The New Paradigm for Financial Markets: The Credit Crisis Of 2008 and What It Means Hardcover – May 5 2008
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"The London Times" "They're wrong about oil, by George: In short, the standard economic assumption that supply and demand drive prices is only a starting point for understanding financial markets. In boom-bust cycles, the textbook theory is not just slightly inaccurate but totally wrong. This is the main argument made by George Soros in his fascinating book on the credit crunch, "The New Paradigm for Financial Markets," launched at an LSE lecture last night."
About the Author
George Soros is chairman of Soros Fund Management and is the founder of a global network of foundations dedicated to supporting open societies. He is the author of several best-selling books including 'The Bubble of American Supremacy', 'Underwriting Democracy', and 'The Age of Fallibility'. He was born in Budapest and lives in New York City.
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Top Customer Reviews
un outil de référence pour choisir la façon la plus adéquate de s'introduire au domaine de l'économie
Very insightful, at times not easy to digest but overall gives a coherent picture of what was to happen in anticipation (and finally did) which is true testament to a genius in his field.
We should all learn from such wise men.
Most Helpful Customer Reviews on Amazon.com (beta)
Theories abound on why this turmoil is occurring, one of these being discussed in this book, which is written by one of most well-known financial speculators of all time. The tone of the book is general and philosophical, and the author refrains from indulging in mathematical considerations, but there are many concepts in the book that are interesting and merit further investigation. The author's intellectual honesty is refreshing, in that he admits the job he has taken on is a formidable one. Describing the workings of the financial markets is challenging, and has occupied the time of countless researchers and financial analysts.
The author wants to get rid of the "market equilibrium" paradigm in traditional economics and replace it with one that he has called "reflexivity". This concept is similar to a few that have been discussed in recent months, one holding that investor analysis and modeling activities actually serve to change the markets, rather than just "mirror" them. The author's idea is that humans have both a cognitive function and a "manipulative" one when they approach the financial markets. This has the implication that social phenomena cannot be described or studied in the same way as natural phenomena. They are separate areas of study, he argues, and he attempts to justify their separation on the pages of this very short book.
His analysis is interesting and provocative, and certainly worthy of attention, but to put it on a firm quantitative foundation would require a large amount of work. The theory of reflexivity is not the only proposal to be put forward that differs from the classical one. There have been many in recent years due to the increasing importance of financial engineering, the latter of which has been applied on a massive scale. But the author proposed this theory almost two decades ago, when derivatives trading and financial modeling were beginning to ramp up. He therefore foresaw the need for alternative points of view when dealing with financial instruments and market activities that cannot be captured by the classical paradigm.
The book is part autobiographical and could probably be better appreciated if the reader was familiar with the author's earlier works. But anyone interested in making sense out of the current news reports will find an interesting read here, even though at times the author's political affiliation comes out a bit heavy-handed. In addition, his attitude about free markets and "laissez faire" is somewhat puzzling since a purely "laissez faire" economy has not been realized historically. Any arguments against its efficacy are therefore misplaced. Those who still believe in "laissez faire" may therefore object strongly to many of the author's assertions and his recommendations at the end of the book for fixing the current "credit crisis." Whatever your world view though it is perhaps fair to say that the increasing complexity of the financial markets demands new ideas and approaches.If anything a good understanding of financial dynamics is a matter of survival. The financial markets of the twenty-first century take no prisoners.
I won't bash the book, exactly, but it was pretty rambling, pretty repetitive, and spent a considerably longer time trying to defend/explain his theory of "reflectivity" and bashing Republican politics than discussing the credit crisis. Still it offered some useful points and observations. It's personal account of worlwide historical financial events that Mr. Soros himself not only lived through but participated in as well as a concise account of the events that comprise the subprime mortgage meltdown were themselves worth, in my view, the price of admission.
In the end, though, the central theme of the book, it's overarching structure, is Mr. Soro's longstanding theorem about "reflectivity" in financial markets. He maintains that both the factual "reality" and the participants' resort to emotional facilities as a result of imperfect informational access interact with each other in a kind of feedback loop. As a result of this "reflectivity" serious degrees of uncertainty are injected into the marketplace that are not predicted by "classical" economic theories of "rationality" or "equilibrium". This, he says, invalidates market models based on those classic concepts. What to do about that, of course, he's not quite so clear about, except, perhaps, you should vote Democratic (his advice, not mine).
Unfortunately by his own analysis, this theorem is unsatisfactory as anything other than a cautionary alarm bell. By it's own definition and assertion it is untestable and (in the terms of one of Mr. Soros's own favorite philosophers, Karl Popper) incapable of falsification. Since it's prime tenent is that it's unpredictable and not even of consistent relevance in any given situation, it is roughly akin to the statement of Cretan philosopher, Epimenides, (quoted by Soros himself) that "all Cretans always lie". If, claiming unpredictablility, "reflectivity" yields accurate predictions, it is false.
