Thursday, March 5, 2009

Can the perceptions of participants influence market fundamentals?

“Reflexivity can be interpreted as a circularity, or two way feedback loop, between the participants’ views and the actual state of affairs. People base their decisions not on the actual situation that confronts them but on their perception or interpretation of that situation. Their decisions make an impact on the situation ... and changes in the situation are liable to change their perceptions ... . The two functions operate concurrently, not sequentially” (George Soros, “The New Paradigm for Financial Markets”, 2008, p 10).

“Many critics of reflexivity claimed that I was merely belabouring the obvious, namely that the participants’ biased expectations influence market prices. But the crux of the theory of reflexivity is not so obvious; it asserts that market prices can influence the fundamentals. The illusion that markets are always right is caused by their ability to affect the fundamentals that they are supposed to reflect. The change in the fundamentals may then reinforce the biased expectations in an initially self-reinforcing but eventually self-defeating process” (Soros, op cit, p 57-8).

Does George Soros know what he is talking about? The fact that he has operated successfully in financial markets for a long time suggests to me that he might have a few clues about how they work. But I struggle to understand him.

As is the case with many other problems of understanding, I think my problem in this instance relates to definition of terms. What does Soros mean by fundamentals? If a process is eventually self-defeating then it seems to me that this means that it is inconsistent with the fundamentals of the real world – i.e. it is inconsistent with what we know to be true about such things as resource availability, technology or human nature.

When Soros suggests that market prices can influence the fundamentals he may have something less fundamental in mind such as widely accepted perceptions of investors and credit providers about particular markets or the wider economic situation. It seems plausible that a widespread view that housing was a very safe investment, for example, could be reinforced if house prices began to increase more rapidly and if credit providers perceived that this made lending more secure. Under some circumstances that might, perhaps, result in a self-reinforcing process of increases in house prices that would eventually become self-defeating, for example because increasing numbers of people might decide that they would be better off renting rather than owning a house.

If this is what Soros means by reflexivity, does it help to explain the current financial turmoil? In explaining his super-bubble hypothesis Soros writes:

“The belief that markets tend toward equilibrium is directly responsible for the current turmoil; it encouraged the regulators to ... rely on the market mechanism to correct its own excesses. The idea that prices, although they may take random walks, tend to revert to the mean served as the guiding principle for the synthetic financial instruments and investment practices which are currently unravelling” (Soros, op cit, p 102).

It seems to me that the second part of that statement, relating to synthetic financial instruments, may help to explain the current financial turmoil. With the benefit of hindsight it is apparent that the world economy is suffering from, among other things, the development of a self-reinforcing belief system which led many financial firms to over-value synthetic financial instruments.

However, the first part of Soros’ statement doesn’t make sense. Regulators have not relied on the market mechanism to correct its own excesses. The current turmoil is partly a consequence of a history of financial firms being bailed out by regulators on the grounds that they were too big to be allowed to fail. George Soros is on much firmer ground when he recognises that most reflexive processes involve an interplay between market participants and regulators (p77).

Hopefully, the regulatory environment that emerges from the current turmoil will recognise that participants in financial markets are human. It should not surprise anyone that when financiers are given incentives to behave imprudently they tend to act accordingly.

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