Soros: "He Foresaw the End of an Era"

John Cassidy, in the New York Review of Books, discusses George Soros’ latest book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, emphasizing how the storied investor’s views differ from those of the efficient markets/rational expectations school of economics. It also weaves in a wide-ranging discussion of the growth of credit and the cascading financial crisis. The piece is long, but well worth your attention.

From the New York Review of Books:

George Soros has been an active investor for more than half a century. In the mid-1980s, when I started writing about Wall Street, he was already a leading hedge fund manager. Not many people understood hedge funds back then, but for those in the know Soros’s Quantum Fund, which he founded in 1973, was the model: year after year, it had achieved returns in excess of the broader market. After weathering the 1987 stock market crash, Quantum, since 1989 under the day-to-day management of Stanley Druckenmiller, 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 has never publicly confirmed the exact figure. The British newspapers put it at $1.1 billion.)

Thereafter, Soros spent an increasing amount of his time on philanthropic activities throughout the world, including many laudable efforts to promote the spread of democracy in his native Eastern Europe. (He was born in Budapest in 1930.) After 2001, he also involved himself in domestic politics. A vocal critic of the Bush administration, in the run-up to the 2004 election he donated considerable sums to, the liberal Internet organization. More recently, he and his family have contributed to Barack Obama’s presidential campaign.

But Soros remains first and foremost a speculator. In 2007, after the subprime crisis erupted, he returned, at the age of seventy-seven, to directing Quantum’s investments, with results suggesting he hadn’t lost his touch. Alpha magazine, a glossy publication that covers hedge funds, estimates that he made $2.9 billion in 2007, placing him second on its list of mega-speculators, behind only John Paulson, of Paulson & Co., who raked in an even more astonishing $3.7 billion.

At the start of this year, Soros, convinced (correctly) that the financial crisis was far from over, adopted a bearish investment strategy, which he describes thus: “short US and European stocks, US ten-year government bonds, and the US dollar; long Chinese, Indian, and Gulf States stocks and non-US currencies.” Initially, some of these positions didn’t pay off. Between January and March, US bonds rallied and Indian stocks tumbled, wiping out gains in other parts of Quantum’s portfolio. Just how Soros has fared in the past few months of market turmoil may be known only to investors in Quantum, but it would be foolhardy to bet against him.

Forbes magazine recently estimated Soros’s net worth at $9 billion. For all his worldly success, though, he 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,” which claims that major market movements, such as the recent rise in commodity prices, sometimes take on lives of their own, entrapping investors in illusions and imparting a fundamental instability to the economic system.

The book proved popular with other investors. Paul Tudor Jones II writes: “When I enter the inevitable losing streak that befalls every investor, I pick up The Alchemy and revisit Mr. Soros’s campaigns.” But many professional economists, who tend to take a more sanguine view of financial markets, dismissed it out of hand. Writing in The New Republic, MIT’s Robert Solow, one of the most respected macroeconomists of the twentieth century, doubted that Soros understood “simultaneous” equations, i.e., systems of equations that involve more than one dependent variable. (For those unfamiliar with economics, this was a bit like accusing a carpenter of not knowing how to use a chisel.)

Solow had a point—he usually does. Soros’s presentation of his ideas was a bit garbled. The suspicion lingers, however, that his principal offense was challenging professional economists on their own ground. Now he is at it again—in a much shorter and more digestible book entitled The New Paradigm for Financial Markets—and this time around he and his pet theory cannot be so easily dismissed. Since the publication of The Alchemy of Finance, the global economy has witnessed a long and geographically dispersed series of boom-and-bust cycles, the latest of which is currently ravaging the US economy. While episodes such as these would be perfectly recognizable to Victorian economists such as John Stuart Mill or Alfred Marshall, who referred to them as “trade cycles,” they defy modern orthodoxy, which depicts the economy in general, and financial markets in particular, as effective, stable, and self-correcting mechanisms.

As of mid-September, the credit crunch was showing no sign of letting up, indeed it was getting more severe. One big Wall Street investment bank, Lehman Brothers, went bankrupt; another, Merrill Lynch, averted a similar fate by merging with a big commercial bank, Bank of America; AIG, the biggest insurance company in the country, got into such a perilous state that the Federal Reserve, fearful its collapse would bring down a number of other financial institutions, agreed to lend the firm $85 billion, while acquiring 80 percent ownership of the company. Finally, amid signs that despite the AIG bailout the markets were on the verge of a complete breakdown, Treasury Secretary Hank Paulson unveiled a plan for the federal government to buy from the banks up to $700 billion in distressed mortgage securities.

