The prevailing interpretation of financial markets – the Efficient Market Hypothesis (EMH) – has been well and truly discredited by the Crash of 2008. The current financial crisis was not caused by some exogenous factor – like the formation or dissolution of an oil cartel – but by the financial system itself. This puts the lie to the assertion that financial markets tend towards equilibrium and deviations are caused by external shocks. But the alternative theory of how markets work that I am proposing – the theory of reflexivity – has not taken its place. It has not even received serious consideration by the economics profession.

When I ask why, I get various answers. One is that my theory of reflexivity merely states the obvious, namely that market prices reflect the participants’ biases. That is an obvious misunderstanding of my theory, which holds that mispricing in financial markets can, in specific circumstances and ways, affect the fundamentals that market prices are supposed to reflect. Other experts say that my theory of bubbles is already incorporated in existing models.

Those who are most sympathetic to my views explain to me that my theory is not getting more attention because it cannot be formalized and modeled. But that is exactly the point I am trying to make: reflexivity gives rise to uncertainties that cannot be quantified and probabilities that cannot be calculated. Frank Knight made that point a century ago in Risk, Uncertainty and Profit, and John Maynard Keynes recognized it, too. Yet participants, rating agencies, and regulators alike came to depend on quantitative models in calculating risks.

One question to which I am seeking an answer is whether it is possible to model reflexivity, or whether one should continue using quantitative models but take reflexivity into account by adding a margin for error due to incalculable uncertainties. My hunch is that we need to do both. Reflexivity cannot be modeled in the abstract, but it should be possible to model specific instances of it, such as the effect on real estate prices of the willingness to lend. At the same time, quantitative models may be useful for calculating the risks that prevail in near-equilibrium conditions, though one must remember, particularly for regulatory purposes, that conditions may occasionally veer quite far away from equilibrium. I wish other people were also engaged in exploring this question.

The Limits of Behavioralism

Insofar as there is a new paradigm emerging to explain how markets work, it is based on behavioral economics and evolutionary systems theory. I have followed their development with great interest, and I recognize their merits; yet I worry that they leave out some important insights. Indeed, I believe that if they became the new orthodoxy, this would stand in the way of a proper understanding of financial markets. Let me explain why.

Behavioral economics explores the quirks of human behavior and its implications for market behavior. It has demonstrated through experiments a number of departures from rational behavior in the form of specific behavioral biases that are characteristic of decision making under conditions of uncertainty, and that are detrimental to an agent’s own best economic interests. This has challenged the assumption of rational behavior and EMH. The supporters of EMH have responded by admitting the existence of these inefficiencies, but they claim that they can be eliminated by arbitrage.

This claim has provided the justification for so-called market-neutral hedge funds, which claim to be able to make high profits by exploiting arbitrage opportunities on a leveraged basis. The most famous example is Long Term Capital Management (LTCM), which blew up in 1998, nearly causing a meltdown in financial markets. Behavioral economics has no explanation for why LTCM blew up. More precisely, its implied explanation is that the forces of behavioral bias proved stronger than LTCM’s capacity to withstand them. That is far less satisfactory than the concept of self-reinforcing biases or bubbles that I put forward.

Indeed, the charge leveled against reflexivity – that it merely states the obvious fact that human psychology affects market prices – can more justifiably be raised against behavioral economics. What would be lost if it became the new paradigm is the insight that mispricing can affect the fundamentals, and that financial markets, far from being merely passive reflections of underlying conditions, constitute an active force that changes the course of history. After all, markets often force managements and even governments to act in specific ways to address their concerns.

Even in exploring human psychology, behavioral economics is more rudimentary than my theory: it explores only behavioral biases, not misconceptions like market fundamentalism. It is also more rudimentary than EMH, because it does not formulate any overarching hypothesis.

Man or Machine?

By contrast, evolutionary systems theory does formulate an overarching hypothesis. Andrew W. Lo of MIT has formalized this approach as the Adaptive Markets Hypothesis (AMH), and he is not alone. The Santa Fe Institute is heading in the same direction. Indeed, it has become very fashionable to apply Charles Darwin’s concept of the survival of the fittest to as many domains as possible.

The AMH proposed by Lo views financial markets as an eco-system in which participants pursuing different strategies compete with each other to maximize the survival rate of their genetic material, i.e., profits. It escapes the constraints of EMH by admitting any strategy as long as it promotes survival.

AMH has the great merit that it can be modeled, and the models are dynamic: both the strategies and their prevalence evolve in the course of iteration. The concept of equilibrium can be replaced by a two-way interaction akin to reflexivity. This modeling technique has been developed in studying the two-way relationship between populations of predators and prey, and there it works very well. Since then, such “adaptive” models have spread to many other subjects besides financial markets, including the study of religion.