Nassim Nicholas Taleb has called these same kind of events as said to be caused by "reflectivity" black swans. Inductive reasoning in financial markets has led to some frightening financial meltdowns. Having seen only white swans (even in their hundred thousands) and therefore betting the ranch there ARE only white ones is a sound foundation for disaster. Mr. Taleb helpfully also points out that somewhere downunder there are, in fact, black swans.
Benoit Mandelbrot has suggested that his fractile geometry, rather than bell curves, is a better financial model and, in fact, perhaps allows for better predictability. Don't know about that. The intersection between regulators and markets that Mr. Soros rather convincingly argues must be, at least in part, responsible for the subprime mortgage meltdown, doesn't strike me as a geometric intersection, fractile or otherwise. And besides, Herr Doktor Mandelbrot's math is WAY beyond my (or I'd postulate any other non genius math brain's) comprehension.
For me though, the persuasiveness of Mr. Soros's point about unpredictablity and odd shaped (non bell) curves can be found in the seminal work of William James, who demonstrated 100 years ago what every good salesman has always known (at least by instinct, if not overtly): that human beings ACT on feelings and use their intellectual reasoning to rationalize the result. I would accept, a priori, that no single individual actor in today's complex financial markets in our globally interwoven world can possibly know all the relevant facts about any one proposed action therein. Thus he must have imperfect information. And even as among the myriad of facts he does "know", he will use his experience, his intuition based on it and on the recounted experiences of those he has learned to trust, to value those various factual inputs.
I would submit (and I don't think Mr. Soros would raise too strenous an objection) that gernerally speaking, in a broad enough marketplace, all those individual "emotional" decisions ought to cancel each other out to a degree that would render them indistinguishable for practical purposes from randomness. Perhaps not perfect bell curves (some fat tails and modified kurtosis), but within acceptable (and perhaps hedgeable) limits.
But humans are also herd animals (we, however, call them tribes), and that instinct is a survival trait and still strong. One need only contemplate the blowing of a single car horn on a gridlocked highway that is inevitably followed in nanoseconds by hundreds more, to understand it's continued pervasive presence. When that happens in financial affairs, when smart guys get afraid of being left behind the "easy" money, when they can't stand the other tribe harvesting all that golden fleese or bear the thought of some young ambitious upstart taking over their hard won desk by merely following sombody else's playbook (what have you done for me lately says the boss), then homework vanishes. Smart guy follows smart guy in a kind of stampede. Risk of loss no longer matters or is outweighed by the risk of being stranded alone. Each of us (no I'm not a trader, but empathy demands the collective pronoun) falls all over ourselves to steal candy from the blind confectioner, never mind that we know that the poison pill is there in one of those jars on one of those shelves. It won't happen to me, we say. I'm too smart, I'll see it coming, I'll get away. This time it'll be different. We rationalize the emotional decision to chase after the leaders, to blow our horn, too.
This is far too long, let me try to wind up. In this crisis surely whole truckloads of the "smartest guys in the room" demonstrated levels of greed, arrogance, and impaired judgment that, despite being all too human (to borrow a phrase from Nietzsche, who seems particularly apt in this context) are still, in retrospect, shocking. Still, "free markets" provide efficiencies and multiplicities of choice that cannot be duplicated (or even approached) by any central planner or micromanaging regulator. But when these herd markets fail as spectacularly as they have here, the individualist free marketer along with the "reflectivist" (if I may be so bold as to lable Mr. Soros) are both left wanting a better way, a better regulatory system, for keeping these rampaging smart guys from trampling in their passing our own hard won little (in my case) or not so little (in Mr. Soros's) net eggs. This is a thoughtful book. Even just trying to "deconstruct" it may lead you down interesting thoughtways.
The existing paradigm, often referred to as free-market fundamentalism, holds that markets are self-correcting, that they naturally tend toward equilibrium. Economists as far back as Adam Smith have argued against regulation or government intervention of any kind since it would interfere with the natural forces of the market.
Soros correctly argues the contrary. In fact government intervention has repeatedly saved the market. A few examples are the bankruptcy of Continental Illinois in 1984, or the failure of Long Term Capital Management in 1998, or the current bolstering of Fannie Mae and Freddie Mac (my example). The notion that the market deviates from an orderly path is the rule rather than the exception.
The new paradigm that is needed, according to Soros, must incorporate the theory of reflexity. Developed in previous works by himself and his mentor Karl Popper, reflexivity examines the relationship between thinking and reality, between the cognitive function and the manipulative function. In the investment world, this means that when investors are bullish on, say, housing or mortgage backed securities their values go up, not because they become intrinsically more valuable, but because everyone else is thinking they are more valuable. This is basically old-fashioned market psychology dressed-up in theory. The mechanism that allows the market to go up is self-reinforcing but ultimately self-defeating. The market goes from euphoria to despair overshooting the top, and ultimately the bottom too. Witness today's housing market.
We are currently experiencing the consequences of unregulated credit markets and Soros argues that if more is not done the crisis could get much worse. He points out that moneterist doctrine in inadequate. Controlling the money supply is only half of the picture. The internet bubble, the housing bubble, and the current commodities bubble were created through excessive use of leverage. The amount of debt currently outstanding is unprecedented. Any new financial regulations will need to temper the use of credit to avoid future bubbles.