It hardly needs saying that these events were without precedent in postwar history, although students of the Great Depression, such as Fed chairman Ben Bernanke, saw much that was frighteningly familiar. And yet, despite all this, 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.

Soros doesn’t have all the answers, not by any means. But unlike some of the professors who dismissed him as an overremunerated gadfly, he has something to say. (In recent years, it should be noted, a number of theorists, some rallying under the banner of “behavioral finance,” have created more realistic models in which financial markets can depart from economic fundamentals, speculation can be destabilizing, and boom-and-bust cycles can persist. Until very recently, however, these new theories had little or no impact on economic policymaking.[*])

Financial markets perform two essential roles in the economy: (1) they take money from those with no immediate use for it, such as people saving for retirement and the hereditary rich, and put it into the hands of firms and entrepreneurial individuals with productive investment ideas but a shortage of cash to finance them; (2) they allow individuals and institutions to reapportion risk to those more willing to bear it. If Wall Street didn’t exist, another method of allocating savings and risks would have to be found. One alternative is diktat, but the history of the Soviet Union and other Communist countries amply demonstrated the difficulties involved in centralizing economic decisions.

The great advantage of a market system is that it draws on information from throughout the economy and translates it into public signals—prices—that investors and firms can react to. Earlier this year, investors woke up to the fact that Detroit had ignored the threat of dwindling oil stocks and had bet its future on gas-guzzling SUVs: the stock prices of American car companies plummeted, making it much more expensive for them to sell equity in their corporations. Toyota and Honda, which had invested heavily in smaller, more fuel-efficient vehicles, have seen their stocks hold up much better, enabling them to raise funds cheaply. Nobody planned it, but in this instance the market rewarded foresight and innovation.

For financial markets to allocate resources to their most productive uses on an ongoing basis, the price signals they send must be the right ones day after day after day. Is this a realistic goal? A typical investor following the Dow’s gyrations on CNBC or Yahoo Finance might be tempted to say no, but then the typical investor doesn’t have the benefit of an economics Ph.D. from the University of Chicago.

The benign view of markets owes much to three Chicago economists: Milton Friedman, Eugene Fama, and Robert Lucas. Although best known for his work on monetary theory and his enthusiastic espousal of capitalism, early in his career Friedman had played a key part in developing the “efficient markets hypothesis,” which, together with its younger sibling the “rational expectation hypothesis”—see below—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, such as inflation, exports, and corporate profitability. The proof proceeds by contradiction. Suppose stock prices have risen above levels justified by the fundamentals. Then clever speculators, such as Soros, will step in and sell them, thereby restoring prices to their proper levels. If stocks fall below their fundamental value, speculators will step in and buy them.

Friedman actually formulated the efficient markets hypothesis in an analysis of currencies. It was Fama, one of his students, who applied it to the stock market and pointed out an interesting corollary: if stock prices already reflect everything that is known and knowable, then investors can’t hope to outperform the market using trading strategies based on publicly available information. Rather than wasting time and effort trying to pick individual stocks, they would be well advised to place their savings in a broadly diversified mutual fund that tracks the daily movement of the market. Largely thanks to Fama and his followers, so-called index funds today have a central part in many Americans’ retirement planning.

Lucas, the third member of the Chicago triumvirate, was arguably more influential even than Friedman. In a series of ingenious papers published in the 1960s and 1970s, he and several colleagues extended the hyperrational methodology underpinning the efficient markets hypothesis to other parts of the economy, such as the job market, the output decisions of firms, and the formulation of economic policy. By the time they were done, Lucas et al. had invented a new way of doing macroeconomics, known as the rational expectations approach, which enshrined in higher mathematics the stabilizing properties of unfettered markets. You don’t have to spend much time on Wall Street to recognize that expectations are what drive the markets. If investors anticipate good news, they buy; if they expect bad news, they sell.

Where, though, do these economic expectations come from? According to Lucas, they 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—from Ph.D. economists at the University of Chicago to nurses and cab drivers. Utilizing this common knowledge, people form “rational expectations” of things like inflation and interest rates. They don’t always get things right—a certain amount of randomness is allowed for—but they are precluded from making systematic errors. If in one period the economy gets out of sync, in the next period it jumps back to the “equilibrium” defined by the model.

