George Soros’ Inspiration for INET:
George Soros was the driving force behind the establishment of the Institute for New Economic Thinking (INET), providing the initial funding and vision.

Soros’ Understanding of Economics:
Soros had long recognized the need to better understand the relationship between economics, financial systems, and political realities. He was critical of dogmatic free-market economics and its internal contradictions.

Soros’ Commitment to Open Societies:
Soros dedicated much of his life to promoting open societies and politics worldwide, advocating for open-minded thinking about economic and political issues.

INET’s Creation:
Soros’ realization that prevailing dogmatic academic economics was a hindrance to open-minded thinking inspired the creation of INET. Soros appointed Rob Johnson to lead the organization, and INET was established within a few months.

INET’s Independence:
Soros aimed for INET to become financially independent and self-sufficient, ensuring its long-term sustainability. Support from various organizations and individuals, including CG, Mercator, Paul Volcker, and James Martin, contributed to INET’s stability.

Relevance of the Conference:
This third plenary conference of INET marks a significant milestone, as Soros transitions from being a sponsor to an active participant in the reinvention of economics.

Themes of Soros’ Speech:
Soros will address two main themes in his speech: Reinventing economics as an intellectual pursuit Reinventing economics as a practical tool for understanding financial markets, political systems, and policy design.

Discussants and Q&A:
Following Soros’ speech, two distinguished economists, Axel Leon Hufvud and Perry Mehrling, will provide their perspectives as discussants. A question and answer session with the audience will be held to encourage further engagement and discussion.

Introduction:
George Soros argues that the failure of economic theory is more profound than generally recognized, going back to the very foundations of the discipline. He emphasizes the fundamental difference between natural and social sciences and the challenges in establishing universally valid laws in social phenomena.

Critique of Mainstream Economics:
Soros criticizes the axiomatic approach in economics, particularly the theory of rational expectations and efficient market hypothesis, for being far removed from reality. He highlights the unrealistic assumption of perfect knowledge in these theories, especially in the context of production, the use of money, and credit, where the future is uncertain.

Alternative Approach: Feedback Reflexivity:
Soros proposes a radically different approach to financial markets based on feedback reflexivity. He emphasizes the circular relationship between participants’ thinking and the situation in which they participate, where the cognitive function and causative function interfere with each other. In a reflexive situation, participants’ views cannot correspond to reality due to the contingency of reality on their views and decisions.

Fallibility and Reflexivity:
Soros introduces the concept of fallibility, the inherent bias and guesswork in decision-making due to imperfect knowledge. He argues that fallibility and reflexivity are tied together, ensuring a divergence between participants’ views and the actual state of affairs, as well as between expectations and outcomes.

Financial Bubbles:
Soros develops a model of boom-bust or bubble formation that is endogenous to financial markets, not the result of external shocks. He explains that financial bubbles have two components: a trend in reality and a misconception relating to that trend. Bubbles develop when the feedback is initially positive, but eventually, the gap between the trend and its biased interpretation becomes unsustainable, leading to a sudden and devastating bust.

Conclusion:
Soros emphasizes the importance of recognizing the limitations of economic theory and the need for a more realistic interpretation of financial markets. He argues that his approach, based on feedback reflexivity and fallibility, provides a better understanding of the misconceptions and misunderstandings that shape the course of events in financial markets.

The Interplay of Markets and Regulators:
Financial markets can produce bubbles and crises, leading to regulatory responses that evolve alongside the markets themselves. Market participants and regulators act on imperfect knowledge, making the interplay between them reflexive.

Reflexivity and Fallibility in Markets:
Reflexivity and fallibility extend beyond financial markets, characterizing other social spheres like politics. Studying markets in isolation is misleading; the visible hand of politics influences the invisible hand of the market. Events should be studied in their time-bound context rather than relying on timeless laws and models.

Limitations of the Prevailing Paradigm:
The prevailing economic paradigm emphasizes rationality, efficiency, and predictable equilibrium. Soros’s interpretation highlights the role of misunderstandings and unpredictable bubbles. Soros argues that treating fallibility as the starting point makes his conceptual framework more realistic.

Pre- and Post-2008 Recognition:
Soros’s interpretation was previously ignored or dismissed by academic economists. Since the 2008 crash, reflexivity has been recognized, but economic theory’s foundations have not been greatly reevaluated.

