George Soros Lecture Series: General Theory of Reflexivity

good afternoon and welcome to the ceu lectures i'm john shattuck president and director of central european university it's my great privilege to introduce this special series of five lectures by george soros held here in budapest at the hungarian academy of sciences under the auspices of central european university in these lectures george soros will draw upon a lifetime of practical and philosophical reflection and share his latest thinking on economics and politics today mr soros will present the fundamentals of his philosophical theory each lecture will be video conferenced to one of five universities on four continents creating

an unprecedented interactive international audience of students in real time today's lecture will include students from the london school of economics in addition to the invited guests and central european university students who are here at the academy our moderator today is the distinguished philosopher colin mcginn renowned for his work in the philosophy of mind mr soros will lecture for approximately 50 minutes and mr mcginn will offer a brief response mr soros will then take questions from the audience starting with three questions from the london school of economics and then from our audience here in budapest i'm

now delighted to present george soros who truly needs no introduction thank you very much and thank you for all for coming and both here and in london in the course of of my life i've developed a conceptual framework which has helped me both in make money making money as a hedge fund manager and in spending it as a policy oriented philanthropist but the framework itself is not about money it's about the relationship between thinking and reality a subject that is extensively studied by philosophers from early on i started developing my philosophy as a student at

the london school of economics in the late 1950s i took my final exams one year early and i had a year to fill before i was qualified to receive my degree i could choose my own tutor and i chose karl popper who whose book the open society and its enemies had made a profound impression on me in his books popper argued that the empirical truth can't be known with absolute certainty even scientific laws can't be verified beyond the shadow of a doubt they can only be falsified by testing one fair test is enough to to

falsify but no amount of confirming instances is sufficient to verify scientific laws are hypothetical in character and their truth remains subject to testing ideologies which claim to be in possession of the ultimate truth are making a false claim therefore they can be imposed on society only by force this applies to communism fascism and national socialism alike all these ideologies lead to repression papa proposed a more attractive form of social organization a society an open society in which people are free to hold diverse divergent opinions and the rule of law allows people with different views and

different interests to live together in peace having lived through both nazi and communist occupation here in hungary i found the idea of an open society immensely attractive while i was reading popper i was also studying economic theory and i was struck by the contradiction between papa's emphasis on imperfect understanding and the theory of perfect competition in economics which postulated perfect knowledge this led me to start questioning the assumptions of economic theory these were the two major inspirations of my philosophy it's also deeply rooted in my personal history the formative the formative experience of my life

was the german occupation of hungary in 1944 i was not yet 14 years old at the time coming from a reasonably well to do middle class background suddenly confronted with the prospect of being deported and killed just because i was jewish fortunately my father was well prepared for this far from equilibrium experience he had lived through the russian revolution and that was diplomatic experience of his life until then he had been an ambitious young man when the first world war broke out he volunteered to serve in the austro-hungarian army he was captured by the russians

and taken as a prisoner of war to siberia being ambitious he became the editor of a newspaper produced by the prisoners it was hand written and displayed on a plank and it was called the plank this made him so popular that he was elected the prisoner's representative then some soldiers escaped from a neighboring camp and their prisoners representative was shot in retaliation my father is instead of waiting for the same thing to happen in his camp organized a breakout his plan was to build a raft and sail down to the ocean but his knowledge of

geography was somewhat deficient he didn't realize that all the rivers in siberia flow into the arctic they drifted for several weeks before their they realized that they were heading for the arctic and it took them several more months to make their way back to civilization across the tiger in the meantime the russian revolution broke out and they became caught up in it only after a variety of adventures did my father manage to find his way back to hungary had he remained in the camp he would have arrived home much sooner my father came home a

changed man his experiences during the russian revolution profoundly profoundly affected him he lost his ambition and wanted nothing more from life than to enjoy it he imparted to his children values that were very different from those of the milieu in which we lived he had no desire to amass wealth or become socially prominent on the contrary he worked only as much as was necessary to make ends meet i remember being sent to his main client to borrow some money before we went on a skiing holiday my father was grouchy for months afterwards because he had

to work to pay it back although we were reasonably prosperous we were not the typical bourgeois family and we were proud of being different in 1944 when the germans occupied hungary my father immediately realized that these were not normal times and the normal rules didn't apply he arranged false identities for his family and the number number of other people those who could paid others he held for free most of them survived that was his finest hour living with false identity turned out to be an exhilarating experience for me too we were in mortal danger people

