CHAPTER 6
My Conceptual Framework
(This is a condensed version of an article published in the Journal of Economic Methodology on January 13, 2014.)
SECTION 1: INTRODUCTION
Reflexivity, the idea central to my conceptual framework, was not discovered by me. Earlier observers recognized it—or, at least, aspects of it—often under a different name. Frank Knight (1921) explored the difference between risk and uncertainty. John Maynard Keynes (1936, chap. 12) compared financial markets to a beauty contest, where the participants had to guess who would be the most popular choice. The sociologist Robert Merton (1949) wrote about self-fulfilling prophecies, unintended consequences, and the bandwagon effect. Karl Popper spoke of the “Oedipus effect” in the Poverty of Historicism (1957, chap. 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 The Open Society and Its Enemies (1945) had made a profound impression on me.
In Popper’s other great work, The Logic of Scientific Discovery (1935/1959), 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 most people in the hedge fund industry, and it is taught in business schools. But the philosophical arguments in that book and subsequent books (Soros 1998, 2000) 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 at the University of Vienna in 1995 entitled “A Failed Philosopher Tries Again.” Inspired by the height of the cathedral, I decreed the “doctrine of fallibility.”
All that changed as a result of the financial crash 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 United States 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 realized how badly traditional economics has failed, interest in reflexivity grew.
In this essay, I will articulate my current thinking. In Section 2, I will 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 attention to financial bubbles and the ongoing euro crisis. I will then conclude with some thoughts on the need for a new paradigm in social science.
SECTION 2: FALLIBILITY, REFLEXIVITY, AND THE HUMAN UNCERTAINTY PRINCIPLE
My conceptual framework is built on two relatively simple propositions. The first I call the principle of fallibility. In situations that have thinking participants, their 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.
The second proposition is what I call the principle of reflexivity. The imperfect views that people hold can influence or change the state of affairs through their actions. For example, if investors believe that markets are efficient, then that belief will change the way they invest, which in turn will change the behavior of the markets in which they are participating.
The two principles are tied together like Siamese twins, but fallibility is the firstborn: without fallibility, there could 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.
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.
Reflexivity
The concept of reflexivity 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—which I refer to as subjective reality—and the actual state of affairs—which can be described as 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 functions are at work at the same time, they affect both subjective and objective reality. Because of fallibility, the outcome rarely corresponds to the agents’ intentions.
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. But if the manipulative function is at work, the facts no longer serve as an independent criterion of truth.
Consider the statement “It is raining.” That statement is true or false depending on whether it is, in fact, raining. 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 affection, and the recipient’s response may then affect the feelings of the person making the statement, changing the truth value of the statement. Since the response comes later than the original statement, reflexivity often leads to feedback loops.
The feedback loop connects the realms of beliefs and events. Since both the cognitive and manipulative functions are subject to fallibility, the uncertainty associated with reflexivity is introduced into both realms. The process may be initiated from either direction, from a change in views or from a change in circumstances.
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 are free to switch.
In extreme cases, the process may occur within a solitary individual—for example, a person asking herself who she is and what she stands for, which leads her to take actions, which in turn affect her perceptions of her identity. This might be called self-reflexivity.
Reflexive Systems
Let me illustrate the complex relationship between thinking and reality with the help of a diagram. Figure 1 describes the roles of the cognitive and manipulative functions, fallibility, reflexivity, and intentionality. Together this might be thought of as 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.
The Human Uncertainty Principle
The economist Frank Knight (1921) introduced an important distinction between risk and uncertainty. Risk is when there are multiple possible future states and the probabilities of those different future states occurring are known. Risk is well defined by the laws of probability and statistics. Knightian uncertainty occurs when the probabilities of future states or even the nature of possible future states is not known.
Fallibility is a key source of Knightian uncertainty in human affairs, but it is by no means the only one. For instance, different participants have different goals, some of which may be in conflict with each other. Moreover, as Isaiah Berlin pointed out, each participant may be guided by a multiplicity of values that may not be self-consistent. The uncertainties created by these factors are more extensive than those specifically associated with reflexivity.