“Reflexivity can be interpreted as a circularity, or two way feedback loop, between the participants’ views and the actual state of affairs. People base their decisions not on the actual situation that confronts them but on their perception or interpretation of that situation. Their decisions make an impact on the situation ... and changes in the situation are liable to change their perceptions ... . The two functions operate concurrently, not sequentially” (George Soros, “The New Paradigm for Financial Markets”, 2008, p 10).
“Many critics of reflexivity claimed that I was merely belabouring the obvious, namely that the participants’ biased expectations influence market prices. But the crux of the theory of reflexivity is not so obvious; it asserts that market prices can influence the fundamentals. The illusion that markets are always right is caused by their ability to affect the fundamentals that they are supposed to reflect. The change in the fundamentals may then reinforce the biased expectations in an initially self-reinforcing but eventually self-defeating process” (Soros, op cit, p 57-8).
Does George Soros know what he is talking about? The fact that he has operated successfully in financial markets for a long time suggests to me that he might have a few clues about how they work. But I struggle to understand him.
As is the case with many other problems of understanding, I think my problem in this instance relates to definition of terms. What does Soros mean by fundamentals? If a process is eventually self-defeating then it seems to me that this means that it is inconsistent with the fundamentals of the real world – i.e. it is inconsistent with what we know to be true about such things as resource availability, technology or human nature.
When Soros suggests that market prices can influence the fundamentals he may have something less fundamental in mind such as widely accepted perceptions of investors and credit providers about particular markets or the wider economic situation. It seems plausible that a widespread view that housing was a very safe investment, for example, could be reinforced if house prices began to increase more rapidly and if credit providers perceived that this made lending more secure. Under some circumstances that might, perhaps, result in a self-reinforcing process of increases in house prices that would eventually become self-defeating, for example because increasing numbers of people might decide that they would be better off renting rather than owning a house.
If this is what Soros means by reflexivity, does it help to explain the current financial turmoil? In explaining his super-bubble hypothesis Soros writes:
“The belief that markets tend toward equilibrium is directly responsible for the current turmoil; it encouraged the regulators to ... rely on the market mechanism to correct its own excesses. The idea that prices, although they may take random walks, tend to revert to the mean served as the guiding principle for the synthetic financial instruments and investment practices which are currently unravelling” (Soros, op cit, p 102).
It seems to me that the second part of that statement, relating to synthetic financial instruments, may help to explain the current financial turmoil. With the benefit of hindsight it is apparent that the world economy is suffering from, among other things, the development of a self-reinforcing belief system which led many financial firms to over-value synthetic financial instruments.
However, the first part of Soros’ statement doesn’t make sense. Regulators have not relied on the market mechanism to correct its own excesses. The current turmoil is partly a consequence of a history of financial firms being bailed out by regulators on the grounds that they were too big to be allowed to fail. George Soros is on much firmer ground when he recognises that most reflexive processes involve an interplay between market participants and regulators (p77).
Hopefully, the regulatory environment that emerges from the current turmoil will recognise that participants in financial markets are human. It should not surprise anyone that when financiers are given incentives to behave imprudently they tend to act accordingly.
Thursday, March 5, 2009
Thursday, February 26, 2009
What will it take to get sustainable recovery?
As readers of this blog will know already, Jim often asks me questions that I can’t answer. This morning he asked me how long it will take for the Australian economy to get back on a sustainable growth path. I was not able to answer directly. I suggested that what happens to economic growth in Australia will depend on what happens in the rest of the world. I added that if the U.S. starts to grow again in 2010 then that will have a positive impact on growth prospects for Japan and China and for commodity exporters like Australia.
Jim asked: “How confident are you about the U.S. starting to grow in 2010?” I started making excuses about my lack of knowledge of the U.S. economy and my poor knowledge of short term macroeconomics. That was when Jim said: “You know that political leaders all over the world have been saying that they will do what it takes to restore confidence and get sustainable recovery.” I nodded as Jim went on: “What they seem to be implying is that they will just keep increasing government spending until people become more confident. Does that make you feel confident?”. I shook my head. Jim then asked: “So what will it take to restore investor and consumer confidence and get sustained recovery?”
