ALCHEMY. FINANCE. READING THE MIND OF THE MARKET. GEORGE SOROS. NEW PREFACE • FOREWORD BY PAUL TUDOR JONES II. CA. John Wiley. The Scope for Financial Alchemy: A n Evaluation of the Experiment The Quandary of the Social Sciences Part V PRESCRIPTION Free Markets Versus. the economic theory in general is flawed, and how he sees the financial world. success, I think the practicality of The Alchemy of Finance is very limited for.
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Reflexivity has been taken up as the issue of "reflexive prediction" in economic science by Grunberg and Modigliani and Herbert A. Simon , has been debated as a major issue in relation to the Lucas Critique , and has been raised as a methodological issue in economic science arising from the issue of reflexivity in the sociology of scientific knowledge SSK literature.
Reflexivity has emerged as both an issue and a solution in modern approaches to the problem of structure and agency , for example in the work of Anthony Giddens in his structuration theory and Pierre Bourdieu in his genetic structuralism.
Giddens , for example, noted that constitutive reflexivity is possible in any social system, and that this presents a distinct methodological problem for the social sciences. Giddens accentuated this theme with his notion of " reflexive modernity " — the argument that, over time, society is becoming increasingly more self-aware, reflective, and hence reflexive. Bourdieu argued that the social scientist is inherently laden with biases , and only by becoming reflexively aware of those biases can the social scientists free themselves from them and aspire to the practice of an objective science.
For Bourdieu, therefore, reflexivity is part of the solution, not the problem. Foucault examines the history of Western thought since the Renaissance and argues that each historical epoch he identifies 3, while proposing a 4th has an episteme , or "a historical a priori ", that structures and organizes knowledge.
Foucault argues that the concept of man emerged in the early 19th century, what he calls the "Age of Man", with the philosophy of Immanuel Kant. He finishes the book by posing the problem of the age of man and our pursuit of knowledge- where "man is both knowing subject and the object of his own study"; thus, Foucault argues that the social sciences, far from being objective, produce truth in their own mutually exclusive discourses.
In economics[ edit ] Economic philosopher George Soros , influenced by ideas put forward by his tutor, Karl Popper ,  has been an active promoter of the relevance of reflexivity to economics, first propounding it publicly in his book The Alchemy of Finance.
Reflexivity is inconsistent with general equilibrium theory , which stipulates that markets move towards equilibrium and that non-equilibrium fluctuations are merely random noise that will soon be corrected. In equilibrium theory, prices in the long run at equilibrium reflect the underlying economic fundamentals , which are unaffected by prices.
Reflexivity asserts that prices do in fact influence the fundamentals and that these newly influenced set of fundamentals then proceed to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. Because the pattern is self-reinforcing, markets tend towards disequilibrium. Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles  An example Soros cites is the procyclical nature of lending, that is, the willingness of banks to ease lending standards for real estate loans when prices are rising, then raising standards when real estate prices are falling, reinforcing the boom and bust cycle.
He further suggests that property price inflation is essentially a reflexive phenomenon: house prices are influenced by the sums that banks are prepared to advance for their download, and these sums are determined by the banks' estimation of the prices that the property would command.
This is why Soros has been able to fail to predict things about the world, but still rake in big bucks. The Market operates as a product of social phenomena- it's not like nature, where "laws operate independently of what anybody thinks. Operational success can be achieved without attaining scientific knowledge.
By the same token, scientific method is rendered just as ineffectual in dealing with social events as alchemy was in altering the character of natural substances. I'm no economist, but I do like to dabble in the study of decision making, cognition and human behavior and, turns out, those things are pretty darn interrelated. My point? I'm probably going to bungle any attempt at real explanation, so I'll just point out a few bits and pieces.
Humans are not rational actors and, even if we were, no one actually has all the options laid before them. Sometimes events fail to occur because they were anticipated. Why the low rating? To understand the role of the regulators it must be realized that they are also participants: The relationship between the regulators and the economy is reflexive and it also exhibits cyclical characteristics in the sense that it tends to swing from one extreme to another.
What is the connection between the regulatory cycle and the credit cycle? At this point, my views become very tentative. But within this chronological coincidence there is constant interaction between the two cycles that influences the shape and duration of both.
