Error-proneness, Reflexivity, and the Principle of Human Uncertainty

Soros Investment Theory

George Soros, a Hungarian-born Jew, was born in 1930, graduated from the London School of Economics, moved to the United States in 1956, and founded the Quantum Fund in 1969, achieving great success. He subsequently established a series of foundations dedicated to open society and charitable causes. Briefly: Soros is a legendary figure who experienced hardship as a child, and his survival instincts are ingrained in his hedge fund operations; influenced by Popper during his studies, he developed a love for philosophy, allowing him to understand the shortcomings of market economics (mechanisms) as a whole, profiting from the mistakes of his opponents in trading; his trading cannot be imitated, only learned from and appreciated, showcasing a distinctive personal style.

In "The Alchemy of Finance," I wrote: "This book represents the struggle of my life."
The concept of reflexivity is actually quite simple: in any situation involving thinking participants, there exists a mutual influence between the participants' thoughts and the reality.
Traditional theories that conform to truth believe that knowledge is expressed through true propositions: a proposition x is true if and only if the fact it describes actually occurs. Such facts must be independent of the proposition to constitute a credible judgment.

Comment: A more accurate statement is that facts are at least not influenced by the proposition.

Another comment: In the social domain, it is exactly the opposite; propositions and facts always influence each other. Moreover, propositions that influence facts are good propositions, while good propositions are not necessarily true.

The participants' imperfect understanding of facts leads to behaviors that may result in unforeseen consequences.
This book will detail many specific examples to discuss how popular trends prove their own validity. Once a certain limit is exceeded, this self-reinforcing feedback loop becomes difficult to maintain.
Our view of the world is part of the real world—we are participants.
"The Principle of Human Uncertainty." This principle holds that people's understanding of the world they live in cannot simultaneously satisfy truth, completeness, and coherence.
I believe the theory of equilibrium applicable to financial markets is an illusion. This theory stems from its success in the natural sciences, so economic theories attempt to mimic Newtonian mechanics. It tries to establish universally valid paradigms under equilibrium conditions, as long as its analysis is confined to the material world without other interferences, it is generally successful.
Credit cannot merely be seen as a reflection of underlying supply and demand relationships, as it is an active factor shaping those relationships.
In pure exchange, equilibrium has a definite definition, namely clear market prices. When applied to financial markets, equilibrium becomes more of a theoretical concept.

Comment: Reality is not always balanced; financial markets are often extreme. This does not prevent a sense of balance, a perspective of balance, or balanced thinking.

In sociology, socialization (modern English; or socialisation - see [spelling differences]) is the process of internalizing social norms and ideologies. Socialization includes learning and teaching, thus serving as a means of achieving social and cultural continuity.

Socialization is closely related to developmental psychology and behaviorism. Humans need social experiences to learn their culture and survive.

Socialization essentially represents a learning process throughout the entire life course, having a core influence on the behavior, beliefs, and actions of both adults and children.

Socialization can lead to ideal outcomes—sometimes referred to as "morality"—in terms of the society in which it occurs. Individual viewpoints are influenced by social consensus, often leaning towards what society deems acceptable or "normal." Socialization can only partially explain human beliefs and behaviors, as the subject is not predetermined by its environment; rather, it is shaped by both social influences and genetics.

Genetic research shows that a person's environment interacts with their genotype, thereby affecting behavioral outcomes.

This is the process by which individuals learn their own social culture.

In epistemology, more specifically in the sociology of knowledge, reflexivity refers to the circular relationship between cause and effect, especially the embedded causal relationships within human belief structures. When causes and effects influence reflexive subjects within layered or complex social relationships, reflexive relationships are multidirectional. When epistemology includes religion, the complexity of these relationships increases further.

In broader sociology (the field of origin), reflexivity refers to a self-referential behavior where there exists an incitement to examine, through which thought processes "turn" and refer to and influence the entities that incite action or examination. It typically refers to the ability of subjects to recognize socializing forces and change their status within social structures. Low levels of reflexivity lead to individuals being largely influenced by their environment (or "society"). High levels of social reflexivity are defined by individuals shaping their own norms, tastes, politics, desires, etc. This is similar to the concept of autonomy.

In economics, reflexivity refers to the self-reinforcing effects of market sentiment, where rising prices attract buyers, and buyer behavior further drives up prices until the process becomes unsustainable. This is an example of a positive feedback loop. The same process can run in reverse, leading to catastrophic price declines.

Reflexivity

Reflexivity typically refers to examining one's beliefs, judgments, and practices during the research process, and how these beliefs, judgments, and practices affect the research. If positionality refers to what we know and believe, then reflexivity refers to what we do with that knowledge. Reflexivity involves questioning assumptions that we take for granted. Essentially, it involves drawing attention to the researcher rather than "covering up" the researcher and pretending that the researcher has no impact. It requires an open attitude and acceptance that the researcher is part of the research (Finlay 1998).

