, the debt
ratio was treated as if it were independent of the lending activities of
the banks.  But there are other cases where no such fallacy is involved.
For instance, in a freely-fluctuating currency market, a change in
exchange rates has the capacity to affect the so-called fundamentals which
are supposed to determine exchange rates, such as the rate of inflation in
the countries concerned; so that any divergence from a theoretical
equilibrium has the capacity to validate itself.  This self-validating
capacity encourages trend-following speculation, and trend-following
speculation generates divergences from whatever may be considered the
theoretical equilibrium.  The circular reasoning is complete.  The outcome
is that freely-fluctuating currency markets tend to produce excessive
fluctuations and trend-following speculation tends to be justified.

I believe that these examples are sufficient to demonstrate that
reflexivity is real; it is not merely a different way of looking at
events; it is a different way in which events unfold.  It doesn't occur in
every case but, when it does, it changes the character of the situation.
Instead of a tendency towards some kind of theoretical equilibrium, the
participants’ views and the actual state of affairs enter into a process
of dynamic disequilibrium which may be mutually self-reinforcing at first,
moving both thinking and reality in a certain direction, but is bound to
become unsustainable in the long run and engender a move in the opposite
direction.  The net result is that neither the participants’ views nor the
actual state of affairs returns to the condition from which it started.
Once the phenomenon of reflexivity has been isolated and recognized, it
can be seen to be at work in a wide variety of situations.  I studied one
such situation in The Alchemy of Finance which was particularly relevant
at the time the book was written.  I called it “Reagan’s Imperial Circle.”
It consisted of financing a massive armaments program with money borrowed
from abroad, particularly from Japan.  I showed that the process was
initially self-reinforcing but it was bound to become unsustainable.  A
similar situation has arisen recently with the reunification of Germany,
which eventually led to the breakdown of the European Exchange Rate
Mechanism.  The ERM operated in near- equilibrium conditions for about a
decade before the reunification of Germany created a dynamic
disequilibrium.

What renders reflexivity significant is that it occurs only
intermittently.  If it were present in all situations all the time, it
would merely constitute a different way of looking at events and not a
different way for events to evolve.  That is the point I failed to make
sufficiently clear in my book.  I presented my theory of reflexivity as a
general theory in which the absence of reflexivity appears as a special
case.  I was, of course, trying to imitate Keynes, who proposed his
general theory of employment in which full employment was a special case.
But Keynes proposed his theory when unemployment was a well-established
fact, whereas I proposed the theory of reflexivity before the phenomenon
has been recognized.  In doing so, I both overstated and understated my
case. I overstated it by arguing that the methods and criteria of the
natural sciences are totally inapplicable to the study of social
phenomena.  I called social science a false metaphor.  That is an
exaggeration because there are many normal, everyday, repetitive
situations which can be explained and predicted by universally valid laws
whose validity can be tested by scientific method.  And even historical,
reflexive processes have certain repetitive aspects which lend themselves
to statistical generalizations. For instance, the trade cycle follows a
certain repetitive pattern, although each instance may have some unique
features and there is a lot more to be gained from understanding the
unique features than the repetitive pattern.

I have also understated my case by presenting reflexivity as a different
way of looking at the structure of social events rather than a different
way in which events unfold when reflexivity comes into play.  I made the
point that, in natural science, one set of facts follows another
irrespective of what anybody thinks; whereas in the events studied by
social science, there is a two-way interaction between perception and
facts.  I also drew a distinction between humdrum, everyday events in
which the element of indeterminacy introduced by the reflexive connection
can be treated as mere noise, and historical events where the reflexive
interaction brings about an irreversible change both in the participants'
views and the actual state of affairs. All this is very profound and very
significant, but the really interesting undertaking is to study the
difference between humdrum and historical events and to gain a better
understanding of historical processes.

I have done a lot of work in that direction since I wrote The Alchemy of
Finance, not so much in the financial markets as in the historical arena.
I have come to distinguish between normal conditions and
far-from-equilibrium conditions.  In normal conditions, there is a
tendency for the participants’ views and the actual state of affairs to
converge or, at least, there are mechanisms at work to prevent them from
drifting too far apart.  I call these conditions “normal,” because that is
what our intellectual traditions—including philosophy and scientific
method —have prepared us for.  I contrast them with far-from- equilibrium
conditions, where the participants’ views are far removed from the actual
state of affairs and there is no tendency for the two of them to come
together.  I have always found the far-from-equilibrium conditions much
more fascinating, and I have studied them both in theory and in practice.

There are two very different kinds of far-from-equilibrium conditions: one
is associated with the absence of change, and the other with revolutionary
change.  These two opposite poles act as “strange attractors”—an
expression with which has become familiar since chaos theory has come into
vogue.

So we can observe three very different conditions in history: the
“normal,” in which the participants’ views and the actual state of affairs
tend to converge; and two far-from- equilibrium conditions, one of
apparent changelessness, in which thinking and reality are very far apart
and show no tendency to converge, and one of revolutionary change in which
the actual situation is so novel and unexpected and changing so rapidly
that the participants’ views cannot keep up with it.

Interestingly, the rise and fall of the Soviet system presents both
extremes.  During Stalin’s time, reality and dogma were very far apart,
but both of them were very rigid and showed no tendency to come together.
Indeed, the divergence increased with the passage of time.  When the
system finally collapsed, people could not cope with the pace of change
and events spun out of control.  That is what we have witnessed recently.

But the two extremes can also be observed in totally unrelated contexts.
Take, for instance, the banking industry in the United States.  After the
breakdown of the banking system in the Great Depression, it became closely
regulated and very rigid; but when the restrictions were relaxed, the
industry swung to the other extreme and entered a period of revolutionary
change.  I can locate the transition point with great precision: it was on
that evening in 1973 when the management of First National City Bank held
an unprecedented meeting for securities analysts in order to promote the
stock as a growth stock.  The pattern in the rise and fall of the Soviet
system closely parallels the pattern in the fall and rise of the American
banking system.

These three conditions are perhaps better explained by using an analogy.
The analogy is with water, which also can be found in nature in three
conditions: as a liquid, a solid or a gas.  The three historical
conditions I am trying to describe are as far apart as water, ice and
steam.  In the case of H2O, we can define exactly the three conditions; it
has to do with temperature.  Can we establish a similar demarcation line
among the three conditions of historical change?  I believe we can, and it
has to do with the values that guide people in their actions. But I am not
yet ready to give a firm answer.  That is the problem that I am currently
working on.  But I feel rather exposed in dealing with such an esoteric
issue.  I need to know whether what I have said so far makes any sense;
that is why I have imposed on you by giving you this rather heavy
theoretical lecture, and I would welcome your comments either here or on
another occasion.
 

George Soros.