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A New Essay from George Soros - Fallibility, Reflexivity and the Human Uncertainty Principle

January 21, 2014 | About:
Canadian Value

Canadian Value

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I am honored that the editors of the Journal of Economic Methodology have created this special issue on the subject of reflexivity and have invited me, as well as a distinguished group of scholars, to contribute.

Of course I did not discover reflexivity. Earlier observers recognized it, or at least aspects of it, often under a different name. Knight (1921) explored the difference between risk and uncertainty. Keynes (1936, Chapter 12) compared financial markets to a beauty contest where the participants had to guess who would be the most popular choice. The sociologist Merton (1949) wrote about self-fulfilling prophecies, unintended consequences, and the bandwagon effect. Popper spoke of the ‘Oedipus effect’ in the Poverty of Historicism (1957, Chapter 5).

My own conceptual framework has its origins in my time as a student at the London School of Economics in the late 1950s. I took my final exams one year early, so I had a year to fill before I was qualified to receive my degree. I could choose my tutor, and I chose Popper whose book TheOpen Society and Its Enemies (1945) had made a profound impression on me.

In Popper's other great work Logik der Forschung (1935), which was published in English as The Logic of Scientific Discovery (1959), he argued that the empirical truth cannot be known with absolute certainty. Even scientific laws cannot be verified beyond a shadow of a doubt: they can only be falsified by testing. One failed test is enough to falsify, but no amount of conforming instances is sufficient to verify. Scientific laws are always hypothetical in character, and their validity remains open to falsification.

While I was reading Popper I was also studying economic theory, and I was struck by the contradiction between Popper's emphasis on imperfect understanding and the theory of perfect competition in economics, which postulated perfect knowledge. This led me to start questioning the assumptions of economic theory. I replaced the postulates of rational expectations and efficient markets with my own principles of fallibility and reflexivity.

After college, I started working in the financial markets where I had not much use for the economic theories I had studied in college. Strangely enough, the conceptual framework I had developed under Popper's influence provided me with much more valuable insights. And while I was engaged in making money I did not lose my interest in philosophy.

I published my first book, The Alchemy of Finance, in 1987. In that book, I tried to explain the philosophical underpinnings of my approach to financial markets. The book attracted a certain amount of attention. It has been read by many people in the hedge fund industry, and it is taught in business schools. But the philosophical arguments in that book and subsequent books (Soros, 19982000) did not make much of an impression on the economics departments of universities. My framework was largely dismissed as the conceit of a man who has been successful in business and therefore fancies himself as a philosopher. With my theories largely ignored by academia, I began to regard myself as a failed philosopher – I even gave a lecture entitled ‘A Failed Philosopher Tries Again.’

All that changed as a result of the financial crisis of 2008. My understanding of reflexivity enabled me both to anticipate the crisis and to deal with it when it finally struck (Soros, 2008, 2009). When the fallout of the crisis spread from the USA to Europe and around the world it enabled me to explain and predict events better than most others (Soros, 2012). The crisis put in stark relief the failings of orthodox economic theory (Soros, 2010). As people have realized how badly traditional economics has failed, interest in reflexivity has grown.

Thus, this issue of the Journal of Economic Methodology is timely. Economics is in a period of intellectual flux and while some economists will cling to ideas of market efficiency and rationality to their final days, many others are eager to pursue alternative approaches.

In this essay, I will articulate my current thinking. In Section 2, I shall explain the concepts of fallibility and reflexivity in general terms. In Section 3, I will discuss the implications of my conceptual framework for the social sciences in general and for economics in particular. In Section 4, I will describe how my conceptual framework applies to the financial markets with special mention of financial bubbles and the ongoing euro crisis. I will then conclude with some thoughts on the need for a new paradigm in social science.

Fallibility and reflexivity

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I have a peculiar problem in explicating my conceptual framework. The framework deals with the relationship between thinking and reality, but the participants' thinking is part of the reality that they have to think about, which makes the relationship circular. Circles have no beginning or end, so I have to plunge in at an arbitrary point. That makes my ideas less clear when I put them into words than they are in my own mind. I am not the only one affected by this difficulty but I feel obliged to warn the reader that this section will be more convoluted and less elegant than it ought to be; the rest of the paper is not affected.

My conceptual framework is built on two relatively simple propositions. The first is that in situations that have thinking participants, the participants' views of the world never perfectly correspond to the actual state of affairs. People can gain knowledge of individual facts, but when it comes to formulating theories or forming an overall view, their perspective is bound to be either biased or inconsistent or both. That is the principle of fallibility.

