The real future of finance: a golden age for the humanities bluffers
Reflections on reflexivity
In his book Boston Politics, the eccentric German political scientist Tilo Schabert describes how the waspy young Harvard graduates staffing the office of Boston Mayor Kevin White, in office from 1968 to 1984, would customarily quote ‘facts and figures’ at each other to justify a preferred course of action. He writes this as though statistics were a kind of court poetry; as if, sequestered within the tenebrous inner chambers of Boston City Hall, Chinese mandarins were citing passages from the four books and five classics while disputing whether to launch a fresh expedition against the southern barbarians. A prestige dialect from a secluded garden, akin to the lofty Pekingese received pronunciation in which the characters in Cao Xueqin’s Dream of the Red Chamber converse — this is the literary register of late twentieth century technocratic liberalism.
Economics, too, is a genre of literature; yet another variety of court poetry. This is why the best economists are Zoltán Pozsár (who knows this) and Ludwig von Mises (who didn’t, but still wrote beautiful, geometric economics with a Ciceronian cadence, as though every sentence were gazing out longingly over the Piraeus). The global financial crisis and a burgeoning scepticism as to — putting it diplomatically — the stringency with which certain national statistics are compiled forever discredited the old Cold War notion of ‘the economy’ in the eyes of anyone under around forty-five. The vision of a vast network of interconnected balance sheets or the pure logic of human action now seem more appropriate geometries on which to graph reality. Yet the dismal science still waits for the economist who fully leans into the nature of this fallen world and speaks economic phenomena into being purely through the enthralling beauty of his definitions and theorems.
Arguably, the trio of Fischer Black, Myron Scholes, and Robert Merton already did this. From a high promontory in futures markets, their formidable equation ruled the bourse, expelling from the temple of commerce those traders whose impoverished sensibilities could not fathom its mathematical serenity. Without burdening the reader with the details of what is a fairly complex piece of mathematics grounded in neoclassical economic theory (a basic summary can be found here), ‘Black-Scholes’, as it came to be known, is a model for pricing options (i.e., a contract giving the holder the right to buy an underlying asset, usually but not necessarily a stock, at a fixed date) based on the future volatility (an unknown value which can be guessed at through application of the model) of the underlying asset, ostensibly allowing investors to construct a perfectly hedged portfolio offering returns at the riskless rate of interest.
So thoroughly was it applied by traders in the ’80s that the deafening roar of the machine at work blunted the signals thus received. This story is told at greater length by Donald Mackenzie in his classic sociological study of options pricing models, An Engine, Not a Camera. Mackenzie shows that those who saw through the professors’ theory, those who recognised it as a theory not simply reflecting but forming the world around it, were well-positioned to reap the whirlwind during the market crash of October 19, 1987, generally recognised as exacerbated by the portfolio hedgers’ behaviour.
One man who did not reap the whirlwind was George Soros. This was surprising, since Soros, a former student of Karl Popper who sidelined philosophy for an altogether more profitable form of speculation, had in that selfsame year published a treatise entitled The Alchemy of Finance, in which he outlined precisely the kind of epistemics of financial markets that might have allowed one to foresee the crash.
Soros’s theory is simple. When an idea enters the market — that is, whenever an investor buys or sells an asset on the basis of some particular conception of reality — his action generates positive feedback by creating demand or supply that increases or reduces the value thereof. In other words, the act of valuation itself creates value, the idea speaks itself into being, movements in markets have a self-perpetuating tendency. Soros called this phenomenon ‘reflexivity’. ‘In most situations’, he writes, ‘it is so feeble that it can be safely ignored’. In a properly functioning market, these feedback loops eventually grind to a halt as other players adjust their own holdings in response to price fluctuations until the market has either fully digested or spat out the new idea, creating a new ‘equilibrium’ (though it should be noted that Soros rejects the concept, as he does neoclassical economics writ large, while conceding that it fits how markets appear to behave) in which the advantage of the initial investors’ unique knowledge is negated by its widespread diffusion, or restoring the old one at a loss to either the investor or to those latecomers onto which he managed to pass on the costs of his erroneous judgement.
