What Is Reflexivity?

What Is Reflexivity?

Let me explain reflexivity in economics to you directly: it's the idea that a feedback loop exists where investors' perceptions influence economic fundamentals, and those changes then alter perceptions again. This concept originates from sociology, but in economics and finance, George Soros is its biggest advocate. He argues that reflexivity undermines much of mainstream economic theory and should be a central focus for research—he even claims it leads to a new morality and epistemology.

Understanding Reflexivity

You need to grasp that reflexivity theory says investors make decisions based on their perceptions of reality, not reality itself. These actions then impact the actual fundamentals, which in turn affect perceptions and prices. This creates a self-reinforcing process that pushes toward disequilibrium, detaching prices from reality. Soros sees the global financial crisis as a prime example: rising home prices led banks to lend more for mortgages, and that lending drove prices even higher. Without checks, this formed a bubble that burst, causing the crisis and Great Recession.

Soros's theory opposes ideas like economic equilibrium, rational expectations, and the efficient market hypothesis. In standard theory, equilibrium prices come from real fundamentals driving supply and demand. Shifts in fundamentals, like consumer tastes or resource scarcity, prompt market participants to adjust prices based on rational expectations of the future. This involves both positive and negative feedback between prices and expectations, balancing out at a new equilibrium. Without barriers to information or transactions, markets move efficiently toward this balance.

But Soros argues reflexivity challenges equilibrium because prices can persistently stray far from equilibrium values. He says price formation is reflexive, dominated by positive feedback loops between prices and expectations. When fundamentals change, these loops cause prices to under- or overshoot the new equilibrium. Somehow, the usual negative feedback fails to counterbalance this. Eventually, the trend reverses when participants realize prices are detached from reality and adjust expectations—though Soros doesn't frame this as negative feedback.

For evidence, Soros points to boom-bust cycles and price bubbles followed by crashes, where prices clearly deviate from fundamental equilibrium. He often highlights leverage, credit availability, and floating exchange rates as key factors in starting these episodes.