Soros' Split Personality: Scanty Proposals from the Financial Wizard
Article Summary
In his new book, George Soros the philanthropist argues that markets are too volatile and need regulation. But the speculator is short on specifics.
Jeffrey A. Frankel is the New Century Chair at the Brookings Institution. Until March 1999 he was a Member of the President's Council of Economic Advisers, and he will become a Professor at Harvard University in July.
The centerpiece of Soros' grand theory is his idea of reflexivity: "On the one hand, the participant seeks to understand the situation in which he participates. . . . On the other hand, he seeks to make an impact. . . . When both functions are at work at the same time I call the situation reflexive." The core application of his theory is to financial markets. Investors form expectations about a stock's or a foreign currency's future value based on the current market price. At the same time, the market price depends on investors' expectations as transmitted through their buy-and-sell orders. Both relationships must be taken into account simultaneously.
It is distressing for an economist to hear it claimed that this idea has been ignored by economists. The simultaneous determination of market prices and investor expectations features in virtually every recent study of financial markets, including orthodox theories based on economic fundamentals or rational expectations, as well as those that challenge the orthodoxy.
But what Soros means by reflexivity is something beyond this rather obvious simultaneity definition. He believes that markets from time to time carry prices far away from economic fundamentals. Any increase in price -- even if it originates in a random blip -- generates expectations of future price increases. Participants respond by placing buy orders, which drive the price up further -- a form of destabilizing speculation. To express this idea, theorists have developed models of bandwagons, rational speculative bubbles, fads, second-generation speculative attacks, multiple equilibriums, and bank runs. In contrast, the most orthodox theorists argue that normal investors respond to rising prices by expecting a future reversal, placing sell orders to take profits, and push the price back down. This is stabilizing speculation.
If one gives Soros the benefit of the doubt, one suspects that by reflexivity he means something more profound than that the typical speculator forms expectations extrapolatively. Contrary to most economists' theories, there is no such thing as the typical speculator. Various kinds of speculators operate with different models and thus produce wide-ranging expectations of future prices. After all, if there were not diverse expectations, there would not be such tremendous trading volume ($1.5 trillion per day in the world's foreign exchange markets alone). It is differences in opinion that make a horse race. The interaction of these varied speculators gives the market interesting dynamics.
Stabilizing speculators estimate currency or stock worth from economic fundamentals such as growth, interest, and inflation rates. In normal times, especially in the long run, their views roughly determine the market price. But many other participants eschew economic fundamentals, believing them to be irrelevant in the short term where their interests lie. Instead, many use technical analysis, which looks for trends within the currency or stock markets.
Soros argues that there has been a noticeable increase in the weight given to short-term technical analysis at the expense of fundamentals. Such a shift has important implications. When traditional models indicate that the stock market is overvalued, those investors who respond by selling stocks depress the market and thereby dampen the overvaluation. But if fundamentals are accorded less weight over time, the pressure to sell diminishes. As a result, market prices continue to rise, generating a self-confirming market bubble.
To be sure, the shift away from fundamentals is not wholly irrational on the part of the individual speculator. Investors are reasonably responding to a market rise that has repeatedly proven fundamentals models wrong and technical analysis right. Every month that the fundamentalists' predictions of doom go unrealized, the more their importance diminishes. It is not that investors necessarily decide that the market is correctly valued; it is that they lose money if they do not follow the herd. There is little use "being right" if everyone else persists in being wrong -- and makes a profit. By the time the bubble reaches its peak, fundamentals models have been proven wrong so many times that they have lost credibility. The market is operating far from equilibrium, outside the range that their models specified. Of course, this may be precisely the point that the momentum to technical analysis is spent and market sentiment begins to turn.
CLIPPING THE HEDGES
Financial markets do not always work as perfectly as orthodox economic theory assumes -- consider such recent disruptions as the 1982 international debt crisis, the 1992-93 crisis in the European exchange-rate mechanism, the 1994-95 Mexican peso crisis, and the 1997-98 Asian financial crisis. First, large inflows can suddenly give way to large outflows, with little news to explain why. Second, contagion sometimes spreads even to countries with relatively strong fundamentals and sound government policies. Third, the recessions that have hit emerging markets in such crises have been so large that it is difficult to argue that the system is working well.
With this in mind, most readers will come to Soros' book expecting a proposal for regulating international financial markets. But he offers little indication of which measures he favors. He argues that markets should not be left to themselves, but devotes only brief passages to specific controls on capital inflows or hedge funds. Soros gives no clue to how controls would be enforced or how they could weed out destabilizing flows while still "weeding in" desirable capital.
