Before the meltdown, the master of the markets understood how rationality could give way to mass misjudgment

IN OCTOBER 2008, Alan Greenspan, former chairman of the Federal Reserve, testified to Congress that he had “found a flaw” in his fundamental view of how financial markets operate. Coming on the heels of a government takeover of mortgage giants Fannie Mae and Freddie Mac, the dissolution of venerable Wall Street investment banks Bear Stearns and Lehman Brothers, a partial nationalization of America’s largest banks, and a crisis of confidence that threatened to push the American economy into a recession on par with the Great Depression, a harsher critic might describe Greenspan’s comment as slightly understated.

What that flaw was, Greenspan declined to specify. No doubt, the man who had once been crowned “The Oracle” of macroeconomic foresight has retreated to a cave of contemplative isolation, examining the shattered pieces of free-market capitalism like a spurned boyfriend re-reading old love letters and wondering how it all went wrong.

In the meantime, in what is likely one of the first of many tracts to challenge the orthodoxies of market fundamentalism, George Soros, the multi-billionaire financier and philanthropist, brings to our attention a “flaw” in the predominant conception of capital markets in his new book – wait for it – The New Paradigm for Financial Markets. While Soros wins zero points for book-title originality, he does beat to the punch Greenspan and other free-market cheerleaders, not only because he wrote his book in early 2008, before the markets melted like ice cream in the sun, but because New Paradigm is a distillation of a theory he had propounded in The Alchemy of Finance all the way back in 1987, another bruising year for stock markets.

The name of his theory (which reminds one of the coinages made popular by Scientology and the mobile-phone industry) is reflexivity. But underneath Soros’s sometimes inflexibly jargonistic prose is a valuable idea that, as he bemoans in his introduction, “was not taken seriously in academic circles.” Soros in New Paradigm admirably attempts to form a lasting theory of market mechanisms by straddling two sometimes disparate views: those who look from above, the academics, and the players in the trenches. And Soros is together with Warren Buffett as the preeminent players of this generation.

So what is wrong with market fundamentalism, the view that markets function best without interference? According to Soros, the flaw is the notion that “markets are self-correcting and tend towards equilibrium.” In other words, banks, hedge funds, private equity firms and other financial institutions, brimming with the best and brightest recruits from the country’s top universities, would never, given the information available to them, act against their own self-interest and fall over a cliff like so many lemmings.

But, Soros asks, what if the information was wrong? Wait – how could the information be wrong?

That is where reflexivity comes in. Investors, through their attempts to interpret information and manipulate it for profits, fundamentally alter information so that it becomes something else: in Soros’s words, a “misjudgment,” a “misperception,” that is then acted upon as if it were cold, objective data, leading to disastrous results.

It is like a scientist observing an experiment, who is unaware that as he leans over the test tube, the breath from his nostrils is affecting the outcome. Human fallibility introduces an X-factor, or “uncertainty,” into the equation. Soros argues that too much faith is placed in financial models that attempt to map the vagaries of human behavior, and warns not to treat them as if they were scientific guidelines for how the natural world works.

The result of reflexivity is a boom and bust cycle, of which Soros has had plenty of experience, and has profited from greatly. An example of a misperception that led to a boom and bust cycle is the idea that housing prices would continue to rise eternally, allowing even the least creditworthy borrowers to refinance their homes. Investors who had bought tranches of mortgages convinced themselves that defaults on their mortgage-backed investments were unlikely, and bought more and more. But housing prices in the real world started to plummet in late 2006 and defaults spiked accordingly. All the elaborate mechanisms concocted to mitigate the risks of default – collateralized debt obligations, credit default swaps – proved useless as housing prices fell across the board and in an unprecedented fashion. As Greenspan complained, the US “had never seen a significant decline in prices.”

Reflexivity does not merely say that traders sometimes behave irrationally; anyone who has watched the Dow Jones index in recent months can appreciate the panicked, herd-like mentality of a trader. It does not merely proclaim that traders, through buying, selling and various other attempts to manipulate the future, distort market prices and cause the occasional, if eventually manageable, boom and bust.

It says that while the boom normally stretches the notion of equilibrium, the bust is even worse, shattering the idea of a “bottom” or “floor” that is tethered to reality. The “thick tail” of the bust, as it is known, is the prolonged free-fall of indeterminate duration in which markets currently find themselves. As Soros writes, policy-makers “are waiting for the housing market to find a bottom on its own, but it is farther away than they think,” because they rely too heavily on the idea of equilibrium.

And what financial markets are currently experiencing, as Soros and others have pointed out, is the devastating end of a mega, 30-year boom and bust cycle of available credit, which has thrown the conventional ideas of market equilibrium into the harshest light. Soros argues that this bust will be longer and more painful than previous ones, and when a new economic order emerges from the rubble, it will be far removed from any current definition of equilibrium. Everyone from the poorest consumer to the richest country will find it harder to access loans. The financial industry as a whole will be smaller and less influential.

In this macro view, financial institutions bear their fair share of responsibility for the crisis. But Soros argues that it is really the policy-makers, the stewards of the economy with an interest beyond profit margins, who should have known better. The solution is more government oversight, and a willingness to nip asset and credit bubbles in the bud. Government should not rely on financial institutions or credit-rating agencies to develop their own risk-management models. Soros also hints at, thought unfortunately doesn’t flesh out more descriptively, the need for a government that relies less on abstract notions of equilibrium, and more – of course – on reflexivity; in other words, a government entity that interprets information so as to manipulate it in a beneficial way. Here, he cites Greenspan as a master of such manipulation, who with his public pronouncements was able to affect market trends somewhat, but in the end was too attached to his “Ayn Rand-inspired political views.”

Soros, writing in early 2008, offers his predictions, some of which are accurate (the government will have to use taxpayer money to bail out the financial system), and others that are questionable (China will not be pulled into a global recession, and investors will flee from the US dollar), but all of which are fascinating, as the reader watches the mind of a venerable financial player work in real time. And agree with his diagnosis or not, there is one thing we can be sure of: the old paradigms have been thrown out the window. It’s time for Soros, and others, to have their say.

POWER will run extracts of The New Paradigm for Financial Markets in its January issue