The New Paradigm for Financial Markets by George Soros

Author:George Soros
Language: eng
Format: mobi, epub, pdf
Publisher: PublicAffairs
Published: 2008-02-09T21:00:00+00:00

MARKETS VERSUS REGULATORS

Because financial markets do not tend towards equilibrium they cannot be left to their own devices. Periodic crises bring forth regulatory reforms. That is how central banking and the regulation of financial markets have evolved. While boom-bust sequences occur only intermittently, the reflexive interplay between financial markets and the financial authorities is an ongoing process. The important thing to realize is that both market participants and financial authorities act on the basis of imperfect understanding; that is what makes the interaction between them reflexive.

Misunderstandings by either side usually stay within reasonable bounds because market prices provide useful information which allows both sides to recognize and correct their mistakes, but occasionally mistakes prove to be self-validating, setting in motion vicious or virtuous circles. Such circles resemble boom-bust processes in the sense that they are initially self-reinforcing but eventually self-defeating. Vicious and virtuous circles are few and far between, while reflexive interactions go on all the time. Reflexivity is a universal condition, while bubbles constitute a special case.

The distinguishing feature of reflexive processes is that they contain an element of uncertainty or indeterminacy. That uncertainty ensures that the behavior of financial markets is not determined by universally valid generalizations but follows a unique, irreversible path. Within that one-directional process we may distinguish between humdrum, everyday events, which are repetitive and lend themselves pretty well to statistical generalizations, and unique, historical events whose outcome is genuinely uncertain. Bubbles and other vicious or virtuous circles belong to the latter category. It should be realized, however, that reflexive, circular relationships do not necessarily generate historically significant processes. Those which are self-defeating to start with disappear without trace. Others are aborted along the way. Relatively few reach far-from-equilibrium territory. Moreover no process takes place in total isolation. Usually there are several reflexive processes going on at the same time, interfering with each other and producing irregular shapes. Regular patterns arise only on those rare occasions when a particular process is so powerful that it overshadows all the others. Perhaps I did not make this point sufficiently clear in The Alchemy of Finance.

THE FLAW IN EQUILIBRIUM THEORY

Equilibrium theory is not without merit. It provides a model with which reality can be compared. When I speak of far-from-equilibrium conditions I am also using the concept of equilibrium.* And economists have made many valiant attempts to adjust their models to take account of reality. So-called second-generation business cycle models have sought to analyze boom-bust situations. I cannot judge their validity,

*This could be easily misunderstood. Indeed it was misunderstood by one of my correspondents; hence this footnote. When I speak of far-from-equilibrium conditions, I am using "equilibrium" as a figure of speech. I do not mean to imply that there is a stable equilibrium from which a boom-bust process occasionally deviates. I think of equilibrium as a moving target because market prices can affect the fundamentals they are supposed to reflect.

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