George Soros is the best-known financial speculator of our time, godfather of hedge funds, those fast-moving and largely unregulated raiders in the corporate jungle that make their killings from fluctuations in the prices of stocks, commodities, currencies. When he writes books readers might reasonably expect tips on how to make money. They will be disappointed. Soros’s ambitions are altogether more exalted. Having become a billionaire, he has set himself up as the philosopher and statesman of global capitalism, tirelessly telling the world that it now needs to remove the ladder by which he himself climbed to fame and fortune. On January 2 he was reported predicting a “hard and bouncy” landing for the US economy.
It is true that recently his predictions have been less successful. In his book The Crisis of Global Capitalism (1998), he foretold the imminent collapse of the world economy. However, it was not global capitalism that collapsed, but Soros’s reputation as a financial wizard and post-Communist guru. He was revealed as fallible, both as a moneymaker and as a thinker. As he now admits, he failed to foresee that the Federal Reserve Bank of New York would organize a bailout of Long Term Capital Management, the US hedge fund that found itself with capital of $600 million against debts of more than $1 trillion. He also failed to give “adequate weight” to the Internet revolution which pulled up the US economy and stock market to new heights, and locked peripheral countries ever more tightly into the global market. His “boom-bust” model, he now concedes, is silent on when the bust will happen. Chastened, he writes: “I made my bet and lost. It was a painful experience to endure both personally and professionally.”
His new book, Open Society: Reforming Global Capitalism, may be read as an effort at retrieval. It is a reworking of his much-criticized earlier work, but is more modest in its theoretical claims and predictions, though no less ambitious in its pol-icy proposals. He has added a new chapter, “Who Lost Russia?,” which has this somber passage: “Russia is not lost; on the contrary, it may revive under Putin. But the West has lost Russia as a friend and ally.” What survives is Soros’s conviction that the global capitalist economy is inherently unstable, and that new institutions of world government will need to be devised to keep the peace and prevent depressions. These are serious arguments. It is no longer so easy to dismiss his ideas as “at best an incoherent rendition of some common themes,” as the MIT economist Rudi Dornbusch did in 1998. Now that Soros is no longer a figure of fable, it is time to take him seriously.
Soros’s has been one of the most extraordinary careers of the postwar era. He was the archetypal outsider, determined to break into a privileged world which refused to take him seriously. He was born in Budapest in 1930, of Hungarian Jewish parents. He and his family avoided the Holocaust and emigrated to England in 1947. He graduated from the London School of Economics in 1952, where he was greatly influenced by Karl Popper, and had an unhappy time in the City of London. “Who is this fella Soros?” one can just imagine that coterie of Old Etonian bankers saying to one another. Revenge must have been sweet when he “broke the Bank of England” in 1992, by betting successfully on a devaluation of sterling, a transaction that netted him $1 billion.
In 1956 he moved to New York, where, in 1969, he set up the Quantum Fund, a pioneer hedge fund. Over thirty-one years, the Quantum Fund provided its shareholders a better than 30 percent annual return: $100,000 invested in the fund in 1969 would be worth $420 million today. Soros’s uniqueness, however, does not lie in his success in moneymaking. He is a much rarer bird: a successful man of action who is also an intellectual. I don’t suppose he worked out in advance a system for beating the market. Like all successful tycoons he acted on instinct, hunch, judgment, bias, inside information. But unlike most successful men of action he had the capacity for reflecting systematically on the reasons for his success, and it is not implausible to believe that as he prospered, he did increasingly come to see business life as a laboratory for testing his theories of how markets worked.
Using the conglomerate boom of the 1960s as his model, Soros worked out an eight-stage archetypal “boom-bust” sequence, in which herd behavior, latching on to an existing market trend, carries prices to dizzying heights before “reality” brings about a catastrophic crash. In his book The Alchemy of Finance (1987), he developed the idea of “reflexivity,” which was neatly summed up in these pages as follows:
People habitually misperceive the world around them and either are unable or refuse to acknowledge this fact. In the financial markets—which are, of course, a natural laboratory for examining misperceptions—investors’ often superficially arrived-at beliefs about market tendencies are reinforced when the market price goes their way when they buy or sell. They gain confidence in their mistaken notions and push prices even further in the same direction. This feedback, or what Soros calls reflexivity, is to him a natural law. Thus, prices typically run up too high or stay too low for far too long, because people become fixed in their partial convictions.1
In Opening the Soviet System (1990), he applied his boom-bust theory of financial cycles to historical cycles like the rise and fall of communism.
