The Financial Crisis
By George Soros
The New York Review of Books, December 4, 2008
Edited by Andy Ross
The current financial crisis was generated by the financial
system itself. This fact contradicts the prevailing theory that financial
markets tend toward equilibrium. The crisis provides convincing evidence that
there is something fundamentally wrong with this prevailing theory.
The proximate cause of the crisis is to be found in the excesses of the subprime
mortgage market. People could borrow 100 percent of inflated house prices with
no money down. Insiders referred to subprime loans as ninja loans — no income,
no job, no questions asked. House prices peaked in 2006 and subprime mortgage
lenders began declaring bankruptcy around March 2007. The problems reached
crisis proportions in August 2007. The crisis spread rapidly to other markets.
Confidence in the creditworthiness of many financial institutions was shaken and
interbank lending was disrupted. A variety of esoteric credit markets broke down
one after another. Crisis episodes recurred in January 2008. The deepest fall of
all came in September, caused by the disorderly bankruptcy of Lehman Brothers.
Then the financial system actually melted down. A large money market fund that
had invested in commercial paper issued by Lehman Brothers saw its asset value
fall below the dollar amount deposited. This started a run on money market funds
and the funds stopped buying commercial paper. The issuers of commercial paper
were forced to draw down their credit lines, bringing interbank lending to a
standstill. The stock market was overwhelmed by panic. All this happened in the
space of a week.
With the financial system in cardiac arrest, resuscitating it took precedence
over considerations of moral hazard and the authorities injected ever larger
quantities of money. American and European financial authorities committed
themselves not to allow any other major financial institution to fail.
These measures have begun to have an effect. The financial crisis has shown
signs of abating. But guaranteeing that the banks at the center of the global
financial system will not fail has precipitated a new crisis. Countries at the
periphery could not offer similarly credible guarantees, and financial capital
started fleeing from the periphery to the center. Currencies fell against the
dollar and the yen. 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.
The International Monetary Fund is establishing a new credit facility for
financially sound periphery countries, but a much larger pool of money is needed
to reassure markets. The race to save the international financial system is
still ongoing. A deep recession is now inevitable and the possibility of a
depression cannot be ruled out.
My new theory of market behavior differs from the current one in two respects.
First, financial markets do not reflect prevailing conditions accurately.
Second, the distorted views expressed in market prices can affect the
fundamentals that the prices are supposed to reflect. This interaction between
market prices and the underlying reality I call reflexivity.
Usually markets correct their own mistakes, but occasionally there is a
misconception that reinforces a real trend and thus reinforces itself. Such
processes may carry markets far from equilibrium. The interaction may persist
until the misconception becomes glaring and the trend becomes unsustainable. The
self-reinforcing process then starts working in the opposite direction.
The typical sequence of boom and bust has an asymmetric shape. The boom develops
slowly and accelerates gradually. The bust is short and sharp. The asymmetry is
due to the role of credit. As prices rise, the same collateral can support a
greater amount of credit. At the peak of the boom, both the value of the
collateral and the degree of leverage reach a peak. When the price trend is
reversed, participants are vulnerable to margin calls. The forced liquidation of
collateral leads to a catastrophic acceleration on the downside.
Bubbles thus have two components: a trend that prevails in reality and a
misconception relating to that trend. For example, in real estate, the trend
consists of an increased willingness to lend and a rise in prices. The
misconception is that the value of the real estate is independent of the
willingness to lend. That misconception encourages bankers to become more lax in
their lending practices. The misconception recurs despite a long history of real
estate bubbles bursting.
Bubbles always involve the expansion and contraction of credit and they tend to
have catastrophic consequences. Since financial markets are prone to produce
bubbles, the markets are 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.
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 regulators and markets goes on continuously.
