More from Stiglitz and Soros: Asymetric information and reflexivity

The argument of Adam Smith [1776], the
founder of modern economics, that free markets led to efficient outcomes,
“as if by an invisible hand” has played a central role in these debates: it suggested
that we could, by and large, rely on markets without government intervention.
There was, at best, a limited role for government. The set of ideas that
I will present here undermined Smith’s theory and the view of government
that rested on it. They have suggested that the reason that the hand may be
invisible is that it is simply not there – or at least that if is there, it is palsied.


While a number of critics wish to maintain a reformed capitalism Soros and Stiglitz are particularly interesting because they challenge not just the excesses of global neo-liberalism but also some of the foundations of economics. Economists, even many Keynesians, assume that markets generally work, with the actions of consumers and producers leading to efficient outcomes at a micro level. Stiglitz and Soros accept the principle of a market-based society but doubt that the market automatically delivers efficiency. Their critique based on notions of reflexivity and asymmetric information is similar to that of Keynes.
Economists since Alfred Marshall, in the nineteenth century, have argued that human beings are ‘rational’ in that they seek to maximise their personal benefits and minimise the costs of any transaction. Consumers aim to maximise ‘utility’ and producers profit. Both groups calculate the best course of action during millions of transactions. The actions of millions of producers and consumers functions as an invisible hand creating choice, prosperity and even justice. The liberalisation suggested by the Washington consensus is founded on Marshall and Smith’s assumptions of rationality, calculation and maximising behaviour. Given these foundations it is safe to assume that the market should be extended as far as possible because it generates efficient outcomes.
Typically we might argue that if a country removes capital controls, its entry into a global money market will bring benefits. If a country has sound economic policies, money will flow in as investors ‘buy’ its currency so as to make gains. If a country is running a trade deficit, demand for its currency will fall, because foreigners will demand less of it to buy the country’s goods and services. Because demand falls the value of the currency will fall, in turn its exports will become cheaper and its imports more expensive. As more of its exports are sold and fewer imports are bought the deficit will be magicked away. The market is a structural device, a mechanism, for restoring ‘equilibrium’ or balance.
Yet, as Soros and Stiglitz argue, this notion of the market bears little resemblance to the conditions and complexities of modern economic reality. The money traded for goods is a tiny percentage of speculative currency flows, meaning that currencies are little affected by trade balances and therefore unlikely to float downwards to restore imbalance. With capital liberalisation billions of dollars’ worth of currencies flow in and out of economies in seconds. Such flows create waves of chaos rather than restoring equilibrium.
Shares, it is assumed, are bought for profit, so potentially profitable, well-managed companies will enjoy increased demand followed by rising share values. Rising share values will make it easier for such companies to expand. In reality share values can reach mountainous heights before crashing back, as the dot com bubble of the 1990s illustrated. Share values are often unrelated to company performance. Soros, who has made a billion dollar fortune from such movements, particularly currency movements, argues that the market is shaped by reflexivity. Economic rationality increasingly depends on our ability to successfully guess the behaviour of other economic actors. Such reflexivity, where individuals reflect on what they think will happen in markets and change their behaviour in response, leads to an increasingly abstract and exaggerated economic system. If share holders think others are likely to sell their stocks, shareholders sell anticipating that prices will fall, such action leads to a stampede to sell and market instability. Even if dot coms have little value the belief that others will buy pushes up share values into a bubble of inflated stock market value. Soros’s appreciation of the potentially negative consequences of a market based not on rationality but predictions of mass and often hysterical behaviour is profound:
The prevailing doctrine on how financial markets operate has not changed. It is assumed that with perfect information markets can take care of themselves; therefore the main task is to make the necessary information available and to avoid any interference with the market mechanism. Imposing market discipline remains the goal.

