George Soros Speech on Reflexivity at INET Conference (4/9/2010)

INETeconomics (Youtube)
On April 9, 2010, George Soros gave a speech (Anatomy of a Crisis: The Living History of the Last 30 years) at an Institute for New Economic Thinking (INET) conference at King's College in Cambridge, UK. He explained his theory of reflexivity and how it relates to economic behavior and financial markets. Below I provided quotes from the speech transcript. Watch the full video after the jump courtesy of INET.

Rational expectations and the Efficient Market Hypothesis failed:

"Anyhow, rational expectations theory was pretty conclusively falsified by the crash of 2008 which caught most participants and most regulators unawares. The crash of 2008 also falsified the Efficient Market Hypothesis because it was generated by internal developments within the financial markets, not by external shocks, as the hypothesis postulates.

The failure of these theories brings the entire edifice of economic theory into question. Can economic phenomena be predicted by universally valid laws? I contend that they can’t be, because the phenomena studied have a fundamentally different structure from natural phenomena."

Theory of Reflexivity:

"In human affairs thinking serves two functions: a cognitive one and a causal one. The two functions interfere with each other: the independent variable of one function is the dependent variable of the other. And when the two functions operate simultaneously, neither function has a truly independent variable. I call this interference reflexivity.

Reflexivity introduces an element of uncertainty both into the participants’ understanding and into the situation in which they participate. It renders the situation unpredictable by timelessly valid laws. Such laws exist, of course, but they don’t determine the course of events.

Economic theory jumped through many hoops trying to eliminate this element of uncertainty. It started out with the assumption of perfect knowledge. But as Frank Knight showed in his book, “Risk, Uncertainty, and Profit” published in 1921, in conditions of perfect knowledge there would be no room for profits.

The assumption of perfect knowledge was replaced by the assumption of perfect information. When that proved insufficient to explain how financial markets anticipate the future, economists developed the theory of rational expectations. That is when economic theory parted company with reality." (