ABSTRACT
In his previous writings, Soros laid out the elements of his theory of reflexivity, which I will illustrate here with reference to financial markets. He advances three general theses: expectations affect actual values, actual values can affect fundamentals, and expectations in turn are influenced by the behavior of actuals and fundamentals. On the first proposition, a general expectation that a stock’s price will rise will tend to raise its market price (Soros, 2009, pp. 3-5, 8, 10, 66-71, 73). The second proposition, which is ‘the crux of the theory of reflexivity’, is ‘that market prices can influence the fundamentals’ (Soros, 2009, p. 59). The first two propositions therefore imply that expectations affect both ‘market prices . . . [and] the fundamentals they are supposed to reflect’ (Soros, 2009, pp. 66-71, footnote p. 73). The third proposition is that expectations are in turn influenced by both actual and fundamental prices. This proposition is stated less directly than the other two, but is nonetheless implicit in Soros’ statements. For instance, he says that the ‘change in fundamentals may then reinforce the biased expectations in an initially self-reinforcing but eventually self-defeating process’ (Soros, 2009, p. 59, emphasis added). One may say that as actual values pull away from fundamentals, the growing distance between the two undermines the confidence that the boom will continue. Path dependence is a natural consequence of this theory, which means that social systems are non-ergodic. Market events ‘are best interpreted as a form of history. The past is uniquely determined, the future is uncertain’ (Soros, 2009, p. 106). Hence, ‘financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it’ – even to the extent of affecting the fundamentals which they are supposed to reflect (Soros, 1994).
