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George Soros: Forget About Adam Smith; My Invisible Pimp Hand Is Strong

Posted on | April 29, 2011 | 15 Comments

by Smitty (via George Scoville)

Via the BlogCon email list, Scoville pointed to a George Soros column Politico. First, it’s a brief article. At just under 1,500 words, there is no way to shoehorn complex ideas into a small space. Nevertheless, it is revealing, and you should read the whole thing.

Soros gives us some biographical information, and then sets up Popper and Hayek as intellectual competitors. Popper preaching falsifiability, Hayek the invisible hand that plays Freedbird on the guitar of the marketplace. I’ll note that Popper offers a methodological tool; Hayek an analysis.

Soros offers a play-by-play of the Popper/Hayek debate in Economica for which he is old enough to have been present.

With that, here is what I think is the center of Soros’ argument, emphasis mine throughout:

While I was admiring the elegance of Popper’s theory, I was also studying elementary economics. I was struck by a contradiction between the theory of perfect competition, which postulated perfect knowledge, with Popper’s theory, which asserted that perfect knowledge was unattainable. The contradiction could be resolved by recognizing that economic theory cannot meet the standards of Newtonian physics.


Theories are Newtonian, and reality is quantum mechanical.

That is why I sided with Hayek — who warned against the slavish imitation of natural science and took issue with Popper — who asserted the doctrine of unity of method.
Hayek argued that economic agents base their decisions on their interpretation of reality, not on reality — and the two are never the same.
That is what I call fallibility. Hayek also recognized that decisions based on an imperfect understanding of reality are bound to have unintended consequences. But Hayek and I drew diametrically opposed inferences from this insight.

Ah!

Hayek used it to extol the virtues of the invisible hand of the marketplace, which was the unintended consequence of economic agents pursuing their self-interest. I used it to demonstrate the inherent instability of financial markets.
In my theory of reflexivity I assert that the thinking of economic agents serves two functions. On the one hand, they try to understand reality; that is the cognitive function. On the other, they try to make an impact on the situation. That is the participating, or manipulative, function.

Wikipedia aside: “Reflexivity is discordant with equilibrium theory, which stipulates that markets move towards equilibrium and that non-equilibrium fluctuations are merely random noise that will soon be corrected. In equilibrium theory, prices in the long run at equilibrium reflect the underlying fundamentals, which are unaffected by prices. Reflexivity asserts that prices do in fact influence the fundamentals and that these newly-influenced set of fundamentals then proceed to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. Because the pattern is self-reinforcing, markets tend towards disequilibrium. Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles.”

The two functions connect reality and the participants’ perception of reality in opposite directions. As long as the two functions work independently of each other they produce determinate results. When they operate simultaneously they interfere with each other. That is the case not only in the financial markets but also in many other social situations.
I call the interference reflexivity. Reflexivity introduces an element of unquantifiable uncertainty into both the participants’ understanding and the actual course of events.
This two-way connection works as a feedback loop. The feedback is either positive or negative. Positive feedback reinforces both the prevailing trend and the prevailing bias — and leads to a mispricing of financial assets. Negative feedback corrects the bias. At one extreme lies equilibrium, at the other are the financial “bubbles.” These occur when the mispricing goes too far and becomes unsustainable — boom is then followed by bust.
In the real world, positive and negative feedback are intermingled and the two extremes are rarely, if ever, reached. Thus the equilibrium postulated by the efficient market hypothesis turns out to be an extreme — with little relevance to reality.

My undergraduate degree was in Weapons and Systems Engineering, which is all about control theory. I’ve never actually been paid Real Cash Money to work as an engineer, mind you. However, when people discuss systems, I tune in. The questions are all about where the system state is kept, how it changes over time, and where is the negative feedback loop.

The world economy is an Nth order system. By which I mean the places where the energy is stored and the interactions are not going to be cleanly modeled and managed the way, say, the controller on the Otis elevator gooses it to the correct position on the desired floor. So I can agree with Soros that a magic wand is not to be had anywhere, at any price.

Soros’ reflexivity contention seems to be, and I might be mischaracterizing: “Since there is no ideal pimp hand, to manage a crash-free market, any other one is morally equivalent: why not mine?”

Here is the metaphor I think pertinent: seasons. We call Autumn ‘Fall’ because decline and decay are simply the natural collapse of Summer into Winter, which is necessary for Spring. Soros’ notion (I infer) of one big eternal Summer managed by the pimp hand of reflexivity can extend a Summer a little while, to the great rejoicing of some, and profit of a few. But the economic forces of celestial motion governing the axial tilt of things are going to bring a Winter, in their time. And, having tampered with the natural cycle of Fall, will the renewal of Spring occur in good season?

The inherent instability of markets could also be handled by trying to keep them from growing too big. Idiocy will happen in banking, but if a Virginia bank existed and managed to tube the housing market in the Commonwealth, such a problem would be more readily manageable if the other 49 States were not at risk, as with Fannie and Freddie. Can the pimp hand of Soros save us? Oh, for blood-on-goatskin values of ‘save’, and for a season, I have the utmost confidence in the fellow.

Update: Linked by Little Miss Attila, who has more.

Category: George Soros

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