The Theory of Reflexivity by George Soros

Delivered April 26, 1994 to the MIT Department of Economics World Economy
Laboratory Conference Washington, D.C.

When Rudi Dornbusch invited me to speak at this conference, he gave me
a totally free hand in deciding what I wanted to talk about. Well, I
want to discuss a subject which fascinates me but doesn’t seem to
interest others very much. That is my theory of reflexivity which has
guided me both in making money and in giving money away, but has
received very little serious consideration from anybody else. It is
really a very curious situation. I am taken very seriously; indeed, a
bit too seriously. But the theory that I take seriously and, in fact,
rely on in my decision-making process is pretty completely ignored. I
have written a book about it which was first published in 1987 under
the title The Alchemy of Finance; but it received practically no
critical examination. It has been out of print for the last several
years but demand has been building up as a result of my increased
visibility, not to say notoriety, and now the book is being re issued.
I think this is a good time to get the theory seriously considered.

I was invited to testify before Congress last week and this is how I
started my testimony. I quote: “I must state at the outset that I am in
fundamental disagreement with the prevailing wisdom. The generally
accepted theory is that financial markets tend towards equilibrium, and
on the whole, discount the future correctly. I operate using a
different theory, according to which financial markets cannot possibly
discount the future correctly because they do not merely discount the
future; they help to shape it. In certain circumstances, financial
markets can affect the so called fundamentals which they are supposed
to reflect. When that happens, markets enter into a state of dynamic
disequilibrium and behave quite differently from what would be
considered normal by the theory of efficient markets. Such boom/bust
sequences do not arise very often, but when they do, they can be very
disruptive, exactly because they affect the fundamentals of the
economy.” I did not have time to expound my theory before Congress, so
I am taking advantage of my captive audience to do so now. My apologies
for inflicting a very theoretical discussion on you.

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