Obviously, AMH has great affinity with reflexivity. I am fascinated by it, and I hope that it may provide a way to model reflexivity – which seems to be the main obstacle to my conceptual framework being taken seriously. Yet I also dread it. I am afraid that my insights may be distorted in the process of being adapted to a modeling technique. Let me try to articulate my fears.

Central to my worldview is the idea that human affairs – events with thinking participants – have a fundamentally different structure from natural phenomena. The latter unfold without any interference from human thought; one set of facts follows another in the causal chain. Not so in human affairs. The causal chain does not lead from one set of facts to the next, but connects the situation and the participants’ thinking in a two-way, reflexive feedback loop.

Since there is always a divergence between the participants’ views and the actual state of affairs, reflexivity introduces an element of uncertainty into the course of events that is absent in natural phenomena. I am afraid that this idea may get lost in AMH, because evolutionary systems theory does not distinguish between human and natural phenomena. It deals with the evolution of populations whether they consist of microbes or market participants.

To be even more specific: I draw a distinction between machines like automobiles and power plants, on the one hand, and social institutions like states or markets or matrimonial arrangements, on the other. I contend that machines need to be well-formed in order to survive, i.e., they must do the job for which they were designed. Social institutions are different: they may not serve their purpose well, yet they may survive indefinitely. In other words, markets may be maladaptive. This is the distinction that AMH fails to recognize.

There is something suspicious about the concept of adaptive systems, whether we talk about markets or governments or religions. It seems to justify whatever prevails merely because it prevails. That ignores the most important lesson to be learned from the Crash of 2008. An immensely impressive and imposing edifice, the international financial system, collapsed not because of some extraneous shock, but because it was ill conceived. How was that possible?

There has to be some difference between social constructs like the banking system and physical constructs like the buildings resembling Greek temples in which banks used to be located. Market participants, including regulators, discovered this truth at great cost and with great consternation in the Crash of 2008; the world economy is reeling from the consequences. My conceptual framework identifies what the difference between mechanical and social constructs is, namely reflexivity. AMH fails to acknowledge that there is any difference at all, and thus perpetuates the root error of the efficient market hypothesis (EMH). 

Reflections on Reflexivity

How could economics produce two hypotheses that suffer from the same error? The explanation lies in the fact that both EMH and AMH proceed by analogy, applying to the social sphere an approach that was successful in another field – EMH draws on Newtonian physics, AMH on evolutionary biology. In this context, I invoke my postulate of radical fallibility: whenever we acquire some useful knowledge, we tend to extend it to areas where it is no longer applicable.

By contrast, I start with an exploration of the relationship between thinking and reality. That is how I arrive at the concept of reflexivity, which can then be applied to the study of financial markets. I contend that my approach produces better results than either EMH or AMH, and I expressly repudiate any attempt to reconcile my conclusions with either of those hypotheses. Since EMH has been thoroughly discredited, I am more worried about being overshadowed by AMH, which is ascendant.

I understand the motivation behind AMH: the desire to protect the scientific status of economics. But I consider that a misplaced endeavor, the product of what in Freudian terms might be described as economists’ “physics envy.” The social and natural sciences face different tasks and require different approaches.

Here, I must introduce a cautionary noted about my own argument. I am troubled by the sharp distinction that I have drawn between human affairs and natural phenomena. Such sharp dividing lines are not characteristic of nature, but of human efforts to make sense of an infinitely complicated reality. This is also in accordance with my postulate of radical fallibility.

Nevertheless, I am eager to understand better the connection between evolutionary systems theory and reflexivity. I posed the question at the Santa Fe Institute, which is devoted to the study of complexity, but I have not yet found the answer. That is another question I wish other people would think about.

I am willing to admit that reflexivity does not meet the currently accepted standards of scientific theory. That is why I called my first book on the subject The Alchemy of Finance. I contend, however, that we must either modify the standards or study financial markets in a non-scientific way. The former may be difficult, because it would involve a loss of status for economists.

It may be easier to gain acceptance for the new paradigm by calling it a philosophical rather than a scientific paradigm. Philosophy used to occupy a preeminent position before scientific method took its place. Scientific method has worked wonders in the study of nature, but it has been less successful in the human domain. That is what led me to take issue with Karl Popper’s doctrine of the unity of scientific method.

It may be appropriate to restore philosophy to its preeminent position. My conceptual framework could then serve as the new philosophical paradigm for understanding human affairs in general and financial markets in particular. I happen to be more interested in its philosophical than its financial implications, although it would be disingenuous of me to downplay the latter. There is a lot more to be said on both topics. I must stop here, but I do not consider this the end of the discussion.

Copyright: Project Syndicate, 2009.
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