In my book
The New Paradigm for Financial Markets, I argue that the current crisis
differs from the various financial crises that preceded it. I base that
assertion on the hypothesis that the explosion of the US housing bubble acted as
the detonator for a much larger "super-bubble" that has been developing since
the 1980s. The underlying trend in the super-bubble has been the ever-increasing
use of credit and leverage. Credit has been growing at a much faster rate than
the GDP ever since 1945. But the rate of growth accelerated and took on the
characteristics of a bubble when it was reinforced by a misconception that
became dominant in 1980.
The misconception is that the pursuit of self-interest should be given free rein
and markets should be deregulated. I call that belief market fundamentalism and
claim that it employs false logic. 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 well
the interests of the owners and managers of financial capital. The globalization
of financial markets allowed financial capital to move around freely and made it
difficult for individual states to tax it or regulate it. The financial industry
grew to a point where it represented 25 percent of the stock market
capitalization in the United States and an even higher percentage in some other
countries.
Since market fundamentalism is built on false assumptions, its adoption in the
1980s as the guiding principle of economic policy was bound to have negative
consequences. The adverse consequences were suffered principally by the
countries that lie on the periphery of the global financial system. 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, the
authorities intervened. Thus the periodic crises served 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 the intervention of the financial authorities that made the tests
successful. But it was convenient for investors and governments to deceive
themselves. The United States sucked up the savings of the rest of the world and
ran a current account deficit that reached nearly 7 percent of GNP at its peak
in the first quarter of 2006. Regulators succumbed to the market fundamentalist
ideology and abdicated their responsibility to regulate.
Financial engineering involved the creation of increasingly sophisticated
instruments, or derivatives, for leveraging credit and "managing" risk in order
to increase potential profit. The regulators could no longer calculate the risks
and came to rely on the risk management models of the financial institutions
themselves. The models were based on the false premise that deviations from the
mean occur in a random fashion. But the increased use of financial engineering
set in motion a process of boom and bust.
My interpretation of financial markets based on reflexivity can explain events
but it does not 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
either the extent or the duration of a boom. Indeed, those of us who saw the
housing bubble expected it to burst much sooner. Had it done so, the damage
would have been much smaller and the super-bubble may have remained intact.
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 debt into
tradable securities. Uncertainty by definition cannot be quantified. Excessive
reliance on those mathematical models did untold harm.
The new paradigm has far-reaching implications for the regulation of financial
markets. Regulators such as the Fed, the Treasury, and the SEC must accept
responsibility for preventing bubbles from growing too big. Until now, financial
authorities have explicitly rejected that responsibility.
Alan Greenspan believed that giving users of financial innovations such as
derivatives free rein brought such great benefits that having to clean up behind
the occasional financial mishap was a small price to pay. He was a master of
manipulation, but he pretended that he was merely a passive observer of the
facts. Reflexivity remained a state secret. That is why the super-bubble could
develop so far during his tenure.
Regulators must also take into account credit conditions because money and
credit do not move in lockstep. Markets have moods and biases and it falls to
regulators to counterbalance them. That requires the use of judgment. Feedback
from the market should enable regulators to correct their mistakes. The search
for the optimum equilibrium has to be a never-ending process of trial and error.
Credit default swaps are intended to insure against the possibility of bonds and
other forms of debt going into default. Their price captures the perceived risk
of default. They grew to more than $50 trillion in nominal size. Yet the market
in credit default swaps has remained entirely unregulated. The sheer existence
of an unregulated market of this size has been a major factor in increasing risk
throughout the entire financial system.
Since the risk management models used until now ignored the uncertainties
inherent in reflexivity, limits on credit and leverage will have to be set
substantially lower than those that were tolerated in the recent past. The
financial industry has already dropped from 25 percent of total market
capitalization to 16 percent. This ratio is unlikely to recover to anywhere near
its previous high.
Sophisticated financial engineering can render the calculation of margin and
capital requirements extremely difficult. Financial engineering must also be
regulated and new products must be registered and approved by the appropriate
authorities. Such regulation should be a high priority of the new Obama
administration.
