New Part-time Career Opportunities for 2009. George Soros on Credit Crisis

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George Soros on Global Credit Crisis
A Taped Speech at CICC Forum 2008
Diaoyutai State Guesthouse, Beijing Nov 21, 2008

By George Soros

You have asked me to explain the crisis that has engulfed the global
financial system. I'll do my best.

The salient feature of the crisis is that it was not caused by some
extraneous event such as the OPEC raising the price of oil; it was
generated by the financial system itself. This fact—that the defect
was inherent in the system — discredits the prevailing theory, which
holds that financial markets tend toward equilibrium, and that
deviations from the equilibrium are caused by some sudden external
shock which markets have difficulty adjusting to. I have developed an
alternative theory that differs from the current one in two important
respects. First, financial markets don't reflect the underlying
conditions accurately. They provide a picture that is always biased or
distorted in some way or another. Second, the distorted views held by
market participants and expressed in market prices can, under certain
circumstances, affect the so-called fundamentals that market prices
are supposed to reflect. I call this two-way circular connection
between market prices and the underlying reality 'reflexivity'.

I contend that financial markets are always reflexive and on occasion
they can veer quite far away from the so-called equilibrium. While
markets are reflexive at all times, financial crises occur only
occasionally, and in very special circumstances. Usually markets
correct their own mistakes, but occasionally there is a misconception
or misinterpretation that finds a way to reinforce a trend that is
real and by doing so it also reinforces itself. Such self- reinforcing
processes may carry markets into far-from-equilibrium territory.
Unless something happens to abort the reflexive interaction sooner, it
may persist until the misconception becomes so glaring that it has to
be recognized as such. When that happens the trend becomes
unsustainable and when it is reversed the self-reinforcing process
starts working in the opposite direction, causing a catastrophic
downturn.

The typical sequence of boom and bust has an asymmetric shape. The
boom develops slowly and accelerates gradually. The bust, when it
occurs, tends to be short and sharp. The asymmetry is due to the role
that credit plays. As prices rise, the same collateral can support a
greater amount of credit. And rising prices also tend to generate
optimism and encourage a greater use of credit. At the peak of the
boom both the value of the collateral and the degree of leverage are,
by definition, at a peak. When the price trend is reversed
participants are vulnerable to margin calls and, as we have seen
recently, the forced liquidation of collateral leads to a catastrophic
acceleration on the downside.

Thus bubbles have two components: a trend that prevails in reality and
a misconception relating to that trend. The simplest and most common
example is to be found in real estate. The trend consists of an
increased willingness to lend and a rise in the price of real estate.
The misconception is that the price of real estate is somehow
independent of the willingness to lend. That misconception encourages
bankers to become more lax in their lending practices as prices rise
and defaults on mortgage payments diminish. That is how real estate
bubbles, including the recent housing bubble in the United States, are
born. It is remarkable how the misconception continues to recur in
various guises in spite of a long history of real estate bubbles
bursting.

Bubbles are not the only manifestations of reflexivity in financial
markets, but they are the most spectacular. Bubbles always involve the
expansion and contraction of credit and they tend to have catastrophic
consequences. Since financial markets are prone to produce bubbles and
bubbles cause trouble, financial markets have become regulated by the
financial authorities. In the United States they include the Federal
Reserve, the Treasury, the Securities and Exchange Commission, and
many other agencies.

It's important to recognize that regulators base their decisions on a
distorted view of reality just as much as market participants—perhaps
even more so because regulators are not only human but also
bureaucratic and subject to political influences. So the interplay
between regulators and market participants is also reflexive in
character. In contrast to bubbles, which occur only infrequently, the
cat-and-mouse game between markets and regulators goes on
continuously. As a consequence reflexivity is at work at all times and
it is a mistake to ignore its influence. Yet that is exactly what the
prevailing theory of financial markets has done and that mistake is
ultimately responsible for the severity of the current crisis. I have
originally proposed my theory of financial markets in my first book,
The Alchemy of Finance, published in 1987 and I brought it up to date
in my latest book
The New Paradigm for Financial Markets:
The Credit Crisis of 2008 and What It Means.
http://astore.amazon.com/zw-20/detail/1586486837

In that book, I argue that the current crisis differs from the various
financial
crises that have preceded it. I base that assertion on the hypothesis
that
the explosion of the US housing bubble acted as a detonator of a much
larger "super-bubble" that has been developing since the 1980s.

The housing bubble is simple; the super-bubble is much more
complicated. The underlying trend in the super-bubble has been the
ever-increasing use of credit and leverage. In the United States,
credit has been growing at a much faster rate than the gross national
product ever since the end of World War II. But the rate of growth
accelerated and took on the characteristics of a bubble in the 1980s
when it was reinforced by a misconception that became dominant when
Ronald Reagan became president and Margaret Thatcher was prime
minister in the United Kingdom.

