This Disequilibrium Baloon Filled With Hot, Group Think Air
"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. For instance, treating drug addicts as criminals creates criminal behavior. It misconstrues the problem and interferes with the proper treatment of addicts. As another example, declaring that government is bad tends to make for bad government.
Both fallibility and reflexivity are sheer common sense. 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 their significance has not been generally appreciated. The concept of reflexivity, in particular, has been studiously avoided and even denied by economic theory. So my conceptual framework deserves to be taken seriously-not because it constitutes a new discovery but because something as commonsensical as reflexivity has been so studiously ignored.
Recognizing reflexivity has been sacrificed to the vain pursuit of certainty in human affairs, most notably in economics, and yet, uncertainty is the key feature of human affairs. Economic theory is built on the concept of equilibrium, and that concept is in direct contradiction with the concept of reflexivity. As I shall show in the next lecture, the two concepts yield two entirely different interpretations of financial markets.
The concept of fallibility is far less controversial. It is generally recognized that the complexity of the world in which we live exceeds our capacity to comprehend it. I have no great new insights to offer. The main source of difficulties is that participants are part of the situation they have to deal with. Confronted by a reality of extreme complexity we are obliged to resort to various methods of simplification-generalizations, dichotomies, metaphors, decision-rules, moral precepts, to mention just a few. These mental constructs take on an existence of their own, further complicating the situation.
The structure of the brain is another source of distortions. Recent advances in brain science have begun to provide some insight into how the brain functions, and they have substantiated Hume's contention 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, and mistakes and distortions can't be avoided.
Brain science adds many new details to my original contention that our understanding of the world in which we live is inherently imperfect."
--George Soros, "General Theory of Reflexivity," Financial Times
"Group stink" is multiplying -- in the canyons of Wall Street where so many investors and traders worship at the altar of price momentum; in the coding of machines and their algorithms; in the leveraged and unleveraged market ETFs that have garnered so much popularity; and in the herd-like opinions of commentators and the legions of talking heads who parade their views daily in our business media platforms.
Group stink has gotten so pervasive that it now can be seen as the ultimate form of George Soros' reflexivity theory, which attempts to link the nature of relationship between the mode of thinking with actual events.
It was through the study of Viennese-born Karl Popper's "The Open Society and Its Enemies" that enabled Soros to explain and predict events better than most. And it was that theory and framework that allowed Soros to anticipate the 2008-2009 crisis and deal with it when it finally struck.
In "The Alchemy of Finance," Soros' seminal book, he observes that the view of the world by market participants is always partial and distorted. This group stink is incorporated in his principle of fallibility and the distorted views (e.g., bullishness) that can influence our decisions and lead to inappropriate actions; it is the core principle of reflexivity:
"It is generally recognized that the complexity of the world in which we live exceeds our capacity to comprehend it. I have no great new insights to offer. The main source of difficulties is that participants are part of the situation they have to deal with. Confronted by a reality of extreme complexity we are obliged to resort to various methods of simplification-generalizations, dichotomies, metaphors, decision-rules, moral precepts, to mention just a few. These mental constructs take on an existence of their own, further complicating the situation."
Closed society and group stink tends to be dogmatic; open society has a more critical tone.
Group stink is a reflexive feedback loop. It is a vain pursuit of certainty, often falsified by testing or the idea of a new paradigm in valuation. In our markets it has led to a state of uber and almost perma-bullishness over the last few years as the irrational may have been rationalized in a world of fake news. To use Soros' terms, they might claim to be in possession of the truth, but they may be making a false claim.
The bullish feedback loop has become self-reinforcing, but it cannot go on forever because eventually the participants' views will become so far removed from objective reality that the participants ultimately will need to recognize them as unrealistic.
Today's machine- and algo-aided dynamic disequilibrium or fertile fallacies, whereby the interpretation of reality is distorted, have had what Soros calls a manipulative function and a positive feedback loop that has produced market results that have reinforced those distortions.
Market participants' perceptions and reality progressively may have produced a far-from-equilibrium condition, leading to a climax early yesterday afternoon and a move that shortly will be going in the opposite direction in a self-correcting negative feedback process that brings the market back down and closer to a reflection of the reality I see in the real economy.
As George Soros wrote in "The Alchemy of Finance":
"The alchemists made a mistake in trying to change the nature of base metals by incantation. Instead, they should have focused their attention on the financial markets where they could have succeeded."