Tag: finance

Reflexivity

I’ve always been fascinated by the concept of reflexivity. What is reflexivity? It is the bidirectional relationship of a subject as both a participant (manipulative function) and observer (cognitive function) between “cause and effect”. As an observer I watch a fire burn; as a participant I add fuel to the fire or stifle its flame: my beliefs about the observed fire, if it is growing or dwindling, influence how I engage with it.  Maybe a more accurate example relates to prices: my current willingness to buy a good is influenced by the price I observe and, in turn, the act of buying drives up demand which increases the price and influences my price observations, affecting my future willingness to buy (I’ll work on a clearer example).

While I’m fascinated with the sociological implications, I’m even more fascinated with how these implications manifest within economic decision making. I really need to investigate and read up on behavioral economics more thoroughly.

I’ve been aware of the concept of reflexivity for quite awhile but only recently has it perked my interest in the context of economics and finance. Before that my understanding was confined to the psychological decision making aspects. What really brought these two together was my recent interest in how mass speculation affects the market place. Two books cultivated this interest, specifically “A Short History of Financial Euphoria” and “The Big Short”.

So reflexivity. Karl Popper introduced this idea into social theory, and social theory and economics, as you can imagine, are intimately linked. George Soros, a pupil of Popper, really capitalized on the utility of synthesizing and applying the two concepts to finance. That’s where I want to continue my study.

There are three areas of study that fascinate me at the moment: Evolutionary Economics, Reflexivity and Social Theory, and Disequilibrium States (more specifically, the process of creative destruction as coined by Schumpeter).  I’d really like to apply some philosophy and social theory to economics and come up with a qualitative economic system that capitalizes on the current short comings of neoclassical thought and market structures. Soros has done it, but I’d like to master his ideas and continue progressing with them. There’s gotta be some piece of the puzzle, or pie, that I can really develop and utilize for gain. I found this lil’ power point to be a helpful introduction to some of Soro’s ideas. My next readings will involve the works of Karl Popper (Philosophy of Science), Robert Schiller (Behavioral Economics), George Soros (Reflexivity), and Hyman Minsky (Disequilibrium States).

Soro’s provides a brief introduction to his concept of reflexivity in his book The Age of Fallibility:

”On the one hand, we seek to understand our situation. I call this the cognitive function. On the other hand, we seek to make an impact on the world. I call this the participating function. The two functions work in opposite directions and they can interfere with each other. The cognitive function seeks to improve our understanding. The participating function seeks to improve our position in the world. If the two functions operated independently of each other, they could in theory serve their purpose perfectly well. If reality were independently given our views could correspond to reality. And if our decisions were based on knowledge, the outcomes would correspond to our expectations. But that is not the case because the two functions intersect, and where they intersect they may interfere with each other. I have given the interference a name: reflexivity. . . .”

Here’s a video where Soro’s goes further in depth with his thoughts on reflexivity titled The New Paradigm for Financial Markets.

http://mitworld.mit.edu/flash/player/Main.swf?host=cp58255.edgefcs.net&flv=mitw-01094-sloan-econ-soros-financial-mkts-28oct2008&preview=http://mitworld.mit.edu//uploads/mitw01094sloaneconsorosfinancialmkts28oct2008.jpg

 

Why I think this concept is so interesting is that it incorporates a multitude of qualitative cognitive functions as well as mechanisms that result from enculturation and socialization that guide choice and action.

All that aside, today I read an amazing article on evolutionary economics titled Evolutionary Economics and the Extension of Evolution to the Economy. I’d recommend the read if nothing else but to expand your knowledge on the promising subject of evolutionary economics.

More thoughts later.

I’m never sold on one person’s theory or another’s. My aim is always to understand and synthesize them all into my own unique perspective that I can successfully apply.