The interaction between the two cycles yields a unique path that cannot be fitted into any regular or repetitive pattern. I have tried to apply this complex and tentative framework to an interpretation of recent economic and financial history. Needless to say, a great many factors come into play; but my focus is on the twin cycles in credit and regulation. The main topics I deal with are the transformation of banking from a highly regulated to a less regulated industry, the boom and bust in international lending, mergermania, and international capital movements.
Until , the story is a fairly straightforward case of boom Introduction 19 and bust, but after the situation gets very complicated. Since then, we have been passing through uncharted waters. The great boom exhausted itself some time ago but its life span has been extended by artificial means in order to avoid a great bust.
I try to trace the unique path that events have taken: They gave rise to this strange constellation that I have called the Imperial Circle: The Imperial Circle held the international economic and financial system together but it was inherently unstable because the strong dollar and high real interest rates were bound to outweigh the stimulating effect of the budget deficit and weaken the U.
The Imperial Circle could not last indefinitely. What would happen next? To answer that question, I conducted an experiment from August onward. In effect, I kept a diary in which I recorded the thoughts that went into my investment decisions on a real-time h s i s.
The experiment was a roaring success in financial terms-my fund never did better. It also produced a surprising result: I came out of the experiment with quite different expectations about the future. I started with the presumption that the benign circle was in danger of reversing itself: By changing from a system of freely floating exchange rates to a "dirty float," the decline of the dollar was cushioned, and, with the help of lower interest rates and booming financial markets, the economy was prevented from slipping into recession.
We entered a new phase which I describe, with only a modicum of irony, as the "Golden Age of Capitalism. It propounds not just one general theory -the theory of reflexivity-but also another specific theory, that of a credit-cum-regulatory cycle. The latter idea is so tentative y that it hardly qualifies as a theory.
Yet I try! I also try to draw some general conclusions from the analysis. The most important ones are, first, that it is credit that matters, not money in other words, monetarism is a false ideology , and, second, that the concept of a general equilibrium has no relevance to the real world in other words, classical economics is an exercise in futility.
Financial markets are inherently unstable; that leads to a third conclusion that is better stated as a question than an assertion: The book would be easier to read if it tried to make just one point at a time. Unfortunately, that is not possible, because the various points are interconnected. As it is, I had to try to make several points more or less simultaneously. To make matters worse, the book does not qualify as a finished product.
When I started writing it, I thought I had a theory of reflexivity to present and my difficulties related only to its presentation. As I tried to apply the theory to various situations, I discovered that I do not actually have a well-formed theory. The idea that the participants' biases play an important causal role in historical events is both valid and interesting, but it is too general to Introduction 21 qualify as a theory that can help to explain and predict the course of events.
The boomhust pattern I have established applies to some developments but not to others. To try to fit every initially self-reinforcing and eyentually self-defeating development into its mold can give rise, to serious distortions. I feel like the early astronomers who tried to describe the elliptical paths of the planets in terms of circles and semicircles; the only difference is that the path of reflexibe events is irregular to start with.
My fantasy was to present a general theory of reflexivity that would explain the great bust of the s in the same way that Keynes's General Theory of Employment, Interest and Money explained the Great Depression sf ihz s.
As it tr;rns or;: What I have is an approach that can help to illuminate the present precarious state of our financial system. It cannot explain and predict the course of events in the manner to which we have become accustomed during our long love affair with natural science for the simple reason that reflexive processes cannot be explained and predicted in that Aanner.
A different approach is needed and this book is an attempt to develop one. It is best regarded as part of a process of discoveky rather than the finished product. All this makes for a difficult, dense book, although I can promise the reader that nothing in the rest of the book is quite as dense as this introduction. I explore a complex subject. I bring a complex mind to bear on it. I can argue in my defensethat the complexity of my thinking mirrors the complexity of the financial markets rather well, as demonstrated by the financial outcome of the real-time experiment.
There is, therefore, at least a prima facie case fcrr giving me 3 hearicg. I shall t-ry ncii to abuse the pdvilege. It may be helpful if I sketch out the structure of the book. Part I propounds the theory, The first chapter deals with the concept of reflexivity in general terms and explores the difficulties in understanding reflexive phenomena.