He Foresaw the End of an Era
By John Cassidy
The New York Review of Books, October 23, 2008
Edited by Andy Ross
George Soros has been an active investor for more than half a
century. He founded the Quantum Fund in 1973, which year after year achieved
returns in excess of the broader market. After weathering the 1987 stock market
crash, Quantum racked up more big gains, culminating in a huge bet against the
pound sterling in 1992, which reportedly netted more than a billion dollars.
Thereafter, Soros spent an increasing amount of his time on philanthropic
activities throughout the world. After 2001, he also involved himself in
domestic politics. More recently, he and his family have contributed to Barack
Obama's presidential campaign.
But Soros remains first and foremost a speculator. In 2007, he returned to
directing Quantum's investments, with results suggesting he hadn't lost his
touch. Alpha magazine estimates that he made $2.9 billion in 2007. Forbes
magazine recently estimated his net worth at $9 billion.
For all his worldly success, Soros still has an unfulfilled ambition: to be
taken seriously not just as a financial practitioner but also as a theoretician.
In 1987, Simon and Schuster published his first book, The Alchemy of Finance, in
which he revisited some of his investments and expounded his theory of
"reflexivity."
But many professional economists dismissed it out of hand. Writing in The New
Republic, Robert Solow, one of the most respected macroeconomists of the
twentieth century, doubted that Soros understood "simultaneous" equations. The
suspicion lingers that his principal offense was challenging professional
economists on their own ground.
Now he is at it again, and this time around he and his pet theory cannot be so
easily dismissed. As of mid-September, the credit crunch was showing no sign of
letting up, indeed it was getting more severe. And yet the economists who
promulgated the reassuring orthodoxy about financial markets and force-fed it to
generations of graduate students have been notably quiet about what went wrong
with their theories.
Financial markets perform two essential roles in the economy. They take money
from those with no immediate use for it and put it into the hands of those with
productive investment ideas, and they allow individuals and institutions to
reapportion risk to those more willing to bear it. For financial markets to work
correctly, the price signals they send must be the right ones day after day
after day.
The benign view of markets owes much to three Chicago economists: Milton
Friedman, Eugene Fama, and Robert Lucas. Early in his career, Friedman played a
key part in developing the "efficient markets hypothesis," which, together with
its younger sibling the "rational expectation hypothesis," provided the
intellectual underpinning for more than two decades of financial deregulation.
Briefly put, the efficient markets hypothesis states that prices of stocks,
bonds, and other speculative assets necessarily reflect everything that is known
about economic fundamentals. If stock prices have risen above levels justified
by the fundamentals, then speculators will step in and sell them, thereby
restoring prices to their proper levels. If stocks fall below their fundamental
value, speculators will buy them.
Friedman formulated the efficient markets hypothesis in an analysis of
currencies. Fama, one of his students, applied it to the stock market: if stock
prices already reflect everything that is known and knowable, then investors
cannot hope to outperform the market using trading strategies based on publicly
available information. They would be better advised to place their savings in a
broadly diversified mutual fund.
Lucas, the third member of the Chicago triumvirate, extended the methodology
behind the efficient markets hypothesis to other parts of the economy, to invent
a new way of doing macroeconomics, known as the rational expectations approach,
which enshrined in higher mathematics the stabilizing properties of unfettered
markets. Expectations drive markets. If investors anticipate good news, they
buy. If they expect bad news, they sell.
According to Lucas, economic expectations reflect a predefined, externally
grounded, and commonly agreed upon reality. In his models, the economy's
equations of motion are well defined and known to all. Utilizing this common
knowledge, people form "rational expectations" of things like inflation and
interest rates. Systematic errors are corrected: If in one period the economy
gets out of line, in the next period it jumps back to "equilibrium."
