A successful prophet of the markets

By John Authers

Published: May 19 2008

This was a book that George Soros badly wanted to write. It is probably
not what many of its readers expect to read. But it shows that in his
deeper thinking about the way markets operate, Soros was several decades
ahead of his time.

The New Paradigm for Financial Markets includes Soros' verdict on the
credit crisis. He thinks, as has been widely reported, that it is the
most severe since the 1930s, and that it marks the end of a 25-year "era
of credit expansion based on the dollar as the international reserve
currency".

He also offers some solutions, which centre on new regulation for
markets, and how to avoid forced sales for US homeowners. A highly
entertaining diary recounts his investment moves in the first three
months of this year, culminating with the confusion surrounding the fire
sale of Bear Stearns.

His insights are clear and concisely expressed. They are worth reading
for anyone interested in the topic. But what is most interesting, and
obviously engages Soros at an emotional level, is the idiosyncratic
philosophy he has developed to explain the metaphysics of how markets
work. Even before the emergence of the efficient markets hypothesis,
which has dominated academic thinking on markets for at least three
decades, Soros had devised his own theory to prove markets were not
efficient. He acted on this philosophy as an investor with spectacularly
successful results.

That philosophy derived from his undergraduate studies at the London
School of Economics under Karl Popper. The "relationship between
thinking and reality", Soros calls "reflexivity." It fills the book's
centre in chapters which he admits many will find "heavy going". In
markets, Soros says, participants' thinking plays a dual function: they
try to understand the situation (the "cognitive function"), and to
change it (the "manipulative function"). The two functions can interfere
with each other; when they doso the market displays "reflexivity".

So an investor's misperception of reality can help to change that
reality, begetting further misperceptions. When market actors' decisions
affect outcomes, patterns emerge. If a lot of people are bullish about
internet stockstheir price goes up. Soros used the theory to predict,
and profit from, a series of "initially self-reinforcing but eventually
self-defeating boom-bust processes, or bubbles". Each bubble "consists
of a trend and a misconception that interact in a reflexive manner".

A key implication of this is that markets do not tend towards
"equilibrium", as predicted by modern portfolio theory. And they will
not move in the "random walk" promulgated by efficient markets theory,
which holds that prices always incorporate all known information and so
move randomly in response to new information.

This is important, as the architecture of modern capital markets depends
on these theories.And it begins to look as though the credit crisis was
the tipping point at which academics and practitioners decided a new
paradigm was needed to replace the efficient markets hypothesis.
Alternative theories borrow from experimental psychology, advanced
mathematics and evolutionary biology and have been built in response to
experience in the markets.

The theory of "adaptive markets" - that markets follow trends until they
become overblown and then start building up other trends - seems to be
gaining ground as an alternative paradigm. Soros' title is a bid for his
own theory of reflexivity to become the new paradigm. What is
fascinating is how much modern thinking is in line with the theory he
developed decades ago.

How does it help explain the credit crisis? Soros believes that a "super
bubble" has been formed as the result of a "long-term reflexive process"
over the last 25 years. Its hallmarks include credit expansion (boosted
by the belief that inflation has been vanquished), and a prevailing
misconception, which Soros unsurprisingly blames on Ronald Reagan and
Margaret Thatcher, that markets should be given free rein.

There have been numerous financial crises in this period. According to
Soros, these "served as successful tests which reinforced the prevailing
trend and the prevailing misconception". Thus the current crisis grows
in severity because it marks "the turning point when both the trend and
the misconception have become unsustainable".

Many will dislike Soros' politics. Others will find the book
self-indulgent. He calls himself a "failed philosopher" and badly wants
his theory to reach a broader public. It is hard to imagine it would
have been published were he not so famous and successful. But his
restless intellectual curiosity commands respect. So does his ability to
foresee the debate in theoretical finance. He may have been a failed
philosopher, but he was a successful prophet.

The writer is the FT's investment editor