The Crisis Of Global Capitalism

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The global economy, on which the world now depends more than ever, is in crisis. The Russian economy has collapsed, leading to punishing inflation and economic hardship. Scores of Japanese banks are in ruin while the Japanese government muddles along, the nation falling deeper and deeper into recession. The once-booming economies of Thailand, Malaysia, and Indonesia have imploded. Brazil and the rest of Latin America has begun to edge toward the precipice, and even in Europe and America the markets lurch ...

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The global economy, on which the world now depends more than ever, is in crisis. The Russian economy has collapsed, leading to punishing inflation and economic hardship. Scores of Japanese banks are in ruin while the Japanese government muddles along, the nation falling deeper and deeper into recession. The once-booming economies of Thailand, Malaysia, and Indonesia have imploded. Brazil and the rest of Latin America has begun to edge toward the precipice, and even in Europe and America the markets lurch violently, wiping out gains with each passing week.

No one is better positioned to explain the current global financial crisis than George Soros, the man Morgan Stanley head Barton Biggs calls "the finest analyst of the world in our time." In The Crisis of Global Capitalism, Soros, chairman of Soros Fund Management (whose Quantum Fund is considered to have been the best performing investment fund in the world over the past thirty years), dissects the current crisis and economic theory in general, revealing how theoretical assumptions have combined with human behavior to lead to today's mess. He shows how unquestioning faith in market forces blinds us to crucial instabilities, and how those instabilities have chain-reacted to cause the current crisis—a crisis that has the potential to get much, much worse. Offering brilliant solutions to the global meltdown, based on years of Soros's own experience as a financier and philanthropist, this is essential reading for anyone involved with the new economy—that is, all of us.

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Editorial Reviews

Charles R. Morris
A very good book...A sharp attack on the assumptions behind conventional economics and the theory of finance. obviously a very smart man, with a crisp writing style, considerable modesty and many useful things to say about global finance and the state of the world. -- Los Angeles Times Book Review
Charles Wolf Jr.
Some books stir as much interest for the celebrity of their authors as for what they actually say. George Soros' The Crisis of Global Capitalism might seem to be such a book...Mr. Soro's facts are unreliable...[his] emergency prescription is a formula for folly....Although in his personal philosophy Mr. Soros admirably advocates humility and the redemptive effects of recognizing personal 'fallibility,' he rarely displays either trait in this book. -- The Wall Street Journal
William Greider
The most successful hedge-fund manager in the world[Soros] is also an incisive critic of the system — the unregulated global financial markets where he accumulated a billionaire's fortune many times overthe system that is now falling apart. —Rolling Stone
Floyd Norris
Brilliant and persuasive....At the heart of his argument are two beliefs: First, that the financial markets have grown so large and powerful that they can destroy countries, and second, that those same markets have now become so frightened that they will withdraw capital from most countries in the world.
The New York Times Book Review
Holman W. Jenkins Jr.
...Soros asks how the world got into its present fix. But he really seems to be asking, How did I get so rich?....[I]t is always a mistake to write a book and not tell readers what they most care to know. For him the age has truly been golden....We'd like to know why.
National Review
Expanding themes from his article "The Capitalist Threat" (February, 1997), market analyst and author Soros serves up a hodgepodge of theory, criticism, and advice. He describes how unquestioning faith in market forces blinds us to crucial instabilities, links those instabilities to the current crisis, and shows how the concept of open society (adapted from Karl Popper) can save civilization. Annotation c. Book News, Inc., Portland, OR (
William Greider
The most successful hedge-fund manager in the world, [Soros] is also an incisive critic of the system — the unregulated global financial markets where he accumulated a billionaire's fortune many times over, the system that is now falling apart.
Rolling Stone
Business Week
A brilliant narrative of what went wrong in Asia, Russia, and other emerging markets.
Robert M. Solow
The problem is that [Soros] wants to be a philosopher, indeed a sort of philosopher-king. In straining, he rveals a fundamental difficulty with the role....It is too damn hard.
The New Republic
Floyd Norris
Brilliant and persuasive....At the heart of his argument are two beliefs: First, that the financial markets have grown so large and powerful that they can destroy countries, and second, that those same markets have now become so frightened that they will withdraw capital from most countries in the world.
The New York Times Book Review
International Herald Tribune
A wake-up call from a man who knows his subject first-hand.
Holman W. Jenkins Jr.
...Soros asks how the world got into its present fix. But he really seems to be asking, How did I get so rich?....[I]t is always a mistake to write a book and not tell readers what they most care to know. For him the age has truly been golden....We'd like to know why.
National Review
Anthony Neoh
Two themes permeate the book: an assertion that financial markets are inherently unstable, and a contention that moral values have failed at national and international levels....His prescription for helping the world financial system get back on its feet and the establishment of an International Credit Insurance Corp. is worth serious consideration. At a time when it is difficult for most developing countries to raise capital internationally, this is a worthy idea, though whether it can perform more effectively than the International Monetary Fund remains debatable.
Far Eastern Economic Review
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Product Details

  • ISBN-13: 9781891620270
  • Publisher: PublicAffairs
  • Publication date: 1/1/1998
  • Pages: 288
  • Lexile: 1340L (what's this?)
  • Product dimensions: 0.75 (w) x 6.00 (h) x 9.00 (d)

Meet the Author

George Soros heads Soros Fund Management and is the founder of a global network of foundations dedicated to supporting open societies. The author of several previous bestselling books, including The Alchemy of Finance and Soros on Soros, he lives in New York City.

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Read an Excerpt

Chapter One

Fallibility and Reflexivity

    Strange as it may seem for someone who has made his reputation and his fortune in the very practical world of business, my financial success and my political outlook have rested largely on a number of abstract philosophical ideas. Until these are understood, none of the other arguments presented in this book, whether on financial markets, geopolitics, or economics, can make much sense. This is why the rather abstract discussion of the next two chapters is required. Specifically, it is necessary to explain in detail the three key concepts on which all my other ideas--and most of my actions in business and philanthropy--are founded. These concepts are fallibility, reflexivity, and open society. Such abstract nouns may seem far removed from the everyday world of politics and finance. One of the main purposes of this book is to convince the reader that these concepts go to the heart of the real world of affairs.

Thinking and Reality

    I must start at the beginning, with an old philosophical question that seems to lie at the root of many other problems. What is the relationship between thinking and reality? This is, I admit, a very roundabout way of approaching the world of affairs but it cannot be avoided. Fallibility means that our understanding of the world in which we live is inherently imperfect. Reflexivity means that our thinking actively influences the events in which we participate and about which we think. Because there is always a divergence between reality and our understanding of it, the gap between the two, which I call the participants' bias, is an important element in shaping the course of history. The concept of open society is based on the recognition of our fallibility. Nobody is in possession of the ultimate truth. This may seem obvious enough to ordinary readers, but it is a fact that political and economic decision makers, and even academic thinkers, are often unwilling to accept. This refusal to accept the inherent gap between reality and our thinking has had a far-reaching, and historically very dangerous, impact.

    The relationship between thinking and reality has been, in one form or another, at the center of philosophical discourse ever since people became aware of themselves as thinking beings. The discussion proved to be very fertile. It has allowed the formulation of basic concepts such as truth and knowledge and it has provided the foundations of scientific method.

    It is no exaggeration to say that the distinction between thinking and reality is necessary for rational thought. But beyond a certain point, the separation of thought and reality into independent categories runs into difficulties. Although it is desirable to separate statements and facts, it is not always possible. In situations that have thinking participants, the thoughts of these participants are part of the reality about which they have to think. It would be foolish not to distinguish between thinking and reality and to treat our view of the world as if it were the same as the world itself; but it is just as wrong to treat thinking and reality as if they were totally separate and independent. People's thinking plays a dual role: It is both a passive reflection of the reality they seek to understand and an active ingredient in shaping the events in which they participate.

    There are, of course, events that occur independently of what anybody thinks; these phenomena, such as the movement of planets, form the subject matter of natural science. Here thinking plays a purely passive role. Scientific statements may or may not correspond to the facts of the physical world, but in either case the facts are separate and independent of the statements that refer to them. Social events, however, have thinking participants. Here the relationship between thinking and reality is more complicated. Our thinking is part of reality; it guides us in our actions and our actions have an impact on what happens. The situation is contingent on what we (and others) think and how we act. The events in which we participate do not constitute some sort of independent criterion by which the truth or falsehood of our thoughts could be judged. According to the rules of logic, statements are true if, and only if, they correspond to the facts. But in situations that have thinking participants, the facts do not occur independently of what the participants think; they reflect the impact of the participants' decisions. As a result, they may not qualify as an independent criterion for determining the truth of statements. That is the reason why our understanding is inherently imperfect. This is not an abstruse philosophical debating point, comparable to Berkeley's question about whether the cow in front of him ceases to exist when he turns his back. When it comes to decision making, there is an inherent lack of correspondence between thinking and reality because the facts lie somewhere in the future and are contingent on the participants' decisions.