Soros had neither the inclination nor the technical ability to challenge the
Chicago school's formal arguments. He says he got poor grades at the London
School of Economics, where he studied in the late 1940s. But he has a lot of
firsthand knowledge gained in the financial markets, together with a keen
interest in formulating a theory on the basis of his observations.
Outside the idealized world of Lucas's theory, knowledge is imperfect, people
stick to wrongheaded ideas, and there is no agreed version of how the economy
works. In these circumstances, Soros rightly points out, economic expectations,
even biased ones, can help to determine economic fundamentals:
"Reflexivity can be interpreted as a circularity, or two-way feedback loop,
between the participants' views and the actual state of affairs. People base
their decisions not on the actual situation that confronts them but on their
perception or interpretation of that situation. Their decisions make an impact
on the situation (the manipulative function), and changes in the situation are
liable to change their perceptions (the cognitive function)."
Soros provides a handy eight-stage guide to the typical boom-bust cycle,
together with a series of stock charts to help readers spot one in the making.
Turning to the current situation, he says that the recent housing bubble in the
United States fit the historic pattern. As house prices shot up between 2001 and
2005, credit standards deteriorated sharply. It was only when borrowers who had
taken out loans they couldn't afford started to default in large numbers that
the housing bubble finally burst.
Soros: "Superimposed on the US housing bubble is a much larger boom-bust
sequence which has finally reached its inflection, or crossover, point." As
described by Soros, the "super-bubble" developed over the past quarter-century
and is the result of three underlying trends: globalization, credit expansion,
and deregulation. Globalization includes the emergence of the United States as
the world's biggest debtor. In the past couple of years, the United States has
been running a current account deficit of more than 6 percent of GDP.
Soros: "There was a symbiotic relationship between the United States, which was
happy to consume more than it produced, and China and other Asian exporters,
which were happy to produce more than they consumed. The United States
accumulated external debt: China and the others accumulated currency reserves."
In 1980, the total amount of credit market debt outstanding in the United States
was roughly the same as the GDP: by 2007, it had risen to about 350 percent of
GDP. The bundling of residential mortgages into widely traded securities played
a significant role in this transformation, but so did increased federal lending
resulting from large-scale budget deficits, the securitization of credit card
debt and auto loans, and an expansion in corporate debt issuance.
Soros: "The risk models of the banks were based on the assumption that the
system is stable. But, contrary to market fundamentalist beliefs, the stability
of financial markets is not assured; it has to be actively maintained by the
authorities. By relying on the risk calculations of the market participants, the
regulators pulled up the anchor and unleashed a period of uncontrolled credit
expansion."
Lawrence Summers, the Harvard economist and former Treasury secretary, recently
noted in the Financial Times that several vicious cycles are operating
simultaneously. Falling asset prices are forcing investors with heavy borrowings
into distress sales, which is putting more downward pressure on prices. As GDP
growth slows, firms are laying off workers. Higher unemployment leads households
to cut back on their spending, which reduces economic growth.
In early September, the Bush administration effectively nationalized Fannie Mae
and Freddie Mac. The federal takeover added more than $5 trillion to the
national debt, and represented a historic extension of public intervention in
the American economy. Yet rates on jumbo mortgage loans remain close to 8
percent. Not surprisingly, house prices in most major markets are still falling.
History shows that ad hoc attempts to resolve banking crises seldom work. The
only thing that puts an end to the downward spiral is government intervention on
a grand scale, socializing the losses that have been incurred, and freeing up
the surviving institutions to start lending again.
Soros points out that the market behavior he calls reflexivity adds a
fundamental indeterminacy to economic events, which makes prediction very
tricky. With his taste for the grand philosophical statement, he couldn't resist
imparting a few thoughts about the future. Writing well before the latest
dramatic developments, he said:
"Eventually, the US government will have to use taxpayers' money to arrest the
decline in house prices. Until it does, the decline will be self-reinforcing,
with people walking away from homes in which they have negative equity and more
and more financial institutions becoming insolvent, thus reinforcing both the
recession and the flight from the dollar."