Only in cases where an idea concerns the fundamental properties of economic phenomena — when the idea stakes a claim to be scientific — and is accepted by a critical mass of market participants as such does true reflexivity kick in. Social sciences like economics, argues Soros, cannot accurately mirror social reality in a way analogous to the natural sciences because they are themselves social phenomena, altering society by the fact of their presence within it in a way that cannot be independently observed, and therefore also never reliably controlled for. In other words, the method of controlled experimentation employed by natural scientists to isolate the causal nexus between two variables cannot be reproduced in the social sciences because the social scientist’s perceptions of a social phenomenon are themselves a variable affecting their object in a way that tends to reaffirm their assumptions.
Soros spends most of the book discussing through concrete examples how economics influences the economy and vice versa, but the crux of it is this: economists make causal claims, they use these causal claims to model economic phenomena in a way allowing them to make predictions, and financial markets, insofar as their participants are economists, are liable to price assets following the guidance these models provide (as actually occurred with the Black-Scholes in the ’80s), thus bringing the real data into line with the predictions of the theory. Eventually, the cumulative, systematic misevaluation of assets on the basis of self-validating economic ideas proceeds to the point where, in Soros’s words, ‘there is no tendency for perceptions and reality to come close together without a significant change in the prevailing conditions, a change of regime’ — for example, Black Monday.
When Soros first promulgated his doctrine of reflexivity, the economists had only just planted their flag atop the market massif. Financial economics only emerged as a respectable academic discipline in the United States (although curiously not in Britain) in the late ’60s and ’70s, and it took still another decade for traders deploying sophisticated models like Black-Scholes to show up en masse at the futures exchanges. In those days, the discipline still carried itself with a certain swagger. With the Reagan Revolution ensconced in the Oval Office, economists like Milton Friedman and the Chicago School could congratulate themselves on delivering America from the long socialist nightmare of the ’70s through the power of ideas, whilst the keystone Chicagoan doctrine of market efficiency resplended in the apodeictic certainty of the mathematical formulae apparently underpinning it. It is the cool self-assurance of this young and irreverent science at which Soros levelled his polemic, and as a student of philosophy — whose perennial enemy, as we know from Plato, is the poets — he could not have done otherwise.
Where Soros betrays himself is to formulate all this with the hard necessity of a physical law. We see more of Marx than the old master Popper in the Alchemy. Reflexivity is a catastrophe theory; a secular eschatology of markets in which the contradictions between base and superstructure intensify until the centre can hold no longer, and a vanguard party, the hedge fund manager, steps from the shadows to deliver the coup de grâce. Soros presents the collapse as an objective necessity, as if a day will come when the economists’ delusions are broken on the hard rocks of reality, as though the real economy actually were an independent variable acting on the markets — and yet it never did. ‘My fantasy was to present a general theory of reflexivity that would explain the great bust of the ’80s in the same way that Keynes’s General Theory explained the Great Depression’, writes Soros in the prologue to the Alchemy’s second edition. ‘As it turns out, we do not have a great bust and I do not have a general theory.’
The Alchemy is a premonition of The Big One; the splendid, satisfying krach in which the neoclassicism-induced bubble shatters into a gorillion pieces. Yet all that took place in 1987 was a market correction mild by historical standards, upon which the traders adjusted their options-pricing models and the eagle soared again. The fabric of the markets, woven from ideas, proved more resistant to reality than Soros had anticipated.
Soros’s tragedy in the Alchemy was to find himself caught between trying to disprove the possibility of a social science while simultaneously seeking to fine-tune its methods. The speculator remained trapped within the terminology of a causal science, describing ideas and market prices as independent and dependent variables mutually reinforcing each other in a mechanistic process. If one understands the mechanism, one can spot regular trends and predict future ones; reflexivity becomes a less-ambitious replacement for hard science, and thus vulnerable to immanent critique. In this way, Soros falls back into the Humean problem of induction that his old teacher famously tried to bury for good; drawing inferences about the future by assuming, without evidence, that it will resemble the past.
