Fund manager George Soros sought to explain the global financial crisis through his theory of “reflexivity” to a packed auditorium at MIT last week. Soros’ October 28 talk was titled “A New Paradigm for the Financial Markets,” which is also the title of his recently published book on reflexivity.

Reflexivity, originally developed by Soros over 50 years ago, argues that the measurement of valuations in the market affects the valuations themselves, and the result can be a disequilibrium where prices undershoot or overshoot their true values.

Traditional economics argues that actors make decisions rationally so as to maximize their personal gains. But Soros’ theory is based on inefficient markets, where actors often make mistakes, and those mistakes feed on themselves in a self-reinforcing manner.  

Many economists dismiss reflexivity as amateurish. "It is difficult to conceive of a more mistaken understanding of the profession's research in the last 10-15 years," wrote Christopher Neely, an economist at the Federal Reserve Bank of St. Louis.   

Soros’ theories are not grounded in any specific mathematical formulation.  Nonetheless, reflexivity is central to his thinking, and it played a role in his correctly predicting the current crisis. It is also central to an investment philosophy that has helped him amass a personal net worth estimated to be $9 billion.

“I think I have a theory that explains the current crisis better that the existing paradigm,” Soros said at MIT.

Bubbles are a natural consequence of reflexivity — a result of the “reinforcement of trends,” according to Soros.  Two elements must be in place for a bubble to form: There must be an underlying trend, such as the increasing use of leverage, and there must be a misinterpretation or misconception.  In the case of the dot-com bubble, he said there was a misinterpretation of technology — people did not understand what the internet could and could not do.

 “Initially, reality confirms both the trend and the misconception,” Soros told his audience.  But then the trend becomes a self-reinforcing process, eventually making the misconception “so glaring it is unsustainable,” he said.  What was initially self-reinforcing becomes self-defeating; a bubble results.

But bubbles are “an exception,” he said.  “Usually markets correct themselves.”

The current global economy, however, is facing the bursting of a “super bubble” that has been growing for 25 years. The housing bubble served as a “detonator,” Soros said, but the real problem is the global “explosion” that resulted — Soros’ “super bubble.” The explosion owes to two factors: the expansion of credit and leverage, and a misguided belief — he calls it “market fundamentalism” — that markets would be self-correcting.  These factors emerged during the Ronald Reagan and Margaret Thatcher era of the 1980s, and they were propagated through globalization, market deregulation, and the freedom to engage in financial engineering.

“The problem was that regulators believed the market was self-correcting,” said Soros.  He blamed regulators for incremental interventions, like facilitating mergers and fiscal and monetary policy responses — steps he said were taken “to avoid affecting the real economy.”

“Each crisis was a successive test of the misconception of market fundamentalism,” Soros said, adding that policy responses “reinforced these misconceptions.” 

“Now, authorities have lost control,” Soros said.

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