The second proposition is that these imperfect views can influence the situation to which they relate through the actions of the participants. For example, if investors believe that markets are efficient then that belief will change the way they invest, which in turn will change the nature of the markets in which they are participating (though not necessarily making them more efficient). That is the principle of reflexivity.

The two principles are tied together like Siamese twins, but fallibility is the firstborn: without fallibility there would be no reflexivity. Both principles can be observed operating in the real world. So when my critics say that I am merely stating the obvious, they are right – but only up to a point. What makes my propositions interesting is that they contradict some of the basic tenets of economic theory. My conceptual framework deserves attention not because it constitutes a new discovery, but because something as commonsensical as reflexivity has been so studiously ignored by economists. The field of economics has gone to great lengths to eliminate the uncertainty associated with reflexivity in order to formulate universally valid laws similar to Newtonian physics. In doing so, economists set themselves an impossible task. The uncertainty associated with fallibility and reflexivity is inherent in the human condition. To make this point, I lump together the two concepts as the human uncertainty principle.

Fallibility

The complexity of the world in which we live exceeds our capacity to comprehend it. Confronted by a reality of extreme complexity, we are obliged to resort to various methods of simplification: generalizations, dichotomies, metaphors, decision rules, and moral precepts, just to mention a few. These mental constructs take on a (subjective) existence of their own, further complicating the situation.

The structure of the brain is another source of fallibility. Recent advances in brain science have begun to provide some insight into how the brain functions, and they have substantiated David Hume's insight that reason is the slave of passion. The idea of a disembodied intellect or reason is a figment of our imagination. The brain is bombarded by millions of sensory impulses, but consciousness can process only seven or eight subjects concurrently. The impulses need to be condensed, ordered, and interpreted under immense time pressure; mistakes and distortions cannot be avoided. Brain science adds many new insights to my contention that our understanding of the world in which we live is inherently imperfect.

Fallibility pervades our attempts to understand both natural and social phenomena, but it is not fallibility that distinguishes the social from the physical sciences. Rather, as will be discussed further in Section 3, the distinction comes from the fact that in social systems fallible human beings are not merely scientific observers but also active participants in the system themselves. That is what makes social systems reflexive.

Reflexivity

The concept of reflexivity needs some further explication. It applies exclusively to situations that have thinking participants. The participants' thinking serves two functions. One is to understand the world in which we live; I call this the cognitive function. The other is to make an impact on the world and to advance the participants' interests; I call this the manipulative function. I use the term ‘manipulative’ to emphasize intentionality.

The two functions connect the participants' thinking (subjective reality) and the actual state of affairs (objective reality) in opposite directions. In the cognitive function, the participant is cast in the role of a passive observer: the direction of causation is from the world to the mind. In the manipulative function, the participants play an active role: the direction of causation is from the mind to the world. Both functions are subject to fallibility.

When both the cognitive and manipulative functions operate at the same time they may interfere with each other. How? By depriving each function of the independent variable that would be needed to determine the value of the dependent variable. The independent variable of one function is the dependent variable of the other, thus neither function has a genuinely independent variable – the relationship is circular or recursive. It is like a partnership where each partner's view of the other influences their behavior and vice-versa.

Lack of an independent criterion of truth

If the cognitive function operated in isolation, without any interference from the manipulative function, it could produce knowledge. Knowledge is represented by true statements. A statement is true if it corresponds to the facts – that is what the correspondence theory of truth tells us. But if there is interference from the manipulative function, the facts no longer serve as an independent criterion because the statement may be the product of the manipulative function.

Consider the statement ‘It is raining.’ That statement is true or false depending on whether it is, in fact, raining. And whether people believe it is raining or not cannot change the facts. The agent can assess the statement without any interference from the manipulative function and thus gain knowledge.

Now consider the statement ‘I love you.’ The statement is reflexive. It will have an effect on the object of the affections of the person making the statement and the recipient's response may then affect the feelings of the person making the statement, changing the truth value of his or her original statement.

Self-reference

Reflexivity has some affinity with the Liar's Paradox, which is a self-referential statement. ‘This sentence is false’ is paradoxical. If the sentence is true, it means it is false, but if it is false, it means it is true. Bertrand Russell resolved the paradox by putting self-referential statements into a separate category and declaring them to be meaningless.