Reflexivity is different from "reflectivity": all researchers think and judge their data (for example, "Does the data suggest a certain conclusion?"); whereas reflexivity steps back to examine the person making the judgments ("Am I the kind of person who tends to believe the data suggests this conclusion?"). Different research traditions have different views on reflexivity and positionality. Positivism, in trying to mimic the methods of the natural sciences, adopts a third-person narrative, creating the myth of value-neutral research. Of course, this does not mean that positivist researchers fail to reflect on their data or lack reflexivity; they may have engaged in long and deep reflection on their positionality but accepted the convention of not discussing it. In more interpretive approaches, discussion of reflexivity may be encouraged, especially in longer, more personalized documents like theses, although there is no consensus on the form such discussions should take.

Reflexivity brings dilemmas and challenges. These issues often become explicit when there is a significant gap in background knowledge, behavior, and fundamental beliefs between the researcher and the researched, but they should be a universal consideration for all research. Personal positionality is increasingly being placed within a broader context of social identity, so establishing rapport in interviews with people of different genders, races, ages, or sexual orientations is more important than demonstrating an open-minded and unbiased attitude; whatever you do, there will be deeper factors determining your interactions. Reflexive checks should extend beyond behaviors in research projects and consider the positionality of the broader research discipline. This can cover what is taken for granted in problem definitions, which research questions tend to be included or excluded, whether there are restrictive dominant paradigms, and even liberal orthodoxy or cultural relativism, where "anything can happen." Like positionality, discussions of reflexivity have been criticized as narcissistic and self-indulgent; it is important to remember that readers' interest in the researcher may be far less than the researcher's interest in the research. Discussions of reflexivity may also lead to paralysis (Johnson and Duberley 2003), as every judgment is nested within layers of personal and disciplinary reference frameworks. One way to address these difficulties is to bring discussions of reflexivity back to specific issues in the research, where the researcher may wish to illustrate interpretive patterns rather than describe every reflexive judgment. Reflexivity should be seen as a virtue rather than a vice. Winter (1989) likened research to a detective story, where the detective learns about themselves through solving the case. This metaphor was proposed in the context of action research but is undoubtedly a broader comment on the humanistic nature of reflexive judgment.

1. The Idea of Radical Fallibility#

Human understanding of the world they inhabit is inherently incomplete, meaning there is always a distortion between people's thoughts and objective reality; no one can claim to have grasped ultimate truth.

All constructions of the human mind, whether limited to the depths of our thinking or manifested as various disciplines, ideologies, or systems, are flawed. Here, "flawed" does not imply "potentially fallible," but rather "certainly fallible."

If we acknowledge that there is always a gap (distortion) between objective reality and our understanding of it, then recognizing this gap and its implications becomes significant. This notion suggests that even in the natural sciences, it is impossible to absolutely distinguish between thought and reality, especially in understanding social phenomena. Furthermore, it should be recognized that human thinking generally has a dual role:

On one hand, it passively reflects the reality that the thinking activity seeks to understand to some extent.
On the other hand, the results of thinking can also become, to varying degrees, components of reality itself.

Therefore, there is no knowledge that absolutely reflects objective reality.

The idea of radical fallibility has a very positive and enlightening aspect; it opens the door to our critical rational thinking, metaphorically suggesting that our understanding of objective reality has infinite space for improvement, and that our thinking or society has limitless room for enhancement and development. In practical action, the idea of fallibility encourages us to seek out the flaws in every situation and benefit from identifying those flaws.

Although financial investors have attempted countless times to use models and theories to deduce market developments, "to reduce the information encountered to a manageable level, various techniques must be employed, which distort the information being processed and may even complicate reality, making understanding more difficult." Thus, we find that even the most classic pricing theories and the most powerful indicators often serve more as "reference values" in actual investment processes; they cannot fully align with the final facts, which is the reality of fallibility.

Therefore, the first principle of radical fallibility theory is the courageous acknowledgment of the normality of error; errors are a norm, an unavoidable fact.

Human understanding is inherently imperfect because humans are part of reality, and the part cannot fully comprehend the whole. The human brain's capacity to process information is limited, while the information that needs to be processed is, in fact, infinite. We do not truly understand the world we inhabit. At the same time, people's erroneous perceptions of the world can also impact the world; the two are not entirely independent.

2. Reflexivity Theory#

Reflexivity theory refers to the interactive relationship between investors and financial markets, where investors form expectations about the market based on the information they receive and take action, which in turn alters the original development direction of the market, reflecting a new market form and continuing to change the trajectory of the financial market.

It can be said that such reflexive connections exist in many fields of human activity, including politics, economics, and history.

Specifically, reflexivity has two meanings:

Firstly, current biases can influence prices.
Secondly, under certain circumstances, current biases can also affect the fundamentals, leading to further changes in market prices.

