The theory holds, in the most general terms, that the way philosophy and natural science have taught us to look at the world is basically inappropriate when we are considering events which have thinking participants. Both philosophy and natural science have gone to great lengths to separate events from the observations which relate to them. Events are facts and observations are true or false, depending on whether or not they correspond to the facts.
This way of looking at things can be very productive. The achievements of natural science are truly awesome, and the separation between fact and statement provides a very reliable criterion of truth. So I am in no way critical of this approach. The separation between fact and statement was probably a greater advance in the field of thinking than the invention of the wheel in the field of transportation.
But exactly because the approach has been so successful, it has been carried too far. Applied to events which have thinking participants, it provides a distorted picture of reality. The key feature of these events is that the participants’ thinking affects the situation to which it refers. Facts and thoughts cannot be separated in the same way as they are in natural science or, more exactly, by separating them we introduce a distortion which is not present in natural science, because in natural science thoughts and statements are outside the subject matter, whereas in the social sciences they constitute part of the subject matter. If the study of events is confined to the study of facts, an important element, namely, the participants’ thinking, is left out of account. Strange as it may seem, that is exactly what has happened, particularly in economics, which is the most scientific of the social sciences.
Classical economics was modeled on Newtonian physics. It sought to establish the equilibrium position and it used differential equations to do so. To make this intellectual feat possible, economic theory assumed perfect knowledge on the part of the participants. Perfect knowledge meant that the participants’ thinking corresponded to the facts and therefore it could be ignored. Unfortunately, reality never quite conformed to the theory. Up to a point, the discrepancies could be dismissed by saying that the equilibrium situation represented the final outcome and the divergence from equilibrium represented temporary noise. But, eventually, the assumption of perfect knowledge became untenable and it was replaced by a methodological device which was invented by my professor at the London School of Economics, Lionel Robbins, who asserted that the task of economics is to study the relationship between supply and demand; therefore it must take supply and demand as given. This methodological device has managed to protect equilibrium theory from the onslaught of reality down to the present day.
I don’t know too much about the prevailing theory about financial markets but, from what little I know, it continues to maintain the approach established by classical economics. This means that financial markets are envisaged as playing an essentially passive role; they discount the future and they do so with remarkable accuracy. There is some kind of magic involved and that is, of course, the magic of the marketplace where all the participants, taken together, are endowed with an intelligence far superior to that which could be attained by any particular individual. I think this interpretation of the way financial markets operate is severely distorted. That is why I have not bothered to familiarize myself with efficient market theory and modern portfolio theory, and that is why I take such a jaundiced view of derivative instruments which are based on what I consider a fundamentally flawed principle. Another reason is that I am rather poor in mathematics.
It may seem strange that a patently false theory should gain such widespread acceptance, except for one consideration; that is, that all our theories about social events are distorted in some way or another. And that is the starting point of my theory, the theory of reflexivity, which holds that our thinking is inherently biased. Thinking participants cannot act on the basis of knowledge. Knowledge presupposes facts which occur independently of the statements which refer to them; but being a participant implies that one’s decisions influence the outcome. Therefore, the situation participants have to deal with does not consist of facts independently given but facts which will be shaped by the decision of the participants. There is an active relationship between thinking and reality, as well as the passive one which is the only one recognized by natural science and, by way of a false analogy, also by economic theory.
I call the passive relationship the “cognitive function” and the active relationship the “participating function,” and the interaction between the two functions I call “reflexivity.” Reflexivity is, in effect, a two-way feedback mechanism in which reality helps shape the participants’ thinking and the participants’ thinking helps shape reality in an unending process in which thinking and reality may come to approach each other but can never become identical. Knowledge implies a correspondence between statements and facts, thoughts and reality, which is not possible in this situation. The key element is the lack of correspondence, the inherent divergence, between the participants’ views and the actual state of affairs. It is this divergence, which I have called the “participant’s bias,” which provides the clue to understanding the course of events. That, in very general terms, is the gist of my theory of reflexivity.
The theory has far-reaching implications. It draws a sharp distinction between natural science and social science, and it introduces an element of indeterminacy into social events which is missing in the events studied by natural science. It interprets social events as a never-ending historical process and not as an equilibrium situation. The process cannot be explained and predicted with the help of universally valid laws, in the manner of natural science, because of the element of indeterminacy introduced by the participants’ bias. The implications are so far-reaching that I can’t even begin to enumerate them. They range from the inherent instability of financial markets to the concept of an open society which is based on the recognition that nobody has access to the ultimate truth. The theory gives rise to a new morality as well as a new epistemology. As you probably know, I am the founder—and the funder—of the Open Society Foundation. That is why I feel justified in claiming that the theory of reflexivity has guided me both in making and in spending money.
But is it possible to come up with a valid new theory about the relationship between thinking and reality? It seems highly unlikely. The subject has been so thoroughly explored that probably everything that can be said has been said. In my defense, I did not produce the theory in a vacuum. The logical indeterminacy of self-referring statements was first discussed by Epimenides, the Cretan philosopher, who said, “Cretans always lie,” and the paradox of the liar was the basis of Bertrand Russell’s theory of classes. But I am claiming more than a logical indeterminacy. Reflexivity is a two-way feedback mechanism, which is responsible for a causal indeterminacy as well as a logical one. The causal indeterminacy resembles Heisenberg’s uncertainty principle, but there is a major difference: Heisenberg’s theory deals with observations, whereas reflexivity deals with the role of thinking in generating observable phenomena.
I am thrilled by the possibility that I may have reached a profound new insight, but I am also scared because such claims are usually made by insane people and there are many more insane people in the world than there are people who have reached a profound new insight. I wonder whether my insight has an objective validity or only a subjective significance.
That is why I am so eager to submit my ideas to a critical examination and that is why I find the present situation, where I am taken so seriously but my theory is not, so frustrating. As I have said before, the theory of reflexivity has received practically no serious consideration. It is treated as the self-indulgence of a man who made a lot of money in the stock market. It is generally summed up by saying that markets are influenced by psychological factors, and that is pretty trite. But that is not what the theory says. It says that, in certain cases, the participants’ bias can change the fundamentals which are supposed to determine market prices. "