Following Russell, an important school of philosophy, logical positivism, banned self-referential statements. Ludwig Wittgenstein carried this program to its logical conclusion in his Tractatus Logico-Philosophicus and in the end he concluded that he had embarked on an impossible task. In practice, it is impossible to avoid either self-referential or reflexive statements. Consequently, the cognitive function cannot produce all the knowledge agents need to make decisions; they have to act on the basis of imperfect understanding. While the manipulative function can make an impact on the world, outcomes are unlikely to correspond to expectations. There is bound to be some slippage between intentions and actions, and further slippage between actions and outcomes. Since agents base their decisions on inadequate knowledge, their actions are liable to have unintended consequences. This means that reflexivity introduces an element of uncertainty both into the agents’ view of the world and into the world in which they participate.

While self-reference has been extensively analyzed by the Vienna school with which Popper was associated, reflexivity has received much less attention. This is strange because reflexivity has an impact on the real world, while self-reference is confined to the universe of statements. In the real world, the participants’ thinking finds expression not only in statements but also, of course, in various forms of action and behavior. That makes reflexivity a much broader phenomenon than self-reference: it connects the universe of thoughts with the universe of events. Bertrand Russell analyzed the Liar’s Paradox in a timeless fashion. But reflexive systems are dynamic and unfold over time as the cognitive and manipulative functions perpetually chase each other. Once time is introduced, reflexivity creates indeterminacy and uncertainty rather than paradox.

Reflexive feedback loops between the cognitive and manipulative functions connect the realms of beliefs and events. The participants’ views influence but do not determine the course of events, and the course of events influences but does not determine the participants’ views. The influence is continuous and circular; that is what turns it into a feedback loop. As both the cognitive and manipulative functions are subject to fallibility, uncertainty is introduced into both the realms of beliefs and events. The process may be initiated from either direction, from a change in views, or from a change in circumstances.

Objective and subjective aspects of reality

Reflexive feedback loops have not been rigorously analyzed and when I originally encountered them and tried to study them, I ran into various difficulties. The main source of the trouble was that thinking is part of reality and the relationship of a part to the whole is very difficult to describe. The fact that thinking is not directly observable adds further complications; consequently, the definition of reflexivity will be much more complicated than the concept itself. The idea is that there is a two-way feedback loop connecting thinking and reality. The main feedback is between the participants’ views and the actual course of events. But what about a direct two-way interaction between the various participants’ views? And what about a solitary individual asking herself who she is and what she stands for and changing her behavior as a result of her own internal reflections?

To resolve these difficulties, I propose distinguishing between the objective and subjective aspects of reality. Thinking constitutes the subjective aspect. It takes place in the privacy of the participants’ minds and is not directly observable; only its material manifestations are. The objective aspect consists of observable events. In other words, the subjective aspect covers the participants’ thinking and the objective aspect denotes all observable facts, whether in the outside world or inside the brain.

Free will versus determinism

There is only one objective reality, but there are as many different subjective views as there are thinking participants. The views can be divided into different groups such as doubters and believers, trend followers and contrarians, Cartesians and empiricists – but these are simplifications and the categories are not fixed. Agents may hold views that are not easily categorized; moreover, they are free to choose between categories and they are free to switch. This is what is usually meant by free will but I consider free will a misnomer. People’s views are greatly influenced but not determined by external factors such as the views of others, heredity, upbringing, and prior experiences. So, reality is halfway between free will and determinism.

Reflexivity can connect any two or more aspects of reality, setting up two-way feedback loops between them. We may then distinguish between two kinds of reflexivity: reflexive relations, like marriage or politics, which connect the subjective aspects of reality, and reflexive events, like the fiscal cliff or the euro crisis, which connect the subjective and objective aspects. In exceptional cases, reflexivity may even occur within a single subjective aspect of reality, as in the case of a solitary individual reflecting on his own identity. This may be described as self-reflexivity.

When reality has no subjective aspect, there can be no reflexivity. In other words, the presence or absence of reflexivity serves as a criterion of demarcation between social and natural phenomena – a point I will discuss in detail in the next section.

Let me illustrate the difficulties in analyzing the relationship between thinking and reality with the help of a diagram. Figure 1 describes the roles of the cognitive and manipulative functions, fallibility, and intentionality. Together this might be thought of as a reflexive system.


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Figure 1 A reflexive system.


 

I have indicated the presence of multiple participants, and therefore multiple subjective realities. Nevertheless, the diagram is inadequate because it would require three dimensions to show the multiple participants interacting with each other as well as with the objective aspect of reality.

Continue reading: http://www.tandfonline.com/doi/full/10.1080/1350178X.2013.859415

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Canadian Value
http://valueinvestorcanada.blogspot.com/

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