    The lack of correspondence is an important factor in making the world the way it is. It has far-reaching implications both for our thinking and for the situations in which we participate--implications that are deliberately ignored in standard economic theory, as we shall see in Chapter 2. The point I want to make here is that participants in social events cannot base their decisions on knowledge for the simple reason that such knowledge does not exist at the time they make their decisions. Of course people are not bereft of all knowledge; they have the whole body of science (including social science, for what it is worth) at their disposal as well as the practical experience accumulated through the ages, but this knowledge is not enough to reach decisions. Let me cite an obvious example from the world of finance. If people could act on the basis of scientifically valid knowledge, then different investors would not be buying and selling the same stocks at the same time. Participants cannot predict the outcome of their decisions the way scientists can predict the movement of celestial bodies. The outcome is liable to diverge from their expectations, introducing an element of indeterminacy that is peculiar to social events.

The Theory of Reflexivity

    The best way to approach the relationship between the participants' thinking and the social events in which they participate is to examine first the relationship between scientists and the phenomena they study.

    In the case of scientists, there is only a one-way connection between statements and facts. The facts about the natural world are independent of the statements that scientists make about them. That is a key characteristic that renders the facts suitable to serve as the criterion by which the truth or validity of statements can be judged. If a statement corresponds to the facts, it is true; if not, it is false. Not so in the case of thinking participants. There is a two-way connection. On the one hand, participants seek to understand the situation in which they participate. They seek to form a picture that corresponds to reality. I call this the passive or cognitive function. On the other hand, they seek to make an impact, to mold reality to their desires. I call this the active or participating function. When both functions are at work at the same time, I call the situation reflexive. I use the word in the same way as the French do when they describe a verb as reflexive when it has its subject as its object: Je me lave (I wash myself).

    When both functions are at work at the same time, they may interfere with each other. Through the participating function, people may influence the situation that is supposed to serve as an independent variable for the cognitive function. Consequently, the participants' understanding cannot qualify as objective knowledge. And because their decisions are not based on objective knowledge, the outcome is liable to diverge from their expectations.

    There are vast areas where our thoughts and reality are independent of each other and keeping them separate poses no problem. But there is an area of overlap where the cognitive and participating functions can interfere with each other and when they do our understanding is rendered imperfect and the outcome uncertain.

    When we think about events in the outside world, the passage of time can provide some degree of insulation between thought and reality. Our present thoughts can influence future events, but future events cannot influence present thinking; only at a future date will those events be converted into an experience that may change the participants' thinking. But this insulation is not fool proof, because of the role of expectations. Our expectations about future events do not wait for the events themselves; they may change at any time, altering the outcome. That is what happens in financial markets all the time. The essence of investment is to anticipate or "discount" the future. But the price investors are willing to pay for a stock (or currency or commodity) today may influence the fortunes of the company (or currency or commodity) concerned in a variety of ways. Thus changes in current expectations affect the future they discount. This reflexive relationship in financial markets is so important that I deal with it later at much greater length. But reflexivity is not confined to financial markets; it is present in every historical process. Indeed, it is reflexivity that makes a process truly historical.

    Not all social actions qualify as reflexive. We may distinguish between humdrum, everyday events and historical occasions. In everyday events, only one of the two reflexive functions is at work; either the cognitive or the participating function remains idle. For instance, when you register to vote in a local election, you do not alter your views about the nature of democracy; when you read in the newspaper about a rigged election in Nigeria, your changed perception does not affect what is actually going on in that part of the world, unless you are an oil executive or a human rights activist engaged in Nigeria. But there are occasions when the cognitive and participating functions operate simultaneously so that neither the participants' views nor the situation to which they relate remain the same as before. That is what justifies describing such developments as historic.

    A truly historic event does not just change the world; it changes our understanding of the world--and that new understanding, in turn, has a new and unpredictable impact on how the world works. The French Revolution was such an event. The distinction between humdrum and historic events is, of course, tautological, but tautologies can be illuminating. Party congresses in the Soviet Union were rather humdrum, predictable affairs, but Khrushchev's speech to the Twentieth Congress was a historic occasion. It changed people's perceptions and, even if the communist regime did not change immediately, the speech had unpredictable consequences: The outlook of the people who were in the forefront of Gorbachev's glasnost was shaped in their youth by Khrushchev's revelations.

    Of course, people think not only about the outside world but also about themselves and about other people. Here the cognitive and participation functions may interfere with each other without any lapse of time. Consider statements like "I love you" or "He is my enemy." They are bound to affect the person to which they refer, depending on how they are communicated. Or look at marriage. It has two thinking participants, but their thinking is not directed at a reality that is separate and independent of what they think and feel. One partner's thoughts and feelings affect the behavior of the other and vice versa. Both feelings and behavior can change out of all recognition as the marriage evolves.

    If the passage of time can insulate the cognitive and participating functions, reflexivity can be envisaged as a kind of short circuit between thinking and its subject matter. When it occurs, it affects the participants' thinking directly, but the outside world only indirectly. The effect of reflexivity in shaping the participants' self-images, their values, and their expectations is much more pervasive and instantaneous than its effect on the course of events. It is only intermittently, in special cases, that a reflexive interaction significantly affects not only the participants' views but also the outside world. These occasions take on special significance because they demonstrate the importance of reflexivity as a real-world phenomenon. By contrast, the endemic uncertainty in people's values and self-images is primarily subjective.


    The next step in analyzing the impact of reflexivity on social and economic phenomena is to point out that the element of indeterminacy I speak about is not produced by reflexivity on its own; reflexivity must be accompanied by imperfect understanding on the part of the participants. If by some fluke people were endowed with perfect knowledge, the two-way interaction between their thoughts and the outside world could be ignored. Because the true state of the world was perfectly reflected in their views, the outcome of their actions would perfectly correspond to their expectations. Indeterminacy would be eliminated, as it derives from the feedback between inaccurate expectations and the unintended consequences of people's perhaps changing but always biased expectations.

    The contention that situations that have thinking participants contain an element of indeterminacy is amply supported by everyday observation. Yet it is not a conclusion that has been generally accepted in economics or social science. Indeed, it has rarely even been proposed in the direct form in which I have put it here. On the contrary, the idea of indeterminacy has been vehemently denied by social scientists who assert their ability to explain events by scientific method. Marx and Freud are prominent examples, but the founders of classical economic theory have also gone out of their way to exclude reflexivity from their field of study, despite its importance for financial markets. It is easy to see why. Indeterminacy, the lack of firm predictions and satisfactory explanations, can be threatening to the professional status of a science.

    The concept of reflexivity is so basic that it would be hard to believe that I was the first to discover it. The fact is, I am not. Reflexivity is merely a new label for the two-way interaction between thinking and reality that is deeply ingrained in our common sense. If we look outside the realm of social science, we find a widespread awareness of reflexivity. The predictions of the Delphic oracle were reflexive and so was Greek drama. Even in social science, there are occasional acknowledgments: Machiavelli introduced an element of indeterminacy into his analysis and called it fate; Thomas Merton drew attention to self-fulfilling prophesies and the bandwagon effect; and a concept akin to reflexivity was introduced into sociology by Alfred Schutz under the name of intersubjectivity.

    I do not want people to think that I am discussing some mysterious new phenomenon. Yes, there are some aspects of human affairs that have not been properly accounted for, but that is not because reflexivity has only just been discovered; it is because the social sciences in general and economics in particular have gone out of their way to cover it up.

Reflexivity in the History of Ideas

    Let me try to position the concept of reflexivity in the history of ideas. The fact that statements may affect the subject matter to which they refer was first established by Epimenides the Cretan when he posed the paradox of the liar. Cretans always lie, he said, and by saying it he brought into question the truth of his statement. Being a Cretan, if the meaning of what he said was true, then his statement had to be false; conversely, if his statement was true, then the meaning it conveyed would have to be false.

    The paradox of the liar was treated as an intellectual curiosity and neglected for the longest time because it interfered with the otherwise successful pursuit of truth. Truth came to be recognized as the correspondence of statements to external facts. The so-called correspondence theory of truth came to be generally accepted at the beginning of the twentieth century. That was a time when the study of facts yielded impressive results and the achievements of science enjoyed widespread admiration.