Markets are not always correct; from the perspective of how market prices reflect future trends, markets are often wrong. The role of this error is twofold:

On one hand, it leads to deviations in market participants' understanding of market expectations.
On the other hand, this deviation also affects their investment activities, resulting in incorrect judgments about market development trends.

In other words, it is not that current expectations align with future situations; rather, current expectations create what happens in the future.

Market participants' understanding of the market is inherently flawed; this flawed understanding is interconnected with what actually occurs, and the two are not completely independent but interact and determine each other, with no correspondence or symmetry.

Through this bidirectional connection, participants' thoughts influence their circumstances and experiences, shaping a dynamic relationship that is unpredictable.

Since investors cannot obtain complete information, and individual issues can affect their understanding of the market, leading to differing opinions about market expectations, these differing opinions are what we call "investment biases." Investment biases are the fundamental driving force of financial markets. When investment biases are scattered, their influence on financial markets is minimal; when investment biases are continuously reinforced in interaction and generate collective influence, they can create a "butterfly effect," pushing the market in a single direction, ultimately leading to a reversal.

Once people begin to engage in thinking about a phenomenon, the decisive factors of that phenomenon are no longer just the phenomenon itself but also include people's viewpoints. Thus, the development process of a phenomenon is not a direct leap from one event to another but rather a transition from fact to viewpoint and then from viewpoint back to fact.

The reciprocal feedback between understanding and reality causes a process to occur:

First, self-reinforcing and continuously developing.
Then, a peak period occurs.
Next, the situation deteriorates, showing a downward trend.
Finally, a collapse occurs.

Regarding the principle of reflexivity, here are two examples from work and life.

Suppose there is a cup of water that is about to fall off the table due to a strong wind. At this moment, you foresee the trend of the cup falling and reach out to support it, preventing the potential falling incident. As a result, your expectation of the cup falling has altered the final outcome.

3. The Principle of Uncertainty#

Traditional scientific methodologies emphasize the relationship between scientific research and certainty, with certainty becoming a characteristic of judging science and truth. In a philosophical sense, this idea manifests as: only statements that can be judged as true or false are meaningful, while statements that are not true or false (uncertain) are meaningless.

However, in practical work, investment, and life, uncertainty is everywhere; it is not some mysterious new phenomenon but is rooted in common sense.

Traditional truth systems only emphasize the two categories of true or false statements, but for a world that includes thinking individuals, this system is insufficient. We must acknowledge another category of truth, which is uncertain statements or reflexive statements, whose real value depends on their impact. This is what is referred to as the third category of truth; the significance of reflexive phenomena constitutes an important meaning of the concept of truth: facts do not necessarily constitute the only standard for judging truth.

Traditional views hold that the basis for judging truth is whether statements correspond to facts, but if we understand the reflexive view of truth, we can recognize that there are two ways to determine whether a statement corresponds to a fact:

It can either be a true statement.
Or it can influence the fact through the statement.

Karl Popper discussed in "The Open Society and Its Enemies" that empirical cognition cannot be absolutely certain; even scientific principles cannot be completely confirmed without a trace of doubt but can only be falsified through testing. A single failed test is sufficient to falsify, while more confirming instances cannot fully confirm. The characteristic of scientific principles is their hypothetical nature, and their truth must withstand the test of falsification.

Human thoughts are the easiest to change; therefore, any event involving people has a degree of uncertainty due to human variability. A simple certainty system (a bunch of rational people) can produce what appears to be a random process (the unpredictable speculative market).

4. The Theory of Rise and Fall#

1. Initial Stage: During this period, the future development trend of the financial market has not yet been fully determined. Popular trends and biases interact and complement each other.
1. Self-Reinforcing Stage: At this point, the trend has been established. Subsequently, everyone follows suit, and this established trend becomes reinforced and begins to self-reinforce. As popular trends and people's biases mutually promote each other, the influence of biases on the trend increases. Thus, the effect of biases becomes exaggerated, leading to an imbalance.
1. Testing Stage: The gap between biases and actual conditions becomes larger, and the market development trend and people's biases may be impacted by various external shocks; this period is a testing stage for trends and biases.
1. Acceleration Stage: If, after these tests, the trend and biases still exist as they did at the beginning, it indicates that they can withstand external shocks, thereby enhancing their credibility.
1. Peak Stage: As events develop, the truth gradually emerges, and a gap begins to appear between understanding and reality, widening the fissure. At this point, people's biases also become increasingly apparent. This period is when the truth is revealed, and the development of events basically reaches its peak.
1. Decline Stage: After the peak period, like a reflex, due to the self-reinforcing effect, a reversal of the trend is inevitable. The situation begins to move in the opposite direction, showing a continuous rise or fall.