In particular, it argues that the symmetry between explanation and prediction that characterizes the laws of natural science is not attainable. The next three chapters apply the theory to the financial markets: Chapter 2 to the stock market and Chapter 3 to the currency market, with Chapter 4 outlining a credit and regulatory cycle.
Part I1 seeks to explain contemporary economic and financial history using the hypotheses outlined in Chapter 4. The history 22 4 Introduction is, of necessity, selective, concentrating on those developments that are relevant to the concept of a credit and regulatory cycle.
My main topics are banking, international lending, and mergermania. Part I11 consists of a real-time experiment which is both test and prediction at the same time. As a test it does not qualify as a scientific one by the standards of natural science; but it may serve as an example of how theories about reflexive developments can be tested. Part IV evaluates the results of the real-time experiment.
Chapter 15 explores the scope for what I provocatively call alchemy. The real-time experiment can be regarded zs. Chapter 16 examines the limitations of social science. Part V seeks to provide some prescriptions for economic policy. Chapter 17 examines the relative merits of free markets and regulation, and Chapter 18 argues in favor of an international central bank. Since both the market mechanism and the attempts to regulate it are inherently flawed, it may be argued that all attempts at systemic reform are doomed to failure.
I reject that argument in Chapter In the Epilogue I explore the implications of the concept of reflexivity outside the sphere of finance and in a final flight of fancy I attempt to provide my own answers to some age-old metaphysical questions.
Since my thinking has evolved in the course of writing, it may be helpful for the reader to know when the various chapters were written. Mcreovei, Chapters , which deal with recent history, preceded in time Chapter 4, which outlines the concept of the credit and regulatory cycle. Chapter 4 incorporates discoveries I made in the course of writing; that is why it is so tentative in character. Most of what 1 know is in the book, at least in theoretical form.
I have not kept anything deliberately hidden. But the chain of reasoning operates in the opposite direction: I am not trying to explain how to use my approach to make money; rather, I am using my experiences in the financial markets to develop an approach to the Introduction 23 study of historical processes in general and the present historical moment in particulai. If I did not believe that my investment activities can serve that purpose, I would not want to write about them. As long as I am actively engaged in business, I would be better off to keep theq a trade secret.
The concept of an equilibrium is very useful. It allows us to focus on the final outcome rather than on the process that leads up to it. But the concept is also very deceptive. It has the aura of something empirical: That is not true. Equilibrium itself has rarely been observed in real life-market prices h w e a notorious habit of fluctuating.
The process that can be observed is supposed to move toward an equilibrium. Why is it that the equilibrium is never reached? It is true that market participants adjust to market prices Llit they may be adjusting to a constaxitly moving talgei. In that case, calling the participants' behavior an adjustment process may be a misnomer and equilibrium theory becomes irrelevant to the real world.
Equilibrium is the product of an axiomatic system. Economic theory is constructed like logic or mathematics: The possibility that equilibrium is never reached need not invalidate the logical construction, but when a hypothetical equilibrium is presented as a model of reality a significant distortion is introduced.
If we lived in a world in which the angles of a triangle did not add up to degrees, Euclidean geometry would constitute such a misleading model. Although it was first propounded nearly two hundred years ago, it has never been superseded; only the method of analysis has been refined. The theory holds that under certain specified circumstances the unrestrained pursuit of self-interest leads 40 the optimum allocation of resources.
The equilibrium point is reached when each firm produces at a level where its margina1;cost equals the market price and each consumer downloads an amount whose marginal "utility" equals the market price. Analysis shows that the equilibrium position maximizes the benefit of all participants, provided no individual downloader or seller can ihfluence market prices. It is this line of argument thaihas served as the theoretical underpinning for the laissez-faire policies of the nineteenth century, and it is also the basis of the current belief in the "magic of the marketplace.
Those that are spelled out include perfect knowledge; homogeneous ,and divisible products; and a large enough number of participarjts so that no single participant can influence the market price. The assumption of perfect knowledge is suspect because understanding a situation i n which one participates cannot qualify as knowledge.
That was the assumption that I found so unacceptable as a student. I have Lo doubt that classical economists used the assumption in exactly that sense in which I found it objectionable because nineteenth-century thinkers were less aware of the limitations of knowledge than we are today.
