Standard economic theory is flawed, Soros says, because it treats markets populated by thinking human beings as if they operated according to the natural laws that govern atoms and molecules. Economists say Soros badly exaggerates the limitations of standard theory and ignores subsequent refinements. But if conventional economics teaches that markets are always (eventually) right, Soros insists they are always wrong.
What does this have to do with house prices in Las Vegas or credit availability in Tampa? Plenty. Only people who were overly confident about how markets operate could have come up with the innovative financial instruments — such as collateralized debt obligations (CDOs) — that ultimately proved so toxic. The banks that developed and sold these products did so comforted by arcane mathematical models that ostensibly demonstrated how these securities would behave under various scenarios.
The only problem was that when the crunch hit, the securities didn't behave the way the models said they should. That came as a surprise to the bankers responsible for the models. Soros said it wouldn't have come as a surprise to anyone who believed in reflexivity.
"They would not have designed these CDOs, for instance, or CDOs squared. They would not have engaged in trading strategies that assumed that markets, that deviations are random. They would change the amount of leverage that they use, the amount that they are willing to borrow, because of the element of uncertainty," he said in an hour-long interview last week.
So far, so good?
Soros received a harsh lesson in uncertainty, false truths and the vagaries of human behavior at an early age. He was a teenager when Nazi soldiers occupied his native Hungary in March 1944. Within less than two months, more than 440,000 Hungarian Jews were deported, many to Auschwitz.
The Soros family was among the one-third of Hungary's Jewish population who survived the Holocaust, thanks to Soros' father, Tivadar, who arranged false identities for his family.
"My life, my sort of formative experience, was the Nazi occupation, you know, when (I was) 14 years old. They would have exterminated me," Soros says quietly. "And everything grew out of that. I always tried to understand reality — and that's been my passion."
By February 1945, advancing Russian soldiers had replaced the Germans, bringing a new totalitarian ideology just as certain of ultimate truth as the National Socialist ideology it supplanted. As conditions deteriorated under the postwar Soviet occupation, Soros eventually emigrated to London. He studied at the London School of Economics, got a foothold in finance, and moved to the USA in 1956.
In 1970, he started the Quantum fund, a hedge fund that returned better than 42% per year for a decade. The explanation for that outsize success, Soros says, is reflexivity.
"You have got to make decisions even though you know you may be wrong," he says. "You can't avoid being wrong, but by being aware of the uncertainties, you're more likely to correct your mistakes than the traditional investor."