Thoughts on Reflexivity

I’ve always been fascinated by the concept of reflexivity. What is reflexivity? It is the bidirectional relationship of a subject as both a participant (manipulative function) and observer (cognitive function) between “cause and effect”. As an observer I watch a fire burn; as a participant I add fuel to the fire or stifle its flame: my beliefs about the observed fire, if it is growing or dwindling, influence how I engage with it.  Maybe a more accurate example relates to prices: my current willingness to buy a good is influenced by the price I observe and, in turn, the act of buying drives up demand which increases the price and influences my price observations, affecting my future willingness to buy (I’ll work on a clearer example).

While I’m fascinated with the sociological implications, I’m even more fascinated with how these implications manifest within economic decision making. I really need to investigate and read up on behavioral economics more thoroughly.

I’ve been aware of the concept of reflexivity for quite awhile but only recently has it perked my interest in the context of economics and finance. Before that my understanding was confined to the psychological decision making aspects. What really brought these two together was my recent interest in how mass speculation affects the market place. Two books cultivated this interest, specifically “A Short History of Financial Euphoria” and “The Big Short”.

Karl Popper introduced the idea of reflexivity into social theory, and social theory and economics, as you can imagine, are intimately linked. George Soros, a pupil of Popper, really capitalized on the utility of synthesizing and applying the two concepts to finance. That’s where I want to continue my study.

There are three areas of study that fascinate me at the moment: Evolutionary Economics, Reflexivity and Social Theory, and Disequilibrium States (more specifically, the process of creative destruction as coined by Schumpeter).  I’d really like to apply some philosophy and social theory to economics and come up with a qualitative economic system that capitalizes on the current short comings of neoclassical thought and market structures. Soros has done it, but I’d like to master his ideas and continue progressing with them. There’s gotta be some piece of the puzzle, or pie, that I can really develop and utilize for gain. I found this lil’ power point to be a helpful introduction to some of Soro’s ideas. My next readings will involve the works of Karl Popper (Philosophy of Science), Robert Schiller (Behavioral Economics), George Soros (Reflexivity), and Hyman Minsky (Disequilibrium States).

Soro’s provides a brief introduction to his concept of reflexivity in his book The Age of Fallibility:

”On the one hand, we seek to understand our situation. I call this the cognitive function. On the other hand, we seek to make an impact on the world. I call this the participating function. The two functions work in opposite directions and they can interfere with each other. The cognitive function seeks to improve our understanding. The participating function seeks to improve our position in the world. If the two functions operated independently of each other, they could in theory serve their purpose perfectly well. If reality were independently given our views could correspond to reality. And if our decisions were based on knowledge, the outcomes would correspond to our expectations. But that is not the case because the two functions intersect, and where they intersect they may interfere with each other. I have given the interference a name: reflexivity. . . .”

Here’s a video where Soro’s goes further in depth with his thoughts on reflexivity titled The New Paradigm for Financial Markets.

 

Why I think this concept is so interesting is that it incorporates a multitude of qualitative cognitive functions as well as mechanisms that result from enculturation and socialization that guide choice and action.

All that aside, today I read an amazing article on evolutionary economics titled Evolutionary Economics and the Extension of Evolution to the Economy. I’d recommend the read if nothing else but to expand your knowledge on the promising subject of evolutionary economics.

More thoughts later.

I’m never sold on one person’s theory or another’s. My aim is always to understand and synthesize them all into my own unique perspective that I can successfully apply.

Financial Euphoria & Its Speculative Ruin

The recent financial and economic crisis is yet again the result of the same speculative orgy that happened not twenty years prior in the 1987 market crash. When the dust settled, the same inimical features culpably appear as reason for the disaster. As happened so many times in history, there was intense speculation that was fueled by misplaced faith in the lenders and rich. The association with intelligence and money contributed to a speculative boom that lead individuals to risks and over extend their confidence and credit. In addition, financiers at large investment banking companies were hailed for their seemingly innovative, yet unoriginal, practices of leveraging debt through financial instruments taking the forms of derivatives, securities and ARM’s (adjustable rate mortgages).

