Yes I believe in free markets, but the problem is that free markets can’t control themselves. And from none other than George Soros did I hear an argument that supports my belief.


Reflexivity, financial markets, and economic theory

Soros’ writings focus heavily on the concept of reflexivity, where the biases of individuals enter into market transactions, potentially changing the fundamentals of the economy. Soros argues that such transitions in the fundamentals of the economy are typically marked by disequilibrium rather than equilibrium, and that the conventional economic theory of the market (the ‘efficient market hypothesis’) does not apply in these situations. Soros has popularized the concepts of dynamic disequilibrium, static disequilibrium, and near-equilibrium conditions.[11]

Reflexivity is based on three main ideas[11]:

   1. Reflexivity is best observed under special conditions where investor bias grows and spreads throughout the investment arena. Examples of factors that may give rise to this bias include (a) equity leveraging or (b) the trend-following habits of speculators.
   2. Reflexivity appears intermittently since it is most likely to be revealed under certain conditions; i.e., the equilibrium process’s character is best considered in terms of probabilities.
   3. Investors’ observation of and participation in the capital markets may at times influence valuations AND fundamental conditions or outcomes.

A current example of reflexivity in modern financial markets is that of the debt and equity of housing markets. Lenders began to make more money available to more people in the 1990s to buy houses. More people bought houses with this larger amount of money, thus increasing the prices of these houses. Lenders looked at their balance sheets which not only showed that they had made more loans, but that their equity backing the loans–the value of the houses, had gone up (because more money was chasing the same amount of housing, relatively). Thus they lent out more money because their balance sheets looked good, and prices went up more, and they lent more, etc. Prices increased rapidly, and lending standards were relaxed. The salient issue regarding reflexivity is that it explains why markets gyrate over time, and do not just stick to equilibrium–they tend to overshoot or undershoot.[11]

Robert in my Jim Rogers and smoke blog entry said.

If people are still buying steel somewhere in the world, than not everyone would go out of business and there would still be supply available. The stronger players would buy assets from the weaker ones – Yes, there would be a lag time when supply would be tight while the economy first starts to recover, but it would catch up with demand… You’re also forgetting something – Why is one company able to survive and another not? It’s cost structure could be lower due to differing labour rates, currency differentials, or it may be a well structured company with less debt and more efficient steel plants… Almost any company can do well when times are good – but when times start to slow, the real test occurs. There is a reason why one company survives and another fails – economics. You can’t cheat economics – you can delay it a while.

I agree with this when everything is rational. But as George Soros points out markets have a tendency to overshoot or undershoot. And that is where the problem lies.

In his recent testimony to the US House Committee George Soros said many things, but the following bears real attention.

This remarkable sequence of events can be understood only if we abandon the prevailing theory of market behavior. As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.

While the two-way connection is present at all times, it is only occasionally, and in special circumstances, that it gives rise to financial crises. Usually markets correct their own mistakes, but occasionally there is a misconception or misinterpretation that finds a way to reinforce a trend that is already present in reality and by doing so it also reinforces itself. Such self-reinforcing processes may carry markets into far-from-equilibrium territory. Unless something happens to abort the reflexive interaction sooner, it may persist until the misconception becomes so glaring that it has to be recognized as such. When that happens the trend becomes unsustainable and when it is reversed the self-reinforcing process starts working in the opposite direction, causing a sharp downward movement.

The problem is that the market is not rational and when things become irrational then all heck breaks loose. So a company that supposedly was strong is pulled down in the muck and fighting for its own survival.

It is a death spiral and it does not stop until everything is destroyed. The most glaring example of this occurred in the 1600’s and 1700’s. At that time the markets were completely free and completely speculative. And each time (eg South Sea crisis) the market blew up it wiped out the market by about 90% of the companies.

Imagine the financial chaos that would occur if 90% of the stock market was wiped out. Our economic system would collapse.

Look at the death spiral that is happening now even though the governments and banks are pouring in billions. Nobody wants to buy stocks, cars, or anything because they are fearful. This begets more fear, and begets more fear and as George Soros points out the misplaced fear becomes reality!

I make the point with Toyota. You would say, "now this is a company that is doing everything right. Yet their stock is tanking, Fast Money is saying, ‘short this stock whenever it rises because there is still plenty of meat on the bone.’" If the free market is saying that Toyota is a good company why are they not investing in it? Answer, because the free market has collapsed and fear rules.

I agree the free market works when things are pretty rational, NOT when things are irrational!

I found the following books most helpful to understand how systems can collapse:

Devil Take The Hindmost

Against the Gods

The Rise and Fall of Great Empires