The misconception is derived from the prevailing theory of financial
markets, which, as I mentioned, holds that financial markets tend
toward equilibrium and deviations are random and can be attributed to
external causes. This theory has been used to justify the belief that
the pursuit of self-interest should be given free rein and markets
should be deregulated. I call that belief market fundamentalism and I
contend that it is based on a false argument. Just because regulations
and all other forms of governmental interventions have proven to be
faulty, it does not follow that markets are perfect.

Although market fundamentalism is based on false premises, it has
served the interests of the owners and managers of financial capital
very well. The globalization of financial markets has allowed
financial capital to move around freely and made it difficult for
individual states to tax it or regulate it. Deregulation of financial
transactions and the freedom to innovate have enhanced the
profitability of financial enterprises. The financial industry grew to
a point where it produced about a third of all corporate profits both
in the United States and in the United Kingdom.

Since market fundamentalism is built on false assumptions, its
adoption in the 1980s as the guiding principle of economic policy was
bound to have adverse consequences. Indeed, we have experienced a
series of financial crises since then, but the negative consequences
were suffered principally by the countries that lie at the periphery
of the global financial system, not by those at the center. That's
because the system is under the control of the developed countries,
especially the United States, which enjoys veto rights in the
International Monetary Fund.

Whenever a crisis endangered the prosperity of the United States—as
for example the savings and loan crisis in the late 1980s, or the
collapse of the hedge fund Long Term Capital Management in 1998—the
authorities intervened, finding ways to bail out the failing
institutions and providing monetary and fiscal stimulus when the pace
of economic activity was endangered. Thus the periodic crises served,
in effect, as successful tests that reinforced both the underlying
trend of ever-greater credit expansion and the prevailing
misconception that financial markets should be left to their own
devices. It was of course the intervention of the financial
authorities that made the tests successful, not the ability of
financial markets to correct their own excesses. But it was convenient
for investors and governments to deceive themselves. The relative
safety and stability of the United States, compared to the countries
at the periphery, allowed the United States to suck up the savings of
the rest of the world and run a current account deficit that reached 7
percent of GNP at its peak in the first quarter of 2006.

Eventually even the Federal Reserve and other regulators succumbed to
the market fundamentalist ideology and abdicated their responsibility
to regulate. They ought to have known better since it was their
actions that kept the United States economy on an even keel. Alan
Greenspan, in particular, believed that giving financial innovations
free rein brought such great benefits that having to clean up behind
the occasional financial mishap was a small price to pay for the gain
in productivity. And while the super-bubble lasted his analysis of the
costs and benefits of his permissive policies was not totally wrong.
Only now has he been forced to acknowledge that there was a flaw in
his argument. Financial engineering involved the creation of synthetic
financial instruments for leveraging credit with names like Collateral
Debt Obligations and Credit Default Swaps. It also involved
increasingly sophisticated mathematical models for calculating risks
in order to maximize profits. This engineering reached such heights of
complexity that the regulators could no longer calculate the risks and
came to rely on the risk management models of the financial
institutions themselves. The rating agencies followed a similar path
in rating synthetic financial instruments, they relied on information
provided by the issuing houses and they derived considerable
additional revenues from the increase in their business. The esoteric
financial instruments and sophisticated techniques for risk management
were based on the false premise that deviations from the equilibrium
occur in a random fashion. But the increased use of financial
engineering disturbed the so-called equilibrium by setting in motion a
self-reinforcing process of credit expansion. So eventually there was
hell to pay. At first the occasional financial crises served as
successful tests. But the subprime crisis came to play a different
role: it served as the culmination or reversal point of the
super-bubble.

It should be emphasized that this interpretation of the current
situation on the bursting of the super-bubble does not necessarily
follow from my theory of reflexivity. Had the financial authorities
succeeded in containing the subprime crisis—as they thought at the
time they would be able to do—this would have been seen as just
another successful test instead of the reversal point. My theory of
reflexivity can explain events better than it can predict them. It is
less ambitious than the previous theory. It doesn't claim to determine
the outcome as equilibrium theory does. It can assert that a boom must
eventually lead to a bust, but it cannot determine the extent of or
the duration of a boom. Indeed, those of us who recognized that there
was a housing bubble expected it to burst much sooner. Had it done so,
the damage would have been much smaller and authorities might have
been able to keep the super-bubble going. Most of the damage was
caused by mortgage-related securities issued in the last two years of
the housing bubble.

The fact that the new paradigm doesn't claim to predict the future
explains why it did not make any headway until now, but in light of
the recent experience it can no longer be ignored. We must come to
terms with the fact that reflexivity introduces an element of
uncertainty into financial markets that the previous theory left out
of account. That theory was used to establish mathematical models for
calculating risk and converting bundles of subprime mortgages into
tradable securities. But the uncertainty connected with reflexivity
can't be quantified. Excessive reliance on those mathematical models
did untold harm. In my book, I predicted that the current financial
crisis would be the worst since the 1930s but the actual course of
events actually exceeded my worst expectations.

