Reflexivity in economics is the theory that a feedback loop exists where investors’ perceptions, in turn, shape economic fundamentals, perpetually influencing and being influenced by them. Originally rooted in sociology, reflexivity has found extensive application in economics and finance, primarily propagated by George Soros. Soros argues that reflexivity challenges mainstream economic theories by highlighting the continuous intertwining of perception and reality, causing substantial deviations in market prices over time.
Key Takeaways:
- Reflexivity creates a feedback loop where investor perceptions influence economic fundamentals and vice versa, causing price deviations from equilibrium levels.
- George Soros credits the theory of reflexivity for his significant successes and posits that conventional economic theories are refuted by its implications.
- Reflexivity challenges the conventional notions of economic equilibrium, rational expectations, and the efficient market hypothesis.
Unveiling the Concept of Reflexivity
Reflexivity theory posits that investor decisions are primarily influenced by perceptions rather than the underlying reality. These perceptions lead to actions that subsequently impact economic fundamentals, shaping new investor perceptions and altering market prices perpetually. This creates a self-reinforcing loop, often leading to disequilibrium, where prices deviate significantly from their intrinsic values.
A Case Study: The Global Financial Crisis
George Soros points to the global financial crisis as an exemplary case of reflexivity in action. Rising home prices persuaded banks to increase mortgage lending, in turn inflating home prices further. This unchecked feedback resulted in a housing price bubble, eventually bursting and giving rise to the financial crisis and Great Recession.
Contrasting Mainstream Economic Theories
Traditional economic theories suggest market prices are governed by economic fundamentals underpinning supply and demand. In these theories, prices move towards equilibrium driven by balanced interactions of positive and negative feedback. Economic equilibrium concepts argue that market participants’ rational expectations about economic fundamentals cause market adjustments towards a balanced price level. Reflexivity counters this by projecting persistent and amplified deviations from such equilibrium due to dominant positive feedback loops.
Soros’s view posits that the process of price formation through reflexivity involves significant over- and under-shooting of equilibrium prices as changes in fundamentals occur. This results because positive feedback loops between investor expectations and prices overshadow any negative feedback, which aims to correct the market imbalances. Such bubbles continue to inflate until market acknowledgment and reevaluation of overextended prices cause rapid reversals—a scenario Soros does not classify as negative feedback.
Evidence of Reflexivity in Practice
The boom and bust cycles, characterized by significant price bubbles followed by crashes, exemplify reflexivity. Soros mentions the influential role of leverage and readily available credit in initiating and perpetuating such market dynamics. Additionally, the flexibility of floating currency exchange rates often parallels these feedback loops, intensifying the impacts of reflexivity.
Related Terms: Economic Equilibrium, Rational Expectations, Efficient Market Hypothesis, Positive Feedback, Negative Feedback.