Yet something of the theory of reflexivity remains salvageable if we concentrate it to its idealist core. The high road of economic truth begins by setting down a few banal postulates. The inseparability of the social scientist from his object of study is, in the case of financial markets, thicker than Soros realised: markets and the instruments traded thereon are not ‘real’, but ideal: that is to say, they do not exist in material form, and to the extent that they do (i.e., in laws, contracts, etc.), their existence as something more than paper and ink is given by social norms, i.e., by ideas. Financial markets, in which claims on future values are exchanged — technically claims on assets, but these assets are not typically ‘claimed’ in the colloquial sense of that word, but simply held until their value can be realised through forward sale — are the instantiation of a causa finalis: the ends or purpose for which a thing comes into being. Since pure economic values cannot by definition exist, these future values, insofar as they are so generally held for the speculator to turn a profit (or their opposites so universally reviled as for the corresponding assets to be bet against), must be the values current in society, independent of — though surely influenced by — the movement of the market. Financial markets are like the Greek temple as described by Heidegger, or the Concorde besang by Pimlico Journal: the work that ‘gathers arounds itself the unity’ of its world, that articulates the totality of a people’s way of life.
It follows that in order to accurately price an asset it is insufficient to grasp the apparent mechanics or observe past behaviour. One must understand the moral, spiritual, and aesthetic values reflected therein; the way of life that it affirms. Quantitative analysis works by analogy, by assuming the phenomena captured in the data are analogous to those phenomena which will occur in the future; these data points may seem similar insofar as they refer to physically identical objects, yet no object can ever be truly identical to even one endowed with all the same material properties, should this latter have been produced in a distinct institutional context, by the motion of a different spirit, under the tutelage of completely different historical processes. One cannot step in the same river twice; or, as expressed more prosaically by the former Harvard endowment manager Stephen Blyth, tellingly a mathematician rather than an economist:
…the actual universe of possible outcomes and price action is vastly different from that which people have experienced in the past twenty years. The limited set of data and the limited experience of market participants are combined with products that themselves have only existed for a similarly short period.
So swift the current of the markets that the trading data of a day may as well be from the Dōjima Rice Exchange.
Since Soros took the field against scientism, the financial sector has only doubled down on the efficientisation and mathematisation against which the young Popperite cautioned. The strength of the dollar, the concomitant (but not entirely causal) weakness of domestic industry, and the allure and prestige of ‘high finance’ have for decades now sucked graduates from engineering and the hard sciences into the market maelstrom. The supreme irony of the post-’80s financial sector is that Anglo-America’s finest technical-scientific minds — what Blyth termed the ‘SSC generation’ — should be dragooned into constructing a cloud palace of the mind. This has meant the proliferation of increasingly arcane financial instruments and the swift (and highly creative!) integration of new information technologies. These developments have — through a witch’s cauldron of too much liquidity sloshing around the market and a Woke, overregulation-induced lack of appetite for risk-taking despite gloomily low interest rates — transfigured the financial services sector into an infernal machine designed to squeeze out ever-smaller drops from the orange.
Consider it from another angle. Strides in information technology, more stringent transparency requirements, and the opening up of financial markets to an increasingly numerous entourage have minimised the extent to which informational asymmetries based on spatial and temporal lags in the diffusion of data develop, while simultaneously accelerating the pace at which arbitrageurs can close remaining ones. Friedrich von Hayek’s old model capitalist, the ‘shipper, estate agent, or arbitrageur’ diligently ‘performing eminently useful functions based on special knowledge of circumstances of the fleeting moment not known to others’, is out of business; arbitrage opportunities are now sought not in the dearth of information, but in its excess. Electronic exchanges on which trades are posted and settled at close to the speed of light, algorithms which identify patterns in large volumes of data that no human eye could pick out — these have filled the role of Hayek’s merry middleman. In the future, it will require ever-more complex algorithms and ever-more powerful machines (with the higher overheads these entail) to generate increasingly diminishing returns. The knowledge useful in the society to come will be not that of the gaps; rather, it will be that of depths.
One need not venture into esoteric goldbug forums to hear reports of the epistemological crisis facing quantitative finance. ‘The mathematicians who build state-of-the-art quantitative systems’, writes the journalist Sebastian Mallaby in his rip-snorting pop-science history of hedge funds More Money Than God, ‘are delighted when they call the market right on six out of ten occasions’. That doesn’t sound very good. The aforementioned Blyth is anything but when diagnosing quantitativity’s quandaries:
The edifice of quantitative finance built over fifteen years by the SSC generation was dramatically rocked by the events of 2008. Fundamental logical arguments that practitioners had taken for granted were shown not to hold. Decades of modeling advances were revealed to be invalid or thrown into question.
