Sunday, July 31, 2016

Soros: General Theory of Reflexivity
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 participant’s views and the actual course of events. But what about a two-way connection between the participants’ views? And what about a 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 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.
To avoid that trap let me propose the following terminology. Let us distinguish between the objective and subjective aspects of reality. Thinking constitutes the subjective aspect, events the objective aspect. In other words, the subjective aspect covers what takes place in the minds of the participants, the objective aspect denotes what takes place in external reality. There is 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 between them. Exceptionally it may even occur with 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. Marriage is a reflexive relationship; the Crash of 2008 was a reflexive event. When reality has no subjective aspect, there can be no reflexivity.
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Feedback loops can be either negative or positive. Negative feedback brings the participants’ views and the actual situation closer together; positive feedback drives them further apart. In other words, a negative feedback process is self-correcting. It can go on forever 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 is supposed to happen in financial markets. So equilibrium, which is the central case in economics, turns out to be an extreme case of negative feedback, a limiting case in my conceptual framework.
By contrast, a positive feedback process is self-reinforcing. It cannot 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 is 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 in motion 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 found in other spheres. There, I call them fertile fallacies—interpretations of reality that are distorted, yet produce results which reinforce the distortion.