Soros brushed aside fears that the international banking system would collapse.
He called for more regulation, including stricter limits on leverage. But his
main conclusion went beyond specific policy recommendations. The period of
history that the elections of Margaret Thatcher and Ronald Reagan ushered in had
come to an end, he said:
"So what does the end of an era really mean? I contend that it means the end of
a long period of relative stability based on the United States as the dominant
power and the dollar as the main international reserve currency. I foresee a
period of political and financial instability, hopefully to be followed by the
emergence of a new world order."
A successful prophet of the markets
By
John Authers
Financial Times, May 19, 2008
Edited by Andy Ross
George Soros thinks that the credit crisis marks the end of a
25-year "era of credit expansion based on the dollar as the international
reserve currency".
What is most interesting is the philosophy he has developed to explain how
markets work. Even before the emergence of the efficient markets hypothesis,
which has dominated academic thinking on markets for at least three decades,
Soros had devised his own theory to prove markets were not efficient. He acted
on this philosophy as an investor with spectacularly successful results.
That philosophy derived from his undergraduate studies at the London School of
Economics under Karl Popper. In the relationship between thinking and reality,
Soros says, thinking plays a dual role: participants in a market try to
understand the situation (the "cognitive function"), and to change it (the
"manipulative function"). When the two functions interfere with each other, the
market displays "reflexivity".
So an investor's misperception of reality can help to change that reality,
begetting further misperceptions. When market actors' decisions affect outcomes,
patterns emerge. If a lot of people are bullish about internet stocks their
price goes up. Soros used the theory to predict, and profit from, a series of
"initially self-reinforcing but eventually self-defeating boom-bust processes,
or bubbles".
A key implication of this is that markets do not tend towards "equilibrium", as
predicted by modern portfolio theory. And they will not move in the "random
walk" promulgated by efficient markets theory, which holds that prices always
incorporate all known information and so move randomly in response to new
information. The architecture of modern capital markets depends on these
theories.
Soros believes that a "super-bubble" has been formed as the result of a
"long-term reflexive process" over the last 25 years. Its hallmarks include
credit expansion (boosted by the belief that inflation has been vanquished) and
a prevailing misconception, which Soros blames on Ronald Reagan and Margaret
Thatcher, that markets should be given free rein.
Many will dislike Soros' politics. Others will find the book self-indulgent. He
calls himself a "failed philosopher" — but he was a successful prophet.
AR George and I are
entangled in intrigung ways. I too studied philosophy in Karl Popper's department
at the London School of Economics, albeit a quarter of a century later, when Popper had
retired. More painfully, George's speculation against the pound in 1992 cost me
several hundred pounds on the value of my British investments. But since George
then spent his gains on philanthropic ventures, I guess that episode is forgiven.
His views on economics I find good. As an economics student at Oxford, I recall
denouncing the efficient market and rational expectations theories as based on a
classic liberal philosophy that failed to account for the deep irrationalism of
human agents in economic markets. I soon found a ready echo for my critique of the
prescientific fragments of psychology and sociology that are used to shore up economic
orthodoxy in the writings of Karl Popper, which led me away from economics and toward
the LSE, where I studied logic and scientific method.
More specifically, the Soros concept of "reflexivity" recalls my own envisaged repair
of economic theory. In economic life, thought and reality are coupled in an ongoing
feedback loop. At the time, I unpacked this in terms of the Hegelian concept of a dialectic,
which in effect means that thought and reality co-evolve in reciprocal feedback
cycles. In my gloss, these cycles form the stages of a dialectic, which I then proceeded
to model in formal logic, or rather in axiomatic set theory, in order to avoid the charge of
fuzzy thinking that attends any appeal to dialectics in the context of hard science. But
all my esoteric theorizing rather deflected me from the simple truths of economic life —
and from the stern task of getting rich.