Reflexivity and the Euro Crisis:
Reflexivity has been recognized by discussing multiple equilibria, but this is not sufficient. The fallibility of market participants, regulators, and economists must also be acknowledged. The euro crisis is a prime example of how policies that were effective at one point become inadequate later on. Imperfect understanding and misconceptions shape the course of history.

The Euro Crisis and Its Global Impact:
The euro crisis is significantly influencing the global economy. Soros’s discussion extends beyond economic theory into politics and social philosophy. The crisis exemplifies the reflexive interaction between imperfect markets and imperfect authorities. This interaction is rare but has a profound impact on the global economy.

A Political Bubble:
Soros proposes that the euro crisis is caused by a political bubble rather than a financial one. This political bubble has significant consequences for the global economy.

The Boom-Bust Process:
George Soros’ theory of the boom-bust process involves two components: a trend in reality and a misconception related to it. In the EU’s case, the boom phase was characterized by its depiction as a “fantastic object” embodying open society principles.

Piecemeal Social Engineering:
Integration was driven by far-sighted statesmen who practiced incremental progress, setting limited objectives and mobilizing political will for small steps forward. This process of piecemeal social engineering fueled its own success, like a financial bubble.

Germany’s Role:
Germany was initially at the forefront of EU integration, seeking reunification within a more united Europe. German statesmen believed Germany had no independent foreign policy, only a European one. This led to sacrifices and concessions to facilitate agreement among member states.

Maastricht Treaty and the Euro:
The Maastricht Treaty established a monetary union without a political union, relying on the generation of political will when needed. The euro had defects, such as no enforcement or exit mechanism and an assumption that only the public sector could produce unacceptable imbalances.

Financial Crisis and Disintegration:
After the 2008 crash, Germany declared separate action by countries, not joint action, for financial guarantees, revealing the Maastricht Treaty’s flaws. Interest rate convergence led to divergences in economic performance, creating conditions far from the Maastricht Treaty’s expectations. Government bonds, once considered riskless, carried significant credit risk, leading to a banking and balance of payments crisis.

Political Disintegration:
European authorities failed to understand the nature of the crisis and resorted to buying time, which usually works in financial panics. However, the crisis was reinforced by political disintegration, with those against the status quo adopting an anti-European posture. This political dynamic made disintegration self-reinforcing, similar to the self-reinforcing creation of the EU.

Financial Reorientation and Breakup Possibility:
The financial system has been reoriented along national lines, enabling profitable arbitrage and discouraging sovereign debt investment. A breakup of the euro could become possible without a meltdown if this trend continues for a few more years. However, this would leave creditor countries’ central banks with large claims against debtor countries, difficult to collect.

Bundesbank’s Response and Its Impact:
The Bundesbank is aware of the danger and is campaigning against indefinite money supply expansion. It is taking measures to limit potential losses in case of a breakup, creating a self-fulfilling prophecy. Bundesbank’s tightening of credit conditions at home negatively affects heavily indebted member countries, hindering their recovery and fiscal compact implementation.

Long-Term Economic Stagnation:
Europe faces a long period of economic stagnation or worse, regardless of the euro’s fate. Other regions have experienced similar stagnation, such as Latin America’s lost decade after 1982 and Japan’s stagnation for a quarter of a century.

Conceptual Issues in Economic Analysis:
Soros criticizes the axiomatic approach in economics, where economists attempt to deduce the way the world works from a few postulates. He argues that many economists see no difference between using math to test the building blocks of a theory and using math to deduce the entire workings of the world. This problem is particularly evident in macroeconomics, where economists deal with large systems in their entirety.

The Eurozone Crisis:
Soros believes that the deflationary debt trap is threatening to destroy the incomplete political union of the European Union. He argues that the European Union needs to recommit itself to the principles of open society and correct its mistakes to avoid this fate. German authorities, particularly the Bundesbank and the Constitutional Court, are enforcing unworkable laws that hinder finding a solution.

Proposed Solution:
Soros proposes a practical solution published in the Financial Times, but he does not discuss it in detail due to time constraints. He believes that the rules governing the Eurozone need to be radically revised, current conditions require exceptional measures, and new rules must allow for inherent financial market instability.

Implications of the Eurozone Crisis:
Soros’s analysis of the Eurozone crisis illustrates how fallibility and reflexivity provide insights into social change. He believes that his conceptual framework has the potential to serve as a new paradigm for economic analysis if others develop it further.