As the epistemological problems began to surface, exponents of the theory found that they could get by using a more modest word: In its modern formulation the theory merely postulates perfect information. To make up for the deficiency, modern economists resorted to an ingenious device: They did not present this as a postulate; rather, they based their claim on methodological grounds. They argued that the task of economics is to study the relationship between supply and demand and not either by itself.
The Theory of Reflexivity I I 29 Yet, if we stop to ask what it means that the conditions of supply and demand are independently given, it is clear that an additional assumption has been introduced. Otherwise, where would those curves come from? We are dealing with an assumption disguised as a methodological device. Participants are supposed to choose between alternatives in accordance with their scale of preferences. The unspoken assumption is that the participants know what those preferences and alternatives are.
As I shall try to show, this assumption is untenable. The shape of the supply and demand curves cannot be taken as independently given, because both of them incorporate the participants' expectations about events that are shaped by their own expectations.
Nowhere is the role of expectations more clearly visible than in financial markets. download and sell decisions are based on expectations about future prices, and future prices, in turn, are contingent on present download and sell decisions.
To speak of supply and demand as if they were determined by forces that are independent of the market participants' expectations is quite misleading. The situation is not quite so clear-cut in the case of commodities, where supply is largely dependent on production and demand on consumption. But the price that determines the amounts produced and consumed is not necessarily the present price.
On the contrary, market participants are more likely to be guided by future prices, either as expressed in futures marketg or as anticipated by themselves. In either case, it is inappropriate to speak of independently given supply and demand curves because both curves incorporate the participants' expectations about future prices. The very idea that events in the marketplace may affect the shape of the demand and supply curves seems incongruous to those who have been reared on classical economics.
The demand and supply curves are supposed to determine the market price. If they were themselves subject to market influences, prices would cease to be uniquely determined. Instead of equilibrium, we would be left with fluctuating prices. This would be a devastating state of affairs. All the conclusions of economic theory would lose their relevance to the real world. It is to prevent this outcome that the methodological device that treats the supply and demand curves as independently given was introduced.
Yet there is something insidious about using a meth- 30 Theory odological device to obscure an assumption that would be untenable if it were spelled out. To preserve the integrity of economic theory as an axiomatic system, its assumptions ought to be explicitly stated.
We may then conclude that economic theory is no more relevant to the real world than non-Euclidean geometry, but at least we would know where we stand. Instead, we have been deceived by a methodological subterfuge. The demand and supply curves are prpsented in textbooks as though they were grounded in empirical evidence. But there is scant evidence for independently given demand and supply curves. Anyone who trades in markets where prices are continuously changing knows that participants are very much influenced by market developments.
How could self-reinforcing trends persist if supply and demand curves were independent of market prices? Yet, even a cursory look at commodity, stock, and currency markets confirms that trends are the rule rather than he exception. The theory of perfect competition could be defended by arguing that the trends we can observe in commodity and financial markets are merely temporary aberrations which will be eliminated in the long run by the "fundamental" forces of supply and demand.
It should be remembered that the theory of perfect competition does not claim to define the path of adjustment; it merely analyzes the situation after all the adjustments have taken place. The trouble with the argument is that there can be no assurance that "fundamental" forces will correct "speculative" excesses.
It is just as possible that speculation will alter the supposedly fundamental conditions of supply and demand. In the normal course of events, a speculative price rise provokes countervailing forcss: But there are exceptions. In foreign exchange, for example, a sustained price movement can be self-validating, because of its impact on domestic price levels. The same is true in the stock market where the performance of a stock may affect the performance of the company in question in a number of ways.
And in examining the recent history of international lending we shall find that excessive lending first increased the borrowing capacity of debtor countries, as measured by their debt ratios, and then, when the banks wanted to be repaid, the debtor countries' ability to do so evaporated.
Generally speaking, we shall find that the expansion The Theory of Reflexivity I I 31 and contraction of credit can affect the debtors' ability and willingness to pay. Are these exceptions that confirm the rule, or do they necessitate a revision of accepted theory?
The answer depends on the frequency and severity of their occurrence.