Not content to create new models, Lucas also disparaged older theories that viewed financial capitalism more skeptically. Keynesianism wasn’t merely wrong, he declared at one point: it was no longer intellectually respectable.

Soros had neither the inclination nor the technical ability to challenge the Chicago school’s formal arguments. (In a charming passage, he reveals that he wasn’t very good at math, and that he achieved poor grades at the London School of Economics, where he studied in the late 1940s.) What he does possess, however, is voluminous amounts of firsthand knowledge gained in the financial markets, together with a keen interest in formulating a theory on the basis of his observations. Academic criticism of The Alchemy of Finance didn’t put him off that effort. “My conceptual framework remained something very important for me personally,” he writes. “It guided me both in making money as a hedge fund manager and in spending it as a philanthropist: and it became an integral part of my identity.”

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. One way to grasp what Soros is getting at is to look at the diagram on this page, in which the arrows indicate the directions of causation. Soros doesn’t refer to this diagram, which I drew up myself, but he spells out the relations it illustrates:

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).

A simple hypothetical example—for which I also take responsibility—may help to illustrate what can happen in such a reflexive system.

Imagine that ABC Corp. makes profits of $W per share, pays dividends of $X a share, and is growing at Y percent per annum. If you assume that this rate of earnings growth will persist indefinitely, it is a matter of high school arithmetic to figure out what ABC Corp.’s stock is worth on a fundamental basis, an amount I will call $Z. In the world of the Chicago economists, well-informed investors bid the price up to $Z and stop there. If prices rise above that level, they step in and sell; if prices fall below $Z, they buy. All is rational: all is efficient.

Now imagine that a group of irrationally exuberant investors come to believe that ABC Corp.’s growth rate is about to accelerate to 2Y percent, and, as a result, they bid up its stock up $2Z and keep it there for a while. What happens next? One possibility is that ABC Corp. could issue more of its highly rated shares and use them to purchase a rival, DEF Corp., whose stock price has been lagging—hence presenting a relative bargain. Thanks to the magic of acquisition accounting, the mere act of ABC Corp. buying DEF Corp. would make it appear that its earnings per share were growing rapidly. Voilà, the inflated earnings expectations that drove up ABC Corp.’s stock would have turned out to be justified. Most likely, the stock would rise even further—for a while, anyway.

If the previous discussion seemed a bit abstract, don’t lose heart. In the second half of his book, Soros applies his theoretical frame to events he has lived through, beginning with the conglomerates boom of the late 1960s and ending with today’s credit crunch. Reflecting on the harsh reception afforded to his earlier book, he writes:

Many critics of reflexivity claimed that I was belaboring the obvious, namely that the participants’ biased perceptions influence market prices. But the crux of reflexivity is not so obvious; it asserts that market prices can influence the fundamentals. The illusion that markets manage to be always right is caused by their ability to affect the fundamentals they are supposed to reflect. The change in the fundamentals may then reinforce the biased expectations in an initially self-reinforcing but eventually self-defeating process.

Of course, such boom-bust sequences do not happen all the time. More often the prevailing bias corrects itself before it can affect the fundamentals. But the fact that [such sequences] can occur invalidates the theory of rational expectations. When they occur, boom-bust processes can take on historic significance. That is what happened in the Great Depression, and that is what is unfolding now, although it is taking a very different shape.

One of Soros’s earliest professional coups was investing in fast-growing industrial conglomerates, such as Textron, LTV, and Teledyne, which during the early days of the Nixon administration used their inflated stocks to buy out a succession of other companies. Just as in the example of ABC Corp., simply combining a lower-rated company with a higher-rated one boosted reported earnings per share for the lower-rated company. Even though investors such as Soros knew full well that much of this growth was an accounting illusion, they continued to bid up the conglomerates’ stocks, thereby keeping the game going.

In order for it to continue indefinitely, however, the acquirers had to target bigger and bigger companies. Eventually, the Reliance Group, Saul Steinberg’s outfit, launched a takeover bid for the venerable Chemical Bank that generated an establishment backlash. Steinberg’s bid failed, and investors began to question the reported earnings growth of Reliance and other conglomerates. Knowing that the jig was almost up, Soros sold out and moved on to the next boom-bust cycle, which, in his case, turned out to be in real estate investment trusts.