We need to broaden the debate. It is time to recognize that financial markets are inherently unstable. Imposing market discipline means imposing instability, and how much instability can society take? (Soros 1998: 175-176)

To understand such instability Soros uses the concept of reflexivity which he traces from Greek drama to the introduction of intersubjectivity into sociology by Alfred Schutz:

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. (Soros 1998: 10)

Keynes was one of the few academic economists to make large amounts of money from commodity markets! The fact that he, like Soros, had a sharp understanding of reflexivity should be instructive to those who seek to play the markets. Keynes put the concept at the centre of his theoretical system:

[economics] deals with motives, expectations, psychological uncertainties. One has to be constantly on one’s guard against treating the material as constant and homogeneous. It is as though the fall of the apple to the ground depended on the apple’s motives, on whether it is worthwhile falling to the ground, and whether the ground wants the apple to fall, and on mistaken calculations on the part of the apple as to how far it was from the centre of the earth. (quoted in Moggridge 1976: 27)

Keynes feared the effect of capital liberalisation as a means of shifting investment from productive activity to a form of gambling:
The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is ‘to beat the gun’, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow. (Keynes 1960: 155)
Keynes while no anti-capitalist believed that extending the market meant extending uncertainties to new areas of human existence with destabilising and potentially damaging consequences. In the third millenium see-sawing currency and share values mean that jobs may be swept away with one spin of the economic roulette wheel.
Stiglitz specifically examines asymmetric information as a form of market failure. He suggests that in the real world information is always imperfect to a lesser or greater extent. Such asymmetry means that markets may not work efficiently and if some actors have access to greater information than others there is potential for injustice. Assumptions of reflexivity and asymmetric information, ignored by the Washington consensus, powerfully shape the operation of real markets and have important consequences.

Against Washington

Why the Washington Consensus does not work.

In the same way that revolutionary socialists argue that Stalin betrayed Lenin or Marx, moderate advocates of capitalism like Soros and Stiglitz argue that the IMF et al have abandoned Keynes’ original vision. It isn’t that capitalism doesn’t work; it is more the case that it hasn’t been tried. According to Stiglitz:

In its original conception, the IMF was based on a recognition that markets often did not work well – that they could result in massive unemployment and might fail to make needed funds available to countries to help restore their economies. The IMF was based on the belief that there was a need for collective action at the global level for economic stability[…]Keynes would be rolling over in his grave if he could see what has happened to his child. (Independent on Sunday, 9 November 2003)

Since the 1980s the IMF, WTO and World Bank have advocated the so-called ‘Washington Consensus’ of fiscal austerity (government spending cuts), privatisation and market liberalisation. Swept along by the neo-liberal counter-revolution against Keynesian economics the consensus argues that for development to occur barriers to the market should be swept away. The policies that failed in 1930s Europe have been exported to almost the entire globe. The Washington consensus argues that the poorest countries in the world should cut government spending and increase taxes to reduce indebtedness. The tax burden should, of course, fall on ordinary citizens; taxes on profits would discourage investment and enterprise. State assets should be privatised as thoroughly as possible, while barriers to free trade should be swept away. Export led growth is also advocated along with the removal of controls on capital. Multinationals are to be welcomed and government regulation slashed to the minimum.

While Soros and Stiglitz are by no means naturally hostile to the US, given their close links with previous American governments, they believe that the Washington consensus, rather than being based purely on market ideology, is also inspired by the interests of an essentially US corporate elite. The Bretton Woods institutions have massive power to impose their free market medicine because if they refuse to give a country a clean bill of health, foreign capital floods out, leading to economic chaos. If a country rejects free market approaches, money floods out, forcing a rethink. By insisting that barriers to the movement of financial capital are removed the Bretton Woods institutions make it difficult for countries to act independently and they become more closely tied to the whims of global financial markets. Indebted countries that reject the consensus are refused financial stabilization deals by the IMF and aid from the World Bank. Even countries that are independent of IMF financial aid are influenced by the institution’s prescriptions. Typically, British Chancellors of the Exchequer and Japanese finance ministers take close interest in the IMF’s annual report of their countries’ financial health.

Stiglitz believes that the emphasis on fighting inflation and reducing debt advocated by the IMF can be appropriate in some circumstances. He suggests that some Latin American countries during the 1980s attempted to print money to spend their way of crisis with predictable results in terms of high inflation, ‘Countries cannot persistently run large deficits; and sustained growth is not possible with hyperinflation. Some level of fiscal discipline is required’. Neither does he reject all privitisation, ‘Most countries would be better off with governments focussing on providing essential public services rather than running enterprises that would arguably perform better in the private sector, and so privitization often make sense’ . Equally, ‘When trade liberalization – the lowering of tariffs and elimination of other protectionist measures – is done in the right way’, so that inefficient sectors of the economy are removed and replaced with more competitive ones, there can be ‘significant efficiency gains’ (Stiglitz 2002: 53). Soros argues that in an ‘ideal world’ the complete removal of capital controls would be beneficial, noting that restrictions to prevent money moving across national borders creates ‘evasion, corruption and the abuse of power’ (Soros 1998: 192). Suggesting that the collapse of the Soviet economy demanded significant change including major privatisation, Soros notes ‘The fact that radical reforms are often radically misconceived does not obviate the need for radical reforms’ (1998: 226).