I told Jim that was a very good question. That only bought me about a second to gather my thoughts. The only sensible answer that I could think of was that restoring confidence was a matter of establishing a general expectation in the U.S. (and other major economies) that GDP would grow at about the same rate as the trend rate of growth in their productive capacity.
Jim interrupted: “That means boosting aggregate demand. Isn’t that what governments are trying to do now?” My response was that our focus should be on establishing the expectation of sustainable growth in the monetary aggregates rather than just a short-term boost in aggregate demand, with the expectation of a subsequent contraction as soon as inflation raises its ugly head again.
Jim interrupted again: “Next you will be telling me that Milton Friedman was right and what we need is a rule requiring the monetary authority to maintain a specified rate of growth in the stock of money.” I admitted that I still thought Friedman was on the right track, but technical difficulties involved in targeting the money supply would make it more sensible to target growth in nominal GDP (i.e. PY rather than M).
Jim said: “So what you are saying is that if the U.S. central bank were to announce a target rate of growth of nominal GDP and start making appropriate adjustments in monetary policy to achieve that target, then this would restore confidence and promote a sustainable recovery.”
I wish I had sufficient confidence to tell Jim that he had hit the nail on the head. Instead I suggested that rather than trying to put words in my mouth he should take a look at Scott Sumner’s blog: TheMoneyIllusion.
Postscript:
I particularly liked the following posts on Sumner's blog: Why did monetary policy fail?; and The Economics Babel.
Jim asked: “How confident are you about the U.S. starting to grow in 2010?” I started making excuses about my lack of knowledge of the U.S. economy and my poor knowledge of short term macroeconomics. That was when Jim said: “You know that political leaders all over the world have been saying that they will do what it takes to restore confidence and get sustainable recovery.” I nodded as Jim went on: “What they seem to be implying is that they will just keep increasing government spending until people become more confident. Does that make you feel confident?”. I shook my head. Jim then asked: “So what will it take to restore investor and consumer confidence and get sustained recovery?”
I told Jim that was a very good question. That only bought me about a second to gather my thoughts. The only sensible answer that I could think of was that restoring confidence was a matter of establishing a general expectation in the U.S. (and other major economies) that GDP would grow at about the same rate as the trend rate of growth in their productive capacity.
Jim interrupted: “That means boosting aggregate demand. Isn’t that what governments are trying to do now?” My response was that our focus should be on establishing the expectation of sustainable growth in the monetary aggregates rather than just a short-term boost in aggregate demand, with the expectation of a subsequent contraction as soon as inflation raises its ugly head again.
Jim interrupted again: “Next you will be telling me that Milton Friedman was right and what we need is a rule requiring the monetary authority to maintain a specified rate of growth in the stock of money.” I admitted that I still thought Friedman was on the right track, but technical difficulties involved in targeting the money supply would make it more sensible to target growth in nominal GDP (i.e. PY rather than M).
Jim said: “So what you are saying is that if the U.S. central bank were to announce a target rate of growth of nominal GDP and start making appropriate adjustments in monetary policy to achieve that target, then this would restore confidence and promote a sustainable recovery.”
I wish I had sufficient confidence to tell Jim that he had hit the nail on the head. Instead I suggested that rather than trying to put words in my mouth he should take a look at Scott Sumner’s blog: TheMoneyIllusion.
Postscript:
I particularly liked the following posts on Sumner's blog: Why did monetary policy fail?; and The Economics Babel.
Thursday, February 19, 2009
What are the links between freedom and flourishing?
I think the best way to summarize the links between freedom and flourishing is by trying to answer the following questions.
1. What is the relationship between happiness, well-being and flourishing?
If happiness is viewed as a positive emotional state (involving, for example, peace of mind, optimism, uncompression, exuberance, flow, joy and cheerfulness) then well-being (utility) cannot be the same thing as happiness. (See: What is happiness? and Do good decisions always make us happy?) Well-being (utility) involves several other factors - including personal security and security of property, health and longevity, access to goods and services – as well as a positive emotional state.