5. The Theory of Boom and Bust (The Cycle of Prosperity and Decline)#

The cycle of prosperity and decline begins with self-propulsion, then becomes unsustainable, ultimately leading to the opposite. Individuals with flawed perspectives cause the market to amplify their emotions, meaning that investors become trapped in a kind of blind frenzy or a primal-like emotional state, which is the herd effect.

The more uncertain factors there are in the market, the more people will flow with market trends. The greater the impact of this instantaneous speculative behavior, the more uncertain the situation becomes. The essence of investment is to bet on instability, seeking trends that exceed expectations.

First, we do not truly understand the world we inhabit, which is fallibility.
Second, our understanding of the world does not align with reality, which is reflexivity.

After biases persist for a while, they form a mainstream force in the market, causing the trend to diverge further from reality, resulting in a greater herd effect. This pattern, when inflated repeatedly over time, will inevitably burst when the deviation becomes excessively apparent, returning to reality.

The entire text: The principles of fallibility, reflexivity, and human uncertainty. I am honored that the editors of the "Journal of Economic Methodology" have created this special issue...

Introduction#

I am honored that the editors of the "Journal of Economic Methodology" have created this special issue on reflexivity and invited me and a group of distinguished scholars to contribute.

Of course, I am not the discoverer of reflexivity. Early observers have recognized it, or at least some aspects of it, but often under different names. Knight (1921) explored the distinction between risk and uncertainty. Keynes (1936, Chapter 12) likened financial markets to beauty contests, where participants must guess who the most popular choice is. Sociologist Merton (1949) wrote about self-fulfilling prophecies, unintended consequences, and the effects of the masses. Popper discussed the "Oedipus effect" in The Poverty of Historicism (1957, Chapter 5).

My own conceptual framework originated in the late 1950s when I was studying at the London School of Economics. I took my final exams a year early, so I had a year to fill before obtaining my degree. I chose my supervisor, and I chose Popper, whose work The Open Society and Its Enemies (1945) left a profound impression on me.

Popper's other great work, The Logic of Scientific Discovery (1935), was published in English as The Logic of Scientific Discovery (1959), where he argued that the possibility of empirical truth is established as absolutely equal. Even scientific logic cannot be confirmed without a hint of doubt: they can only be falsified through testing. A single failed test is sufficient to falsify, while more confirming instances cannot fully confirm. The characteristics of scientific principles are hypothetical; their truth must withstand the test of falsification.

While reading Popper, I was also studying economic theory. Popper emphasized imperfect understanding, while the theory of perfect competition in economics assumes perfect knowledge, and the contradiction between the two deeply shocked me. This led me to begin questioning the assumptions of economic theory. I replaced the assumptions of rational expectations and efficient markets with my principles of fallibility and reflexivity.

After graduating from university, I began working on concepts in financial markets, where the economic theories I learned in school were of little use. Strangely, the framework I developed under Popper's influence provided me with more valuable insights. While I was busy making money, I did not lose interest in philosophy.

In 1987, I published my first book, The Alchemy of Finance. In that book, I attempted to explain the philosophical foundations of my views on financial markets. The book attracted some attention. Many in the hedge fund industry read it, and business schools taught it. However, the philosophical debates in the book left little impression; it was more understood as the vanity of a successful businessman, who, having made money, fancied himself a philosopher.

I began to doubt whether I had made a significant discovery. After all, I was dealing with a topic that philosophers have explored for centuries. What reason did I have to believe I had made a new discovery, especially when others did not think so? Undoubtedly, the conceptual framework was beneficial to me personally, but it seemed others did not see it as having much value. I had to accept others' judgments. I did not abandon my interest in philosophy, but I had come to regard it merely as a personal preference. In my business and charitable activities (charity has increasingly become an important part of my life), I continued to operate according to this conceptual framework, and each time I wrote a book, I would faithfully reiterate my arguments. This helped me develop my conceptual framework, but I still considered myself a failed philosopher. Once, I even gave a talk titled "A Failed Philosopher's Retry."

Everything changed with the 2008 financial crisis. My understanding of reflexivity allowed me to foresee the crisis and to respond effectively when it finally occurred. I was able to explain and predict events better than most people. This changed the evaluation of my theory by myself and many others; my philosophy was no longer a personal matter; it deserved serious consideration as a potential contribution to understanding reality. This was the reason for my series of lectures.

Back to the point. Today, I will explain the concepts of "fallibility" and "reflexivity" as a whole. Tomorrow, I will apply them to financial markets, and later, to politics. This will also introduce the concept of "open society." In the fourth lecture, I will explore the differences between market value and moral value; in the fifth lecture, I will present some predictions and prescriptions for the current moment.

I can state the core idea in two relatively simple propositions. One is that in situations that have thinking participants, the participants' view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity. For example, viewing drug addicts as criminals leads them to actually commit crimes due to the misunderstanding of the issue and interference with appropriate treatment for addicts. Another example is that claiming the government is bad often leads to a bad government.

