Reflexivity, Soros and three months for the euro

The euro crisis needs a collective solution, designed and implemented by both the core and the periphery. It has to be a political solution underpinned by good economic and financial reasoning. What George Soros is telling us is that the latter is by no means guaranteed.

Enrique Mora
18 June 2012

This is the second contribution to our debate on the Euro and European democracy

George Soros says he does not believe in the Efficient Market Hypothesis. No wonder. He is a living proof that the Hypothesis is not true. The EMH is one of the theoretical underpinnings basic to any explanation of the behaviour of markets. It comes in different versions – strong, semi-strong, weak - which is already a bit weird when talking about a ‘scientific’ explanation, but the three flavours basically boil down to the statement that prices in financial markets reflect all the information available at a certain moment. As time goes by, prices incorporate new information. That implies that price movements are as random as the content, character and timing of the information flow. In other words, you cannot ‘beat the market’. You cannot get an extra euro over the global return of the market you are investing in. But that is exactly what George Soros has been doing for decades. In fact, he has made a fortune exploiting the fact that markets, sometimes, are highly inefficient.

The same goes for the second basic ‘scientific’ theoretical explanation of markets: the Theory of Rational Expectations. Indeed, when you approach finance economics from the world of the natural sciences, it is striking how many Nobel Prize winners were born out of theories that are openly rejected by most market participants as not representing the essence of investment behaviour. It is as if most engineers collectively discarded the three basic principles of Thermodynamics. In fact, for almost two centuries, a few in each generation did exactly this, and wasted their lives in the search of the perpetuum mobile. Mr. Soros´ point is that the architects of the euro had too much faith in finance theory. That is a serious point.

Being, as Mr. Soros is, a living denial of theoretical approaches to the financial markets is a strong argument for putting a question mark next to those approaches. That is precisely what he does by advancing his own ideas to explain why markets are far from being an efficient, rational place. But he goes much farther than that and in two different directions:  first, by putting forward a “radically different approach to financial markets”; second, by extending his arguments deep into the political realm. Neither of these avenues is self-evident; but the second is definitely the riskier move.

Fallibility and reflexivity are the two basic concepts of Soros’ theory of financial markets. He says, basically, that when people consider an investment they try first to understand what is going on. After that, they take a decision by which they attempt to influence the situation. These two acts are radically different. The first is a cognitive act; the second, an act of the will deliberately designed to make an impact. The tricky thing, and this is Soros’ main point, is that both acts are intertwined by a feedback loop: reflexivity. In other words, forget about attempting to understand reality because there is no objective reality to grasp. What you get is a picture contingent on people’s views and decisions. And that goes also for the future because it is just the result of people’s current decisions.

With these ideas, George Soros provides a masterly explanation of a fact of life that formally does not exist in academia: bubbles. And what is more interesting and intellectually attractive, he shows why and how bubbles are as natural and logical as market equilibrium. Here is where Soros stretches the argument for the first time: not only does reflexivity affect market participants; it also explains the behaviour of regulators, of financial authorities. Bubbles are normally followed by new regulation, but the interaction between markets and their regulators is not restricted to those moments where the tragic consequences of a punctured bubble take hold of the real economy. Markets and financial authorities interact on a day-to-day basis and so, regulators suffer from imperfect knowledge, from misunderstanding reality, from reflexivity.  This helps Soros explain another fact of life: regulators are always behind the curve. And what is more disturbing, he predicts that they will always be.

At this moment, it must be difficult to resist the temptation to extend such a beautifully simple, well-oiled theory for financial markets to the much broader domain of politics. Mr. Soros does not even pretend to resist. For him, the two pillars of fallibility and reflexivity apply to politics and social change. I doubt that the complex, dynamic, non-linear traits of social and political systems can be properly encapsulated in reflexivity theory. But for this post, what is relevant is the case study that Soros has chosen.

And now enter the euro

The euro crisis is a financial, banking, economic, debt and political crisis. You may feel free to choose which aspect to study and the conceptual framework you need to do so.  But you cannot mix different approaches. A badly designed monetary union led to reckless financial practices which led to wrong public policies which led to social disarray and finally a deep political crisis in both the European Union and its member states.

On the financial side, Soros shares what is becoming a mainstream interpretation of the past. The origin of the crisis is not fiscal profligacy (with the exception of Greece, yes Greece is different) but a flow of cheap money to the periphery that provoked deep imbalances. When real interest rates are negative, as has happened in Spain over a number of years during the last decade, a correct allocation of capital is virtually impossible unless you are dealing with angels, not human beings. In a situation like that, quite rational human beings get heavily indebted. The problem is that they do so in order to buy price-inflated assets. Private balance sheets become a mess, but not that of the government, as happened in Spain. The interesting thing is how Mr. Soros conceptually frames this economic disruption. The way he does it could have potentially enormous consequences.

Everybody agrees on two points: first, the original design of the euro was flawed; second, the architects knew that. They simply took it for granted that the moment the flaws became disruptive, they would be addressed and solved. That approach is not new; it is standard practice in the history of the construction of Europe. But at this point Soros introduces a disturbing distinction between those flaws the architects were aware of and those they were unaware of because they came from a wrong understanding of the financial markets. The most clamorous of these mistakes was restricting the Stability Pact to public imbalances because private imbalances are always, velis nolis, corrected by the ‘invisible hand’. The crisis has shown to what extent this belief was wrong. Yes, there is a final correction for private imbalances but it arrives too late and at an exorbitant price. And the price creeps its way onto the public balance sheet.

Another mistake of this sort was surrendering the right to create fiat money without imposing in parallel certain restrictions on the buying of national debt with a no longer national currency. This has led to the convergence of interest rates. The fact that for seven years thousands of analysts (very well paid and supposedly very sophisticated) around the world considered a German bond and a Greek bond identical in financial terms is one of the most spectacular collective mistakes we have ever seen. One of the unintended consequences, another ‘unaware of’ flaw, was that the convergence of long-term interest rates - without real economic convergence - meant a divergence in competitiveness. This unbalance has ended up being the real killer of the euro.

The euro crisis needs a collective solution, designed and implemented by both the core and the periphery. It has to be a political solution underpinned by good economic and financial reasoning. What George Soros is telling us is that the latter is by no means guaranteed.

But when he enters the politics of the EU, the argument starts to wobble. Describing European construction as a “political bubble” can be an eye-catching flare to attract attention but it by no means reflects the magnificent trial and error method applied. And yes, unfortunately the European Union was a “fantastic object” in the minds of some, just a very few, though vociferous, so-called federalists. The fact is that they have damaged the European project to a far greater extent than any hardline, callous Euroskeptic.

The political decisions that need to be taken next are clear to him (as to almost everybody else): the Eurozone needs urgently to address its banking crisis by adopting a common mechanism for deposit insurance and a single supervisory authority. In parallel, the debtor countries need some relief on their financing costs. We have no more than three months to do this. If not, the EU will simply disintegrate.

But even if we do that, we will be doomed to a Union dominated by Germany, a “German empire with the periphery as the hinterland”. Perhaps Soros thinks that because convincing the German public into some sort of limited debt mutualization and the French elite into sharing sovereignty in fiscal matters falls into the domain of fantastic objects and political bubbles, this is something his reflexivity theory can foresee. I do hope he will prove wrong. 


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