Flourishing can be described as authentic well-being. I am attracted to the idea that flourishing involves self-fulfillment as well as to the idea that it involves a meaningful life and actualization of human potential. It seems to me that the highest level of reflection of a flourishing person would be in harmony with his or her emotional nature, and vice versa (but I don’t claim to know a great deal about this ideal frame of mind or meta-state).
2. What is the relationship between freedom, classical liberalism and rationalistic individualism?
Freedom (liberty) is the condition of society in which the coercion of some by others is reduced as much as possible. It seems to me that classical liberalism is essentially about the rule of law and the protection of freedom. It is the view that people can live together in peace and to their mutual advantage bound only by abstract rules of conduct that protect the life, liberty and property of each person.
It is important to distinguish between rationalistic individualism and classical liberalism. Whereas rationalistic individualism maintains that a person’s wellbeing always increases when he or she has more options to choose from (liberal optimism), classical liberals have a more sober view of human nature. For example, Adam Smith accepted human fallibility but believed that the desire that individuals to better their own condition would generally prevail over their tendency to be prodigal and imprudent. (See: Liberal sobriety plus contextualism equals classical liberalism? and Is freedom a necessary condition for human flourishing?)
Various attempts have been made to measure freedom. The most relevant for present purposes are economic freedom indexes that measure the extent to which economic policies support private property, personal choice, voluntary exchange, freedom to compete etc.
3. What is the relationship between freedom and happiness?
People generally have a passion for control of their own lives. (See: Does inner freedom link liberty with flourishing?) Most people enjoy exercising competence in the face of the challenges that freedom poses. Exercising such competence is no easy matter; people often become unhappy as a result of the poor choices they make. But people whose life stories that are full of challenges, setbacks and triumphs may be happier than those whose lives are uniformly secure, comfortable and tranquil. (See: Does a challenge make us happy?)
The exercise of freedom can result in economic developments that disrupt communities, cultures and lifestyles, and leave many people unhappy. Such problems can be minimized under appropriate constitutional arrangements that decentralize political decision-making (See: Do we have to choose between lifestyles and liberty?)
Inner freedom – the extent to which people feel in control of their own lives – seems to be closely related to the emotional states involved in happiness. The proportion of the population with high levels of inner freedom tends to be higher in countries with higher levels of economic freedom. (See: Is inner freedom related to economic freedom?)
4. What is the relationship between freedom and well-being?
Freedom (as defined above) is inextricably linked to security of persons and property.
The relationship between economic freedom and other aspects of well-being was discussed in my post: What do objective measures of freedom and flourishing tell us?.
1. What is the relationship between happiness, well-being and flourishing?
If happiness is viewed as a positive emotional state (involving, for example, peace of mind, optimism, uncompression, exuberance, flow, joy and cheerfulness) then well-being (utility) cannot be the same thing as happiness. (See: What is happiness? and Do good decisions always make us happy?) Well-being (utility) involves several other factors - including personal security and security of property, health and longevity, access to goods and services – as well as a positive emotional state.
Flourishing can be described as authentic well-being. I am attracted to the idea that flourishing involves self-fulfillment as well as to the idea that it involves a meaningful life and actualization of human potential. It seems to me that the highest level of reflection of a flourishing person would be in harmony with his or her emotional nature, and vice versa (but I don’t claim to know a great deal about this ideal frame of mind or meta-state).
2. What is the relationship between freedom, classical liberalism and rationalistic individualism?
Freedom (liberty) is the condition of society in which the coercion of some by others is reduced as much as possible. It seems to me that classical liberalism is essentially about the rule of law and the protection of freedom. It is the view that people can live together in peace and to their mutual advantage bound only by abstract rules of conduct that protect the life, liberty and property of each person.
It is important to distinguish between rationalistic individualism and classical liberalism. Whereas rationalistic individualism maintains that a person’s wellbeing always increases when he or she has more options to choose from (liberal optimism), classical liberals have a more sober view of human nature. For example, Adam Smith accepted human fallibility but believed that the desire that individuals to better their own condition would generally prevail over their tendency to be prodigal and imprudent. (See: Liberal sobriety plus contextualism equals classical liberalism? and Is freedom a necessary condition for human flourishing?)
Various attempts have been made to measure freedom. The most relevant for present purposes are economic freedom indexes that measure the extent to which economic policies support private property, personal choice, voluntary exchange, freedom to compete etc.