However both he and Stiglitz argue that these radical market-based policies have been applied in an inflexible and inappropriate way. Stiglitz argues that the Washington Consensus’s obsession with reducing inflation is particularly damaging because it means that some of the poorest countries in the world have to cut spending to prevent prices rising when problems of joblessness and low growth are likely to be far more damaging. In Indonesia, to pick just one example, Stiglitz notes how IMF-inspired cuts to food and fuel subsidies for the poor led to rioting (Independent on Sunday, 9 November 2003).

Privatisation breeds corruption when assets are sold off. Even when clean it often enriches an elite of corporate fat cats. Privatisation during a debt crisis when an economy is in chaos can mean that assets are sold at knock-down prices, which may simply mean that they can be bought up by US corporations who become stronger at the expense of developing countries. In Russia, according to Stiglitz, the swift privatisation of state assets led to their purchase by a criminal class who thereby gained massive political power. Capital liberalisation has reinforced the tendency for democratic decision making to become subordinated to the demands of financial markets. Soros notes that tax burdens have been shifted from firms and financial operators to citizens increasing inequality:

Interestingly, the state’s share of GNP has not declined perceptibly. What has happened instead is that the taxes on capital and employment have come down while other forms of taxation particularly on consumption have kept increasing. In other words, the burden of taxation has shifted from capital to citizens. That is not exactly what had been promised, but one cannot even speak of unintended consequences because the outcome was exactly as the free-marketers intended. (Soros 1998: 112)

A country implementing policies that the financial markets find distasteful may find that they take their hot money and emerging share market portfolio funds elsewhere, causing slump and currency collapse. As well as tying developing countries to the free market agenda of the Washington consensus, capital liberalisation means that such states are more susceptible to movements in global currency markets that can cause sudden shocks to fragile economies:

It has become an article of faith that capital controls should be abolished and the financial markets of individual countries, including banking, opened up to international competition. The IMF has even proposed amending its charter to make these goals more explicit. Yet the experience of the Asian crisis ought to make us pause. The countries that kept their financial markets closed weathered the storm better than those that were open. India was less affected than the Southeast Asian countries; China was better insulated than Korea. (Soros 1998: 192)

Free trade is theoretically beneficial, but opening up an underdeveloped economy to trade has several major drawbacks. It may force down the price of commodities such as sugar or coffee, wrecking the livelihoods of peasant farmers who have little possibility of alternative employment. It can also destroy ‘infant industries’, new industries that have yet to mature and become efficient and will be killed by unprotected exposure to foreign competition. Stiglitz notes that to achieve growth the successful Asian economies such as Hong Kong, Japan and South Korea initially used selective protectionism to allow their industries to take off.

Soros and Stiglitz feel that the advocates of the Washington consensus are remote from the problems of the developing world, act arrogantly and are consistently biased to the needs of the rich.

[M]odern high-tech warfare is designed to remove physical contact: dropping bombs from 50,000 feet ensures that one does not ‘feel’ what one does. Modern economic management is similar: from one’s luxury hotel, one can callously impose policies about which one would think twice if one knew the people whose lives one was destroying. (Stiglitz 2002: 24)

The institutions promoting the Washington consensus act as if they continue to bear the ‘[w]hite man’s burden’ persisting according to Stiglitz with the notion that they always know what is best (2002: 25). Stiglitz and Soros argue that the arrogance of the Washington institutions means that developing countries have little say in their own economic development and policies are imposed from above. Such arrogance inevitably breeds discontent and even where globalisation has the potential to bring benefits; the Washington consensus has fuelled a hostile counter movement. Discontent is met by repression: rubber bullets against starving rioters. As Stiglitz observes:

A common characteristic is: We know best, and the developing countries should do what we tell them to […]They really see themselves as a harsh doctor, giving them the cod liver oil they need, even if they don’t want it. The problem, of course, is that quite often the medicine […] kills the patient. (Independent on Sunday, 9 November 2003)
It is difficult to think of a single example of a country that has gained from the IMF model of structural adjustment. Botswana is often mentioned but commentators but despite enjoying one of the globe’s fastest economic growth rates the Washington consensus has not delivered sustainable prosperity:
The richest twenty per cent of the population earned more than twenty-five times as much as the poorest twenty per cent.[…] Botswana, at twenty-two per cent, has the world’s sixth highest unemployment rate […] One of the few products of Botswana’s increased economic activity which has been widely shared by its poorer inhabitants is AIDS. Women driven into prostitution by poverty are purchased by the truck drivers delivering goods to the elite. (Monbiot 2003: 214)

Argentina, the Washington consensus exemplar from South America, plunged into severe recession after following the model rigorously, with resulting mass unemployment, poverty and chaos.


The nice cartoon is from the Global Policy Forumwho have lots of material on the Washington Consensus worth a click

From Keynes to Bretton Woods

Soros, Stiglitz and other establishment critics of neo-liberalism draw upon the work of John Maynard Keynes, who believed in the necessity of managing capitalism, both to provide a fair society and to maintain a capitalist system. During the 1930s Europe and North America were plunged into recession. Economies shrank and unemployment figures mushroomed to millions. The resulting turmoil fuelled the political chaos that lead to World War Two. The conventional ‘liberal’ or ‘classical’ free market economists believed that the economy worked best without government controls and tended to automatically correct any disequilibria. If demand for goods fell, prices would fall too and eventually shoppers would increase demand as they snapped up bargains. If individuals were unwilling to borrow money, interest rates (the price of money) would fall, and if rates fell low enough demand for loans would pick up rescuing the economy. Furthermore if workers became unemployed they could cut their wages until firms found them cheap enough to employ. These market advocates believed that apparently humane attempts to deal with poverty and unemployment such as state welfare benefits would simply make the recession deeper by discouraging wage-setting. Even socialist politicians such as Hilferding in Germany and Snowdon in Britain accepted this orthodoxy. As the years went by and liberal policies of non-intervention were accompanied by deeper recession, conventional economics became increasingly discredited. The only economies that seemed to work were to be found in Hitler’s Germany and Stalin’s Russia.

By the late 1930s the western economies were slowly pulling out of slump and demand rose with employment as war led to large factory orders for guns, planes and assorted military paraphernalia. Nonetheless by the 1940s and 1950s the economic orthodoxy was largely abandoned for Keynesianism. Keynes suggested that economics has a psychological element that means if confidence is low, so too is consumption and growth. Prices, wages and interest rates may be ‘sticky’, by which Keynes meant they would not fall easily, because firms, banks and workers may be reluctant to lower them if they feel that they will still suffer when demand is low. Keynes argued that if people think bad economic news is on the horizon they spend less and the bad economic news becomes a recessionary reality. Businessmen and even women are particularly edgy and suffer from a herd mentality, cutting investment when they fear bad economic news. Like deranged beasts they stampede towards slump. The answer is for governments to inject spending in the economy when recession looks likely. In turn if excessive spending threatens the economy, governments can control it by raising taxes and cutting expenditure.

In July 1944 Keynes acted as the British government’s representative to the Bretton Woods Conference in New Hampshire, USA. Bretton Woods aimed to create a new financial architecture and new global institutions to restore economic stability and remove the threat of world recession, after the war had been won. It called for the creation of three key institutions. During the 1940s the General Agreement on Trade and Tariffs (GATT), now known as the WTO, was established to sweep away barriers to trade so as to promote faster economic growth. The International Bank for Reconstruction and Development, commonly known as the World Bank, was set up to lend money to countries, initially for restoration of infrastructures decayed during recession and smashed by war. Its role has increasingly shifted towards funding development projects in the south of the globe. Finally the IMF was created to help countries faced with severe debt problems or balance of payments deficits. Stiglitz sees all three institutions as essentially Keynesian, examples of government intervention, aimed at making the market work and capitalism expand.