Reheated wizardry

George Soros is perhaps the best- known financier in the world. He sprang to fame in 1992 when he made vast amounts of money on a bet that sterling would be forced out of the European Exchange Rate Mechanism. Soros as a man is far more interesting than the typical player on financial markets. He has used his own money to try to make the world a better place. He has given many millions of dollars to support the countries of the former Soviet bloc and to pay for programmes designed to improve the bleak prospects of those in America's inner cities.

His book is divided into two main sections, the first of which sets out his conceptual framework and the second tries to apply it to recent developments in world financial markets. We are assured that distinguished academics such as Anthony Giddens, a sociologist and director of the London School of Economics, commented on more than one version of the manuscript. But, nevertheless, it remains by no means easy to read. For example, one of Soros's long-standing obsessions has been with the work of Karl Popper; and the subtitle of his book reflects Popper's great book, The Open Society and its Enemies. But even armed with a knowledge of Popper, the philosophical discourses at the beginning of the book are sometimes difficult to penetrate.

The mathematician G. H. Hardy once complained that he was sent huge amounts of unsolicited material written by amateurs. Most of it was worthless, but occasionally something really interesting would turn up. It has to be said that a similar impression is conveyed by Soros's book. There are very valuable nuggets, but substantial parts of the text are simply banal, while yet others appear to yield little meaning. But such a judgement would be too harsh on its own. Soros has clearly spent many years not just operating in financial markets, but reflecting on how they actually work and how they affect the rest of the economy. Purely by his own efforts, he has arrived at a number of powerful insights. Such a feat is impressive by any standards.

The problem with this approach, which is at the same time both the main strength and the main weakness of the book, is twofold. Soros is not the only person, and by no means the first, to have come to similar views. And a familiarity with the work of others would have prevented him from drawing certain key implications that are simply wrong.

The starting point of his analysis is that equilibrium theory in economics is based on a false analogy with physics. He describes the difference between economics and physics clearly: "Physical objects move the way they move irrespective of what anybody thinks ... human beings respond to the economic, social and political forces in their environment." In other words, the behaviour of economic agents can be affected directly by the behaviour of others. In the core theoretical model of economics, this does not happen. Agents have fixed tastes and preferences. This assumption rules out the fact that the decision of lots of people to buy a product can of itself make it more desirable to others.

Soros contends that such behaviour is fundamental to financial markets and in this central insight he is absolutely right. Indeed, we can see the same effect in a wide range of markets. However, he writes as if he is the first person to identify this fundamental difficulty with orthodox economics. He coins the term "reflexivity" to describe the effect, and this phrase pervades the book. But many of the earlier, great economists such as Alfred Marshall at the turn of the last century realised that the assumption of fixed tastes and preferences was an extremely restrictive one.

It is only in more recent years that economists seem to have forgotten its limitations. The tools required to analyse the implications of relaxing this assumption were not available to Marshall. But they are now.

Soros argues correctly that such behaviour completely undermines the concept of equilibrium in economic theory. But his lack of familiarity with the relevant literature leads him to draw several incorrect implications from his principle of "reflexivity". The most important of these, for it dominates his policy analysis in the second half of the book, is that financial markets are "inherently unstable".

We do observe constant change on financial markets, but we very rarely see completely explosive, unstable situations. The hyperinflations of the 1920s and in some former Soviet countries today are such examples, but almost all of the time the swings on markets are far less dramatic. Soros is right in contending that markets never settle to equilibrium, as economic theory requires. But "reflexivity" does not mean that the concept of stability disappears. Rather, equilibrium needs to be redefined in relation to the distribution of possible outcomes, the amount of time that the system spends in different states of the world.

The second part of the book skips through topics with sometimes bewildering speed. The European Union is denounced as "a top-heavy bureaucratic organisation, shrouded in secrecy and not responsible to the public". Turning the page, the United States is urged to "resume its role as leader of the free world", while yet another simple turn of the page leads to prescriptions for the restructuring of the United Nations.

But much of the policy discussion relates back to Soros's idea of reflexivity and to his belief that this creates fundamental economic instabilities. Yet despite his theory, Soros avoids making any specific prediction about when, if ever, what he terms the "final crisis" will take place. History suggests that the predictive success of such apocalyptic theories is not good. Marx diagnosed the ultimate collapse of capitalism 150 years ago, yet the system is still going strong.

This is far from saying that capitalism is a perfect system. Soros draws attention, as do many others, to the inequalities that exist and to problems that can arise when too much emphasis is given to the profit motive alone, a point made forcefully by Adam Smith over 200 years ago. But this is not the same thing as proving that capitalism is inherently unstable.

One is forced to empathise with Soros's struggles to make better sense of the world, and to admire the fact that he has tried to do so. But, even making such allowances, it is hard to identify a group of readers to whom the book could be recommended. Indeed, one suspects that Soros himself anticipated this difficulty. Towards the end of the book, he asks rather plaintively "I wonder if you would be reading this book if I had not gained a reputation as a financial wizard". He does not supply the answer, but he is smart enough to know what it is.

Paul Ormerod is chairman, Post-Orthodox Economics.