George Soros has recently expounds a new theory.
The credit crisis discredited – if not disproved – the efficient market hypothesis, which states that all relevant and available information is represented in market prices. Such a theory struggles to explain bubbles, but has nonetheless been taught for decades at universities and in business schools.
The world is searching for an alternative market theory, and George Soros offers one in a recent series of lectures. His theory has two critical attributes to recommend it: first, it predicted the current crisis, and second, it preceded it.
Below is a summary of his recent lectures.
Mr Soros’ theory is built upon two principles: fallibility and reflexivity. “In situations that have thinking participants, the participants’ view of the world is always partial and distorted. That is the principle of fallibility… These distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity.”
Both principles sound like common sense, but they represent a radical departure from mainstream economic thought. “Economic theory is built on the concept of equilibrium, and that concept is in direct contradiction with the concept of reflexivity.” Participants seek to understand the world even as they seek to alter it, and this sets up a feedback loop. “There is bound to be some slippage between intentions and actions and further slippage between actions and outcomes.”
So there is a gap between perception and reality. This may be a small gap (as markets approach equilibrium) or a large gap (as participants’ views diverge from reality). So equilibrium, the central plank of modern economic theory, is just one limiting case, under Mr Soros’ theory.
The opposite market behaviour – when participants’ views diverge from reality (a “positive” or “self-reinforcing” feedback loop) – can also be iterative. “Positive feedback reinforces whatever tendency prevails in the real world,” even if that tendency is away from an accurate price.
A rising but inaccurate market price is a bubble. “Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend.” Bubbles also have typical shapes: a slow inception, acceleration, interruption and reinforcement through several tests, twilight period, a climax, and then a sharp correction.
For example, in a real estate bubble, the trend that precipitates it is cheaper and more available credit. “The misconception that turns the trend into a bubble is that the value of the collateral is independent of the value of the credit.” In fact the two are not independent: their relationship is reflexive. When credit is more available, property transactions increase and house prices rise.
“Not all bubbles involve the extension of credit; some are based on equity leveraging. The best example is the Internet bubble of the late 1990s. When Alan Greenspan spoke about irrational exuberance in 1996 he misrepresented bubbles. When I see a bubble forming I rush in to buy, adding fuel to the fire. That is not irrational. And that is why we need regulators to counteract the market when a bubble is threatening to grow too big, because we cannot rely on market participants, however well informed and rational they are.”
Mr Soros suggests a number of actions for regulators. “Behind the invisible hand of the market lurks the visible hand of human agency, namely the political process,” he says. And this visible hand should be used to better regulate financial services.
(1) “First and foremost, since markets are bubble-prone, the financial authorities have to accept responsibility for preventing bubbles from growing too big.” They will claim they cannot predict bubbles, and this is true, but their iterative efforts will be better than no action at all.
(2) Regulators should use both monetary and credit tools – the latter including margin requirements and minimum capital requirements. “Currently they are fixed irrespective of the market’s mood, because markets are not supposed to have moods.” But they do, and these requirements need to be changed dynamically to control asset bubbles.
(3) Systemic risks must be monitored by regulators: for example, imbalanced positions. This requires regulators to know the positions of banks and hedge funds. Certain securities that are prone to create hidden imbalances, such as credit default swaps and knockout options, may have to be restricted or forbidden. Synthetic securities must be regulated just as securities are.
(4) “Too big to fail” guarantees have been extended to certain banks, and removing that guarantee is no longer credible. But regulators must ensure banks do not need the guarantee. They can do this by constraining internal and external activity of banks. For example, deposits should not be used for proprietary trading. Trader compensation packages should be balanced between risk and reward. “This may push proprietary traders out of banks into hedge funds where they properly belong.”
(5) Finally, the Basel Accords attached less risk to securities than to regular loans. The decision failed to recognise the risks of concentrated positions in securities, and it should be reversed. “That will probably discourage the securitization of loans.”
“All these measures will reduce the profitability and leverage of banks,” says Mr Soros. “[But] I learned the hard way that the range of uncertainty is also uncertain and at times it can become practically infinite.”
The rest of the Soros lectures focus on the implications of the theory of reflexivity on open society and democracy. Transcripts and videos of all his lectures can be found here.