In the 90’s the US government passed a series of policies allowing home buyers to more easily secure mortgages through government backed debt. As more and more people began buying homes, housing values began to increase all over the countries. In attractive states such as Florida and Nevada, housing prices near tripled their original value. Lending companies began to underwrite mortgages well under standards to meet the demand and soon began pushing sub-prime loans onto home buyers. Many unworthy home buyers maintained poor credit, or bought multiple homes with hopes of flipping the home on speculation that its value will continue appreciating.

The speculative housing mania fostered the creation of massive MDS (mortgage backed securities) and subsequently CDO’s (collateralized debt obligations) which allowed shadow banking systems and credit markets to flourish while operating with little or no oversight. These and other “financial innovations”, nothing more repackaged debt being attractively marketed to meet investor demands, resulted in growing specious debt being incorrectly valued and over leveraged.

To hedge against risk, investors unloaded securities through CDS’s (credit default swaps) to mitigate against potential loss. These CDS’s allowed for more speculation as investors could basis trade on CDS spreads. As more and more loans defaulted, packaged MDS and CDO’s became riddled with unknown risk value and were dubbed toxic. These derivatives soon became worthless as panic stricken investors began selling bonds.

The banks bought these mortgage backed securities with the thought that, being backed by actual homes, they were fairly risk free. They predicted that the home values would sustain and that they could simply turn around and sell the properties at these high prices to compensate for any defaulted debt. In 2006 the crisis was set in motion when the housing bubble began to deflate as economic pressures forced home buyers to walk out on loans, leaving a wake of severely overvalued and ‘toxic’ securities in its path.

Major financial institutions, deemed credible and near prophetic with their steady gains, capitalized on the public’s gullibility for getting rich quick, as well as their short term memory of the financial crash just twenty years prior. These lending and banking institutions were thought to be “too big to fail” and garnered the pollyanna support of investors all over the world. As the housing market evaluations increased so too did the financial and banking markets in exponential disproportion.

In addition, individuals hailed as innovative financial frontiersman possessed the reputations that granted the support of willful and ignorant investors of all over. Such financiers included once NASDAQ chairman Bernard Madoff who masterminded a reminiscent Ponzi scheme that would rob investors of more than $60 billion. Hedge funds and the wealthy elite all over the world became victims of his vacuous enterprise.

As in all major financial disasters to date, the subsequent crash caused a sudden and permanent drop in US wealth as more than a quarter of wealth evaporated from their coffers. A decrease in consumption lead to an increase in unemployment above fourteen percent and the annualized rate of decline in US GDP reached closed to fifteen percent.

As the past has revealed, the aftermath of the crash caused a blind hunt to find and persecute the blameworthy. Everyone from the banks to the investors to the fed chairman and even the president of the US has been subject to scrutiny and called out for not predicting and preventing such an event. While regulation policies and reform measures followed, there was almost predictably no talk to the wide spread delusion and mania persistent throughout society which allowed for such a disaster to take place. Little blame was placed on the mass insanity of those who gullibly entrusted their money to “intelligent investors” of the financial community. Nor was their criticism of the baseless free-enterprise attitudes that the market is a perfect and neutral force absolved from external influences and inherent errors.

Those held responsible, mostly investment bankers and hedge fun managers, found their integrity and confidence completely ruined. As seen in the past, some fled in light of the impending crash, cashing out and leaving with their pockets full before they were apprehended as the cause. Many others, broken and shamed, thought suicide was the more appropriate measure for reconciling their guilt.

In the end euphoric speculation was the crux of the financial disaster as the masses became entranced with the seemingly boundless increases in the market. Vacuous financial innovations that leveraged risky debt were fabricated to promote and continue the growth. Those jumping on the bandwagon only fueled and reinforced the delusion. Caught up in the euphoric mood, many sage and perspicacious people overlooked the risks and the inevitable end that was to come.