    Emboldened by the success of science, Bertrand Russell tackled the paradox of the liar head on. His solution was to distinguish between two classes of statements: a class that included statements that referred to themselves and a class that excluded such statements. Only statements belonging to the latter class could be considered well-formed statements with a determinate truth value. In the case of self-referent statements, it may not be possible to distinguish whether they are true or false. Logical positivists carried Bertrand Russell's argument further and declared that statements whose truth value cannot be determined are meaningless. Remember, that was the time when science was providing determinate explanations for an ever-expanding range of phenomena, while philosophy had become ever more removed from reality. Logical positivism was a dogma that exalted scientific knowledge as the sole form of understanding worthy of the name and outlawed metaphysics. "Those who have understood my argument," said Ludwig Wittgenstein in the conclusion of his Tractatus Logico Philosophicus, "must realize that everything I have said in the book is meaningless." It seemed to be the end of the road for metaphysical speculations and the total victory of the fact-based, deterministic knowledge that characterized science.

    Soon thereafter Wittgenstein realized that his judgment had been too severe and he started to study the everyday use of language. Even natural science became less deterministic. It encountered boundaries beyond which observations could not be kept apart from their subject matter. Scientists managed to penetrate the barrier, first with Einstein's theory of relativity, then with Heisenberg's uncertainty principle. More recently, investigators using evolutionary systems theory, also known as chaos theory, started exploring complex phenomena whose course cannot be determined by timelessly valid laws. Events follow an irreversible path in which even slight variances become magnified with the passage of time. Chaos theory has been able to shed light on many phenomena, such as the weather, that had previously proved impervious to scientific treatment, and it has made the idea of an indeterminate universe, where events follow a unique, irreversible path, more acceptable.

    It so happens that I started to apply the concept of reflexivity to understanding finance, politics, and economics in the early 1960s, before evolutionary systems theory was born. I arrived at it, with the help of Karl Popper's writings, through the concept of self-reference. The two concepts are closely related but they should not be confused. Self-reference is a property of statements; it belongs entirely in the realm of thinking. Reflexivity connects thinking with reality; it belongs to both realms. Perhaps that is why it was ignored for such a long time.

    What reflexivity and self-reference have in common is the element of indeterminacy. Logical positivism outlawed self-referent statements as meaningless, but by introducing the concept of reflexivity I am setting logical positivism on its head. Far from being meaningless, I claim that statements whose truth value is indeterminate are even more significant than statements whose truth value is known. The latter constitute knowledge: They help us understand the world as it is. But the former, expressions of our inherently imperfect understanding, help to shape the world in which we live.

    At the time I reached this conclusion, I considered it a great insight. Now that natural science no longer insists on a deterministic interpretation of all phenomena and logical positivism has faded into the background, I feel as if I were beating a dead horse. Indeed, intellectual fashion has turned to the opposite extreme: The deconstruction of reality into the subjective views and prejudices of the participants has become all the rage. The very basis on which differing views can be judged, namely the truth, is being questioned. I consider this other extreme equally misguided. Reflexivity should lead to a reassessment, not a total rejection, of our concept of truth.

A Reflexive Concept of Truth

    Logical positivism classified statements as true, false, or meaningless. After dismissing meaningless statements, it was left with two categories: true or false. The scheme is eminently suitable to a universe that is separate and independent of the statements that refer to it, but it is quite inadequate for understanding the world of thinking agents. Here we need to recognize an additional category: reflexive statements whose truth value is contingent on the impact they make.

    It was always possible to attack the logical positivist position at the margin by conjuring up certain statements whose truth value could be disputed; for instance, "The present King of France is bald." But such statements are either nonsensical or contrived; either way, we can live without them. By contrast, reflexive statements are indispensable. We cannot live without reflexive statements because we cannot avoid decisions that have a bearing on our fate; and we cannot reach decisions without relying on ideas and theories that can affect the subject matter to which they refer. To ignore such statements or to force them into the categories of "true" and "false" pushes the discourse in a misleading direction and places our interpretation of human relations and history in the wrong framework.

    All value statements are reflexive in character: "Blessed are the poor, for theirs is the kingdom of heaven"--if this statement is believed, then the poor may indeed be blessed, but they will be less motivated to get themselves out of their misery. By the same token, if the poor are held to be guilty of their own misery, then they are less likely to lead blessed lives. Most generalizations about history and society are similarly reflexive in character; consider, "The proletarians of the world have nothing to lose but their chains" or "The common interest is best served by allowing people to pursue their own interests." It may be appropriate to assert that such statements have no truth value but it would be misleading (and has historically been very dangerous) to treat them as meaningless. They affect the situation to which they refer.

    I am not claiming that a third category of truth is indispensable for dealing with reflexive phenomena. The crucial point is that in reflexive situations the facts do not necessarily provide an independent criterion of truth. We have come to treat correspondence as the hallmark of truth. But correspondence can be brought about in two ways: either by making true statements or by making an impact on the facts themselves. Correspondence is not the guarantor of truth. This caveat applies to most political pronouncements and economic forecasts.

    I hardly need to emphasize the profound significance of this proposition. Nothing is more fundamental to our thinking than our concept of truth. We are accustomed to thinking about situations that have thinking participants in the same way as we do about natural phenomena. But if there is a third category of truth, we must thoroughly revise the way we think about the world of human and social affairs.

    I should like to give a minor illustration from the field of international finance. The IMF has come under increasing pressure to operate in a more transparent manner and to disclose its internal deliberations and views on individual countries. These demands ignore the reflexive nature of these statements. If the IMF disclosed its concerns about certain countries, they would affect the countries to which they refer. Recognizing this, IMF officials would be inhibited from expressing their true opinions and internal debate would be stifled. If truth is reflexive, the search for the truth sometimes requires privacy.

An Interactive View of Reality

    We may be justified in drawing a distinction between statements and facts, our thoughts and reality, but we must recognize that this distinction has been introduced by us in an attempt to make sense of the world in which we live. Our thinking belongs in the same universe that we are thinking about. This makes the task of making sense of reality (i.e., reason) much more complicated than it would be if thinking and reality could be neatly separated into watertight compartments (as they can be in natural science). Instead of separate categories, we must treat thinking as part of reality. This gives rise to innumerable difficulties, of which I should like to discuss only one.

    It is impossible to form a picture of the world in which we live without distortion. In a literal sense, when we form a visual image of the world we have a blind spot where our optic nerve is attached to the nerve stem. The image made in our brain replicates the outside world remarkably well, and we can even fill in the blind spot by extrapolating from the rest of the picture, though we cannot actually see what is in the area covered by the blind spot. This may be taken as a metaphor for the problem we confront. But the fact that I rely on a metaphor to explain the problem is an even more powerful metaphor.

    The world in which we live is extremely complicated. To form a view of the world that can serve as a basis for decisions, we must simplify. Using generalizations, metaphors, analogies, comparisons, dichotomies, and other mental constructs serves to introduce some order into an otherwise confusing universe. But every mental construct distorts to some extent what it represents and every distortion adds something to the world that we need to understand. The more we think, the more we have to think about. This is because reality is not given. It is formed in the same process as the participants' thinking: The more complex the thinking, the more complicated reality becomes. Thinking can never quite catch up with reality: Reality is always richer than our comprehension. Reality has the power to surprise thinking, and thinking has the power to create reality.

    That said, I have little sympathy with those who seek to deconstruct reality. Reality is unique and uniquely important. It cannot be reduced or broken down to the views and beliefs of the participants because there is a lack of correspondence between what people think and what actually happens. This lack of correspondence stands in the way of reducing events to the participants' views just as it thwarts the prediction of events on the basis of universally valid generalizations. There is a reality, even if it is unpredictable and unexplainable. This may be difficult to accept but it is futile or downright dangerous to deny it, as any participant in the financial markets who has tried it can testify. Markets rarely gratify people's subjective expectations; yet their verdict is real enough to cause anguish and loss--and there is no appeal. Reality exists. But the fact that reality incorporates inherently imperfect human thinking makes it logically impossible to explain and predict.

    As a child, I lived in a house that had an elevator with two mirrors facing each other. Every day I looked into the mirrors and I saw myself reproduced. It seemed like infinity, but it was not. This experience made a lasting impression on me. The view of the world confronting thinking participants is very much like what I saw in those elevator mirrors. Thinking participants must impose some interpretative patterns on what they see. The reflexive process would never end if they did not end it deliberately. The most effective way to bring closure is to settle on a pattern and emphasize it until the actual picture recedes into the background. The pattern that emerges may be far removed from the underlying sensory perception but it has the great attraction of being understandable and clear. That is why religions and dogmatic political ideologies have so much appeal.

    This is not the place to discuss the many ways in which thinking both distorts reality and alters it. The way I have tried to make some sense out of a complex and confusing reality is by recognizing my own fallibility. I have been practicing a critical attitude based on that insight most of my life--certainly since I read Popper--and this has been absolutely fundamental to my professional success in financial markets. It has only recently dawned on me how unusual this critical attitude is. It has surprised me that other people were surprised by my way of thinking. If this book has something original to say, it is on this subject.