Soros argues that the US must come to grips with the new realities if it is to maintain its preeminent position in the world. If we are not careful the dollar will lose its standing as the reserve currency of choice. The task of regulating credit will now became even more precarious since the credit market is already tightening. Soros, as a former hedge fund manager, realizes that credit is the lifeblood of capitalism and any overregulation will also damage the economy. Reflexivity theory aside, this book is an excellent discussion of the challenges we are facing today.
Had the editor done her job I think this book would have deflated into a paper which presented little to nothing new.
Save your money and I summarize the one valuable nugget to be mined from this book: It's impossible to predict financial markets using scientific statistical based theories (as all financial experts try to do) because those theories are part of what you're trying to predict. (i.e. they are reflexive in that they refer to themselves.) Thus financial markets are inherently unpredictable.
Other authors, I have Taleb's "The Black Swan" in mind here, have covered this same territory much deeper. But I don't want to discount Soros' modest contributions here. Soros gives examples that, at least for financial markets, are more intuitive then Taleb's. For example, you can't necessarily base financial decisions on "fundamentals" because if you are in a credit bubble, like we were previous to 2008, you have essentially ghost earnings and earnings growth. Thus there is no way (at least in the short term, I haven't entirely discounted Shiller's P/E10) to tell what the value of a company is worth.
Unfortunately Soros' takes 50 to 75 pages to say what I just said in two paragraphs because, to be blunt, he doesn't really understand his own "theory." Lacking any clarity for his vague ideas, he slogs along giving example after example and quoting philosopher after philosopher. Worse yet, he misunderstands the implications of his own "theory" in dangerous ways.
Soros' Misunderstandings of His Own "Theory"
For example, Soros insists that one implication of Reflexivity is that we need to regulate markets more. But if we actually follow Reflexivity to its logical end (which Soros never does) this isn't necessarily the case.
Reflexivity, if true, actually suggests that regulation is as likely to cause problems as fix them because regulation is also a manipulative function. A free markets proponent (which I am not) will notice this gap in reason immediately and, I'd imagine, claim that actually it's a bit of regulation known as the Fed that created the bubble in the first place and that if we just let markets to themselves we'd avoid superbubbles altogether. My point here is not that this is true (I have no idea and no one else does either) but that Soros never even anticipates this obvious objection nor notices that both explanations are equally suggested by Reflexivity. (Or in other words, Reflexivity suggests and denies neither course of action.)
Likewise, consider this gem (check your irony detector here) of a statement from the book: "In large part the excesses in the financial markets are due to the regulators' failure to exercise proper control. Some of the newly introduced financial instruments and methods were based on false premises."
But wait! How did Soros, our "Theory of Reflexivity" guru, miss the fact that Reflexivity states you can't know the underlying premises of the market with certainty? In other words, Reflexivity predicts that regulators can't know which financial instruments are based on false premises until after they bust. Then it's obvious. (Or maybe not even then.) So please tell me how to logically reconcile those two sentences above. They are meaningless from a Reflexivity word view.
Then Soros goes on to insist that Reflexivity predicts that it's not true markets naturally seek equilibrium. Huh? Why would reflexivity say something as ridiculous as that? If markets don't seek equilibrium (which they do) we could boom forever so who is worried? But our bust is proof that markets do indeed naturally seek equilibrium.
What Reflexivity actually suggests is that it may take decades before a market seeks natural equilibrium, long enough for us to forget what equilibrium actually looked like and mistake a bubble for equilibrium, complete with seeming "fundamentals" changes to back up the illusion. Thus (Soros gets this part right) markets are not a random walk from equilibrium, they boom and bust all over the place and over long periods of time. (Shiller likens this to microphone feedback that lasts for decades.)
While this is scary, it's not the same as what Soros insists upon and it's not clear at all what regulations could fix the problem, if at all, nor how Reflexivity helps us pick good regulation to avoid future problems. After all, the Bush administration actually had more regulation than any previous administration (Sarbanes Oxley anyone?) but the super bubble still happened. We don't need more regulation per se, we need regulations that forsee what's going to go wrong next. In other words we need regulators with ESP so that they can regulate *before* the market Reflexivly seeks a new way to boom falsely in some currently unregulated area.
Soros Makes No Meaningful Recommendations
Soros' final chapter on policy recommendations literally starts with an excuse for why he isn't going to make any recommendations, so it seems Soros himself realizes Reflexivity doesn't help us out with policy making. He makes a single good recommendation in that chapter: We should admit that large companies will always be bailed out by the government if their size will take down the system, so we tax them differently.
Conclusion - Reflexivity Isn't a Theory at All
Which brings me to my real problem with the book: the "theory of reflexivity" isn't a theory at all, it's only a *theory spoiler*. To use an analogy, if Soros were living at the time of the black plague he just (correctly) discovered that putting leaches on your body doesn't actually cure the plague. So he's replacement theory is to NOT put leaches on your body. It's correct but has no practical value, at least not by itself.
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