Fallibility and reflexivity are purely common sense. Therefore, when my critics say I am merely stating obvious facts, they are correct, but only at the simplest level. What I find more interesting is that their significance has not been universally appreciated. In particular, the concept of reflexivity has been deliberately avoided or even denied in economic theory. Thus, my conceptual framework deserves serious consideration, not because it is a new discovery, but because something as common-sensical as reflexivity has been deliberately overlooked.

In the field of economics, reflexivity has no place; economists always hope to find certainties, yet I argue that uncertainty is a key characteristic of human affairs. Economic theory is built on the concept of equilibrium, but this concept directly contradicts the concept of reflexivity. As I will discuss in the next lecture, these two concepts produce two completely different explanations for financial markets.

The concept of fallibility is uncontroversial. People generally acknowledge that the complexity of the world we live in exceeds our understanding. I have not provided greater or newer insights. The main reason is that participants themselves are part of the situation, and when processing, they often cannot handle themselves. Or rather, when faced with an extremely complex reality, we have to adopt various methods to simplify (just to name a few examples, such as generalization, dichotomy, metaphor, decision rules, moral concepts, etc.), and when people use these methods, if they consider themselves part of the processing object, the situation becomes even more complicated.

The structure of the brain is another source of fallibility. Recent advances in brain science have begun to provide some insights into how the brain works and have confirmed Hume's view that reason is the slave of passion. Reason is derived from the fabrications of our imagination.

The brain is bombarded by millions of sensory impulses, but consciousness can only process seven or eight topics at the same time. Within limited time, these impulses must be condensed, sorted, and interpreted; errors and distortions are inevitable. Brain science provides new perspectives for my original argument that our understanding of the world is inherently imperfect.

The concept of reflexivity needs further explanation. It only applies to situations where thinking participants are part of the event. Two functions form around the thoughts of participants. One is to understand the world we live in, which I call the cognitive function. The other is to change the world in a way that benefits oneself, which I call the participatory (or manipulative) function.

These two functions connect thought and reality from opposite directions. In the cognitive function, reality determines the participant's viewpoint, where the direction of causality is from reality to thought. In contrast, in the participatory function, the direction of causality is from thought to reality, meaning that the participant's intention has an impact on the world. When both functions operate simultaneously, they can interfere with each other.

How do they interfere? By depriving each function of its independent variable, which simultaneously serves as the dependent variable of the other function. Because when one function's independent variable is the dependent variable of another function, neither function has truly independent variables. This means the cognitive function cannot produce sufficient knowledge to serve as the basis for the participant's decision-making. Similarly, the participatory function can influence the outcome of changing the world but cannot determine it independently. In other words, its results are prone to deviate from the participant's intentions. There will inevitably be some deviation between intention and action, and further deviation between action and outcome. The thoughts of participants become an inseparable part of the situation they are trying to understand, and the development of the situation does not have independence from thought. This introduces uncertainty into both our understanding of reality and the actual development of events.

To understand the connection between uncertainty and reflexivity, we need to explore further. If the cognitive function operates in isolation and is completely unaffected by the participatory function, it can produce knowledge. This knowledge is expressed as assertions that are true if they correspond with facts, meaning that these assertions are true if they align with reality (this is the standard of judgment that truth correspondence theory tells us). However, if the participatory function interferes with the facts, thereby changing them, then the facts can no longer serve as an independent standard for judging those assertions produced by the cognitive function, because even if the assertions still correspond with the facts, the correspondence lacks independence since the facts have been altered.

Consider the assertion: "It is raining now." The truth of this assertion depends on the actual weather conditions; in fact, it is raining now. Now consider another assertion: "This is a revolutionary moment." This assertion is reflexive; its truth depends on whether the assertion itself can encourage a group of rebels to act.

Reflexive statements have a certain similarity to the liar paradox (i.e., Socrates says: Socrates is a liar). However, while self-reference has been widely analyzed, reflexivity has received less attention. This is strange because reflexivity has an impact on the real world, while self-reference is purely a linguistic phenomenon.

In the real world, the thoughts of participants manifest not only in assertions but also in various forms of actions and habits. This makes reflexivity a very widespread phenomenon, and its usual form is feedback loops. The opinions of participants influence the development of events, and the development of events influences the opinions of participants. This influence is continuous and cyclical, thus forming a feedback loop.

Reflexivity feedback loops have not yet been rigorously analyzed. When I first encountered this issue and tried to analyze it, I stumbled into the complexity of the problem. I assumed that feedback loops are a bidirectional connection between participants' opinions and the actual processes of events. But what about the bidirectional connections between different participants' opinions? What if an isolated individual asks themselves, "Who am I?" and "What do I stand for?" and changes their behavior in response to their own questions?

