Barry Eichengreen THE CRISIS OF (CONFIDENCE IN) GLOBAL CAPITALISM ABSTRACT: In The Crisis of Global Capitalism, George Soros claims that the international financial economy is inherently unstable, and that while econo- mists have failed to recognize this because of their commitment to static equilib- rium theory, politicians have failed to stabilize the global economy because of their commitment to an unquestioned faith in the complete efficiency of laissez faire.While Soros is right to argue that market participants’ expectations about the future can cause instability,he is wrong to maintain that this has gone unrec- ognized by economists, and his notion that we live in a world of economic laissez faire is equally mistaken. Indeed, his own analysis of the Asian financial crisis points to the “moral hazard” created by expectations of government inter- vention, rather than to laissez faire, as the culprit. In The Crisis of Global Capitalism (New York:PublicAffairs Press, ), George Soros—investment tycoon, philanthropist, and celebrity—lays out his life philosophy, delivers a stinging critique of modern economic theory, and comments on the health of the global financial system. He provides new information about his role and that of his investment partnerships, the Quantum Funds, in the Asian crisis in and Rus- sia’s default and devaluation in . And somewhat surprisingly for our leading international financier, he offers some stunningly ambitious proposals for protecting civil society from financial globalization. Critical Review (), no. ISSN ‒.© Critical Review Foundation. Barry Eichengreen is John L. Simpson Professor of Economics and Political Science at the University of California, Berkeley, CA ; Research Associate of the National Bureau of Economic Research; and Research Fellow of the Centre for Economic Policy Research. Critical Review Vol. 14, No. 1 Soros is a prominent public figure, and his opinions are taken seri- ously by the markets and by the congressional committees before which he is called to testify. It is therefore welcome to have his views in print. Unfortunately, they come in a frustrating form. The Crisis of Global Capitalism shows signs of having been rushed into print in response to what the author perceived as the last gasp of an expiring global finan- cial system. Divided into two parts, one of which lays out the author’s conceptual framework and another of which applies it to the present moment in history, the book in fact wanders back and forth between conceptual and historical material. Repetition is a problem. Together with the book’s informal tone, this leads one to suspect that portions are transcriptions of the author’s conversations with his editor. The book’s fatal flaw, though, is that it is inadequately grounded in the scholarly literature. This is, to be sure, a predictable criticism com- ing from an academic called upon to review a practitioner’s book. But pedantry aside, there is no question that Soros is led to commit some very serious blunders as a result of his ignorance, or at least disregard, of the relevant economic scholarship. “Reflexivity” vs. Economic Equilibrium At the core of the current approach to organizing economic activity, Soros argues, is a deep-seated belief that markets—financial markets in particular—are both stable and the best way of organizing economic and societal affairs. Soros attaches the label “market fundamentalism” to the belief in laissez faire of which he is so critical. He argues that finan- cial markets, contrary to the rigid beliefs of the fundamentalists, are in fact unstable, and that important social needs cannot be met by giving them free reign. Market fundamentalism, according to Soros, is grounded in notions of economic equilibrium. The basis for this argument is the author’s theory of “reflexivity.” In natural sciences such as physics, he observes, the concept of equilibrium is well defined. A swinging pendulum will eventually reach a stable resting point. This metaphor has been invoked by economists to describe the behavior of markets since at least Adam Smith, who argued that the self-interested actions of individuals will guide the economy to a stable, economically efficient outcome. Smith’s notion was extended to the social domain by F. A. Hayek, who argued Eichengreen • Global Capitalism that the common social good was the unintended byproduct of indi- viduals acting in their self-interest. The metaphor was formalized and refined, using the calculus, by the first postwar generation of welfare theorists, who took their cue from Paul Samuelson’s Foundations of Economic Analysis (). The tools of the natural sciences and the pro- fessionalization of academia thus conspired to lend a veneer of re- spectability to the doctrine and the techniques of neoclassical econom- ics—which are, in Soros’s view, built fundamentally on an inappropriate notion of equilibrium. Whatever damage this did to intellectual discourse, however, the damage to society (according to Soros) was far greater. Misguided equi- librium theorizing encouraged the United States (under Reagan), the United Kingdom (under