Reflexivity
What Is Reflexivity?
Reflexivity in economics is the theory that a feedback loop exists in which investors' perceptions influence economic fundamentals, which thusly changes investor discernment. The theory of reflexivity has its foundations in social science, however in the world of economics and finance, its primary defender is George Soros. Soros accepts that reflexivity discredits quite a bit of mainstream economic theory and ought to turn into a major focal point of economic research, and even makes vainglorious claims that it "leads to another profound quality as well as another epistemology."
Figuring out Reflexivity
Reflexivity theory states that investors don't base their choices on reality, yet rather on their perceptions of reality all things being equal. The activities that outcome from these perceptions affect reality, or fundamentals, which then, at that point, influences investors' perceptions and in this manner prices. The cycle is self-building up and inclines toward disequilibrium, making prices become progressively detached from reality. Soros sees the global financial crisis as an illustration of the theory. In his view, rising home prices induced banks to increase their home mortgage lending and, thusly, increased lending helped drive up home prices. Without a check on rising prices, this brought about a price bubble, which eventually fell, bringing about the financial crisis and Great Recession.
Soros' theory of reflexivity runs counter to the concepts of economic equilibrium, rational expectations, and the efficient market hypothesis. In mainstream economic theory, equilibrium prices are implied by the real economic fundamentals that decide supply and demand. Changes in economic fundamentals, for example, consumer preferences and real resource scarcity, will actuate market participants to bid prices up or down based on their pretty much rational expectations of what economic fundamentals suggest about future prices. This cycle incorporates both positive and negative feedback among prices and expectations in regards to economic fundamentals, which balance each other out at another equilibrium price. Without major hindrances to imparting information in regards to economic fundamentals and participating in transactions at mutually agreed prices, this price cycle will quite often keep the market moving rapidly and efficiently toward equilibrium.
Soros accepts that reflexivity challenges the possibility of economic equilibrium since it means prices could digress from the equilibrium values overwhelmingly relentlessly after some time. As Soros would see it, this is on the grounds that the course of price formation is reflexive and overwhelmed by positive feedback loops among prices and expectations. When a change in economic fundamentals happens, these positive feedback loops make prices under-or overshoot the new equilibrium. Here and there, the normal negative feedback among prices and expectations with respect to economic fundamentals, which would counterbalance these positive feedback loops, comes up short. Eventually, the trend turns around once market participants perceive that prices have become detached from reality and modify their expectations (however Soros doesn't perceive this as negative feedback).
As evidence for his theory, Soros points to the win fail cycle and different episodes of price bubbles followed by price crashes, when it is widely accepted that prices digress unequivocally from the equilibrium values implied by economic fundamentals. He frequently makes reference to the utilization of leverage and the availability of credit in starting the cycle, and the job of floating currency exchange rates in these episodes.
Features
- Reflexivity's primary advocate is George Soros, who credits it with quite a bit of his prosperity as an investor.
- Reflexivity is a theory that positive feedback loops among expectations and economic fundamentals can cause price trends that substantially and industriously digress from equilibrium prices.
- Soros accepts that reflexivity goes against the vast majority of mainstream economic theory.