If we are dealing with an isolated instance, we can treat it as a paradox; but if one incident follows another, we must question the theory. I contend that such paradoxical behavior is typical of all financial markets that serve as a discounting mechanism for future developments, notably stock markets, foreign exchange markets, banking, and all forms of credit.
A world of fluctuating exchange rates and large-scale capital movements is characterized by vicious and benign circles in which the "normal" pattern of causation, as defined by classical economics, seems to be reversed: If the process of adjustment does not lead to an equilibrium, what happens to the conclusions of economic theory?
The answer is that they remain valid as deductions but they lose their relevance to the real world. If we want to understand the real world, we must divert our gaze from a hypothetical f i n s outcome and concentrate our attention on the process of change that we can observe all around us. This will require a radical shift in our thinking. A process of change is much more difficult to understand than a static equilibrium.
We shall have to revise many of our preconceived ideas about the kind of understanding that is attainable and satisfy ourselves with conclusions that are far less definite than those that economic theory sought to provide. The Problem of Imperfect Understanding The understanding of the actual course of events, as distinct from a hypothetical equilibrium, poses problems that have not been properly appreciated.
The problems arise because participants 32 4 Theory base their decisions on an inherently imperfect understanding of the situation in which they participate.
There are two related sets of problems to be considered: We must be careful not to confuse the two. In this section I shall try to explain why the participants' understanding is inherently imperfect. In the next section I shall examine why the imperfect understanding of the participants poses difficulties for the social sciences.
The imperfect understanding of the participant is a difficult concept to define and an even more difficult one to work with. I shall try to approach it by comparing the position of the participant vlth that of ;. These will be dealt with in the next section. The purpose of the comparison is to establish a standard in terms of which the understanding of the participant can be called imperfect.
What makes the comparison tricky is that the natural scientist is not capable of perfect understanding either. Far from it. As Karl Popper has shown,3it is a cardinal principle of scientific method that perfect knowledge is not attainable. Scientists work by constantly testing plausible hypotheses and propounding new ones. If they did not treat all conclusions as provisional and subject to improvement, natural science could not have reached its present state of development and it could not progess any further.
Although it is far from perfect, the knowledge attained by natural scientists provides a standard in terms of which the participants' understanding can be called imperfect. The phenomena belong to one universe, the scientists' statements to another. The phenomena then serve as an independent, objective criterion by which the truth or validity of scientific statements can be judged.
Statements that correspond to the facts are true; those that do not are false. To the extent that the correspondence can be established, the scientist's understanding qualifies as knowledge. We do not need to go into the various difficulties that stand in the way of establishing the correspondence.
The important point is that scientists have an objective criterion at their disposal. The Theory of Reflexivity 33 By contrast, the situation to which the participants' thinking relates is not independently given: As an objective criterion for establishing the truth or validity of the participants' views, it is deficient. It does provide a criterion of sorts: But the process of validation leaves something to be desired: The segregation between thoughts and events that prevails in natural science is simply missing.
Thinking plays a dual role. On the one hand, participants seek to understand the situation in which they participate; on the other, their understanding serves as the basis of decisions which influence the course of events.
The two roles interfere with each other. Neither role is 'performed as well as it could be if it were performed separately. If the course of events were independent of the participants' decisions, the participants' understanding could equal that of a naturbl scientist; and if participants could base their decisions on knowledge, however provisional, the results of their actions would have a better chance of corresponding to their intentions.
As it is, participants act on the basis of imperfect understanding and the course of events bears the imprint of. In a milder form, the lack of separation betwmn the subject matter and the act of thinking may also arise in natural science.
The most celebrated example is in quantum physics where the act of observation interferes with the observed phenomenon. It has given rSss to Heisenberg's uncertainty principle which, in effect, establishes a limit to the scientist's ability to attain knowledge.
But in natural science the problem occurs only at the limit, whereas for the participant it is at the very center of his thinking. For one thing, the scientist makes a deliberate attempt not to interfere with his subject matter, whereas the participant's primary purpose is to mold the situation in which he participates to his own satisfaction. More important, in quantum physics it is only the act of observation which interferes with the subject matter, not the theory of uncertainty, whereas in the case of thinking participants their own thoughts form part of the subject matter to which they relate.