Although Soros must have enjoyed making all that money and being able to show his superiority to hereditary wealth, there is no reason to doubt his own claim that he increasingly came to see making money as the means to promoting his ideal of an “open society.” In 1979 he set up the Open Society Fund, whose mission was “to help open up closed societies, to help make open societies more viable, and to foster a critical mode of thinking.” His foundations have provided money to foster democracy and the rule of law in former Communist countries. His belief that market fundamentalism has replaced communism as the greatest threat to the open society has recently led him to concentrate his efforts on reforming capitalism. Despite much disillusionment with his philanthropic activities, Soros intends to keep spending his fortune, currently estimated at between $3 billion and $5 billion, on his causes until the money runs out.
By revealing what is on his mind, Soros has placed himself in triple jeopardy. His profits depended on him “staying ahead of the curve” (i.e., the crowd). Now, he admits, “the glory days are over: Too many people have read my books, and I lost my edge.” The Quantum Fund has been turned into a “more conservative vehicle.” His economic theorizing exposed him to academic attack. His policies for world improvement were dismissed as naive or utopian by critics who saw themselves as hardheaded realists.
Of the three, the academic attack on his economics probably rankled most. Its viciousness cannot be attributed entirely to professional jealousy. Soros has an irritating habit of announcing, as great discoveries of his own, ideas that are, in fact, familiar; and of attacking ideas he does not fully understand. In fact, his economics is quite orthodox: only it is the orthodoxy of thirty years ago—old-fashioned ideas dressed up as novelties. He is a Keynesian in his belief that the market sys-tem is inherently unstable; and a pre-Keynesian in his belief that it swings back and forth like a pendulum, always attracted to, but always overshooting, its equilibrium, or point of rest.
Readers would have got a better idea of where Soros is coming from had he acknowledged this intellectual inheritance (as he amply does his debt to Karl Popper), and confined his attack to that class of economic models produced by the new classical school, which does assume that markets always “clear”—i.e., that supply and demand always balance—and that unemployment is always voluntary. Soros’s attack on economics is further weakened by his confusing the idea of “rational expectations” with the idea of “market clearing.” Normally the first does imply the second, but it need not.2 The most charitable explanation of these lapses is that Soros was too busy making money to keep up with the literature.
If the reader can stifle his irritation at Soros’s ignorance of the discipline he is attacking, he will read Open Society as an intelligent critique of the state of global capitalism written from the vantage point of a successful fund manager. He will also concede that some of Soros’s thrusts strike home. Soros is right to argue that the “new classical” belief that markets always clear encourages “market fundamentalism,” or what used to be called laissez faire. He is right to query the assumption by some economists that fluctuations in prices, output, and employment can be safely ignored by government policymakers because they have already been “discounted” by participants in the market. Soros should be given credit for spotting, earlier than most economists did, the danger that premature financial de-regulation would lead to serious financial instability. Recent models of “multiple equilibria” in financial markets are simply catching up with what Soros was saying in the 1980s.
Soros argues for a more modest economics which accepts the fallibility of knowledge, recognizes market volatility as a major problem, and gives government a role in dampening economic fluctuations. The fact that many economists, some in positions of power, agree with him should not detract from the value of the message coming from this particular source. “After the recent financial crisis,” Soros writes, “the aim has been to impose greater market discipline. But if markets are inherently unstable, imposing market discipline means imposing instability—and how much instability can societies tolerate?” This is not a trivial question.
The first few chapters of Open Society develop Soros’s theory of knowledge as the basis of his attack on “economics” and his explanation of why financial markets are so volatile. Soros’s two organizing concepts are “reflexivity” and “fallibility.” In human affairs, unlike in the natural world, subject and object are not independent. A scientist can study the natural world, and learn its laws, without impinging on it. The apple falls to the ground without knowing what I think it will, or should, do. Scientific inquiry proceeds by the controlled laboratory testing of hypotheses, to build up a body of true statements (laws, generalizations) about nature. At least, this is still a serviceable view of scientific procedure.
Social science cannot do as well, because, as Soros rightly says, “what we think has a way of affecting what we think about.” It is as though the apple’s trajectory is influenced by ideas—its own, and those of other apples—about what it should do. If statements about facts influence the behavior of the facts to which they refer, the truth of such statements cannot be established by testing them against the facts. In economic life, fluctuating beliefs about the future (“expectations”) heavily influence the way people behave today.