The physicist James Owen Weatherall observes that Black-Scholes and models adapted therefrom remain in use despite the fact that traders are keen to their deceptive nature. He suggests that this is because Black-Scholes provides a common language for market participants to communicate about derivatives, and also because the inadequacies of the model provides clues about the fundamental assumptions traders ought instead to be making. In other words, capital asset pricing models like Black-Scholes are a kind of Medieval Latin of the markets, a dead tongue persisting partly as a pidgin for professional communication between traders, but also as a sacred language, elevated above everyday reality and therefore an apt register in which to strive towards the fundamental truths; to a metaphysics of markets. A model with ruinenwert, ‘ruin value’.
The future of investing, if not finance writ large, is Humean. It proceeds deductively, teasing out those latent qualities within the market that have yet to leave any quantifiable footprint. Taking a page from Spengler’s book, we must search for the inherent ideas within assets that work themselves out in time, and whose source is the soul. This method is similar to behavioural finance, except that instead of drawing from the sallow well of psychology, a silly ‘empiricist’ discipline whose results famously fail to replicate, it proceeds upwards to tap the bracing glacial waters of philosophy. One can conceive of, if not calculate, a philosophical beta: a measure of volatility to ideas and other intangible cultural phenomena.
So brimming with ideas are the markets that measuring the correlation of an asset to any given one, let alone to all of them at once, would be a nearly impossible task. The historical development of beta points the way to a workable fudge. Harry Markowitz, the mathematician who elevated ‘portfolio theory’ from something second to gambling into the pantheon of scientific respectability, initially tried to measure volatility by calculating the correlations between all stocks on the market. This proved beyond the capacity of any computer existing at the time (Markowitz published his model in 1952), and it fell to his student William Sharpe to cut the gordian knot by calculating the correlation to fluctuations in the market as such, usually represented by a stock index like the S&P 500. The philosophico-historical equivalent of Sharpe’s ‘market portfolio’ — in other words, the spirit of the age to which all contemporary ideas unavoidably refer — is social democracy.
Finance, at least as we know it today, is inseparable from postwar social democracy and the type of man it produced. A modern industrial economy with a highly specialised division of labour — the musica universalis of speed and steel that readily lends itself to conceptualisation as an economy — unavoidably requires a general staff to direct it, whether this take the form of a state planning board, a domineering central bank, a ‘council of the gods’, or a feudal patchwork of zaibatsu/keiretsu. The delegation of this task to markets — i.e., sites of intermediation regulated by a mixture of public and private law — underwrites social democracy by proscribing the Caesaristic modes of economic organisation that crystallise under these alternative institutional forms, which by their nature incentivise decisionism over proceduralism and concentrate capital in the hands of powerful managers. The emergence of finance as the classic vocation of Anglo-America’s intellectual elite served to civilise the thymos of the best and brightest; to sublate Bronze Age urges into commerce, leaving these would-be captains of industry to channel the surpluses of capital, labour, and the welfare state (the latter two represented by pension funds) into a ‘monetary production economy’ (Minsky) increasingly abstracted from the world of real production. Financial markets have degenerated from a sleek apparatus of control into the dreamtime of social democracy.
As dreams feed on the weariness of the mind, the surpluses that splutter out from the real economy into financial markets are surpluses of mental exhaustion, of spiritual decay, of aporia. Demand in US equities is driven by pension slosh, dodgy foreign cash, and recycled corporate profits whose managers do not know what to do with them and despair of reproducing them through reinvestment within the firm or further down the value chain in the way that, for example, the keiretsu banks in Japan allocate resources within the conglomerate. The ‘pension fund socialism’ prophesied by Peter Drucker in 1976 has planted the red flag over Wall Street: in the search for safe, staid assets, the pension managers have installed financial economics as the state ideology of the markets, flourishing in a thousand index-based derivatives, ETFs, and in the fund supervisors’ derogation of control to gargantuan asset managers like the unjustly scorned BlackRock (anti-lockdown Boomers, were they to open the seventh seal, would only find their own startled faces staring back) with a substantial non-controlling interest in various major players across multiple sectors.