Two Versions of Fallibility

    I offer two versions of fallibility: first, a more moderate, better substantiated "official" version that accompanies the concept of reflexivity and justifies a critical mode of thinking and an open society; and, second, a more radical, idiosyncratic version that has actually guided me through life.

    The public, moderate version has already been discussed. Fallibility means that there is a lack of correspondence between the participants' thinking and the actual state of affairs; as a result actions have unintended consequences. Events do not necessarily diverge from expectations, but they are liable to do so. There are many humdrum, everyday events that play out exactly as expected, but those events that show a divergence are more interesting. They may alter people's view of the world and set in motion a reflexive process as a result of which neither the participants' views nor the actual state of affairs remains unaffected.

    Fallibility has a negative sound, but it has a positive aspect that can be very inspiring. What is imperfect can be improved. The fact that our understanding is inherently imperfect makes it possible to learn and to improve our understanding. All that is needed is to recognize our fallibility. That opens the way to critical thinking and there is no limit to how far our understanding of reality may go. There is infinite scope for improvement not only in our thinking but also in our society. Perfection eludes us; whatever design we choose, it is bound to be defective. We must therefore content ourselves with the next best thing--a form of social organization that falls short of perfection but is open to improvement. That is the concept of the open society: a society open to improvement. The concept rests on the recognition of our fallibility. I explore it further later on, but first I want to introduce a more radical, idiosyncratic version of fallibility.

Radical Fallibility

    At this point, I shall change my tack. Instead of discussing fallibility in general terms, I shall try to explain what it means to me personally. It is the cornerstone not only of my view of the world but also of my behavior. It is the foundation of my theory of history and it has guided me in my actions both as a participant in the financial markets and as a philanthropist. If there is anything original in my thinking, it is my radical version of fallibility.

    I take a more stringent view of fallibility than the one I could justify by the arguments I have presented so far. I contend that all constructs of the human mind, whether they are confined to the inner recesses of our thinking or find expression in the outside world in the form of disciplines, ideologies, or institutions, are deficient in some way or another. The flaw may manifest itself in the form of internal inconsistencies or inconsistencies with the external world or inconsistencies with the purpose that our ideas were designed to serve.

    This proposition is, of course, much stronger than the recognition that all our constructs may be wrong. I am not speaking of a mere lack of correspondence but of an actual flaw in all human constructs and an actual divergence between outcomes and expectations. As I explained earlier, the divergence really matters only in historic events. That is why the radical version of fallibility can serve as the basis for a theory of history.

    The contention that all human constructs are flawed sounds very bleak and pessimistic, but it is no cause for despair. Fallibility sounds so negative only because we cherish false hopes. We yearn for perfection, permanence, and the ultimate truth, with immortality thrown in for good measure. Judged by those standards, the human condition is bound to be unsatisfactory. In fact, perfection and immortality elude us and permanence can only be found in death. But life gives us a chance to improve our understanding exactly because it is imperfect and also to improve the world. When all constructs are deficient, the variations become all important. Some constructs are better than others. Perfection is unattainable but what is inherently imperfect is capable of infinite improvement.

    For good order's sake, I note that my claim that all human and social constructs are deficient does not qualify as a scientific hypothesis because it cannot be properly tested. I can claim that the participants' views always diverge from reality but I cannot prove it because we cannot know what reality would be in the absence of our views. I can wait for events to show a divergence from expectations, but, as I have indicated, subsequent events do not serve as an independent criterion for deciding what the correct expectations would have been because different expectations could have led to a different course of events. Similarly, I can claim that all human constructs are flawed but I cannot demonstrate what the flaw is. The flaws usually manifest themselves at some future date, but that is no evidence that they were present at the time the constructs were formed. The shortcomings of dominant ideas and institutional arrangements become apparent only with the passage of time, and the concept of reflexivity justifies only the claim that all human constructs are potentially flawed. That is why I present my proposition as a working hypothesis, without logical proof or scientific status.

    I call it a working hypothesis because it has worked well both in my financial activities and in my involvement in philanthropy and international affairs. It has encouraged me to look for the flaws in every situation and, when I found them, to benefit from the insight. On the subjective level, I recognized that my interpretation was bound to be distorted. This did not discourage me from having a view; on the contrary, I sought out situations where my interpretation was at variance with the prevailing wisdom. But I was always on the lookout for my error; when I discovered it, I grasped it with alacrity. In my financial dealings, the discovery of error would often present an opportunity to take whatever profits I had made from my flawed initial insight--or to cut my losses if the insight had not yielded even a temporarily profitable result. Most people are reluctant to admit that they are wrong; it gave me positive pleasure to discover a mistake because I knew it could save me from financial grief.

    On the objective level, I recognized that the companies or industries in which I invested were bound to be flawed and I preferred to know what the flaws were. This did not stop me from investing; on the contrary, I felt much safer when I knew the potential danger points because that told me what signs to look for to sell my investment. No investment can offer superior returns indefinitely. Even if a company has superior market position, outstanding management, and exceptional profit margins, the stock may become overvalued, management may become complacent, and the competitive or regulatory environment may change. It is wise to be constantly looking for the fly in the ointment. When you know what it is, you are ahead of the game.

    I developed my own variant of Popper's model of scientific method for use in financial markets. I would formulate a hypothesis on the basis of which I would invest. The hypothesis had to differ from the accepted wisdom and the bigger the difference the greater the profit potential. If there was no difference, there was no point in taking a position. This corresponded to Popper's contention--much criticized by philosophers of science--that the more severe the test, the more valuable the hypothesis that survives it. In science, the value of a hypothesis is intangible; in financial markets it can be readily measured by the profit it yields. In contrast to science, a financial hypothesis does not have to be true to be profitable; it is enough that it should come to be generally accepted. But a false hypothesis cannot prevail forever. That is why I liked to invest in flawed hypotheses that had a chance of becoming generally accepted, provided I knew what the flaw was: It allowed me to sell in time. I called my flawed hypotheses fertile fallacies and I built my theory of history, as well as my success in financial markets, around them.

    My working hypothesis--that all human constructs are always flawed--is not only unscientific but it has a more radical defect: It is probably not true. Every construct develops a defect with the passage of time, but this does not mean that it was inappropriate or ineffective at the time it was constructed. I think it is possible to refine my working hypothesis and cast it in a form that can lay a stronger claim to be true. For this purpose, I must appeal to my theory of reflexivity. In a reflexive process, neither the participants' thinking nor the actual state of affairs remains unaffected. Therefore even if a decision or interpretation was correct at the beginning of the process, it is bound to be inappropriate at a later stage. So I must add an important proviso to the claim that all human constructs are flawed: It is true only if we expect theories or policies to be timelessly valid like the laws of science.

    Constructs, like actions, have unintended consequences and those consequences cannot be properly anticipated at the time of their creation. Even if the consequences could be anticipated, it might still be appropriate to proceed because those consequences would arise only in the future. So my working hypothesis is not incompatible with the idea that one course of action is better than another, that there is indeed an optimum course of action. It does imply, however, that the optimum applies only to a particular moment of history and what is optimum at one point may cease to be so at the next. This is a difficult concept to work with, particularly for institutions that cannot avoid some degree of inertia. The longer any form of taxation is in effect, the more likely it is that it will be evaded; that may be a good reason for changing the form of taxation after a while, but not a good reason for having no taxation. To take an example from a different field, the Catholic Church has evolved into something quite different from what Jesus intended, but that is not sufficient ground for dismissing his teachings.

    In other words, theories or policies may be temporarily valid at a certain point in history. It is to bring this point home that I call them fertile fallacies: flawed constructs with initially beneficial effects. How long the beneficial effects last depends on whether the flaws are recognized and corrected. In this way, constructs may become increasingly sophisticated. But no fertile fallacy is likely to last forever; eventually the scope for refining it and developing it will be exhausted and a new fertile fallacy captures people's imagination. What I am about to say may be a fertile fallacy, but I am inclined to interpret the history of ideas as composed of fertile fallacies. Other people may call them paradigms.

    The combination of these two ideas--that all mental constructs are flawed but some of them are fertile--lies at the core of my own, radical version of fallibility. I apply it to the outside world and to my own activities with equal vigor and it has served me well both as a fund manager and more recently as a philanthropist. Whether it will also serve me well as a thinker is being tested right now, for this radical version of fallibility serves as the foundation for the theory of history and the interpretation of financial markets that I lay out in the rest of this book.

A Personal Postscript

    My radical version of fallibility is not only an abstract theory but also a personal statement. As a fund manager, I depended a great deal on my emotions. That was because I was aware of the inadequacy of knowledge. The predominant feelings I operated with were doubt, uncertainty, and fear. I had moments of hope or even euphoria, but they made me feel insecure. By contrast, worrying made me feel safe. So the only genuine joy I experienced was when I discovered what I had to worry about. By and large, I found managing a hedge fund extremely painful. I could never acknowledge my success, because that might stop me from worrying, but I had no trouble recognizing my mistakes.

