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. The financial system melted down. A large money market fund saw its asset value fall below the dollar amount deposited. This started a run on money market funds. 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.

American and European financial authorities committed themselves not to allow any other major financial institution to fail. 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.

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.

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.

Market fundamentalism is built on false assumptions. 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. Whenever a crisis endangered the prosperity of the United States, the authorities intervened. The United States sucked up the savings of the rest of the world and ran a current account deficit. Regulators 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.
 

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. Soros then spent an increasing amount of his time on philanthropic activities throughout the world.

Soros remains first and foremost a speculator. Alpha magazine estimates that he made $2.9 billion in 2007. Forbes magazine recently estimated his net worth at $9 billion. But Soros also wants to be taken seriously as a theoretician.

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. Friedman played a key part in developing the efficient markets hypothesis, which states that prices of stocks, bonds, and other speculative assets necessarily reflect everything that is known about economic fundamentals.

Fama applied the efficient markets hypothesis to the stock market: investors cannot hope to outperform the market using trading strategies based on publicly available information. Lucas extended the methodology to invent the rational expectations approach, which enshrined in higher mathematics the stabilizing properties of unfettered markets driven by expectations.

Soros had neither the inclination nor the technical ability to challenge the 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.

Soros: "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 says the recent housing bubble in the United States fits 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.

A "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% of GDP.

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."

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 survivors to start again.

Soros points out that reflexivity adds a fundamental indeterminacy to economic events, which makes prediction very tricky.

Soros: "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

By John Authers
Financial Times, May 19, 2008

Edited by Andy Ross

George Soros thinks the credit crisis marks the end of an era of credit expansion based on the dollar. He 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 toward equilibrium. 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.

Soros 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.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, that episode is forgiven.

As an economics student at Oxford, I denounced 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.

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 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 theorizing deflected me from the simple truths of economic life — and from the stern task of getting rich.