Some philosophers, faced with the difficulty of making true statements about the world, have concluded that truth is a matter of logical coherence rather than correspondence with the facts. Soros rejects this solution. He adopts what might be called a loose version of the correspondence theory of truth: reality does in the end impose some limit on what can be truthfully believed, but there is plenty of play for “reflexivity,” or interaction between subject and object, and therefore for the gestation and persistence of false beliefs. Because reflexivity is a fact, our knowledge of the social world is inherently fallible: all our beliefs about what will happen are contingent on their impact on people’s minds and behavior. Soros’s epistemology clearly has some resemblance to pragmatism, the doctrine that what is true is what works—if only for a time. A more direct influence is Karl Popper. Popper did not believe that hypotheses could be verified by the facts, but he did think they could be falsified by them. Soros’s concept of “fertile fallacies,” which are only subject to correction after the fact, is very much in the Popperian mold.
Soros claims that in his concepts of reflexivity and fallibility are to be found the clues to much of what “goes wrong” in human affairs. Flawed thinking, precisely because it cannot be readily corrected, can take on the character of self-fulfilling prophecy. Only abject failure—a collapse in the market—reveals the character of the flaw. Trend-following behavior explains how prices of shares and currencies can deviate for long periods from their “fundamental” values. Soros writes: “In my days of actively managing money, I used to get particularly excited when I picked up the scent of an initially self-reinforcing but eventually self-defeating thesis. My mouth would water as if I were one of Pavlov’s dogs.” Soros attributes his success to his private understanding that all his hypotheses were flawed. “I liked to invest in flawed hypotheses that had a chance of becoming generally accepted, provided I knew their flaws. This approach allowed me to sell in time.”
Social and political life, no less than financial trading, is riddled with flawed hypotheses that persist long past the time when reality should have shown them up to be fraudulent. Social science, he writes, is a compendium of flawed thinking disguised as scientific understanding. “In social, political, and economic matters, theories can be effective without being valid. Although alchemy failed as science, social science can succeed as alchemy.” In the tradition of logical positivism, he proposes “depriving the social sciences of their scientific status,” though he does not suggest how this is to be done. Vicious ideologies masquerading as scientific—Soviet-style Marxism is the obvious example—can cause societies to depart wholesale from “fundamental” decencies. Soros’s main argument for the open society is that competition in ideas, while not necessarily leading to truth as John Stuart Mill thought it would, can impose a provisional character on all thought, outlawing dogmatism and allowing “never-ending improvement” through modest experimentation. This is a powerful argument against state monopoly of education, though one which we almost never hear nowadays.
It is easy to see why Soros regards the new classical economics with disdain, for it rules out by assumption both reflexivity and fallibility. As the Swedish economist Axel Leijonhufvud has written of this kind of theory, market participants “know all that they can know and need to know in order to deduce all utility-relevant consequences of alternative courses of action.”3 Only genuinely unforeseeable events can cause present forecasts to go wrong. The main policy implication of this approach is that systematic Keynesian stabilization policy, by which government intervenes to moderate the effects of the business cycle, is redundant at best, distorting at worst.
Soros states his disagreement forcefully. “Expectations cannot be rational when they relate to something that it is contingent on itself.” Rational expectations theory treats financial markets as passive reflections of “fundamental” facts, such as company performance; whereas, Soros argues, the participants (within limits) make markets what they want them to be. He concedes that “markets often seem to anticipate the future correctly. This is not because events conform to rational expectations, however, but because expectations can influence the so-called fundamentals that they are supposed to discount.” The new classical economics asserts that markets are nearly always right. Soros believes that they are nearly always wrong, but “have the capacity to validate themselves—up to a point.” The Internet boom, recently busted, is an example of a self-fulfilling prophecy in which trend-following behavior pushed prices away from equilibrium, which he defines as “the state in which there is a correspondence between expectations and outcomes.”
Soros does not reject the notion of equilibrium—without it, we could not say whether a process is tending away from or toward it—but insists that equilibrium is the limiting, not general, case. Most of the time markets are in “dynamic disequilibrium.” Specifically, “self-reinforcing but eventually self-defeating processes are endemic in financial markets.” When a reflexive hypothesis has established itself, market stability must be preserved by public policy interventions. He proposes to base economics on “irreversible evolutionary processes and the design of nonlinear models to represent them,” a tall order on which he does not elaborate.
In his attacks on new classical economics, Soros can be criticized for confusing an intellectual project (what conditions would need to be satisfied for perfectly efficient markets to exist) with an account of how markets actually work. Nevertheless, he should not be chastised too harshly for this. Most new classical economists do seem to believe that their models correspond to important features of reality; and this belief gives them a bias against government intervention.