perished all around us but we managed not only to survive but to help other people we were on the side of the angels and we triumphed against overwhelming odds this made me feel very special it was high adventure i had a reliable guide in my father and came through unscathed what more could a 14 year old ask for after the euphoric experience of escaping the nazis life in hungary started to lose its luster during the soviet occupation i was looking for new challenges and with the help of my father i found my way out of

hungary when i was 17 i became a student in london in my studies my primary interest was to gain a better understanding of the strange world into which i had been born but i have to confess i i also harbored some fantasies of become becoming an important philosopher i believed that i had gained insights that set me apart from other people living in london was a bit was a big letdown i was without money alone and people were not interested in what i had to say but i didn't abandon my philosophical ambitions even when circumstances

forced me to make a living in more mundane pursuits after completing my studies i had a number of false starts finally i ended up as an arbitrage trader in new york but in my free time i continued to work on my philosophy that's how i came to write my first major essay entitled the burden of consciousness it was an attempt to model a purpose framework of open and close societies it linked organic society with a traditional mode of thinking close society with a dogmatic mode and uh and open society with a critical mode what i

could not properly resolve was the nature of the relationship between the mode of thinking and the actual state of affairs that problem continued to preoccupy me and that's how i came to develop the concept of reflexivity a concept i shall explore in greater detail a little later it so happened that the concept of reflexivity provided me with a new way of looking at financial markets a better way than the prevailing theory this gave me an edge first as a securities analyst and then as a hedge fund manager i felt as if i were in possession

of a major discovery that would enable me to fulfill my fantasy of becoming an important philosopher at a certain moment when my business career ran into a roadblock i shifted gears and devoted all my energies to developing my theory but i treasured my discovery so much that i couldn't part with it i felt that the concept of reflexivity needed to be explored in great depth as i delved deeper and deeper into the subject i got lost in the intricacies of my own constructions one morning i couldn't understand what i had written the night before at

that point i decided to abandon my philosophical explorations and to focus on making money it was only many years later after a successful run as a hedge fund manager that returned to my philosophy i published my first uh first essay the the the alchemy of finance in 1987. in that book i tried to explain the philosophical underpinnings of my approach to financial markets the book attracted a certain amount of attention it has been read by by most people in the hedge fund industry and it is thought in business schools but the philosophical arguments didn't make

much of an impression they were largely dismissed as the conceit of a man who has been successful in business and fancied himself as a philosopher i myself came to doubt whether i was in possession of a major new insight after all i was dealing with a subject that has been explored by philosophers since time immemorial what grounds did i have for thinking that i had made a new discovery especially as nobody else seems to think so undoubtedly the conceptual framework was useful to me personally but it didn't seem to be equally value considered equally valuable

by others i had to accept that judgment i didn't give up my philosophical interests but i came to regret them as a personal predilection i continued to be guided by my conceptual framework both in my business and in my philanthropic activities which came to assume an increasingly important role in my life and each time i wrote a book i faithfully recited my arguments this helped me to develop my conceptual framework but i can consider continued to consider myself a failed philosopher once i even gave a lecture with the with the title a failed philosopher tried

twice again all this has changed as a result of the financial crisis of 2008. my conceptual framework enabled me both to anticipate the crisis and to deal with it when it finally struck it has also enabled me to explain and predict events better than most others this has changed my own evaluation and that of many others my philosophy is no longer a personal matter it deserves to be taken seriously as a possible contribution to our understanding of reality and that is what has prompted me to give this series of lectures so here it goes today

i shall explain the concept of ref of fallibility and reflexivity in general terms tomorrow i shall apply them to the financial markets and after that to politics that will also bring in the concept of open society in the fourth lecture i shall explore the difference between market values and moral values and in the fifth i shall give some predictions and prescriptions for the present moment in history i can state the core idea in two relatively simple propositions one is that the situation that has thinking participants the participants view of the world is always partial and

distorted that's the principle of fallibility the other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions that's the principle of reflexivity for instance treating drug addicts as criminals creates criminal behavior it misconstrues the problem and interferes with the proper treatment of addicts as another example declaring that government is bad tends to make for bad government both fallibility and reflexivity are sheer common sense so when my critics say that i am merely stating the obvious they are right up to a point what makes my propositions

interesting is that their significance significance has not been generally appreciated the concept of reflexivity in particular has been studiously avoided and even denied by economic theory so my conceptual framework deserves to be taken seriously not because it constitutes a new discovery but because something as commonsensical as reflexivity has been so studiously ignored recognizing reflexivity has been sacrificed to the vain pursuit of certainty in human affairs mostly most notably in economics and yet uncertainty is the key feature of human affairs economic theory is built on the concept of equilibrium and that concept is in direct contradiction