3. What is the relationship between freedom and happiness?
People generally have a passion for control of their own lives. (See: Does inner freedom link liberty with flourishing?) Most people enjoy exercising competence in the face of the challenges that freedom poses. Exercising such competence is no easy matter; people often become unhappy as a result of the poor choices they make. But people whose life stories that are full of challenges, setbacks and triumphs may be happier than those whose lives are uniformly secure, comfortable and tranquil. (See: Does a challenge make us happy?)
The exercise of freedom can result in economic developments that disrupt communities, cultures and lifestyles, and leave many people unhappy. Such problems can be minimized under appropriate constitutional arrangements that decentralize political decision-making (See: Do we have to choose between lifestyles and liberty?)
Inner freedom – the extent to which people feel in control of their own lives – seems to be closely related to the emotional states involved in happiness. The proportion of the population with high levels of inner freedom tends to be higher in countries with higher levels of economic freedom. (See: Is inner freedom related to economic freedom?)
4. What is the relationship between freedom and well-being?
Freedom (as defined above) is inextricably linked to security of persons and property.
The relationship between economic freedom and other aspects of well-being was discussed in my post: What do objective measures of freedom and flourishing tell us?.
Saturday, February 14, 2009
Do we have to choose between lifestyles and liberty?
As noted in my last post, Dan Haybron suggests that our prospects for flourishing may depend importantly on living in the right kind of setting, with the right sorts of people (“The Pursuit of Unhappiness”, p 267) . Haybron is concerned that liberal optimism (the presumption that well-being increases when people have more options to choose from) can result in damage to community attributes that are important to the happiness of many individuals.
One of the examples that Haybron gives has to do with a proposal for intervention in the education of Amish children to give them a wider range of options to choose from in their adult lives. Haybron makes the point that “the Amish are not crazy to fear that such a policy would threaten one of their most cherished values, that of community” (p 266). It seems to me that it would be possible for a classical liberal to take a position on either side of such an issue, depending on the facts of the situation e.g. whether a strong case can be made that the rights of the children are being breached and whether it is likely that government intervention on their behalf would actually improve their chances of having a happy life.
Haybron’s example of the possible harm that could be done to community well-being through economic development of an island is worth considering at greater length. The residents of the island are assumed initially to have relatively low incomes but to enjoy, on average, a high level of happiness, due to strong community bonds and a culture that emphasizes the enjoyment of life. It is possible for any one resident to obtain a substantial net benefit by selling land to developers who wish to develop the tourist potential of the island, since the incremental effect of any one sale on the community lifestyle is minimal. But, taken together, many such sales may have an overall negative effect on the average happiness of the island’s long term residents. Should the development be stopped?
A different example, concerning the views of Justus Moser about the impact of global commerce on local culture, might help to clarify the issues involved. Jerry Muller tells us that Moser was a leading citizen in Osnabruck, a self-governing region in western Germany, in the 18th century (“The Mind and the Market” pp 84-103). Moser, like some modern-day opponents of globalisation, was concerned about the effects of trade on local lifestyles and culture. He condemned the growing taste for new, imported commodities, such as coffee, tea and sugar, especially among the lower ranks. He viewed shopkeepers as the local agents of the new international economy who robbed artisans of their customers and their livelihood. He reserved his greatest condemnation, however, for foreign peddlers who were selling small quantities of imported goods to peasants who were largely outside the market economy. According to Moser, these activities were causing the rural population to be “stimulated, tempted, led astray and deceived”. He argued that the public needed to be protected from the temptation of buying products that they didn’t need like leather gloves, wool stockings, metal buttons, mirrors, cotton caps, knives and needles. Women also needed to be protected from local markets where they would chat and waste money on snacks and pleasantries, while ignoring their household duties. Should trade restrictions be imposed to protect local lifestyles and culture?
What is the main difference between these two examples? It seems to me that it is possible that there could be close to a unanimous view among the long-term residents of Haybron’s island in favour of restricting certain kinds of economic development, but it is unlikely that Justus Moser, and the modern day opponents of globalisation, could persuade many of their fellow citizens that they need to be protected from the temptations of international commerce.
