Reflexivity, Reality and Markets

I have been trying to make sense of the developments in Europe, and especially the huge up move on October 27, 2011 in the US stock market as the plan was announced in Europe to leverage up the stabilization facility (EFSF).   George Soros’ concept of reflexivity comes to mind. I had been wrestling with whether the reported European debt relief plan amounted to just kicking the can down the road in which a debt problem is endeavored to be solved with ever more debt, or whether it amounts to something more substantive. Suddenly it occurred to me that in a way it doesn’t matter, and that the answer lies in reflexivity. Reflexivity is the case where perceptions create a reality which then leads to further actions reinforcing that reality. When you have an illness and you go to a doctor,  the doctor will do an assessment and possibly tests to ascertain the exact illness. You either have the illness or you don’t; the illness is an objective reality. This is not the case in finance and economics, where perceptions can create reality to a high degree, one reason why there are so many tail or rare events in finance. In the case of the Europe sovereign crisis, if a critical mass of market participants believe in the viability of the debt plan and then go on to buy financial assets such as stocks, thereby lifting the price and improving the market and confidence , thereby improving the real economy, increasing tax revenues enabling government debt burdens to be reduced: the perception becomes a reality: In other words real conditions can improve or deteriorate via reflexivity. Reflexivity is close in concept to that of animal spirits, but reflexivity explains the process more exactly.


Of course, perceptions are based at least to some extent on reality. It’s not just a matter of unreasoned reflexivity but of the market now having some evidence via the announced deal that Germany will do anything to save the Euro including issuing Eurobonds or having the ECB print money if need be, even if it has to be forced on Europe via market turmoil.  I think the market  believes Germany will throw overboard its hyper-vigilance regarding inflation to save the Euro. So it’s not so much that the announced deal as given is so good but what it portends for the future. Of course a reflexivity generated reality must in the end must be backed up by the facts. Should there be evidence that Europe is balking at implementing the above scenario, stock markets could fall substantially. In addition, the problem of European growth remains. PIIGS countries are not able to devalue their Euro currency, thus inhibiting one means of future growth, and then there is the general problem of a socialized Europe with structural unemployment. But I do believe that as long as markets see money printing on the horizon they might even be able to live with a managed exit from the Euro for one or more of the PIIGS countries. In the end though ,money printing is no substitute for true debt reduction and restraint in government spending.

I do believe though that more fundamentally through increased fiscal restraint Europe is taking some steps toward a more substantive solution along the lines suggested by Reinhart and Rogoff in their seminal book, This Time Is Different. And grudgingly through mandated cuts (unless the US Congressional Super Committee comes to a solution, which I doubt) , the US may also be pursuing some fiscal restraint. The central question is whether US entitlements of Medicare and social security will be reformed in the next presidential term. Taxing the rich would provide just a drop in the bucket toward reducing a trillion dollar debt problem. There is no long term solution to the US debt problem without entitlement reform. Money printing and a European TARP will only carry the markets so far as we learned via the US TARP and Quantitative easing programs, which led initially to huge stock market rise but then a significant pullback. 


Philip I. Frank, Ph.D.
President and Portfolio Manager,
Insight Asset Management LLC
Tel: 212-223-2715
e-mail: insight-asset@earthlink.net