Commentary from Axel:
Axel draws a parallel between the current state of economics and the early days of rational expectations theory and efficient markets theory. He criticizes economists who used to argue that inflation targeting by independent central banks was sufficient for macro policy and regulation. Axel emphasizes the importance of INET in fostering research that challenges conventional economic wisdom.

Soros’s Fallibility and Reflexivity Concepts:
Soros believes fallibility and reflexivity are interconnected but not necessarily connected conceptually. Rational expectations models exhibit reflexivity without fallibility, assuming agents know the true probability distribution and learn from mistakes. Economics students often accept this concept to progress in their studies.

Fallibility as a Human Condition:
Fallibility is not just a human frailty but a fundamental aspect of the human condition. We may not repeat the same errors, but we repeatedly find ourselves in error due to our inability to differentiate between similar situations.

Bubbles and Trend Misinterpretation:
Bubbles consist of a prevailing trend and a misinterpretation of that trend. It is possible to learn when and how trends are likely to be misperceived and how their macro effects propagate.

Multiple Equilibria and Dynamic Situations:
Soros criticizes the use of multiple equilibria to accommodate reflexivity, arguing it is insufficient for understanding truly dynamic situations. The process of change and decision-makers’ groping towards equilibrium should be studied. This is especially relevant in stochastic valuation models where defaults can occur.

Economists and Safe Driving:
Soros highlights the tendency of economists to rationalize mistakes, even dangerous ones like driving into a ditch, by invoking multiple equilibria.

Fate of the Eurozone:
The author expresses concern about the potential failure of the European project, which was once a symbol of hope for young Europeans.

Soros’ Critique of the Maastricht and Lisbon Treaties:
Soros criticized the institutional arrangements established by the Maastricht and Lisbon treaties for assuming that democratic governments were the only source of problems and ignoring the potential for market instability.

Minsky Fragility and Market Instability:
Soros highlighted the possibility of “Minsky fragility,” where the market system can develop serious instability and become catastrophically unstable.

Changing Worldviews in Economics:
Soros contrasted two opposing worldviews in economics: one that sees governments as the source of problems and markets as the solution, and another that recognizes the instability and inefficiencies of the market system but relies on responsible governments to address them.

The Role of INET:
Soros suggested that a valuable contribution of INET could be to challenge the contest between these two simplistic and dangerous ideologies.

Perry Merling’s Encounter with Soros:
Perry Merling recounted his initial encounter with Soros in 1987 when Soros visited the Brookings Institution to discuss his book, The Alchemy of Finance.

Missed Opportunity and a Second Chance:
Merling expressed his gratitude for a second chance to engage with Soros’ latest thinking, acknowledging that he was unprepared to fully grasp Soros’ ideas during their first encounter due to his limited knowledge of finance.

Imperfect Knowledge and Fantastical Objects:
Economists grapple with imperfect knowledge due to a rapidly evolving world, complexity, and the impact of their actions on reality.

Fantastical Objects:
Economists often rely on “fantastical objects” – idealized models that may not accurately represent reality – leading to mistaken conceptions and methods. Fantastical objects provide succor and guidance in decision-making under radical uncertainty.

Credit and Vision Realization:
Credit enables individuals to materialize their visions of the future, creating a bridge from the present to the imagined future. This can lead to the formation of bubbles as shared visions attract more credit and investment.

Interlocking Structure of Credit:
Credit creates an interlocking structure that privileges certain visions of the future over others. When reality diverges from these visions, a reality check occurs, potentially leading to a collapse of the credit structure.

Central Bank Intervention:
Central banks play a crucial role during crises by extending or canceling promises, delaying liquidation, and providing liquidity.

Economic and European Fantastical Objects:
George Soros advocates for open-ended exploration of new economic thinking, rejecting the fantastical object of intertemporal equilibrium. Soros proposes recommitting to the fantastical object of the European Union as an embodiment of open society.

Conclusion:
The conference explores the choice between familiar but discredited fantastical objects of the past and unknown fantastical objects of the future. The fallibility of human endeavors and the reflexive interaction between the present and the unknowable future are fundamental issues in decision-making.

The Recognition of Fallibility:
Both government and market are prone to failure. Recognizing this fallibility is empowering, not depressing.

The Capacity for Improvement:
Fallibility implies the capacity for improvement. Political and institutional improvement is possible in the political sphere. Theoretical improvement is possible in the economic sphere.

The Future of Economic Policy:
The future of economic policy is about improving both government and market. Debate and discussion are essential for this improvement.