Soros sees 'reflexivity' theory of economics as life's work

WASHINGTON -- For most people, being known as a fabulously wealthy investor, prominent global philanthropist and outspoken critic of the current occupant of the White House would constitute sufficient acclaim.

But George Soros, now in his eighth decade and enjoying a personal fortune estimated at $9 billion, yearns to be seen as something other than a financial oracle or Democratic Party sugar daddy. The Hungarian émigré, who built a worldwide reputation by out-thinking markets, desperately wants to be acknowledged as a philosopher.

His bid for such recognition — in a new book published last week — lies in a theory called "reflexivity," which Soros argues should supplant conventional economic thought that's based on coolly calculating rational actors. Soros, 77, who first read philosophy as a teenager during World War II, has promoted the concept for more than 20 years with little success.

But hailing reflexivity as his "life's work," Soros now says the current financial crisis offers an opportunity for him to garner wider acceptance. "I'm actually hopeful this time I'll break through," he says.

It'll be an uphill fight. Critics of reflexivity, especially among the economists Soros disparages, have been brutal. A reviewer of one of his earlier books savaged his "windy amateur philosophy" and attacked him for being unfamiliar with basic economics.

"It is difficult to conceive of a more mistaken understanding of the profession's research in the last 10-15 years. … The great danger of the (earlier) book is that non-economists will take seriously his ill-founded criticism of economic research," wrote economist Christopher Neely of the Federal Reserve Bank of St. Louis.

In his latest work, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, Soros traces a straight line between today's financial turmoil and what he says are fatally flawed conventional assumptions about how markets behave. If banks, investors and regulators had embraced reflexivity years ago, there never would have been a financial crisis, Soros insists.

Here's why: Since the days of Adam Smith, economists have taught that markets sort out issues of supply and demand by settling at a point of equilibrium. Prices may temporarily deviate from that balanced state, but eventually, they return to it.

Classic free market theory holds that everyone in an economy acts rationally, based on complete information while seeking to maximize their individual welfare or profits.

Of course, real life never matches up exactly with the theory's assumptions. But they represent, economists say, a useful way of making sense of a complex world.

To Soros, the conventional approach is rubbish. Instead of a world of near-identical actors, coolly assessing their economic interests and acting with clear-eyed precision, he sees a world (and markets) governed by passion, bias and self-reinforcing errors. Because fallible human beings are both involved in, and trying to make sense of, this world, they inevitably make mistakes. Those mistakes then feed on themselves in "reflexive" ways that, when taken to extremes, result in situations such as the now-deflating U.S. housing bubble.

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."

Soros retired from full-time investing in 2000 and concentrated on philanthropy through a network of non-profit organizations he had established in the 1980s and his Open Society Institute. Together, the groups distribute $400 million to $500 million each year to "civil society" projects in more than 50 countries, such as election monitoring in Tajikistan and a network of community libraries in Haiti. Soros also has emerged as a major financial contributor to the Democratic Party and harsh critic of President Bush and the "war on terror."

The financier's political views have made him the bête noire of many in the conservative movement. Fox News commentator Bill O'Reilly, for example, has criticized Soros for seeking to impose a "radical left agenda" on the USA, while conservative websites such as freerepublic.com routinely assail him as "anti-American."

The credit crunch that erupted last year prompted Soros to return to investing, to protect his portfolio from the gathering financial catastrophe. Several months later, Soros says the U.S. has weathered the "acute phase" of the markets crisis. "But the impact on the real economy is yet to be felt," he says.

Soros makes no bones about his judgment that the current financial crisis is the "worst since the 1930s." He sees the subprime mortgage debacle as the signal event that unhinged both this decade's housing bubble and a 25-year-long "super-bubble" that originated in the debt-laden policies of the Reagan administration.

But despite Soros' apocalyptic rhetoric, the Dow is hovering near 13,000 and unemployment is a relatively low 5%. Soros explains the disconnect with the tale of the man who falls off the Empire State building and thinks to himself halfway down: "So far, so good."

"That's where we are right now," Soros laughs.

Still, for anyone who's listened to some of the gloomier economic prophets, such as economist Nouriel Roubini or The Trillion-Dollar Meltdown author Charles Morris, Soros' analysis of the financial crisis itself is unremarkable. Like others, he blames a failure of regulators, including Alan Greenspan's Federal Reserve, to keep a tight enough rein on Wall Street. He anticipates further sharp declines in housing prices and says, when pressed, that Americans ultimately won't escape this episode without suffering a noticeable decline in their standard of living.

"I'm afraid that will be the case, and it will be hard to take," he says. "And it will be politically unpalatable, and it will probably give rise to all kinds of populist political appeals (for) a way out that will also be very dangerous."

The Federal Reserve's aggressive efforts to pump cash into the banking system and the government's $168 billion economic stimulus, which began sending taxpayers checks this month, will be insufficient to stir a recovery, he says. Talk — from Bush administration officials and Wall Street optimists — of an economic recovery later this year "is totally without foundation," he says.

Even as clean-up continues on the housing bubble's aftermath, new bubbles are forming in commodities markets and perhaps China, he says. Soros acknowledges that his crystal ball is "cloudy" on the Asian giant, but predicts that the country faces serious domestic inflation and export weakness if the U.S. downturn spreads abroad. "China is not immune to the worldwide dislocation that started here," he says.

What Soros sees as the market economy's inherent tendency to lurch from bubble to bubble and excess to excess makes it all the more essential that those at the economy's helm embrace reflexivity, he says. Reflexivity cannot provide firm predictions about the future, only a better understanding of the past and an awareness of all that could go wrong, he says. Regulators and market participants alike will need to accept a much greater amount of uncertainty — as Soros says he has.

"Being aware of reflexivity, I am often overwhelmed," he says. "Genuinely, I am actually overwhelmed by the uncertainties. And I'm constantly on the watch being aware of my own misconceptions, being aware that I'm acting on misconceptions and constantly looking to correct them."