    Only when others pointed it out to me did I realize that there may be something unusual in my attitude to mistakes. It made so much sense to me that discovering an error in my thinking or in my position should be a source of joy rather than regret that I thought that it ought to make sense to others as well. But that is not the case. When I looked around, I found that most people go to great lengths to deny or cover up their mistakes. Indeed, their misconceptions and misdeeds become an integral part of their personality. I will never forget an experience I had when I visited Argentina in 1982 to look at the mountain of debt that country had accumulated. I sought out a number of politicians who had served in previous governments and asked them how they would handle the situation. To a man, they said they would apply the same policies they followed when they were in government. Rarely had I met so many people who learned so little from experience.

    I carried my critical attitude into my philanthropic activities. I found philanthropy riddled with paradoxes and unintended consequences. For instance, charity may turn the recipients into objects of charity. Giving is supposed to help others, but in reality it often serves for the ego gratification of the giver. What is worse, people frequently engage in philanthropy because they want to feel good, not because they want to do good.

    Holding these views, I had to take a different approach. I found myself behaving not very differently from the way I behave in business. For instance, I subordinated the interests of the foundation personnel and of the individual applicants to the mission of the foundation. I used to joke that ours is the only misanthropic foundation in the world. I remember explaining at a staff meeting in Karlovi Vari, Czechoslovakia, around 1991, my views about foundations, and I am sure that those who were there will never forget it. I said that foundations are hothouses of corruption and inefficiency and I would consider it a greater accomplishment to wind up a foundation that failed than to set up a new one. I also remember telling a gathering in Prague of staff members from European foundations that networking means not working.

    I must confess that I have mellowed with the passage of time. There is a difference between running a hedge fund and a foundation. The external pressures are largely absent and it is only internal discipline that keeps a critical attitude alive. Moreover, heading a large foundation requires people skills and leadership qualifies and people do not like critical remarks--they want praise and encouragement. Not many people share my predilection for identifying error and even fewer share my joy in it. To be an effective leader, one has to gratify people. I am learning the hard way what seems to come naturally to politicians and heads of corporations.

    There is another influence as well. I have to make some public appearances, and when I do I am expected to exude self-confidence. In reality I am consumed by self-doubt and I cherish the feeling. I would hate to lose it. There is a wide gap between my public persona and what I consider my real self, but I am aware of a reflexive connection between the two. I have been watching with amazement how the development of a public persona has affected me. I have become a "charismatic" personality. Fortunately I do not quite believe in myself as others do. I try to remember my limitations even if I do not feel them as acutely as I used to. But other charismatic personalities have not arrived at their leadership position following the same route as I did. They do not have the same memories. They probably remember that they always tried to get others to believe in them and eventually they succeeded. They are not consumed by self-doubt and they do not need to repress the urge to express it. No wonder that their attitude to fallibility is different.

    It is fascinating to consider how my current "charismatic" personality relates to the financial markets and to my previous self as a fund manager. It qualifies me to make deals or even to manipulate markets but disqualifies me from managing money. My utterances can move markets, although I make great efforts not to abuse that power. At the same time, I have lost the ability to operate within the confines of the market as I used to. I have dismantled the mechanism of pain and anxiety that used to guide me. This is a long story, which I recounted elsewhere. The change happened long before I acquired my "charisma." When I was an active fund manager, I used to shun publicity. I considered it the kiss of death to be on the cover of a financial magazine. This amounted to a superstition, but it was well supported by the evidence. It is easy to see why. The publicity would engender a feeling of euphoria and, even if I fought it, it would throw me off my stride. And if I expressed a market view in public, I found it more difficult to change my mind.

    It can be seen that operating in the financial markets requires a different mind-set from that required for operating in a social, political, or organizational setting or, indeed, for acting like a normal human being. This is also borne out by the evidence. There is considerable tension in most financial institutions between profit producers and the managers of the organization, or at least there used to be when I was familiar with these institutions, and the most gifted producers often preferred to go out on their own. That was the genesis of the hedge fund industry.

    The radical version of fallibility I have adopted as a working hypothesis certainly proved effective in the financial markets. It has outperformed the random walk hypothesis by a convincing margin. Does it also apply to other aspects of human existence? That depends on what our goal is. If we want to understand reality, I believe it is helpful; but if our aim is to manipulate reality, it does not work so well--charisma works better.

    Coming back to my personal feelings, I have learned to adjust to the new reality in which I am operating. I used to find public expressions of praise and gratitude positively painful, but I have come to realize that this is a reflex left over from the days when I was actively managing money and I had to be guided by the results of my actions, not by what other people thought of them. I am still embarrassed by gratitude and I still believe that philanthropy, if it is deserving of praise, should put the interests of society ahead of ego gratification, but I am willing to accept praise because my philanthropy has in fact met this condition. Whether it can continue to do so in the light of my changed attitude toward praise is a question that troubles me, but as long as I am troubled the answer will probably remain in the affirmative.

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My original aim in writing this book was to expound the philosophy that has guided me through life. I had become known as a successful money manager and later on as a philanthropist. Sometimes I felt like a gigantic digestive tract, taking in money at one end and pushing it out at the other, but in fact a considerable amount of thought connected the two ends. A conceptual framework, which I had formulated in my student days long before I became engaged in the financial markets, governed both my money making and my philanthropic activities.

I was greatly influenced by Karl Popper, the philosopher of science, whose book Open Society and Its Enemies made sense of the Nazi and communist regimes that I had experienced at first hand as an adolescent in Hungary. Those regimes had a common feature: They laid claim to the ultimate truth and they imposed their views on the world by the use of force. Popper proposed a different form of social organization, one that recognized that nobody has access to the ultimate truth. Our understanding of the world in which we live is inherently imperfect and a perfect society is unattainable. We must content ourselves with the second best: an imperfect society that is, however, capable of infinite improvement. He called it open society, and totalitarian regimes were its enemies.

I absorbed Popper's ideas about critical thinking and scientific method. I did it critically and I came to differ with him on an important point. Popper claimed that the same methods and criteria apply to both natural and social sciences. I was struck by a vital difference: In the social sciences, thinking forms part of the subject matter whereas the natural sciences deal with phenomena that occur independently of what anybody thinks. This makes natural phenomena amenable to Popper's model of scientific method, but not social phenomena.

I developed the concept of reflexivity: a two-way feedback mechanism between thinking and reality. I was studying economics at the time and reflexivity did not fit into economic theory, which operated with a concept borrowed from Newtonian physics, namely, equilibrium.

The concept of reflexivity came in very useful to me when I became engaged in managing money. In 1979, when I had made more money than I had use for, I established a foundation, called the Open Society Fund. I defined its objectives as helping to open up closed societies, helping to make open societies more viable, and fostering a critical mode of thinking. Through the foundation, I became deeply involved in the disintegration of the Soviet system.

Partly as a result of that experience and partly on the basis of my experience of the capitalist system, I came to the conclusion that the conceptual framework I had been working with was no longer valid. I sought to reformulate the concept of open society. In Popper's formulation, it stood in contrast with closed societies based on totalitarian ideologies, but recent experience taught me that it could be threatened from the opposite direction as well: from the lack of social cohesion and the absence of government.

I expressed my views in an article titled "The Capitalist Threat," published in the February 1997 issue of The Atlantic Monthly. This book, which I started writing shortly thereafter, was meant to be a more thorough elaboration of those ideas. In my previous books, I had relegated my conceptual framework to an appendix or served it up buried in personal reminiscences. Now I felt that it deserved a direct hearing. I had always been passionately interested in understanding the world in which I lived. Rightly or wrongly, I felt I had made some progress and I wanted to share it.

The original plan for this book was, however, disrupted by the global financial crisis that began in Thailand in July 1997. I was exploring the flaws of the global capitalist system but I was doing it in a leisurely fashion. I was fully cognizant of the Asian crisis - indeed my fund management company anticipated it six months before it happened - but I had no idea how far-reaching it would turn out to be. I was explaining why the global capitalist system was unsound and unsustainable but until the Russian meltdown in August 1998, I did not realize that it was in fact disintegrating. Suddenly my book took on a new sense of urgency. Here I had a ready-made conceptual framework in terms of which the rapidly evolving global financial crisis could be understood. I decided to rush into print.