This proliferation of spirallingly self-referential stupid money is finance eating itself; the self-abnegation of a once-proud speculative elite anointed to steer industry from the shadows, now merely content to slip away into a Xanadu of market efficiency.
The way in which assets correlate to the temporal status of ideas can be observed by examining the extremes. In intense bursts of regime activity, there occurs a flight into the most nakedly ideological assets. The lockdowns prompted a flight into the most social democratic of all investments: US Treasuries. The situation is no better in Britain, where social democracy seems to be in a permanent state of emergency: like the Croatian Grenzers Maria Theresa mobilised from the Habsburg military frontier to fend off Frederick the Great’s incursions into Bohemia during the Seven Years’ War, capital has been sucked in from the periphery of social democracy’s empire (ordinary decent people) to finance government borrowing in increasingly absurd ways that crowd out the rest of the market, as Pimlico Journal has documented. Leveraged gilts: this is a parody of social democratic finance.
Yet all is not well in paradise. The flight into soft values has been hedged by a quieter, yet still audible descent into hard values. The slither of bitcoin and other cryptocurrencies into the tranquil garden constitute an attempt by speculators to short social democracy, their dramatic fluctuations representing shifting investor confidence in that regime. Crypto, an unmanipulable hard currency that, unlike gold, can be tucked away in the folds of the internet and summoned up with ease, and whose extraction has the additional advantage of being environmentally destructive in the extreme, is the supreme, sovereign rebuke to the dreamy realm of ideas flickering in and out of the sedate social democratic eye — just listen to the way Adam Tooze talks about it! This, to be clear, is not an exhortation to buy crypto, whose price undulations are not purely a function of political volatility (nor even solely of social democratic volatility), but also subject to the pure logic of asset bubbles à la Reinhardt and Rogoff. I merely wish to point out that, so long as the future of social democracy is in doubt, this asset will actually have a stable baseline value.
Should the reader not have closed his browser in frustration at the simplemindedness and naïveté of an argument that has, quite against the spirit of the Pimlico Journal, proceeded from general principles and cited neither facts nor figures, he may shake his head in incredulity at the obviousness of all that I have sketched out. ‘Surely’, he will conjecture, ‘it has all been priced in?’ But it has not been priced in. The markets, weaned off of the difficult work of philosophical speculation by neoclassical economics, quantitative trading, index funds, and easy liquidity, no longer know how to fathom ideas: their recent difficulty in digesting an idea as clear, simple, predictable, and quantifiable as the economic policy proclaimed frequently and publicly by the President of the United States in the course of his election campaign (i.e., tariffs) shows their inability to reliably price in more complex, subtle ideas whose consequences are not immediately apparent. To the able financier, this represents an opportunity. In the future, there will be a premium on humanistic learning; the type of deep knowledge of the world that only comes from hours poring over the works of Polybius, Plutarch, or /pol/; of Strabo and SaloForum.
Such financiers will, in the future, not be hard to find. Think back to the waspy young staffers whom we encountered earlier declaiming ‘facts and figures’ in the swinging Boston Mayor’s Office of the even more swinging ’70s. The past few years have witnessed a phenomenological earthquake amongst the youth; a great vowel shift in the nascent elite’s vernacular. I recall not long ago a season when the sociological idiom still wafted through the Ivy League’s cloisters; today, the discourse is increasingly conducted in a humanistic register. Where once the ‘best and brightest’ earnestly spent long hours in the library studying the econometric blade, today the classics enjoy a wide circulation, and youthful would-be McNamaras busy themselves with history, philosophy, ancient philology, literature, and anthropology.
Finance is, in Anglo-America, an elite profession; it crystallises the elite’s values, perceptions, and worldview, and constitutes the means by which ideas give the material world coherence. Existing market players who read the winds and adapt accordingly will be rewarded exponentially in the world to come.
This article was written by a nameless Budapest economist. Have a pitch? Send it to pimlicojournal@substack.com.
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