Reflexivity on the Financial Crisis

In light of the recent financial crisis, we are more likely to be overwhelmed and swamped by the devastation that it has brought then to look back into history and try to understand how this could have happened. Apart from the primary reason that we would all be so familiar by now, the current nemesis of financial markets, known as "sub prime mortgages", there lies i think other impetus or factors that could have led to the series of catastrophic events. Not to mention, Lehman Bros collapse, Fed's aid to ailing financial giants such as AIG and Citibank etc ....

An article was written by George Soro on his theory known as the theory of"reflexivity". Reflexivity in sociology refers to the circular relationship between cause and effect. A reflexive relationship is bidirectional with both the cause and effect affecting one another i.e the cause results in a effect influences the cause and vice versa.If you were to plot a line for world stock indices for the period of 2005 -2007, it can be seen that the stock market was on a bull run to a point where investors or traders (if there were able to differentiate among themselves) or most of us were led to think that there is safety in numbers i.e if everyone had their money in the market it seems like a safe heaven.The stock markets during this period was trending upwards, from bubble to bubble that did not seem to burst.The bubble that grew and established "equilibrium" (or what we would call support level) to "equilibrium", thereby drawing millions to invest in a falsified notion which provided them with a support/safety in numbers.The market was then grossly overvalued.

This illustrates the theory of reflexivity, where the cause leads to an effect which affects the cause in the first place.If traders believe that prices will fall, they sell thus driving down the prices whereas if they believe prices will rise they will buy thus driving the prices up. The prices that goes up and down then in turn influences the perception/fundamentals of trading/investing in stocks. As you can gather, this can lead to a vicious cycle of two natures,the bull or the bear cycles in stock markets.

An excerpt from wikipedia further illustrates this as below -

"quote
A current example of reflexivity in modern financial markets is that of the debt and equity of housing markets.Lenders began to make more money available to more people in the 1990s to buy houses. More people bought houses with this larger amount of money, thus increasing the prices ofthese houses. Lenders looked at their balance sheets which not only showed that they had made more loans, but that their equity backing the loans--the value of the houses, had gone up (because more money was chasing the same amount of housing, relatively). Thus they lent out more money because their balance sheets looked good, and prices went up more, and they lent more, etc. Prices increased rapidly, and lending standards were relaxed. The salient issue regarding reflexivity is that it explains why markets gyrate over time, and do not just stick to equilibrium--they tend to overshoot or undershoot.

Reflexivity is based on three main ideas:

1. Reflexivity is best observed under special conditions where investor bias grows and spreads throughout the investment arena. Examples of factors that may give rise to this bias include (a) equity leveraging or (b) the trend-following habits of speculators.
2. Reflexivity appears intermittently since it is most likely to be revealed under certain conditions; i.e., the equilibrium process's character is best considered in terms of probabilities.
3. Investors' observation of and participation in the capital markets may at times influence valuations and fundamental conditions or outcomes.
unquote"

But would understanding and applying our understanding of reflexivity have averted this crisis altogether? I think that remains a question to be answered given that the human behaviour have been known not to change over the years......