In trying to solve these difficulties, I became increasingly lost in numerous classifications to the point that one morning I found I could not understand what I had written the night before. It was at that moment I decided to abandon my philosophical explorations and focus on making money.

To avoid this trap, let me propose the following terminology. Let us divide reality into objective and subjective aspects. Thought constitutes the subjective aspect, while events constitute the objective aspect. In other words, the subjective aspect includes what happens in the minds of participants, while the objective aspect refers to what happens in the external reality. There is only one external reality, but there are many different subjective opinions. Reflexivity can connect any two or more aspects of reality (as long as at least one subjective aspect is included) and establish a bidirectional feedback loop between them. In special cases, reflexivity may even occur within a single aspect of reality, reflecting an isolated individual's response to their own identity, which can be referred to as "self-reflexivity."

We can then distinguish between two major categories: reflexive relationships (connections between subjective aspects) and reflexive events (connections that include objective aspects). Marriage is a reflexive relationship; the 2008 crisis is a reflexive event. When there is no subjective aspect involved in reality, there is no reflexivity.

Feedback loops can be negative or positive. Negative feedback brings the participant's viewpoint closer to the actual situation; positive feedback drives them further apart. In other words, a negative feedback process is self-correcting; it can continue indefinitely, and if no significant changes occur in the external reality, it may eventually reach a point of equilibrium where the participant's viewpoint corresponds exactly to the actual situation. This is generally considered to occur in financial markets. Therefore, the concept of equilibrium, which is central to economics, is merely an extreme case of negative feedback, a limited special case within my conceptual framework.

In contrast, a positive feedback process is self-reinforcing; it cannot continue indefinitely because the participant's viewpoint will increasingly diverge from objective reality, ultimately forcing the participant to acknowledge that their views are unrealistic. The interaction between the two will not allow the actual state of affairs to remain stable because positive feedback has the characteristic of exacerbating any prevailing trend in the real world, regardless of what that trend is. Thus, we are not faced with equilibrium but rather dynamic disequilibrium, or any situation that can be described as moving further away from equilibrium. In such cases, the divergence between participants and reality typically reaches a climax, triggering another self-reinforcing process in the opposite direction. This seemingly self-reinforcing process is, in fact, a self-negating cycle of boom and bust, which is characteristic of financial markets but can also be found in other domains. I refer to this as the creative fallacy, meaning that people's interpretations of reality are biased, and the actions stemming from these biased views lead to real deviations in reality, which only become more pronounced.

I know all of this is very abstract and difficult to understand. If I provide some concrete examples, it will be easier to grasp. However, you will have to bear with me. If I want to present a different viewpoint, abstraction can actually help me achieve that. When dealing with topics like the relationship between reality and thought, and their interconnections, people easily become confused and make erroneous simulations. Therefore, distortions and misunderstandings can play a very significant role in human affairs. The recent financial crisis may have led to erroneous interpretations of how financial markets operate. I will discuss this issue in the next lecture. In the third lecture, I will discuss two creative fallacies—the Enlightenment fallacy and the postmodern fallacy. These concrete examples will focus on how misunderstandings are crucial in historical processes. But for today's lecture, I will remain at a highly abstract level.

I argue that when thinking participants engage in social phenomena, the situation has a completely different structure than natural phenomena. The difference lies in the role of thought. In natural phenomena, thought does not play a causal role; it only has a cognitive function. In human affairs, thought itself is part of the problem, possessing both cognitive and manipulative functions. These two functions (or functions) can interfere with each other. This interference does not occur all the time (it occurs in daily activities, such as driving or renovating a house, where these two functions are actually complementary), but once it occurs, it introduces uncertainties that do not exist in natural phenomena. This uncertainty manifests within both functions: participants act based on incomplete cognition, and the outcomes of their actions do not align with their expectations. This is a key characteristic of human affairs.

In contrast, in examples of natural phenomena, the development of events does not shift based on the observer's viewpoint. External observers are only connected to the cognitive function, and the phenomenon itself provides a reliable standard for the observer's theory to clearly judge its truth. Therefore, external observers can obtain knowledge about the natural phenomena they observe. Based on this knowledge, they can successfully manipulate nature. There is a natural divide between the cognitive function and the manipulative function. Because of this divide, the two functions can easily achieve their goals without deviation compared to human domains.

Here I must emphasize that reflexivity is not the only source of uncertainty in human affairs. Yes, reflexivity indeed introduces uncertain factors into participants' viewpoints and the actual processes of events, but other factors can also produce similar effects. For example, participants may not know the information that other participants possess, leading to biases. This is quite different from reflexivity, but it is also a source of uncertainty in human affairs. Different participants have different interests, and some of these interests naturally conflict with others, which is another source of uncertainty. Additionally, as Isaiah Berlin pointed out, the values that each participant follows are also diverse and often contradictory. The uncertainties caused by these factors may be broader than those produced by reflexivity. I group them together to propose the principle of human uncertainty, which is a broader concept than reflexivity.

