Wednesday, October 28, 2009

Reflections on Soros' Reflexivity

I can state the core idea in two relatively simple propositions. One is that in situations that have thinking participants, the participants’ view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity. George Soros

The FT has most kindly provided excellent coverage of George Soros' recent CEU lectures on reflexivity and its relation to economics and finance. Both transcripts and video are available.

While reading his lectures I often found myself nodding in agreement. The man draws from an extremely eventful life with a gifted mind. If you opted to stop reading this blog now and "clicked" over to The Soros Lectures (instead of finishing my two cents worth now) you would only miss a small critique on his conclusions- a critique, however, which may have substantial ramifications.

For all his financial success, Mr. Soros strikes me as a man whose true calling was teaching. He has been pushing "his" Theory of Reflexivity for decades and remains somewhat baffled that it hasn't caught on. He suspects that the Financial Crisis of 2008 might be sufficiently negative feedback to inspire a broader examination of his theories in schools and use of his views in the formulation of public policy.

If I had a chance to offer Mr. Soros one sentence that might help him stop banging his head against the wall, it would be this: The safest general characterization of the European philosophical tradition is that it consists of a series of footnotes to Plato- Alfred North Whitehead.

2400 years ago in a culture that had reached a pinnacle of success in its area of the globe, but had suffered some defeats Plato watched the Athenian Democracy put his teacher, Socrates, to death. He spent the rest of his life exploring human thought individually and collectively in light of Socrates teachings and death as well as those successes and defeats.

He too drew on an extremely eventful life with a gifted mind and left his teachings for any who wished to read (albeit subject to the availability of books, which was a large issue, up until Guttenberg). Judging from his analogy of the cave, I don't think Plato would be surprised that few now "see" the value in his work. Nor, I suspect, would he be surprised by Soros' views, although he might find the term "reflexivity" (the quantum mechanical word is "entanglement") interesting as he wrote of the effects of the observer on the observed, and vice versa.

In other words, as Whitehead noted, the observer-observed problem has been an issue for thousands of years. Soros' views on reflexivity aren't new, but rather, as William James called his Philosophy of Pragmatism, a new name for old ways of thinking. This isn't in any way to diminish their importance. Many of the most important lessons in life are timeless. I'll bet there are quite a few speculators who wished they took to heart the Biblical teaching about 7 fat years and 7 leans years- an oldie but a goody.

What does strike me as somewhat new in reflexivity is the increased number of people observing the action, and acting on their observations, thus creating that which will then be observed- economic and financial self-awareness is on the rise. One additional effect of increasing wealth, not studied by the Greenspan Fed, is an increase in economic and financial reflexivity which reminds me Keynes ruminations on the topic, recently well described by John Cassidy at the New Yorker: He [Keynes] compared investing to newspaper competitions in which “the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.” If you want to win such a contest, you’d better try to select the outcome on which others will converge, whatever your personal opinion might be. “It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest,” Keynes explained. “We have reached the third degree, where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

It's quite a tangle, as Soros found himself: Reflexive feedback loops have not been rigorously analyzed and when I originally encountered them and tried to analyze them, I ran into various complications. The feedback loop is supposed to be a two-way connection between the participant’s views and the actual course of events. But what about a two-way connection between the participants’ views? And what about a solitary individual asking himself who he is and what he stands for and changing his behavior as a result of his reflections? In trying to resolve these difficulties I got so lost among the categories I created that one morning I couldn’t understand what I had written the night before.

The harder you try to get concrete answers based solely on these reflexive feedback loops the more complex the issue becomes- a Mobius strip with no beginning and no end..........

In the short run, the market is a voting machine but in the long run, it is a weighing machine. - Ben Graham

This brings me to an Alexandrian moment before the Gordian Knot. Let's cut the complexity. If one is an investor, which I define as one who acts on the long view, the more Benjamin Graham's weighing machine comes into play. Reflexivity is more a function of action on the short view when Graham's voting machine is in play.

In my view, public policy should not make use of Soros' ideas, which are most suited for his Hedge Fund work, but rather should focus on the long view. That short run fluctuations threaten the system is to me more a sign that leveraged speculation has run amok. There's too much voting, which increasingly drives finance into the political TV talking heads frame of mind-which is as endless as that Mobius strip- and not enough weighing, due, in large part, to increased opportunities to leverage, as Soros noted.

One trend whose premise is false is that increased leverage has made the world's financial system more stable. Leverage tends to increase the importance of short term price fluctuations, and gets people increasingly involved in the endless feedback loop.  The amplitude of the boom-bust cycle increases when leverage is increased.  If financial market stability is a goal of public policy, reducing the amount of leverage seems a wise first step.


STS said...

I've been following Soros' lectures as well. Of course, I've read several of his books and pretty much know the story already. I'm just a bit of a Soros groupie.

Watching Soros, I see a fresh incarnation of David Ricardo -- the stock-jobber with a taste for culture who tries somewhat inarticulately to explain what he knows about markets that others just don't get. Reading Ricardo, I found myself thinking "for God's sake, get yourself a book on differential equations and try writing this damn thing in a year or two". (That may be somewhat anachronistic advice -- I'm not certain what the state of ODE was in Ricardo's day.) Only with Soros, I want him to learn some other math more along the lines of mean field theory (and associated phenomena like long-range correlations and phase transitions). He's trying to write about the emergent behaviors of systems with interacting parts without any sufficiently precise language. Of course his auditors wouldn't be any the wiser if he *did* write in such language. He would just wind up in Doyne Farmer's position.

I realize of course that Soros isn't *only* trying and failing to express mathematical models. (In fact, he may even incline to the view that all mathematical models are useless, which is a little overly pessimistic.) He wants to emphasize the philosophical issues, perhaps especially because they can apply in other deeper spheres than 'mere' finance. But that pulls him towards Hegelian clouds of philosophy where a drop of (mathematical) grammar would serve far better.

The reason Soros' fairly obvious insights get ignored is a combination of (roughly) two things: a) self-interest points people towards the comforting, tautological just-so stories of EMH which always have the same moral: "do exactly what profits you and feel REALLY, really good about it", and b) total lack of mathematical traction on the big empty theoretical space Soros has spent his entire writing career stubbornly pointing at.

People use models because they are precise enough to convey specific meanings. That's incredibly useful in building a vocabulary that allows people to (at least pretend) to communicate. The fact that people tend to be shallow and confuse models with reality is disagreeable, but unavoidable. Better to have a map which literal minded people mistake for reality than to have no map.

Another way of stating these two problems is: a) people have a conflict of interest in trying to understand (eg. Upton Sinclair), but also b) they just plain don't know what he's talking about (eg. H.L. Mencken).

Fortunately, his money may eventually finance expositors capable of getting his ideas into a form people can apply -- and misapply. That's what it takes for ideas to have influence in the world.