My view of the current situation was summed up in the Congressional testimony I delivered on September 15, 1998, where I said, in part, as follows:

The global capitalist system which has been responsible for the remarkable prosperity of this country in the last decade is coming apart at the seams. The current decline in the U.S. stock market is only a symptom, and a belated symptom at that, of the more profound problems that are afflicting the world economy. Some Asian stock markets have suffered worse declines than the Wall Street crash of 1929 and in addition their currencies have also fallen to a fraction of what their value was when they were tied to the U.S. dollar. The financial collapse in Asia was followed by an economic collapse. In Indonesia, for instance, most of the gains in living standards that accumulated during 30 years of Suharto's regime have disappeared. Modern buildings, factories and infrastructure remain, but so does a population that has been uprooted from its rural origins. Currently Russia has undergone a total financial meltdown. It is a scary spectacle and it will have incalculable human and political consequences. The contagion has now also spread to Latin America. It would be regrettable if we remained complacent just because most of the trouble is occurring beyond our borders. We are all part of the global capitalist system which is characterized not only by free trade but more specifically by the free movement of capital. The system is very favorable to financial capital which is free to pick and choose where to go and it has led to the rapid growth of global financial markets. It can be envisaged as a gigantic circulatory system, sucking up capital into the financial markets and institutions at the center and then pumping it out to the periphery either directly in the form of credits and portfolio investments, or indirectly through multinational corporations.

Until the Thai crisis in July 1997 the center was both sucking in and pumping out money vigorously, financial markets were growing in size and importance and countries at the periphery could obtain an ample supply of capital by opening up their capital markets. There was a global boom in which the emerging markets fared especially well. At one point in 1994 more than half the total inflow into U.S. mutual funds went into emerging market funds.

The Asian crisis reversed the direction of the flow. Capital started fleeing the periphery. At first, the reversal benefited the financial markets at the center. The U.S. economy was just on the verge of overheating and the Federal Reserve was contemplating raising the discount rate. The Asian crisis rendered such a move inadvisable and the stock market took heart. The economy enjoyed the best of all possible worlds with cheap imports keeping domestic inflationary pressures in check and the stock market made new highs. The buoyancy at the center raised hopes that the periphery may also recover and between February and April of this year most Asian markets recovered roughly half their previous losses measured in local currencies. That was a classic bear market rally.

There comes a point when distress at the periphery cannot be good for the center. I believe that we have reached that point with the meltdown in Russia. I have three main reasons for saying so. One is that the Russian meltdown has revealed certain flaws in the international banking system which had been previously disregarded. In addition to their exposure on their own balance sheets, banks engage in swaps, forward transactions and derivative trades among each other and with their clients. These transactions do not show up in the balance sheets of the banks. They are constantly marked to market, that is to say, they are constantly revalued and any difference between cost and market made up by cash transfers. This is supposed to eliminate the risk of any default. Swap, forward and derivative markets are very large and the margins razor thin; that is to say, the value of the underlying amounts is a manifold multiple of the capital employed in the business. The transactions form a daisy chain with many intermediaries and each intermediary has an obligation to his counterparties without knowing who else is involved. The exposure to individual counterparties is limited by setting credit lines.

This sophisticated system received a bad jolt when the Russian banking system collapsed. Russian banks defaulted on their obligations, but the Western banks remained on the hook to their own clients. No way was found to offset the obligations of one bank against those of another. Many hedge funds and other speculative accounts sustained large enough losses that they had to be liquidated. Normal spreads were disrupted and professionals who arbitrage between various derivatives, i.e., trade one derivative against another, also sustained large losses. A similar situation arose shortly thereafter when Malaysia deliberately shut down its financial markets to foreigners but the Singapore Monetary Authority in cooperation with other central banks took prompt action. Outstanding contracts were netted out and the losses were shared. A potential systemic failure was avoided.

These events led most market participants to reduce their exposure all round. Banks are frantically trying to limit their exposure, deleverage, and reduce risk. Bank stocks have plummeted. A global credit crunch is in the making. It is already restricting the flow of funds to the periphery, but it has also begun to affect the availability of credit in the domestic economy. The junk bond market, for instance, has already shut down. This brings me to my second point. The pain at the periphery has become so intense that individual countries have begun to opt out of the global capitalist system, or simply fall by the wayside. First Indonesia, then Russia have suffered a pretty complete breakdown but what has happened in Malaysia and to a lesser extent in Hong Kong is in some ways even more ominous. The collapse in Indonesia and Russia was unintended, but Malaysia opted out deliberately. It managed to inflict considerable damage on foreign investors and speculators and it managed to obtain some temporary relief, if not for the economy, then at least for the rulers of the country. The relief comes from being able to lower interest rates and to pump up the stock market by isolating the country from the outside world. The relief is bound to be temporary because the borders are porous and money will leave the country illegally; the effect on the economy will be disastrous but the local capitalists who are associated with the regime will be able to salvage their businesses unless the regime itself is toppled. The measures taken by Malaysia will hurt the other countries which are trying to keep their financial markets open because it will encourage the flight of capital. In this respect Malaysia has embarked on a beggar-thy-neighbor policy. If this makes Malaysia look good in comparison with its neighbors, the policy may easily find imitators, making it harder for others to keep their markets open.

The third major factor working for the disintegration of the global capitalist system is the evident inability of the international monetary authorities to hold it together. IMF [International Monetary Fund] programs do not seem to be working; in addition, the IMF has run out of money. The response of the G7 governments to the Russian crisis was woefully inadequate, and the loss of control was quite scary. Financial markets are rather peculiar in this respect: they resent any kind of government interference but they hold a belief deep down that if conditions get really rough the authorities will step in. This belief has now been shaken.

These three factors are working together to reinforce the reverse flow of capital from the periphery to the center. The initial shock caused by the meltdown in Russia is liable to wear off, but the strain on the periphery is liable to continue. The flight of capital has now spread to Brazil and if Brazil goes, Argentina will be endangered. Forecasts for global economic growth are being steadily scaled down and I expect they will end up in negative territory. If and when the decline spreads to our economy, we may become much less willing to accept the imports which are necessary to feed the reverse flow of capital and the breakdown in the global financial system may be accompanied by a breakdown in international free trade. This course of events can be prevented only by the intervention of the international financial authorities. The prospects are dim, because the G7 governments have just failed to intervene in Russia, but the consequences of that failure may serve as a wake-up call. There is an urgent need to rethink and reform the global capitalist system. As the Russian example has shown, the problems will become progressively more intractable the longer they are allowed to fester.

The rethinking must start with the recognition that financial markets are inherently unstable. The global capitalist system is based on the belief that financial markets, left to their own devices, tend towards equilibrium. They are supposed to move like a pendulum: they may be dislocated by external forces, so-called exogenous shocks, but they will seek to return to the equilibrium position. This belief is false. Financial markets are given to excesses and if a boom/bust sequence progresses beyond a certain point it will never revert to where it came from. Instead of acting like a pendulum financial markets have recently acted more like a wrecking ball, knocking over one economy after another.

There is much talk about imposing market discipline, but if imposing market discipline means imposing instability, how much instability can society take? Market discipline needs to be supplemented by another discipline: maintaining stability in financial markets ought to be the objective of public policy. This is the general principle that I should like to propose.

Despite the prevailing belief in free markets this principle has already been accepted and implemented on a national scale. We have the Federal Reserve System and other financial authorities whose mandate is to prevent a breakdown in our domestic financial markets and if necessary act as lenders of last resort. I am confident that they are capable of carrying out their mandate. But we are sadly lacking in the appropriate financial authorities in the international arena. We have the Bretton Woods institutions - the IMF and the World Bank - which have tried valiantly to adapt themselves to rapidly changing circumstances. Admittedly the IMF programs have not been successful in the current global financial crisis; its mission and its methods of operation need to be reconsidered. I believe additional institutions may be necessary. At the beginning of this year I proposed establishing an International Credit Insurance Corporation, but at that time it was not yet clear that the reverse flow of capital would become such a serious problem and my proposal fell flat. I believe its time has now come. We also have to establish some kind of international supervision over the national supervisory authorities. Moreover, we have to reconsider the workings of the international banking system and the functioning of the swap and derivative markets.

The book is divided in two parts. The first part contains the conceptual framework. I shall not try to summarize it here, but in this age of keywords it can be represented by three keywords: fallibility, reflexivity, and open society. It contains a critique of the social sciences in general and economics in particular. I interpret financial markets in terms of reflexivity rather than equilibrium and I seek to develop a reflexive theory of history, treating financial markets as a laboratory where the theory can be tested. In Part II, I apply the conceptual framework described in the first part to the present moment in history. Although the financial crisis looms understandably large, the analysis goes much deeper. I deal with the discrepancy between a global economy and a political and social organization that is still basically national in scope. I explore the unequal relationship between center and periphery and the unequal treatment of debtors and creditors. I examine the unhealthy substitution of monetary values for intrinsic human values. I interpret global capitalism as an incomplete and distorted form of open society. Having identified the main features of the global capitalist system in Chapter 6, I try to predict its future in terms of a boom/bust sequence in Chapter 7. Chapter 8 contains some practical proposals on how the financial disintegration of the system could be prevented. In Chapter 9, I discuss the prospects for a less distorted and more complete form of open society and, in Chapter 11, I outline some practical steps that could be taken to achieve it.