When Lehman Brothers declared bankruptcy on September 15, the
inconceivable occurred: the financial system actually melted down. A
large money market fund that had invested in commercial paper issued
by Lehman Brothers lost part of its asset value, thereby breaking an
implicit promise that deposits in such funds are totally safe and
liquid. This started a run on money market funds and forced the funds
to stop buying commercial paper. Since they were the largest buyers,
the commercial paper market ceased to function. The issuers of
commercial paper, which include the largest and most respected
corporations, were forced to draw down their credit lines, bringing
interbank lending to a standstill. Credit spreads— that is to say, the
risk premium over and above the riskless rate of interest— widened to
unprecedented levels and eventually the stock market also was
overwhelmed by panic. All this happened in the space of a week.

The world economy is still reeling from the after effects.
Resuscitating the financial system then took precedence over all other
considerations and the authorities injected ever larger quantities of
money. The balance sheet of the Federal Reserve ballooned from $800
billion to $1.8 trillion in a couple of weeks. When that was not
enough, the American and European financial authorities publicly
pledged themselves, that they would not allow any other major
financial institution to fail.

These unprecedented measures began to have some effect: interbank
lending resumed and the London Interbank Offered Rate (LIBOR)
improved. The financial crisis showed signs of abating. But
guaranteeing that the banks at the center of the global financial
system will not fail has precipitated a new crisis that caught the
authorities unawares: countries at the periphery, whether in Eastern
Europe, Asia, or Latin America, couldn't offer similar credible
guarantees, and financial capital started fleeing from the periphery
to the center. All currencies fell against the dollar and the yen,
some of them precipitously. Commodity prices dropped like a stone and
interest rates in emerging markets soared. So did premiums on
insurance against credit default. Hedge funds and other leveraged
investors suffered enormous losses, precipitating margin calls and
forced selling that have also spread to the stock markets at the
center. In recent days, the credit markets have also started to
deteriorate again.

Unfortunately the authorities are always lagging behind events. The
International Monetary Fund is establishing a new credit facility that
allows financially sound periphery countries to borrow without any
conditions up to five times their annual quota, but that is too little
too late. A much larger pool of money is needed to reassure markets.
And if the top tier of periphery countries is saved, what happens to
the lower-tier countries? The race to save the international financial
system is still ongoing. Even if it is successful, consumers,
investors, and businesses have suffered a traumatic shock whose full
impact on the global economic activity is yet to be felt. A deep
recession is now inevitable and the possibility of a depression
comparable to the 1930s cannot be ruled out.

What are the implications of this dire situation for China? In many
ways China is better situated than most other countries. It had been
the main beneficiary of globalization. It has amassed large currency
reserves, its banking system is relatively unscathed and the
government enjoys a greater range of policy choices than other
governments. But China is not immune from the global recession.
Exports have dropped, inventories of iron ore and other commodities
are excessive, the stock market has declined further than in most
other countries, and the real estate boom has turned into a bust.
Domestic demand needs to be stimulated, but that is not enough. China
must also play a constructive role in stimulating the global economy,
otherwise exports can't recover.

The international financial institutions – the IMF and the World Bank
– have a new mission in life: To protect the countries at the
periphery of the system from the effects of a financial crisis that
has originated at the center of that system, the United States. They
cannot carry out that mission without the active support of China,
exactly because China has accumulated tremendous currency reserves.
Fortunately the United States has a new President who fully recognizes
the need for greater international cooperation. Hopefully the Chinese
leadership will also recognize the need.

What is involved in such cooperation? The super-boom was fueled by the
United States consuming more than it produced. In 2006, the current
account deficit of the United States reached 7% of its GNP. The
deficit was financed by China, other Asian exporters and some
oil-producing countries accumulating larger and larger dollar
surpluses. This symbiotic relationship has now ended; the American
consumer can no longer serve as the motor of the world economy. A new
motor has to be found. That means that China and the rest of the world
must stimulate domestic demand by running fiscal deficits during the
recession. China can afford to do so but countries at the periphery of
the global financial system can't because they are suffering from an
exodus of financial capital. The exodus must be stopped and a way must
be found to finance fiscal deficits in periphery countries. This can't
be done without the help of the surplus countries and the large-scale
commitment of sovereign wealth funds. Even that may not be enough
because the collapse of credit and the destruction of wealth are so
severe that there may not be enough money available. It may be
necessary to create additional money by the IMF issuing Special
Drawing Rights or SDRs. In any case, stimulating consumer demand may
not be the right way to go because it involves credit expansion for
financing consumption. Credit ought to be used primarily for financing
investment.

I believe the solution lies elsewhere. The world is confronting an
urgent problem in global warming. To bring it under control will
require tremendous investments in energy savings and alternative
energy sources. That ought to provide the motor for the world economy.
To make that possible we need an international agreement that would
impose a price on carbon emissions that is sufficiently high to pay
for the extraction of carbon from coal. No such agreement is possible
without Chinese participation.

I wish I could be there in person to answer your questions, I'm sure
you have many.


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