with the concept of reflexivity as i shall try to show in the next lecture the two concepts yield to two entirely different interpretations of financial markets the concept of fallibility is far less controversial it's generally recognized that the complexity of the world in which we live exceeds our capacity to comprehend it i have no great new insights to offer the main source of difficulty is that participants are part of the situation they have to deal with confronted by a reality of extreme complexity we are obliged to resort to various methods of simplification generalizations dichotomies metaphors

decision rules moral precepts to mention just a few these mental constructs take on an existence of their own further complicated complicating the situation the structure of the brain is another source of distortions recent advances in brain science have begun to provide some insight into how the brain functions and they have substantiated hume's contention that reason is the slave of passion the idea of a disembodied intellect or reason is a figment of our imagination the being the brain is bombarded by millions of sensory impulses but consciousness can only process only seven or eight subjects concurrently the

impulses need to be condensed ordered and interpreted under events time pressure and mistakes and distortions can't be avoided brain science adds many new details to my original contention that our understanding of the world in which we live is inherently imperfect the concept of reflexivity needs a little more explanation it applies exclusively to situations that have thinking participants the participants thinking serves two functions one is to understand the world in which we live i call this the cognitive function the other is to change the situation to our advantage i call this the part the manipulating or

participating function the two functions connect thinking and reality in opposite directions in the cognitive function reality is supposed to determine at the participants views the direction of causation is from the world to the mind by contrast in the manipulative function the direction of causation is from the mind to the world that is to say the intentions of the participants have an effect on the world when both functions operate at the same time they can interfere with each other how by depriving each function of the independent variable that would be needed to determine the value of

the dependent variable because when the independent variable of one function is the dependent variable of the other neither function has a genuinely independent variable this means that the cognitive function can't produce enough knowledge to serve as the basis of the participants decisions similarly the manipulative function can can have an effect on the outcome but can't determine it in other words the outcome is liable to diverge from the participants intentions there is bound to be some slippage between intentions and actions and further slippage between actions and outcomes as a result there is an element of uncertainty

both in our understanding of reality and in the actual course of in events to understand the uncertainties associated with reflexivity we need to probe a little further if the cognitive function operated in isolation without any interference from the manipulative function it could produce knowledge knowledge is represented by two statements a statement is true if it corresponds to the facts that's what the correspondence theory of truth tells us but if there is interference from the the manipulative function the facts no longer serve as an independent criterion by which the truth of a statement can be judged

because the correspondence may have been brought about by the statement changing the facts consider the statement it's raining that statement is true or false depending on whether it is in fact raining now consider the statement this is a revolutionary moment that statement is reflexive and this truth value depends on the impact it makes reflexive statements have some affinity with the paradox of the liar which is a self-referential statement but while self-reference has been extensively analyzed reflexivity has received much less attention that's strange because reflexivity has an impact on the real world while self-reference is purely

a linguistic phenomenon in the real world the participants thinking finds expression not only in statements but also in various forms of action and behavior that makes reflexivity a very broad phenomenon that typically takes the form of feedback loops the participants views influence the course of events and the course of events influences the participants views the influence is continuous and circular that's what makes that's what turns it into a feedback loop reflexive feedback loops have not been rigorously analyzed and when i originally encountered them and tried to analyze them i ran into various complications the feedback

loop is supposed to be a two-way connection between the participants views and the actual course of events but what about a two-way connection between the participants views and what about the solitary individual asking himself who he is and what he stands for and changing his behavior as a result of his reflections in trying to resolve these difficulties i got so long lost among the categories i created that one morning i couldn't understand what i had written the night before that's when i gave up philosophy and devoted my efforts to making money so to avoid that

trap let me propose the following the terminology let's distinguish between the objective and subjective aspects of reality thinking constitutes the subjective aspect events the objective in other words the subjective aspect covers what takes place in the minds of the participants the objective aspect denotes what takes place in this in external reality there's only one external reality but many different subjective views reflexivity can then connect any two or more aspects of reality setting up two-way feedback loops exceptionally it may even occur within a single aspect of reality as in the case of a solitary individual reflecting

on his own identity this may be described as self reflexivity we may then distinguish between two broad categories reflexive relationships which connect the subjective aspects and reflexive events which involve the objective aspect as well marriage is a reflexive relationship the crash of 2008 was a reflexive event when reality has no subjective aspect there can be no reflexivity feedback pollutes can be either negative or positive negative feedback it brings the participants views and the actual situation closer together positive feedback drives them further apart in other words negative feedback is self-correcting it can go on forever if

