"A 'New' Paradigm for Financial Markets"?

I am reading George Soros's The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means (New York: Public Affairs, 2008).  Soros begins the book by explaining both how he sees the current crisis, why we are in a crisis, and why his theory of reflexivity does a better job than the neoclassical model of perfect knowledge and perfect competition.  All would be good, except that somehow laissez faire is both used to describe the model of perfect knowledge/perfect competition (and equilibrium always), and used to describe the policy reality of the past quarter center of credit expansion and lax regulation of the financial markets world-wide.

But I wonder why this sort of contradiction persists in the literature.  Soros correctly states that: "We are in the midst of the worst financial crisis since the 1930s.  In some ways it resembles other crises that have occurred in the last twenty-five years, but this is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process; the current crisis is the culmination of a super-boom that has lasted for more than twenty-five years."

The super-boom resulted because of "credit expansion, and a prevailing misconception, market fundamentalism (aka laissez faire in the nineteenth century) which holds that markets should be given free rein."

First, explain to me how anyone as well-read and thoughtful as Soros could equate credit expansion and laissez faire?  Isn't the very admission of massive credit expansion also an admission that we deviated from laissez faire.

Second, why do we need a new paradigm if the main problems we are identifying in the crisis are (a) the credit expansion, (b) a conflict between expectations in actors as they strive both to understand the situation and also act to change the situation (Soros's theory of reflexivity), and (c) a boom-bust cycle?  Why doesn't Hayek's work just fit what is needed in Soros's mind?

Is it the case that the answer to my first question explains the answer to the second?  And if so, what can be done to fix the confusions?

Comments

[Greg Ransom]

Soros isn't all that honest.

And he's not that well read.

He starts with deeply false "priors", he builds everything on those -- and he's not giving them up.

1st question answered.

[Jonathan]

Peter,

Would you be willing to comment on this piece by Ray Dalio, CEO of Bridgewater Associates? He argues in favor of a bailout of financial firms, but puts forth a far more thorough argument than I have seen elsewhere. How do you see his arguments jiving with the libertarian position that a bailout was not necessary?

"Great Moves"
http://www.bwater.com/Uploads/FileManager/Bridgewater_Daily_Observations/080919_Great_Moves.pdf

On a related note, this piece on banking is also interesting:
"An Inflection Point in Banking"
http://www.bwater.com/Uploads/FileManager/Bridgewater_Daily_Observations/080429_An_Inflection_Point_In_Banking.pdf

[Daniel J. D'Amico]

A more subtle way of saying, "don't you think Hayek was right and you're wrong."

Zing

[Dave Prychitko]

Pete: check your email today.

[Alex]

An anecdote I read somewhere about Soros.

He would express an elaborate theory as to why the market has to move in a certain way. When market moved in the other way, he said that he made a killing, because he changed his mind.

Maybe this characteristic of his makes him a good entrepreneur, but I doubt it makes him a trustworthy theorist.

[Bob Murphy]

It's funny Pete, but I've been desensitized to people thinking that a central bank is a normal part of government, like the White House. So you can have free market people talking about why the Fed should set interest rates at such-and-such a level, even though they wouldn't dream of saying the government ought to price oil at $x per barrel.

[Josh Hendrickson]

"Why doesn't Hayek's work just fit what is needed in Soros's mind?"

You have stumbled upon something important here. I am currently working on a project in which I discuss these ideas and the impact on the business cycle. This idea of reflexivity is not new. W. Brian Arthur attributed this view to Soros back in 1994 I believe. The idea, however, originates in Chapter 12 of Keynes's General Theory. (I should note that Roger Koppl has a pretty good discussion of this in his book on Big Players.)

I think that Hayek is the proper starting point for an analysis of these ideas and for developing a theory of Austrian expectations (an idea Roger Koppl and Bill Butos have done much to advance). However, I do think that the idea of reflexivity can play an important role in the face of Knightian uncertainty. The major question that arises is how prevalent such uncertainty is in everyday decision-making and the fundamental sources of such uncertainty.

Post Keynesians such as Davidson believe that such uncertainty is axiomatic in an entrepreneurial economy. Others such as Barkley Rosser consider this uncertainty to be the result of complexity.

By contrast, Koppl's theory of Big Players seems to provide a sufficient condition for such uncertainty as well. For example, in the presence of a Big Player central bank it is nearly impossible to predict what its next move (or the duration between moves). His empirical evidence shows that the presence of such players induces herd-like behavior, which is consistent with the idea of reflexivity.

At times I feel like Soros is on to something, but then he falls back into his sort of political agenda.

[DW MacKenzie]

To answer your question, Soros is not well read and thoughtful. Anyone who thinks that mainstream economists are unaware of imperfect competition and imperfect information has no clue...