Thatcher), and other countries to discard the regulated, mixed economy in favor of cut-throat capitalism. The result, Soros continues, has been to fray the social fabric, heighten the inci- dence of financial instability, and undermine political support for the market. Why, according to the author, do models characterized by stable, so- cially efficient equilibria offer a misleading picture of the market sys- tem? The critical point, in his view, is that markets, unlike the systems analyzed by physicists, are inhabited by conscious agents; recognition of this fact leads Soros to his theory of “reflexivity.”While “the facts about the natural world are independent of the statements that scientists make about them” (), financial markets are influenced by what market par- ticipants think other participants are likely to do. Expectations affect ac- tions, and actions affect expectations. Soros distinguishes the “passive function,” in which participants seek merely to understand the situation in which they participate, from the “active function,” in which they seek to make an impact on that situation. “Reflexivity” arises when both functions are at work. The reflexive interaction of expectations and outcomes can give rise to indeterminacy, Soros observes, since what happens will in general depend on what people think is going to happen. And it can give rise to instability, as agents impulsively reject one belief about what will happen in favor of another. When markets move as expected, partici- pants’ confidence in their understanding of the underlying dynamic will be reinforced, sustaining the initial trend. But when expectations are consistently violated, they will have to be revised, and that revision may precipitate a violent change in market direction. Market movements have such a powerful impact on expectations, Critical Review Vol. 14, No. 1 Soros argues, because the world in which we live is complex. Not only is information about its structure incomplete, but our ability to assimi- late the available data is bounded. Individuals make use of generaliza- tion, metaphor, and analogy (in other words, models) to impose order on this complexity. The stock they place in a model will be reinforced (or eroded) by the extent to which outcomes are consistent (or in con- flict) with its predictions. In financial markets, the beliefs and actions of market participants are profoundly conditioned by this “reflexive feedback.”Imagine, for exam- ple, that investors are cautiously bullish about the stock market. If eq- uity prices do rise, their bullishness will be reinforced, and they will adapt their behavior accordingly. As a result, prices may then rise at rates totally out of relation to any discernible change in market funda- mentals. Analogously, pessimism about future asset prices can be rein- forced by a decline in their current level, leading investors to sell into a falling market. Since economic predictions can be self-fulfilling, markets can be highly volatile. Soros adds structure to these observations by dividing the boom-bust cycle into stages: an initial stage at which the trend is not yet recog- nized; a subsequent stage of trend acceleration; and a stage of excessive exuberance, when the trend is sustained by the reinforcement of initial expectations, despite the accumulation of counterevidence. Eventually there comes the moment of truth, when expectations are blatantly vio- lated, and the trend reverses with a vengeance. In the worst-case sce- nario, an economic crisis ensues. Social systems are prone to overshoot, Soros hypothesizes, in much the same way as markets. He observes that the Soviet system became increasingly rigid and authoritarian as a result of the two-way interac- tion of the dogma and practice of bureaucratic planning. Similarly, in the United States, financial deregulation has enhanced the political power of financial-market participants to press for still further deregula- tion, resulting in the creation of a dog-eat-dog “transactional society.” An open society is thus threatened from two directions. While au- thoritarianism was long the more worrisome danger, the collapse of communism has left nothing to resist market fundamentalism. Drawing on Karl Popper’s book, The Open Society and Its Enemies (), Soros argues that unfettered markets dissolve social bonds and set the stage for an authoritarian backlash. They do not deliver the collective goods— the social justice, equity, cohesion, moral values, and support for strong Eichengreen • Global Capitalism families and intellectual achievement—that are the building blocks of an open society. Popper’s concept of the open society, in juxtaposition to authoritari- anism, was already prominent in Soros’s earlier book, The Alchemy of Fi- nance (). What is new here is his opposition to market fundamen- talism. Soros criticizes the Hayekian notion, popularized by works like Milton and Rose Friedman’s Capitalism and Freedom (), that democracy and capitalism go hand in hand. To the contrary, he argues, unfettered capitalism will inevitably provoke a reaction against the depredations of the market.