Breaking up the narrative, 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, in large part, the recent housing bubble in the United States fit the historic pattern, except that in this case reflexivity was centered on the real estate rather than the stock market. As house prices shot up between 2001 and 2005, credit standards deteriorated sharply. Rather than restricting their lending, mortgage financiers deluded themselves into believing that the collateral for the loans they were making would continue to rise in value. The very act of extending more and more credit, on easier and easier terms, kept demand for real estate buoyant, which, in turn, ensured that for several years the lenders’ optimistic expectations were validated. 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.

What distinguishes this process from earlier downturns, and what makes it so dangerous, is the historical and international economic situation in which it is taking place, Soros says. “Superimposed on the US housing bubble,” he writes, “is a much larger boom-bust sequence which has finally reached its inflection, or crossover, point.” The housing slump is following the normal historical pattern, he suggests,

but, in addition, it has also set in motion a flight from the dollar and unwinding of the other excesses introduced into the financial system by recent innovations. That is how the housing bubble and super-bubble are connected.

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. By globalization, he means not just expansion of trade in goods and services, and the rise of China and India, but the US’s emergence as the world’s biggest debtor. In the past couple of years, he reminds us, the United States has been running a current account deficit of more than 6 percent of GDP—a level usually associated with a developing country about to suffer a foreign exchange crisis.

The US has been able to avoid that fate because of the dollar’s status as the main international reserve currency, and because foreign governments, particularly the one in Beijing, have proved willing to purchase enormous quantities of Treasury bonds. “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,” Soros notes. “The United States accumulated external debt: China and the others accumulated currency reserves.”

The lending boom extended far beyond the housing market. Over the past generation, the overall expansion of the US economy has increasingly become an asset-driven phenomenon. 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—”securitization”—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 isn’t the first to point out these trends, but his description of the changes he has witnessed since starting out on Wall Street is instructive, nonetheless. In the years after World War II, he points out:

The total amount of credit outstanding in relation to the size of the economy was much less than it is today, and the amounts that could be borrowed against different types of collateral were also much smaller. Mortgages required at least 20 percent down payment, and borrowing against stocks was subject to statutory margin requirements that restricted loans to 50 percent or less of the value of the collateral. Auto loans, which required down payment, have been largely replaced by leases, which do not. There were no credit cards and very little unsecured credit. Financial institutions represented only a small percentage of the capitalization of US stocks. Very few financial stocks were listed on the New York Stock Exchange. Most banks were traded over the counter, and many of them traded only by appointment.

Until last summer, the US economy was awash in easy credit. In one way or another, the banking system played an important part in issuing many of these loans, which is hardly surprising since that is how banks make money. Rather than criticizing his fellow investors on Wall Street, who created many of the newfangled debt instruments—such as mortgage-backed securities and collateral debt obligations—that have now imploded, Soros puts the blame on the regulators and central bankers who aided and abetted the financiers’ incendiary activities. Under the system of “self-regulation” adopted by American and European banking regulators, many big financial institutions, such as Citigroup, Barclays, and Union Bank of Switzerland, were allowed to rely on their internal risk-management systems. The only outside check on their activities came from commercial ratings agencies, such as Moody’s and Standard & Poor’s, which depended on the banks’ fees for business.

“I find this the most shocking abdication of responsibility on the part of the regulators,” Soros writes.

If they could not calculate the risk, they should not have allowed the institutions under their supervision to undertake them. 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.

As long as credit was flowing freely, the three elements of the “super-bubble” reinforced one another. Now that the housing bubble has burst and economic growth has slowed dramatically, reflexivity is working in the opposite direction: market fundamentals are influencing investor perceptions. The global capital market that enabled the US to finance a huge trade deficit has proved equally adept at transferring the subprime shock to other parts of the world: after rushing in to capture the high yields offered by US subprime securities, big European banks have been forced to write off almost as much money as their American brethren. (Taking the United States and Europe together, banks and other financial institutions have, so far, written off roughly $450 billion in subprime-related charges. Many institutions are sitting on losses that they haven’t yet declared. Estimates of the total losses that will eventually result range from $1 trillion to $2 trillion.)

