Why I agree with (some of) Hayek, by George Soros
Friedrich Hayek is generally regarded as the apostle of a brand of economics which
holds that the market will assure the optimal allocation of resources —
as long as the government doesn’t interfere. It is a formalized and
mathematical theory, whose two main pillars are the efficient market
hypothesis and the theory of rational expectations.
This is usually called the Chicago School, and it dominates the teaching
of economics in the United States. I call it market fundamentalism.
I have an alternative interpretation
— diametrically opposed to the efficient market hypothesis and rational
expectations. It is built on the twin pillars of fallibility and
I firmly believe these principles are in accordance with Hayek’s ideas.
But we can’t both be right. If I am right, market fundamentalism is
wrong. That means I must be able to show some inconsistency in Hayek’s
ideas, which is what I propose to do.
Let’s start with Hayek’s influence on the twin pillars of my
interpretation. I was a student at the London School of Economics in the
late 1940s and read the great methodological controversy between Karl
Popper and Hayek in Economica, the school’s periodical.
I considered myself a disciple of Popper. But here I was on Hayek’s
side. He inveighed against what he called “scientism” — meaning the
slavish imitation of Newtonian physics. Popper took the opposite
position. He argued in favor of what he called the doctrine of the unity
of science — that the same methods and criteria apply to all scientific
I was drawn to this controversy by my interest in Popper. I had read his
book, “Open Society and its Enemies,” in which he argued that the
inconvertible truth is beyond the reach of the human intellect, and
ideologies that claim to hold this truth are bound to be false.
Therefore, he argued, they can be imposed on society only by repressive
This helped me see the similarity between the Nazi and communist
regimes. Having lived through both in Hungary, it made a great
This led me to Popper’s theory of scientific method. Popper claimed that
scientific theories can never be verified — they can only be falsified.
So their validity is provisional — they must forever remain open to
falsification by testing. This avoids all the problems of needing to
prove scientific theories beyond any doubt and establishes the
importance of testing. Only theories that can be falsified qualify as
While I was admiring the elegance of Popper’s theory, I was also
studying elementary economics. I was struck by a contradiction between
the theory of perfect competition, which postulated perfect knowledge,
with Popper’s theory, which asserted that perfect knowledge was
unattainable. The contradiction could be resolved by recognizing that
economic theory cannot meet the standards of Newtonian physics.
That is why I sided with Hayek — who warned against the slavish
imitation of natural science and took issue with Popper — who asserted
the doctrine of unity of method.
Hayek argued that economic agents base their decisions on their
interpretation of reality, not on reality — and the two are never the
That is what I call fallibility. Hayek also recognized that decisions
based on an imperfect understanding of reality are bound to have
unintended consequences. But Hayek and I drew diametrically opposed
inferences from this insight.
Hayek used it to extol the virtues of the invisible hand of the
marketplace, which was the unintended consequence of economic agents
pursuing their self-interest. I used it to demonstrate the inherent
instability of financial markets.
In my theory of reflexivity I assert that
the thinking of economic agents serves two functions. On the one hand,
they try to understand reality; that is the cognitive function. On the
other, they try to make an impact on the situation. That is the
participating, or manipulative, function.
The two functions connect reality and the participants’ perception of
reality in opposite directions. As long as the two functions work
independently of each other they produce determinate results. When they
operate simultaneously they interfere with each other. That is the case
not only in the financial markets but also in many other social
I call the interference reflexivity. Reflexivity introduces an element
of unquantifiable uncertainty into both the participants’ understanding
and the actual course of events.
This two-way connection works as a feedback loop. The feedback is either
positive or negative. Positive feedback reinforces both the prevailing
trend and the prevailing bias — and leads to a mispricing of financial
assets. Negative feedback corrects the bias. At one extreme lies
equilibrium, at the other are the financial “bubbles.” These occur when
the mispricing goes too far and becomes unsustainable — boom is then
followed by bust.
In the real world, positive and negative feedback are intermingled and
the two extremes are rarely, if ever, reached. Thus the equilibrium
postulated by the efficient market hypothesis turns out to be an extreme
— with little relevance to reality.
Frank Knight was the first to identify the unquantifiable uncertainty
inherent in financial markets. John Maynard Keynes and his followers
elaborated his insight.
Classical economists, by contrast, sought to eliminate the uncertainty
connected with reflexivity from their subject matter. Hayek was one of
The methodological debate in Economica took place in the context of the
larger political controversy over the role of the state in the economy.
Hayek was on one side, Keynes and socialist planners on the other.
But Hayek subordinated his methodological arguments to his political
bias. That is the source of his inconsistency. In the Economica, he
attacked scientism. But after World War II, when the communist threat
became more acute, he overcame his methodological qualms and became the
apostle of market fundamentalism — with only a mild rebuke for the
excessive use of quantitative methods in his Nobel Prize acceptance
Because he was fighting communism, a scientific theory that proved that
market participants pursuing their self-interest assure the optimum
allocation of resources was too convenient for him to reject. But it was
also too good to be true.
Human beings act on
the basis of their imperfect understanding — and their decisions have
unintended consequences. That makes human affairs less predictable than
natural phenomenon. So Hayek was right in originally opposing scientism.
At the time of the Economica articles, Popper was between Hayek and the
socialist planners. He was just as opposed as Hayek to communism’s
threat to individual liberty, but he advocated what he called piecemeal
social engineering rather than laissez-faire.
Here I sided with Popper. But Popper and Hayek were not that far apart. I
was influenced by both — and I also found fault with both.
By identifying Hayek’s inconsistency and political bias, I do not mean
to demean him — but to improve our understanding of financial markets
and other social phenomena. We are all biased in one way or another and,
with the help of reflexivity, our misconceptions play a major role in
shaping the course of history.
Because perfection is unattainable, it makes all the difference how
close we come to understanding reality. Recognizing that the efficient
market hypothesis and the theory of rational expectations are both a
dead end would be a major step forward.
As in that earlier time, the political controversy on the role of the
state in the economy is raging today. But the standards of political
discourse have greatly deteriorated. The two sides used to engage in
illuminating arguments; now they hardly talk. That is why I was so
pleased to accept this invitation to the Cato Institute.
As I see it, the two sides in the current dispute have each got hold of
one half of the truth. which they proclaim to be the whole truth. It was
the hard right that took the initiative by arguing that the government
is the cause of all our difficulties; and the so-called left, in so far
as it exists, has been forced to defend the need for regulating the
private sector and providing government services.
Though I am often painted as the representative of the far left — and I
am certainly not free of political bias — I recognize that the other
side is half right in claiming that the government is wasteful and
inefficient and ought to function better.
But I also continue to cling to the other half of the truth — namely
that financial markets are inherently unstable and need to be regulated.
Above all, I am profoundly worried that those who proclaim half truths
as the whole truth, whether they are from the left or the right, are
endangering our open society.
Both Hayek and Popper, I believe, would share that concern. Those of us
concerned with the protection of individual liberty ought to work
together to restore the standards of political discourse that used to
enable our democracy to function better.