One interesting reflection arises. A great deal of modern economics is based on the accommodation of the discipline to the demands of mathematics. Models based on dynamic disequilibrium or nonlinearity such as those suggested by Soros are intractable to mathematical formulation. Without the postulate of general equilibrium there is no solution to the system of simultaneous equations which economics needs to prove that markets allocate resources efficiently. That is why economics has been uncomfortable with attempts to model economies as sequences of events occurring in historical time—which is what they are. There is a nice irony here. The more “formal” economics becomes, the more it has to treat reality as a purely logical construction. When it looks on the market system and finds it good, its admiring gaze is actually directed at its own handiwork. Fortunately, when it comes to giving policy advice, most economists’ common sense overcomes their mathematics.
The real object of Soros’s attack is “market fundamentalism.” His undiscriminating attack on economics is driven by his mistaken belief that most economists support laissez faire, whereas this dogma is a political abuse of economic theory and many economists don’t subscribe to it. Once he is off his hobbyhorse, his arguments become more convincing. Market fundamentalism, he charges, ignores the fact that markets are unstable, that market values undermine social values, and that there are great inequalities between rich and poor. Above all, it diverts attention from the need to develop global institutions with the ability to regulate the activities and tame the power of global capital. In the absence of such countervailing powers, market fundamentalism can produce, in reaction to its excesses, a relapse into barbarism, as happened earlier this century in Russia and Germany.
Again, it is important to realize where Soros is coming from. As an important player himself in the global marketplace, he is impatient with academic disquisitions on the beauties of the “invisible hand.” He supports the market economy not because it invariably produces good results, but because it allows freedom of choice. As an uprooted product of Central Europe, who seems to be at home everywhere and nowhere, he brings to the analysis of markets a tragic historical sense which is largely lacking in Anglo-American thought. There was a more or less liberal global economy early in this century. No one expected it to give way to the era of horrors and tyrannies that opened in 1914. As one looks back, it is easy enough to see that its political and institutional counterparts—competing imperialisms, autocratic rule in some of the major powers—were inimical to its survival. In 1929–1930, the lack of effective international “circuit breakers”—cooperation to make credit available, for example—allowed a Great Depression to develop which completed the ruin of the global economy of that time.
It is precisely this tragic sense which made the postwar German and Austrian liberals (including Friedrich Hayek) devote so much attention to the question of the institutional underpinnings of a free market order. Soros is in this tradition. His open society occupies a “precarious middle ground” threatened with authoritarian control on the one hand and disintegration on the other. To keep it open, political intervention is needed to maintain stability, protect the social sphere, and reduce inequality. The trouble, he suggests, is that we have a global market economy but not a global political system. A huge disparity has arisen between the economic and political organization of the world.
Soros presents today’s global economy as an “abstract” empire of money, more global in its coverage than any previous empire, dominated by a “center” of developed nations which provides the capital and technology used by the regions at the “periphery.” As he warms to his theme, the money economy develops the features of a giant killer shark crunching up in its massive jaws values, morals, communities, families, family businesses, nation-states, and the undeveloped world as it scours the world in search of its nourishment—profits. It rampaged through East Asia and Russia in 1997 and 1998 like a bubonic plague, with the International Monetary Fund in feeble pursuit. As a reformed predator himself, Soros may be expected to know what he is talking about. But the acute reader will detect a typical Soros strategy: that of proclaiming a flawed hypothesis in order to start a trend. Only this time the aim is not to make a killing by selling short, but to promote the cause of the open society and the institutions he believes are needed to support it.
Even a reader unpersuaded by Soros’s relentlessly gloomy outlook may recognize its correspondence with at least three aspects of contemporary reality. The first is what Soros calls the “asymmetry in the treatment of lenders and borrowers.” Every financial crisis is preceded by an unsustainable expansion of credit. As happened in Thailand and other Asian countries in 1996, foreign investors fall over themselves to lend money to countries they know little about because everyone else is lending money to them. But when the crunch comes, extensive protections exist for creditors, but no comparable arrangements for the relief of debtors. Keynes had the same thought in mind when he wrote that, under the classic international gold standard system, adjustment was “compulsory for the debtor and voluntary for the creditor.”4 Creditors are protected against default and can anyway decline to go on lending; debtors have to pay and adjust their economies to the burden of paying. In a crisis, the IMF’s role has hitherto been to facilitate repayment of debt, not to offer the relief to debtors that exists in national bankruptcy codes.
There is hard logic in this. The collapse of the Western banking system would do far more damage to the world economy as a whole than the harm inflicted on the economies of the peripheral debtor countries. This does not make the global system smell any sweeter; and it is a powerful incentive for peripheral countries to reintroduce controls over the inflow of capital, particularly short-term capital which can go out as quickly as it comes in.