The principle of human uncertainty I discuss is more specific and rigorous than the subjective skepticism that runs through Cartesian philosophy. It provides us with objective reasons to believe that the theories held by participants (as opposed to statements of specific facts) are prone to biases, incompleteness, or both.

While human uncertainty primarily affects participants, it has profound implications for social science. By invoking Karl Popper's theory of scientific methodology, I can clearly articulate this impact. It is a beautiful, simple, and elegant theory. It consists of three elements and three actions. The three elements are scientific laws, initial conditions, and final conditions. The three actions are prediction, explanation, and verification. When scientific laws are combined with initial conditions, predictions can be made. When they are combined with final conditions, explanations can be provided. In this sense, prediction and explanation are symmetrical and reversible. Verification, on the other hand, is responsible for comparing predictions derived from scientific laws with actual outcomes.

According to Popper, scientific laws are inherently hypothetical; they cannot be confirmed but can be falsified through testing. The key to the success of scientific methodology is that it can utilize the participation of each individual to collectively verify a theory, and the participation of all individuals becomes part of the verification. A single individual's failed verification is sufficient to falsify a theory, but no amount of confirming instances can fully confirm it.

How can science be both empirical and rational? For this tricky question, Popper provides a clever approach. According to Popper, it is empirical because we test our theories by observing whether the predictions derived from them align with reality; it is rational because we use deductive logic to arrive at those predictions. Popper rejected inductive logic in favor of verification. Induction is not falsifiable, and thus is unscientific. Popper emphasized the central role of verification in scientific methodology and made a strong case for critical thinking by asserting that scientific laws are only temporarily valid and are always open to re-examination. Thus, the three notable characteristics of Popper's theory are the symmetry between prediction and explanation, the asymmetry between verification and falsification, and the central role of verification. Verification allows science to develop, improve, and innovate.

Popper's theory works well for studying natural phenomena, but the principle of human uncertainty injects discord into this extreme simplicity and elegance. Because uncertainty is introduced into predictions, the symmetry between prediction and explanation is disrupted, and the central role of verification is put at risk. Whether or not to include participants' thoughts in the initial and final conditions is a very important question because every verification requires the replication of these conditions. If participants' thoughts are included, it becomes difficult to observe what the initial and final conditions are because participants' viewpoints can only be inferred from their statements or actions. If they are excluded, the initial and final conditions do not constitute a single observation target because the same objective conditions may be associated with very different subjective viewpoints due to the participants' differences. In either case, induction cannot be properly verified. This difficulty does not preclude social scientists from obtaining valuable conclusions through induction, but these conclusions do not meet the requirements of Popper's theory and do not align with the predictive capabilities of physical laws.

Social scientists find this conclusion difficult to accept. Economists, borrowing from Freud, are experiencing "physics envy."

To eliminate the aforementioned difficulties associated with the principle of human uncertainty, many attempts have been made to introduce or assume some fixed relationships between participants' thoughts and reality. Karl Marx asserted that the material conditions of production determine the ideological superstructure. Freud believed that human behavior is determined by a combination of impulses and the subconscious. They both claimed their theories were scientific, but Popper pointed out that they could not be falsified, so they were merely pseudoscience.

However, to date, the most impressive attempts have been made in the field of economic theory. It began with the assumption of perfect knowledge, and when this assumption was proven untenable, it was maintained by continually increasing distortions to uphold the myth of rational behavior. Economics culminated in the rational expectations theory, which posits that if there is an optimistic expectation for the future, as a response to this expectation, eventually all market participants will converge towards it. This assumption is absurd, but it was necessary for modeling economic theory on the basis of Newtonian physics.

Interestingly, when they communicated in the journal "Economics," both Popper and Hayek found that social science cannot produce results comparable to those of physics. Hayek vehemently criticized the mechanical and uncritical application of quantitative methods from natural sciences to physics. He called it scientism. Karl Popper pointed out in "The Poverty of Historicism" that history is not determined by universally valid scientific laws.

However, when Popper proclaimed his so-called "methodological unification thesis," he meant that natural and social sciences should be judged by the same methods. Hayek, of course, became an apostle of the Chicago School of Economics, which is the stronghold of market fundamentalism. But in my view, the implication of the principle of human uncertainty is that the subjects of natural and social sciences are fundamentally different; therefore, they need to develop different methods and should follow different standards. One should not expect economic theory to achieve the standards established by Newtonian physics.

In fact, if it did produce universally valid strategies, as Knight (1921, p. 28) pointed out, economic profits themselves would be impossible:

"If all changes occur according to unchanging, universally known laws and can be predicted indefinitely before they occur, ... there would be no profits or losses."