and if there are no significant changes in external reality it may eventually lead to an equilibrium where the participants views come to correspond to the actual state of affairs that is what's supposed to happen in financial markets so equilibrium which is the central case in economics turns out to be a limiting case in my conceptual framework by contrast a positive feedback process is self-reinforcing it can't go on forever because eventually the participants views would become so far removed from objective reality that the participants would have to recognize them as unrealistic nor can the iterative process

occur without any change in the actual state of affairs because it's in the nature of positive feedback that it reinforces whatever tendency prevails in the real world instead of equilibrium we are faced with a dynamic disequilibrium or what may be described as far from equilibrium conditions usually in far from equilibrium situations the divergence between perceptions and reality leads to a climax which sets emotion a positive feedback process in the opposite direction such initially self-reinforcing but eventually self-defeating boom bust processes or bubbles are characteristic of financial markets but they can also be observed in other spheres

there i call them fertile fallacies interpretations of reality that are distorted yet produce results which reinforce the distortion i realize that this is all very abstract and difficult to follow it would be it would make it much easier if i gave some concrete examples but you'll have to bear with me i want to make a different point and the fact that it's so difficult to follow abstract arguments helps me to make it in dealing with subjects like reality or thinking or the relationship between thinking and reality it's easy to get confused and formulate problems the

wrong way so misinterpretations and misconceptions can play a very important role in your role in human affairs the recent financial crisis can be attributed to a mistaken interpretation of how financial markets work i shall discuss that in the next lecture in the third lecture i shall discuss two fertile fallacies the enlightenment fallacy and the postmodern fallacy these concrete examples will demonstrate how important misconceptions have been in the course of history but for the rest of this lecture i shall stay at the lofty heights of abstraction i contend that situations that have thinking participants have a

different structure from natural phenomena the different difference lies in the role of thinking in a natural phenomena thinking plays no causal role and serves only a cognitive function in human affairs thinking is part of the subject matter and serves both a cognitive and a manipulative function the two functions can interfere with each other the interference doesn't occur all the time in everyday activities like driving a car or painting a house the two functions actually complement each other but when it occurs it introduces an element of uncertainty which is absent from natural phenomena the uncertainty manifests

itself in both functions the participants act on the basis of imperfect understanding and the results of their actions will not correspond to their expectations i call that the human uncertainty principle and i consider it a key feature of human affairs by contrast in the case of natural phenomena events unfold irrespective of the views held by the observers the outside observer is engaged only in the cognitive function and the phenomena provide a reliable criterion by which the truth of the observer's theories can be judged so the outside observer can obtain knowledge based on that knowledge nature

can be successfully manipulated there is a natural separation between the cognitive and manipulative function and due to that separation both functions can serve their purpose better than in the human sphere at this point i need to emphasize that reflexivity is not the only source of uncertainty in human affairs yes reflexivity does introduce an element of uncertainty both into the participants views and the actual course of events but other factors may also have the same effect for instance the fact that participants can't know what the other participants know is something quite different from reflexivity yet it's

a source of uncertainty the fact that different participants have different interests some of which may be in conflict with each other is another source of uncertainty moreover each individual participant may be guided by a multiplicity of values which may not be self-consistent as isaiah berlin has pointed out the uncertainties created by these factors are likely to be even more extensive than those generated by reflexivity i have lumped them all together and and when i speak of the human uncertainty principle which is an even broader concept than reflexivity the human uncertainty principle i'm talking about is

much more specific and stringent than the subjective skepticism that pervades cartesian philosophy it gives an uh an objective reason to believe that our perceptions and expectations are or at least maybe wrong although the primary impact of human uncertainty falls under participants it has far-reaching implications for the social sciences i can explicate them best by invoking karl power's theory of scientific method it's a beautifully simple and elegant scheme it consists of three elements and three operations the three elements are scientific laws and the initial and final conditions to which those laws apply the three operations are

prediction explanation and testing when the scientific laws are combined with the initial conditions they provide predictions when they are combined with the final conditions they provide explanations in this sense predictions and explanations are symmetrical and reversible that leaves testing where predictions derived from scientific laws are compared with the actual results according to popper scientific laws are hypothetical in character they can't be verified they can only be falsified by testing the key to the success of scientific method is that it can test generalizations of universal validity with the help of singular observations one failed test is

sufficient sufficient to falsify a theory but no amount of confirming instances is sufficient to verify this is a brilliant solution to the otherwise intractable problem how can science be both empirical and rational according to popper it's empirical because we test our theories by observing whether the the predictions we derive from them are true and it's rational because we use deductive logic in doing so papa dispenses with inductive logic and relies instead on testing generalizations that can't be tested do not qualify as scientific papers emphasis on the central role of testing plays a very important role