The positive accomplishments of natural science are confined to the area where thinking and events are effec- 34 Theory tively segregated. When events have thinking participants that area shrinks to the vanishing point. The Problem of the Social Sciences We are now in a position to examine the problems of the social sciences.
Again, there are two distinct issues to be considered. One relates to the subject matter, the other to the observer. Scientific method is designed to deal with facts; but, as we have seen, events which have thinking participants do not consist of facts alone.
The participant's thinking plays a causal r d a , ye; i1 does not correspond to the facts for the simple reason that it does not relate to facts. Participants have to deal with a situation that is contingent on their own decisions; their thinking constitutes an indispensable ingredient in that situation. Whether we treat it as a fact of a special kind or something other than a fact, the participants' thinking introduces an element of uncertainty into the subject matter. This element is absent in the natural sciences.
As we have seen, there is some similarity between the uncertainty introduced by the participants' thinking and Heisenberg's uncertainty principle in quantum physics but, as we shall soon see, the parallel is misleading. Now for the role of the scientific observer: Most discussions about the shortcomings of the social sciences have focused on the second issue. Expressioris like "self-fulf lling prophecies" or "self-defeating experiments" are widely used but usually they relate to the would-be scientist.
Yet it is the self-influencing character of the participants' thinking that is responsible for the element of uncertainty or indeterminacy I mentioned before.
The difficulties of scientific observation pale into insignificance when compared with the indeterminacy of the subject matter.
The indeterminacy would remain even if all the problems relating to the observer were resolved, whereas the problems of the observer can be directly attributed to the indeterminacy of the subject matter. Thus the problem of the social sciences is not merely methodological but inherent in the subject matter.
The undue emphasis on the role of the scientific observer can The Theory of Reflexivity 35 be attributed to the false analogy with Heisenberg's uncertainty principle. I am no expert in quantum physics but, as I understand it, the principle holds that the mass and velocity of quantum particles cannot be measured at the same time because the act of measurement interfergs with the object that is being measured.
Whether tlje behavior of quantum particles is inherently random is a separate question. The parallel with the social sciences is misleading because in the latter case the indeterminacy uncertainty is caused by the partikipants. Only if quantum particles behaved as' thinking participants would the analogy hold. I shall try to reverse the discussion to its proper order: The idea that there' is a fundamental difference in the subject matter of the natural sand social sciences has not been generally recognized.
Although it has not been universally accepted, it has not been conclusively refuted either. In order to appreciate the problem posed by thinking participants, let us take a closer look at the way scientifi95 method operates. For this purpose I am invoking Karl Popper's scheme of scientific method, described in technical terms as the "deductivenomological," or "D-N," model.
Like every model, it presents a simplified and idealized version of a more comi;lex reiility, but exactly because it is simple and elegant it suits my purpose very well.
The model is built on three kinds of statements: Combining a set of generalizations with known initial conditions yields predictions; combining them with known final conditions provides explanations; and matching known initial with known final conditions serves as testing for the generalizations involved. It can be seen that there is a symmetry between predictions and explanations; they are logically reversible.
Testing is different, because no amount of testing can prove that a generalization is universally valid. Scientific theories 36 Theory can only be falsified, never verified. The asymmetry between verification and falsification and the symmetry between prediction and explanation are the two crucial features of Popper's scheme.
The model works only if certain conditions are fulfilled. An essential condition is that the content of the statements should exist in total isolation from the statements that are made about them; only then does the content provide an independent criterion for judging the truth or validity of the statements that relate to it. That is, if a given set of conditions recurred, it would have to be followed or preceded by the same set of conditions as before.
It can be seen that the requirement of universal validity defines not only the nature of scientific laws but also the character of initial and final conditions: It is this requirement that is so difficult to meet when a situation has thinking participants.
What constitutes scientific observation is a matter of debate that we need not enter into here. Clearly, a single observation by a single scientist is not admissible. Exactly because the correspondence between facts and statements is so difficult to establish, science is a collective enterprise where the work of each scientist has to be open to control and criticism by others.
The interaction between scientists is governed by certain conventions. These conventions are neither clearly defined nor permanently fixed. They derive their authority from the fact that fiey produce desired results. Individual scientists often find the conventions quite onerous and try various shortcuts in order to attain a desired result. Only because the shortcuts do not work do the conventions of scientific method continue to prevail.