Can the legitimate interests of communities in preserving lifestyles of their members be met without making unacceptable encroachments on liberty? Dan Haybron evidently does not think so. At the end of his book he seems to be suggesting that we have to choose between paternalistic interventions that might, or might not, promote happiness and the individual’s right to pursue unhappiness (like the Savage in Aldous Huxley’s “Brave New World”).
I think that view is too pessimistic. Robert Nozick’s concept of a framework for utopia (briefly discussed here) seems to me to provide a good way to begin thinking more optimistically about these issues. People who want the opportunities that economic growth provides should be able to choose to live in communities that provide those opportunities, while those who value a more simple lifestyle should be able to choose to live in communities in which economic development is restricted in various ways. Do you think that idea is too utopian?
Postscript:
I would like to draw attention to Dan Haybron's comment below.
One of the examples that Haybron gives has to do with a proposal for intervention in the education of Amish children to give them a wider range of options to choose from in their adult lives. Haybron makes the point that “the Amish are not crazy to fear that such a policy would threaten one of their most cherished values, that of community” (p 266). It seems to me that it would be possible for a classical liberal to take a position on either side of such an issue, depending on the facts of the situation e.g. whether a strong case can be made that the rights of the children are being breached and whether it is likely that government intervention on their behalf would actually improve their chances of having a happy life.
Haybron’s example of the possible harm that could be done to community well-being through economic development of an island is worth considering at greater length. The residents of the island are assumed initially to have relatively low incomes but to enjoy, on average, a high level of happiness, due to strong community bonds and a culture that emphasizes the enjoyment of life. It is possible for any one resident to obtain a substantial net benefit by selling land to developers who wish to develop the tourist potential of the island, since the incremental effect of any one sale on the community lifestyle is minimal. But, taken together, many such sales may have an overall negative effect on the average happiness of the island’s long term residents. Should the development be stopped?
A different example, concerning the views of Justus Moser about the impact of global commerce on local culture, might help to clarify the issues involved. Jerry Muller tells us that Moser was a leading citizen in Osnabruck, a self-governing region in western Germany, in the 18th century (“The Mind and the Market” pp 84-103). Moser, like some modern-day opponents of globalisation, was concerned about the effects of trade on local lifestyles and culture. He condemned the growing taste for new, imported commodities, such as coffee, tea and sugar, especially among the lower ranks. He viewed shopkeepers as the local agents of the new international economy who robbed artisans of their customers and their livelihood. He reserved his greatest condemnation, however, for foreign peddlers who were selling small quantities of imported goods to peasants who were largely outside the market economy. According to Moser, these activities were causing the rural population to be “stimulated, tempted, led astray and deceived”. He argued that the public needed to be protected from the temptation of buying products that they didn’t need like leather gloves, wool stockings, metal buttons, mirrors, cotton caps, knives and needles. Women also needed to be protected from local markets where they would chat and waste money on snacks and pleasantries, while ignoring their household duties. Should trade restrictions be imposed to protect local lifestyles and culture?
What is the main difference between these two examples? It seems to me that it is possible that there could be close to a unanimous view among the long-term residents of Haybron’s island in favour of restricting certain kinds of economic development, but it is unlikely that Justus Moser, and the modern day opponents of globalisation, could persuade many of their fellow citizens that they need to be protected from the temptations of international commerce.
Can the legitimate interests of communities in preserving lifestyles of their members be met without making unacceptable encroachments on liberty? Dan Haybron evidently does not think so. At the end of his book he seems to be suggesting that we have to choose between paternalistic interventions that might, or might not, promote happiness and the individual’s right to pursue unhappiness (like the Savage in Aldous Huxley’s “Brave New World”).
I think that view is too pessimistic. Robert Nozick’s concept of a framework for utopia (briefly discussed here) seems to me to provide a good way to begin thinking more optimistically about these issues. People who want the opportunities that economic growth provides should be able to choose to live in communities that provide those opportunities, while those who value a more simple lifestyle should be able to choose to live in communities in which economic development is restricted in various ways. Do you think that idea is too utopian?
Postscript:
I would like to draw attention to Dan Haybron's comment below.
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