in scientific method and establishes a strong case for critical thinking but by asserting that scientific laws are only provisionally valid and remain open to re-examination thus the three salient features of papa's scheme are the symmetry between prediction and explanation the asymmetry between verification and falsification and the central role of testing testing allows science to grow improve and innovate proper scheme works well for the study of natural phenomena but the human uncertainty principle throws a monkey range into the supreme simplicity and elegance of papa's scheme the symmetry mat at the symmetry between predictions and explanations is

destroyed because of the element of uncertainty in predictions and the central role of testing is endangered should the initial and final conditions include or exclude the participants thinking the question is important because testing requires replicating those conditions if the participants thinking is included it's difficult to observe what the initial and final conditions are because the participants views can only be inferred from their statements or actions if it's excluded the initial and final conclusions don't constitute singular observations because the same objective conditions may be associated with very different views held by the participants in either case

generalizations can't be properly tested these difficulties don't preclude social scientists from producing worthwhile generalizations but they are unlikely to meet the requirements of proper scheme nor can they match the predictive power of the laws of physics scientific social scientists have found this this conclusion hard to accept economists in particular suffer from what sigmund freud might call physics envy and there have been many attempts to eliminate the difficulties connected with the human uncertainty principle by in inventing or postulating some kind of fixed relationship between the participants thinking and the actual state of affairs karl marx asserted

that the ideological superstructure was determined by the material conditions of production and freud maintained that people's behavior was determined determined by drives and complexes of which they were not even aware both claimed scientific status for their theories although as popper pointed out they can't be falsified by testing but by far the most impressive attempt has been mounted by economic theory it started out by assuming perfect knowledge and when that assumption turned out to be unsustainable it went through an increasing contortions to maintain the fiction of rational behavior economics ended up with the theory of rational

expectations which maintains that there is a single optimum view of the future that which corresponds to it and eventually all the market participants will converge around that view this postulate is absurd but it is needed in order to allow economic theory to model itself on newtonian physics interestingly both karl popper and friedrich hire recognized in their famous exchange in the pages of economica that the social sciences can't produce results compared comparable to physics hayek invade against the mechanical and uncritical application of the quantitative methods of natural science he called it scientism and carl proper wrote

about the poverty of historicism where he argued that history is not determined by universally valid scientific laws nevertheless popper proclaimed what he called the doctrine of the unity of method by which he meant that both natural and social sciences should be judged by the same criteria and hayek of course became the apostle of the chicago school of economics where market fundamentalism was born but as i see it the implication of the human uncertainty principle is that the subject matter of the natural and social sciences is fundamentally different therefore they need to develop different methods and

they have to be held to different standards economic theory should not be expected to produce universally valid laws that can be used reversally to explain and predict historic events i contend that the slavish imitation of natural science inevitably leads to the distortion of human and social phenomena what is attainable in social science falls short of what is attainable in in in physics i am somewhat troubled however about drawing a sharp distinction between the naturals and social sciences such dichotomies are usually not found in reality they are introduced by us in our efforts to make some

sense out of an otherwise confusing reality indeed while a sharp distinction between physics and social sciences seems justified there are other sciences such as biology than the study of animal societies that occupy intermediate position but i had to abandon my reservations and recognize a dichotomy because the social sciences encounter a second difficulty from which the natural sciences are exempt and that is that social theories are reflexive heisenberg's discovery of the uncertainty principle didn't alter the behavior of of quantum particles one iota but social theories whether marxism market fundamentalism or the theory of reflexivity can affect

the subject matter to which it refers scientific method is supposed to be devoted to the pursuit of truth heisenberg's uncertainty principle does not interfere with that postulate but the reflexivity of social theories does why should social science science confine itself to passively studying social phenomena when it can be used to actively change the state of affairs as i remarked in the alchemy of finance our the the alchemy of finance the alchemists made a mistake in trying to change the nature of base metals by incantation instead they should have focused their attention on the financial markets

where they could have succeeded how how could how could social science be protected against this interference i proposed a simple remedy recognize a dichotomy between the natural and social sciences this will ensure that social theories will be judged on their merits and not by a false analogy with natural science i propose this as a convention for the protection of scientific method not as a demotion or devaluation of social science the convention sets no limits on what social science may be able to accomplish on the contrary by liberating social science for the from the slavish imitation

of natural science and protecting it from being judged by the wrong standards it should open up new vistas it's in this spirit that i shall put forward my interpretation of financial markets tomorrow i apologize for dwelling so long in the rarified realm of abstractions i promise to come down to earth in my next lecture tomorrow thank you you