Perhaps the most outstanding example of the observer trying to impose his will on his subject matter is the attempt to convert base metal into gold. The laws of nature must prevail whether they are recognized or not. This is the basis of Popper's abortive idea of a "third world" of objective thoughts in Objective Knowledge, New York: Oxford University Press, The Theory of Reflexivity 37 lack of success. The lailure was inevitable because the behavior of base metals is governed by laws of universal validity which cannot be modified by any statements, incantations, or rituals.
Let us now consider the behavior of human beings. Do they obey universally valid laws that can be formulated in accordance with the D-N model?
Undoubtedly, there are many aspects of human behavior, from birth to death and in between, which are amenable to the same treatment as other natural phenomena.
But there is one aspect of human behavior which seems to exhibit characteristics different from those of the phenomena which form the subject matter of natural science: Decisions are based on an imperfect understanding of the situation. How does such a situation provide the initial and final conditions which are supposed to be connected according to laws of universal validity? Do those conditions include or exclude the participants' thinking?
If thinking is included, the conditions are not amenable to scientific observation, because only the effects of the participants' thinking can be observed, not the process itself. If the thinking process is excluded and only its effects are admitted as evidence, the universal validity of scientific generalizations is destroyed because a given set of conditions is not necessarily preceded or succeeded by the same set every time: In either case, the D-N modabreaks down.
This may not be the end of the world, but it is a serious blow to scientific method. The method has been so successful that we find it hard to believe that there should be a large and vital area beyond its scope.
Natural science has aiso encountered limitations in the form of Heisenberg's uncertainty principle but the limits were reached only after a number of impressive accomplishments -the uncertainty principle itself counts as one of the great discoveries of natural science. In social science we encounter difficulties even before we get started: This conclusion is so devastating that every effort has been made to escape it.
To review the various attempts would take a whole book-and an interesting one at that. I shall confine my attention to economic theory, which constitutes one of the most ingenious attempts, and in some ways the most effective one, to escape the problems connected with imperfect understanding.
It 38 Theory simply assumes away the problems by erecting a hypothetical system in which the participants' decisions are fully determined by the available information.
This approach yields conclusions which meet some of the requirements of the D-N model. For instance, the theory of perfect competition qualifies as universally valid and-at least in principle-it can be used to explain and predict conditions with equal force. The theory fails, however, when it comes to testing, leaving in doubt the relevance of the hypothetical to actual conditions.
Social scientists have gone to great lengths trying to maintain the unity of method but with remarkably little success. Their endeavors have yielded little more than a parody of natural science. In a sense, the attempt to impose the methods of natural science on social phenomena is comparable to the efforts of alchemists who sought to apply the methods of magic to the field of natural science.
But while the failure of the alchemists was wellnigh total, social scientists have maqaged to make a considerable impact on their subject matter. The thinking of participants, exactly because it is not governed by reality, is easily influenced by theories. In the field of natural phenomena, scientific method is effective only when its theories are valid; but in social, political, and economic matters, theories can be effective without being valid.
Whereas alchemy has failed as natural science, social science can succeed as alchemy. This brings us to an examination of the relationship between the scientist and his subject matter. As we have seen, the ID-N model requires that scie2iists keep their statements and observations rigorously segregated from the subject matter to which they relate; only then can the subject matter fulfill its function and serve as an objective criterion for judging the truth or validity of scientific statements.
The conventions of scientific method are designed to maintain the required segregation. In natural science the conventions are effective because the scientist's thinking is, in fact, distinct from its subject matter. The scientist can influence the subject matter only by actions, not by thoughts, and the scientist's actions are guided by the same laws as all other natural phenomena.
Specifically, nothing the scientist can do will turn base metals into gold. The scientist may gain some personal advantage by flouting the conventions of science, The Theory of Reflexivity 39 but the advantage is achieved only by a deception which is liable to be revealed by those who abide by the conventions.
Social phenomena are different. The imperfect understanding of the participant interferes with the proper functioning of the D-N model. This has far-reaching implications for the conventions of scientific method. It limits the results that can be produced by observing thk conventions and, what is worse, it opens the way to attaining worthwhile results by transgressing them.