What Is Reflexivity? How It Works, History, and Opposing Theories

What Is Reflexivity?

Reflexivity in economics is the theory that a feedback loop exists in which investors' perceptions affect economic fundamentals, which in turn changes investor perception. The theory of reflexivity has its roots in sociology, but in the world of economics and finance, its primary proponent is George Soros. Soros believes that reflexivity disproves much of mainstream economic theory and should become a major focus of economic research, and even makes grandiose claims that it "gives rise to a new morality as well as a new epistemology."

Understanding Reflexivity

Reflexivity theory states that investors don't base their decisions on reality, but rather on their perceptions of reality instead. The actions that result from these perceptions have an impact on reality, or fundamentals, which then affects investors' perceptions and thus prices. The process is self-reinforcing and tends toward disequilibrium, causing prices to become increasingly detached from reality. Soros views 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, in turn, increased lending helped drive up home prices. Without a check on rising prices, this resulted in a price bubble, which eventually collapsed, resulting in the financial crisis and Great Recession.

Soros’s 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 determine supply and demand. Changes in economic fundamentals, such as consumer preferences and real resource scarcity, will induce market participants to bid prices up or down based on their more or less rational expectations of what economic fundamentals imply about future prices. This process includes both positive and negative feedback between prices and expectations regarding economic fundamentals, which balance each other out at a new equilibrium price. In the absence of major obstacles to communicating information regarding economic fundamentals and engaging in transactions at mutually agreed prices, this price process will tend to keep the market moving quickly and efficiently toward equilibrium.

Soros believes that reflexivity challenges the idea of economic equilibrium because it means prices might deviate from the equilibrium values by a significant amount persistently over time. In Soros’s opinion, this is because the process of price formation is reflexive and dominated by positive feedback loops between prices and expectations. Once a change in economic fundamentals occurs, these positive feedback loops cause prices to under- or overshoot the new equilibrium. In some way, the normal negative feedback between prices and expectations regarding economic fundamentals, which would counterbalance these positive feedback loops, fails. Eventually, the trend reverses once market participants recognize that prices have become detached from reality and revise their expectations (though Soros does not recognize this as negative feedback).

As evidence for his theory, Soros points to the boom-bust cycle and various episodes of price bubbles followed by price crashes, when it is widely believed that prices deviate strongly from the equilibrium values implied by economic fundamentals. He often makes reference to the use of leverage and the availability of credit in initiating the process, and the role of floating currency exchange rates in these episodes.