Secondly, it may well be that structural changes have made the market economies of Western countries less stable, even if more efficient, than they were. Publicly traded corporations have much more power to mobilize capital than the private or family businesses they are replacing; but this comes with a cost. Soros points to the increasing domination of economic life by professional fund managers whose sole purpose is to maximize relative profits over a short period, thus encouraging herd behavior. He sees a new source of instability in the explosive growth, especially in the United States, of share ownership through mutual funds, which have largely replaced personal savings. Any sustained decline in the stock market would, as people buy less, have a devastating effect on consumption, and hence on output. Here Soros points to the so-called “wealth effect,” by which people who find themselves with increased net assets acquire an excessive idea of their ability to consume more and can therefore bring about a large drop in consumption when it becomes clear that their wealth is less than they thought it was. He might have added that, particularly in Europe, the privatization of important industries previously owned by the state has removed a built-in barrier to the decline of investment in a slump since government-owned industries can draw on public funds to keep going. In short, there may be a trade-off between efficiency and stability.
Finally, Soros is right in his view that “economic and political arrangements are out of kilter.” Nation-states have lost many of their economic functions without anyone else inheriting them. The result is a failure of political leaders and legislators to take action, which is the more dangerous since nation-states remain the basic units of political life. We may have in the IMF, the WTO, the IBRD, the UN, the EU, NATO, and so on embryos of world or regional government; but they are very far from replacing nation-states since they lack democratic legitimacy, the essential requirement for the exercise of state power. The international system may thus lack the ability to nip dangerous trends as they emerge, in economics or politics.
The last section of Soros’s book, ostensibly about constructing or strengthening circuit breakers, is disappointing, consisting as it does of recycled generalities, delivered in the imperative mode. We need, he writes, a global central bank and other international financial institutions “whose explicit mission it is to keep financial markets on an even keel.” Transfers of resources from rich to very poor countries should be handled by the World Bank, renamed the World Development Agency and equipped with extra discretionary resources. The World Trade Organization should provide incentives for poorer members to conform to labor and environmental standards. The political engine for securing all this should be an “Open Society Alliance” headed by the United States and the European Union. This would foster the development of open societies in the world and establish rules and institutions governing the behavior of states toward their citizens and to each other. NATO would apparently be its military arm but NATO should also become a Partnership for Prosperity. The United States must learn to act multilaterally, not bilaterally. The General Assembly of the United Nations should be converted from a talking shop to more like a “legislature making laws for our global society.” And so on.
All the hard questions raised by these proposals are skirted. To give just one example, Soros recognizes that an international rule of law needs international consent. Otherwise it would be an instance of the “strong lording it over the weak.” Yet he endorses NATO’s military intervention in Kosovo (although disliking the way it was done), which breached the UN Charter, and was opposed by Russia, China, India, and most other countries in the world. Like other apologists for this action he refuses to recognize that the “international community” is not confined to the countries of NATO, and that in some cases an attitude of “live and let live” is a necessary condition of global peace, which in turn is a necessary condition of a global economy.
A good book on the international system needed to support the “open society” remains to be written. In economic affairs it would need to make up its mind on three questions. Is a global economy with exchange rates free to float and capital free to roam likely to be more or less stable than one with fixed exchange rates and capital controls? How much instability can societies stand? How much control of the internal affairs of poor countries do aid donors need to have to make the aid effective? In political affairs, the hard questions are: Does the United States have the will to be the world’s policeman? And on what terms acceptable to themselves can Russia and China be integrated into the international community? George Soros deserves credit for directing our minds to these questions.
March 8, 2001
Rational expectations theory assumes that over time unexpected events will cancel each other out and that, on average, expectations will be fulfilled. This is because people make optimal use of the information available to them and learn from their mistakes. The apparent conclusion that government intervention to “correct” market outcomes is usually futile has been challenged by the “New Keynesians,” who argue that information failures and the costs of decision-making can cause markets to fail even when market agents form their expectations “rationally.” ↩
In “Mr. Keynes and the Moderns,” in The Impact of Keynes on Economics in the 20th Century, edited by Luigi L. Pasinetti and Bertram Schefold (Edward Elgar, 1999), p. 18. ↩
In “Post-War Currency Policy,” September 8, 1941, reproduced in The Collected Writings of John Maynard Keynes, edited by Donald Moggridge, Vol. 25 (Macmillan/Cambridge University Press, 1980), p. 28. ↩