I believe that Popper's framework cannot produce results comparable to the brilliant achievements of physicists in the realm of human affairs. Blindly mimicking natural sciences can easily lead to erroneous results, sometimes even disastrous consequences.

Moreover, the methodology that does not apply the same methods and standards as natural sciences seems to address the shortcomings I have identified. But consider the constraints that Lionel Robbins imposed on economics: it prevents economists from recognizing reflexivity, encourages the development of synthetic financial instruments and risk management techniques that ignore uncertainty, and the consequences are disastrous, leading us to find ways to fix the problems.

I acknowledge that the proposed methodology is only a starting point, raising the question: What should social scientists do, what methods should they use, and what standards should they use to evaluate them? Other authors in this journal may have specific answers, while I only have partial answers. Any effective methodology in social science must explicitly acknowledge their fallibility and reflexivity and the uncertainties they cause. Empirical testing should still be the decisive standard for determining whether a theory is scientific, but due to the principle of human uncertainty in social systems, it may not always be as strict as Popper's framework requires. One should not expect universally and eternally valid theories to produce certain predictions, as future events depend on future decisions, which are based on imperfect knowledge. Compared to eternal and universal truths, time- and context-bound truths may yield more specific explanations and predictions.

Financial Markets#

Financial markets provide an excellent laboratory for testing the views I have presented in the previous sections. Compared to most other fields, financial markets allow for clearer observation of the processes of events. Many facts are presented in quantifiable forms, data is well recorded, and preserved. The opportunity for testing arises because my interpretation of financial markets directly contradicts the efficient market hypothesis, which has long been the mainstream paradigm.

The efficient market hypothesis posits that markets tend toward equilibrium, with deviations occurring randomly and attributable to external shocks. It is a testable proposition to determine whether the efficient market hypothesis or my reflexivity theory better explains and predicts events. I assert that my reflexivity theory is superior, even though it is still in its early stages of development, particularly in explaining and predicting the overall situation of financial markets, especially historical events like the 2007-2008 financial crisis and the subsequent euro crisis.

My Conceptual Framework#

Let me outline three key concepts in my approach: fallibility, reflexivity, and the principle of human uncertainty, as they apply to financial markets. First, fallibility. The market prices of financial assets do not accurately reflect their fundamental values, as they do not even aim to do so. Prices reflect market participants' expectations of future market prices, which are often incorrect. Moreover, market participants are prone to errors; thus, their expectations of the present value of future cash flows may not align with reality. This discrepancy can be trivial or very significant. This directly contradicts the efficient market hypothesis, which does not acknowledge fallibility.

Second, reflexivity. Financial markets play not only a purely passive role in reflecting fundamental realities but also an active role: they can influence the future cash flows they are supposed to reflect. This is a point that behavioral economists focus on, but they only consider the reflexive processes in terms of cognitive errors leading to asset pricing errors; they do not consider how mispricing affects the fundamentals.

Errors in the pricing of financial assets can influence the so-called fundamentals in various ways. The most commonly used method is through leverage—both debt leverage and equity leverage. For example, a company can enhance its accounting profits by issuing stock at a high price—at least for a period. The market may give the impression that it is always correct, but its operating mechanisms differ from those implied by the mainstream paradigm.

Third, the principle of human uncertainty transforms the notion of eternal destruction in economic theory into a historically bounded process. If subjects act based on their perfect understanding, equilibrium is far from a universal and eternal condition in financial markets. Markets may easily tend toward expected equilibrium, but they may also easily tend away from it. Equilibrium is not a universal and eternal condition; it becomes an extreme condition where the correspondence between market expectations and reality is explored. This correspondence can be achieved through cognitive functions or learning functions themselves—either cognition can change cognitive behavior, or cognition can lead to changes in cognitive behavior. However, in practice, this correspondence is more likely to be a product of the two functions of reflexive response. While economics views equilibrium as a normal or even necessary state, I argue that such stable periods are exceptions. Instead, I focus on the unique reflexive feedback loops of financial markets, which lead to changes over time.

Negative Feedback Loops and Positive Feedback Loops#

Reflexive feedback loops can be either positive or negative. Negative feedback brings the participant's viewpoint and actual situation closer together; positive feedback drives them further apart. In other words, a negative feedback process is self-correcting. It can continue indefinitely, and if no significant changes occur in the external reality, it may eventually reach a point of equilibrium where the participant's viewpoint corresponds exactly to the actual situation.

This is generally considered to occur in financial markets. Therefore, the concept of equilibrium, which is central to economics, is merely an extreme case of negative feedback, a limited special case within my conceptual framework.

Social scientists find this conclusion difficult to accept. Economists, borrowing from Freud, are experiencing "physics envy."

In fact, if it did produce universally valid strategies, as Knight pointed out, economic profits themselves would be impossible:

"If all changes occur according to unchanging, universally known laws and can be predicted indefinitely before they occur, ... there would be no profits or losses."

The End