Soros on state of economics

I had posted about Soros initiative to improve state of economic research.

In this paper, he sets out his agenda and also reviews the state of economics.

Economic theory has modeled itself on theoretical physics. It has sought to establish timelessly valid laws that govern economic behavior and can be used reversibly both to explain and to predict events. But instead of seeking laws capable of being falsified through testing, economics has increasingly turned itself into an axiomatic discipline consisting of assumptions and mathematical deductions – similar to Euclidean geometry.

Rational expectations theory and the efficient market hypothesis are products of this approach. Unfortunately they proved to be unsound. To be useful, the axioms must resemble reality. Euclid’s axioms meet that condition; rational expectations theory does not. It postulates that there is a correct view of the future to which the views of all the participants tend to converge. But the correct view is correct only if it is universally adopted by all the participants — an unlikely prospect. Indeed, if it is unrealistic to expect all participants to subscribe to the theory of rational expectations, it is irrational for any participant to adopt it. Anyhow, rational expectations theory was pretty conclusively falsified by the crash of 2008 which caught most participants and most regulators unawares. The crash of 2008 also falsified the Efficient Market Hypothesis because it was generated by internal developments within the financial markets, not by external shocks, as the hypothesis postulates.

Anyone reading Soros, will know all this.

Another interesting bit from his paper is development of financial markts over the last 30 years.

I have formulated a specific hypothesis for the crash of 2008 which holds that it was the result of a “super-bubble” that started forming in 1980 when Ronald Reagan became President of the United States and Margaret Thatcher was Prime Minister of the United Kingdom. The prevailing trend in the super-bubble was also the ever-increasing use of credit and leverage; but the misconception was different. It was the belief that markets correct their own excesses. Reagan called it the “magic of the marketplace”; I call it market fundamentalism. Since it was a misconception, it gave rise to bubbles. So the super-bubble was composed of a number of smaller bubbles — and punctuated by a series of financial crises. Each time the authorities intervened and saved the system by taking care of the failing institutions and injecting more credit when necessary. So the smaller bubbles served as successful tests of a false belief, helping the super-bubble to grow bigger by reinforcing both credit creation and market fundamentalism. 

Actually pretty similar to what Greenspan also said in this paper. Read the whole thing for more details. Interesting throughout.

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