I had meant this to be the definitive statement of my philosophy. Due to the intervention of history, it has become what I would call an instant book.

Copyright © 1998 by George Soros.
Published in the United States by PublicAffairs®,
a member of the Perseus Books Group.
All rights reserved.
Printed in the United States of America
No part of this book may be reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and reviews. For information, address PublicAffairs, 250 West 57th Street, Suite 1825, New York, NY 10107.
Book design by Jenny Dossin.

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This book seeks to lay the groundwork for a global open society. We live in a global economy, but the political organization of our global society is woefully inadequate. We are bereft of the capacity to preserve peace and to counteract the excesses of the financial markets. Without these controls, the global economy is liable to break down.

The global economy is characterized not only by free trade in goods and services but even more by the free movement of capital. Interest rates, exchange rates, and stock prices in various countries are intimately interrelated, and global financial markets exert tremendous influence on economic conditions. Given the decisive role that international financial capital plays in the fortunes of individual countries, it is not inappropriate to speak of a global capitalist system.

Financial capital enjoys a privileged position. Capital is more mobile than the other factors of production and financial capital is even more mobile than direct investment. Financial capital moves wherever it is best rewarded; as it is the harbinger of prosperity, individual countries compete to attract it. Due to these advantages, capital is increasingly accumulated in financial institutions and publicly traded multinational corporations; the process is intermediated by financial markets.

The development of a global economy has not been matched by the development of a global society. The basic unit for political and social life remains the nation-state. International law and international institutions, insofar as they exist, are not strong enough to prevent war or the large-scale abuse of human rights in individual countries. Ecological threats are not adequately dealt with. Global financial markets are largely beyond the control of national or international authorities.

I argue that the current state of affairs is unsound and unsustainable. Financial markets are inherently unstable and there are social needs that cannot be met by giving market forces free rein. Unfortunately these defects are not recognized. Instead there is a widespread belief that markets are self-correcting and a global economy can flourish without any need for a global society. It is claimed that the common interest is best served by allowing everyone to look out for his or her own interests and that attempts to protect the common interest by collective decision making distort the market mechanism. This idea was called laissez faire in the nineteenth century but it may not be such a good name today because it is a French word. Most of the people who believe in the magic of the marketplace and the merits of unlimited competition do not speak French. I have found a better name for it: market fundamentalism.

It is market fundamentalism that has rendered the global capitalist system unsound and unsustainable. This is a relatively recent state of affairs. At the end of the Second World War, the international movement of capital was restricted and the Bretton Woods institutions were set up to facilitate trade in the absence of capital movements. Restrictions were removed only gradually and it was only when Margaret Thatcher and Ronald Reagan came to power around 1980 that market fundamentalism became the dominant ideology. It is market fundamentalism that has put financial capital into the driver's seat.

This is, of course, not the first time that we have had a global capitalist system. Its main features were first identified in rather prophetic fashion by Karl Marx and Friedrich Engels in the Communist Manifesto, published in 1848. The system that prevailed in the second half of the nineteenth century was in some ways more stable than the contemporary version. First, there were imperial powers, Great Britain foremost among them, that derived large enough benefits from being at the center of the system to find it worthwhile to preserve it. Second, there was a single international currency in the form of gold; today there are three major currencies - the dollar; the German mark, which is soon to become the euro; and the yen - which are rubbing against each other like tectonic plates, often creating earthquakes, crashing minor currencies in the process. Third, and most important, there were certain shared beliefs and ethical standards, which were not necessarily practiced but were nevertheless quite universally accepted as desirable. These values combined a faith in reason and a respect for science with the Judeo-Christian ethical tradition and on the whole provided a more reliable guide to what is right and what is wrong than the values that prevail today. Monetary values and transactional markets do not provide an adequate basis for social cohesion. This sentence may not make much sense to the reader as it stands, but it will be expounded in the book. The nineteenth-century incarnation of the global capitalist system, in spite of its relative stability, was destroyed by the First World War. After the end of the war, there was a feeble attempt to reconstruct it, which came to a bad end in the crash of 1929 and the subsequent Great Depression. How much more likely is it, then, that the current version of global capitalism will also come to a bad end, given that the elements of stability that were present in the nineteenth century are now missing?

Yet a calamity could be avoided if we recognized the deficiencies of our system and corrected them in time. How did these deficiencies arise and how could they be corrected? These are the questions I propose to address. I argue that the global capitalist system is a distorted form of an open society and its excesses could be corrected if the principles of open society were better understood and more widely supported. The term open society was given currency by Karl Popper in his book Open Society and Its Enemies. At the time the book was published, in 1944, open society was threatened by totalitarian regimes such as Nazi Germany and the Soviet Union, which used the power of the state to impose their will on the people. The concept of open society could be readily understood by contrasting it with the closed societies that totalitarian ideologies fostered. This remained true right up to the collapse of the Soviet empire in 1989. The open societies of the world - commonly referred to as the West - exhibited considerable cohesion in the face of a common enemy. But after the collapse of the Soviet system, open society, with its emphasis on freedom, democracy, and the rule of law, lost much of its appeal as an organizing principle and global capitalism emerged triumphant. Capitalism, with its exclusive reliance on market forces, poses a different kind of danger to open society. The central contention of this book is that market fundamentalism is today a greater threat to open society than any totalitarian ideology.

This statement is rather shocking. A market economy is an integral part of an open society. Friedrich Hayek, the greatest twentieth-century ideologist of laissez faire economics, was a firm believer in the concept of an open society. How can market fundamentalism threaten open society?

Let me make myself clear. I am not saying that market fundamentalism is diametrically opposed to the idea of open society the way fascism or communism were. Quite the contrary. The concepts of open society and market economy are closely linked and market fundamentalism can be regarded as merely a distortion of the idea of the open society. That does not make it any less dangerous. Market fundamentalism endangers the open society inadvertently by misinterpreting how markets work and giving them an unduly large role to play.

My critique of the global capitalist system falls under two main headings. One concerns the defects of the market mechanism. Here I am talking primarily about the instabilities built into financial markets. The other concerns the deficiencies of what I have to call, for lack of a better name, the nonmarket sector. By this I mean primarily the failure of politics and the erosion of moral values on both the national and the international level.

I want to say at the outset that I consider the failures of politics much more pervasive and debilitating than the failures of the market mechanism. Individual decision making as expressed through the market mechanism is much more efficient than collective decision making as practiced in politics. This is particularly true in the international arena. The disenchantment with politics has fed market fundamentalism and the rise of market fundamentalism has, in turn, contributed to the failure of politics. One of the great defects of the global capitalist system is that it has allowed the market mechanism and the profit motive to penetrate into fields of activity where they do not properly belong.

The first part of my critique concerns the inherent instability of the global capitalist system. Market fundamentalists have a fundamentally flawed conception of how financial markets operate. They believe that financial markets tend toward equilibrium. Equilibrium theory in economics is based on a false analogy with physics. Physical objects move the way they move irrespective of what anybody thinks. But financial markets attempt to predict a future that is contingent on the decisions people make in the present. Instead of just passively reflecting reality, financial markets are actively creating the reality that they, in turn, reflect. There is a two-way connection between present decisions and future events, which I call reflexivity.

The same feedback mechanism interferes with all other activities that involve cognizant human participants. Human beings respond to the economic, social, and political forces in their environment, but unlike the inanimate particles of the physical sciences humans have perceptions and attitudes that simultaneously transform the forces acting on them. This two-way reflexive interaction between what participants expect and what actually happens is central to an understanding of all economic, political, and social phenomena. This concept of reflexivity lies of the heart of the arguments presented in this book. Reflexivity is absent from natural science, where the connection between scientists' explanations and the phenomena they are trying to explain runs only one way. If a statement corresponds to the facts, it is true; if not, it is false. In this way, scientists can establish knowledge. But market participants do not have the luxury of basing their decisions on knowledge. They must make judgments about the future and the bias they bring to bear influences the outcome. These outcomes, in turn, reinforce or weaken the bias with which the market participants began.

I contend that the concept of reflexivity is more relevant to financial markets (and to many other economic and social phenomena) than the concept of equilibrium, on which conventional economics is based. Instead of knowledge, market participants start with a bias. Either reflexivity works to correct the bias, in which case you have a tendency toward equilibrium, or the bias can be reinforced by a reflexive feedback, in which case markets can move quite far from equilibrium without showing any tendency to return to the point from which they started. Financial markets are characterized by booms and busts and it is quite amazing that economic theory continues to rely on the concept of equilibrium, which denies the possibility of these phenomena, in face of the evidence. The potential for disequilibrium is inherent in the financial system; it is not just the result of external shocks. The insistence on exogenous shocks as a kind of deus ex machina to explain away the frequent refutation of economic theory in the behavior of financial markets reminds me of the ingenious contrivances of spheres within spheres and divine forces that pre-Copernican astronomers used to explain the position of the planets instead of accepting that the earth moves around the sun.

Reflexivity is not a widely accepted concept, at least in mainstream thinking, and it will take more than a few sentences to explore all its implications. It will occupy much of Part I of the book. In Part II of the book, I then use this framework to draw some practical conclusions - about financial markets; about the world economy; and about such broader issues as international politics, social cohesion, and the instability of the global capitalist system as a whole.

My second main line of argument is more complex and more difficult to summarize. I believe that the failures of the market mechanism pale into insignificance compared to the failure of what I call the nonmarket sector of society. When I speak of the nonmarket sector, I mean the collective interests of society, the social values that do not find expression in markets. There are people who question whether such collective interests exist at all. Society, they maintain, consists of individuals, and their interests are best expressed by their decisions as market participants. For instance, if they feel philanthropic they can express it by giving money away. In this way, everything can be reduced to monetary values.

It hardly needs saying that this view is false. There are things we can decide individually; there are other things that can only be dealt with collectively. As a market participant, I try to maximize my profits. As a citizen, I am concerned about social values: peace, justice, freedom, or whatever. I cannot give expression to those values as a market participant. Let us suppose that the rules that govern financial markets ought to be changed. I cannot change them unilaterally. If I impose the rules on myself but not on others, it would effect my own performance in the market but it would have no effect on what happens in the markets because no single participant is supposed to be able to influence the outcome.

We must make a distinction between making the rules and playing by those rules. Rule making involves collective decisions, or politics. Playing by the rules involves individual decisions, or market behavior. Unfortunately the distinction is rarely observed. People seem largely to vote their pocketbooks and they lobby for legislation that serves their personal interest. What is worse, elected representatives also frequently put their personal interests ahead of the common interest. Instead of standing for certain intrinsic values, political leaders want to be elected at all costs - and under the prevailing ideology of market fundamentalism, or untrammeled individualism, this is regarded as a natural, rational, and even perhaps desirable way for politicians to behave. This attitude toward politics undermines the postulate on which the principle of representative democracy was built. The contradiction between politicians' personal and public interests was, of course, always present, but it has been greatly aggravated by prevailing attitudes that put success as measured by money ahead of intrinsic values such as honesty. Thus the ascendancy of the profit motive and the decline in the effectiveness of the collective decision-making process have reinforced each other in a reflexive fashion. The promotion of self-interest to a moral principle has corrupted politics and the failure of politics has become the strongest argument in favor of giving markets an ever freer reign. The functions that cannot and should not be governed purely by market forces include many of the most important things in human life, ranging from moral values to family relationships to aesthetic and intellectual achievements. Yet market fundamentalism is constantly attempting to extend its sway into these regions, in a form of ideological imperialism. According to market fundamentalism, all social activities and human interactions should be looked at as transactional, contract-based relationships and valued in terms of a single common denominator, money. Activities should be regulated, as far as possible, by nothing more intrusive than the invisible hand of profit-maximizing competition. The incursions of market ideology into fields far outside business and economics are having destructive and demoralizing social effects. But market fundamentalism has become so powerful that any political forces that dare to resist it are branded as sentimental, illogical, and naive.

Yet the truth is that market fundamentalism is itself naive and illogical. Even if we put aside the bigger moral and ethical questions and concentrate solely on the economic arena, the ideology of market fundamentalism is profoundly and irredeemably flawed. To put the matter simply, market forces, if they are given complete authority even in the purely economic and financial arenas, produce chaos and could ultimately lead to the downfall of the global capitalist system. This is the most important practical implication of my argument in this book.

There is a widespread presumption that democracy and capitalism go hand in hand. In fact the relationship is much more complicated. Capitalism needs democracy as a counterweight because the capitalist system by itself shows no tendency toward equilibrium. The owners of capital seek to maximize their profits. Left to their own devices, they would continue to accumulate capital until the situation became unbalanced. Marx and Engels gave a very good analysis of the capitalist system 150 years ago, better in some ways, I must say, than the equilibrium theory of classical economics. The remedy they prescribed - communism - was worse than the disease. But the main reason why their dire predictions did not come true was because of countervailing political interventions in democratic countries.

Unfortunately we are once again in danger of drawing the wrong conclusions from the lessons of history. This time the danger comes not from communism but from market fundamentalism. Communism abolished the market mechanism and imposed collective control over all economic activities. Market fundamentalism seeks to abolish collective decision making and to impose the supremacy of market values over all political and social values. Both extremes are wrong. What we need is a correct balance between politics and markets, between rule making and playing by the rules.

But even if we recognized this need, how could we achieve it? The world has entered a period of profound imbalance in which no individual state can resist the power of global financial markets and there are practically no institutions for rule making on an international scale. Collective decision-making mechanisms for the global economy simply do not exist. These conditions are widely acclaimed as the triumph of market discipline, but if financial markets are inherently unstable, imposing market discipline means imposing instability - and how much instability can society tolerate?

Yet the situation is far from hopeless. We must learn to distinguish between individual decision making as expressed in market behavior and collective decision making as expressed in social behavior in general and politics in particular. In both cases, we are guided by self-interest; but in collective decision making we must put the common interest ahead of our individual self-interest even if others fail to do so. That is the only way the common interest can prevail.

Today the global capitalist system still stands near the height of its powers. It is certainly endangered by the present global crisis, but its ideological supremacy knows no bounds. The Asian crisis has swept away the autocratic regimes that combined personal profits with Confucian ethics and replaced them with more democratic, reform-minded governments. But the crisis has also undermined the ability of the international financial authorities to prevent and resolve financial crises. How long before the crisis starts sweeping away reform-minded governments? I am afraid that the political developments triggered by the financial crisis may eventually sweep away the global capitalist system itself. It has happened before. I want to make it clear that I do not want to abolish capitalism. In spite of its shortcomings, it is better than the alternatives. Instead, I want to prevent the global capitalist system from destroying itself. For this purpose, we need the concept of open society more than ever.

The global capitalist system is a distorted form of open society. Open society is based on the recognition that our understanding is imperfect and our actions have unintended consequences. All our institutional arrangements are liable to be flawed and just because we find them wanting we should not abandon them. Rather we should create institutions with error-correcting mechanisms built in. These mechanisms include both markets and democracy. But neither will work unless we are aware of our fallibility and willing to recognize our mistakes.

At present there is a terrific imbalance between individual decision making as expressed in markets and collective decision making as expressed in politics. We have a global economy without a global society. The situation is untenable. But how can it be corrected?

This book is quite specific with regard to the deficiencies of financial markets. With regard to the moral and spiritual fields where market fundamentalism is squeezing its way into the nonmarket sector, my views are, of necessity, much more tentative.

To stabilize and regulate a truly global economy, we need some global system of political decision-making. In short, we need a global society to support our global economy. A global society does not mean a global state. To abolish the existence of states is neither feasible nor desirable; but insofar as there are collective interests that transcend state boundaries, the sovereignty of states must be subordinated to international law and international institutions. Interestingly, the greatest opposition to this idea is coming from the United States, which, as the sole remaining superpower, is unwilling to subordinate itself to any international authority. The United States faces a crisis of identity: Does it want to be a solitary superpower or the leader of the free world? The two roles could be blurred as long as the free world was confronting an "evil empire," but the choice now presents itself in much starker terms. Unfortunately we have not even started to consider it. The popular inclination in the United States is to go it alone, but that would deprive the world of the leadership it so badly needs. Isolationism could be justified only if the market fundamentalists were right and the global economy could sustain itself without a global society. The alternative is for the United States to forge an alliance with like-minded nations to establish the laws and institutions that are necessary to the preservation of peace, freedom, prosperity, and stability. What these laws and institutions are cannot be decided once and for all; what we need is to set in motion a cooperative, iterative process that defines the open society ideal - a process in which we openly admit the imperfections of the global capitalist system and try to learn from our mistakes.

It cannot happen without the United States. But conversely, there has never been a time when a strong lead from the United States and other like-minded countries could achieve such powerful and benign results. With the right sense of leadership and with clarity of purpose, the United States and its allies could begin to create a global open society that could help to stabilize the global economic system and to extend and uphold universal human values. The opportunity is waiting to be grasped.

Copyright © 1998 by George Soros.
Published in the United States by PublicAffairs®,
a member of the Perseus Books Group.
All rights reserved.
Printed in the United States of America
No part of this book may be reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and reviews. For information, address PublicAffairs, 250 West 57th Street, Suite 1825, New York, NY 10107.
Book design by Jenny Dossin.

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