As nerves fray and values of collateral plummet, many big financial institutions are desperately trying to eliminate the debt showing on their balance sheets. Individually, this may make sense. When banks do this collectively, it deprives worthwhile capital projects of funding and risks deepening the economic downturn, which, in turn, could well lead to more loans going bad. As Lawrence Summers, the Harvard economist and former Treasury secretary, recently noted in the Financial Times, this is but one of several vicious cycles 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. “Without active efforts to interfere with these mechanisms,” Summers wrote in an article published on August 6, “there can be no basis for confidence that the American economy will recover even in the medium term.”

Soros would surely agree with that statement. Finishing his manuscript earlier this year, he predicted that the economic slump would be prolonged, partly because problems in the financial system would make countercyclical policies—such as easing the money supply to stimulate investment—less effective than usual. During 2008, the Fed has cut short-term interest rates to 2 percent and established virtually unlimited borrowing lines to financial firms. Congress has voted through a refinancing scheme for many of the homeowners who fall behind on their mortgage payments.

In early September, in an effort to bring down mortgage rates and put an end to the housing slump, the Bush administration took the dramatic step of effectively nationalizing Fannie Mae and Freddie Mac, two giant mortgage lenders that the government originally set up but which had for many years operated as private companies. The federal takeover added more than $5 trillion to the national debt, and, especially coming from a Republican administration, it represented a historic extension of public intervention in the American economy; the Treasury Department then, without congressional approval, granted itself warrants to buy up to 80 percent of AIG’s stock. (One Republican senator, Jim Bunning of Kentucky, lambasted the move as socialism and called on Treasury Secretary Hank Paulson to resign.) Yet despite all these moves, rates on jumbo mortgage loans—the type many home buyers have to take out if they live in places like New York, Boston, and Washington—remain close to 8 percent. Not surprisingly, house prices in most major markets are still falling.

Where will it end? Viewed from Soros’s perspective, the dramatic events of mid-September demonstrated how reflexivity was working on the downside, to devastating effect: the slumping real estate market had wreaked havoc on banks and other financial institutions, which had reacted by tightening lending standards, and cutting back on the amount of credit, particularly mortgage finance, that they were willing to extend to households and firms. Tighter credit conditions, in turn, were hurting the economy and putting further downward pressure on property prices, shattering hopes that the credit markets would stabilize of their own accord, and that troubled firms would be able to recapitalize their balance sheets.

Some sort of recovery was what Richard S. Fuld, Lehman’s former chief executive, and his colleagues had been hoping for. From the fall of 2007 onward, the firm, which was founded in 1850, was struggling to survive. Rather than selling out to a bigger, sounder institution, its managers gambled that the credit markets would rebound, arresting the fall in value of tens of billions of dubious real estate assets festering on the firm’s balance sheet. The turnaround never came. By the time that Lehman was prepared to give up its independence, in mid-September, it was facing a funding crisis, and there were no purchasers interested. (The Treasury Department and the Federal Reserve didn’t deem Lehman strategically important enough to save, so it went bust. AIG, on the other hand, was too big to be allowed to fail.)

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. With Hank Paulson’s bailout plan, we have now reached that stage, where the taxpayer is called upon to rectify the bankers’ mistakes. Although the plan comes with a $700 billion price tag, the eventual cost could be even larger. Some observers have compared what is happening now to the S&L crisis of the late 1980s, when the government set up the Resolution Trust Corporation to dispose of the assets of insolvent thrifts, but that was a relatively trivial exercise compared to what is ahead. A better analogy is the Japanese banking crisis of the 1990s, where the government initially refused to recognize the scale of the problem, but ended up, after almost a decade of economic stagnation, having to spend vast sums of public money on recapitalizing the country’s financial sector. Even then, the Japanese economy failed to resume its previous growth rates: after a few years of modest expansion, it has once again slipped into near-recession.

It is to be hoped that the Paulson plan has a more invigorating effect on the US economy, but despite the recent celebrations on Wall Street a happy outcome is far from guaranteed. Critics have questioned the timing, ethics, politics, and efficacy of the proposal. The Treasury secretary is seeking absolute freedom to enact the plan as he sees fit. Under his proposed legislation, “decisions by the secretary pursuant to the authority of this act are nonreviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency”—a position rejected by members of the Senate Banking Committee who questioned Paulson on September 23. (Writing in the Financial Times on September 25, Soros proposed an alternative rescue plan, also suggested by Senator Charles Schumer and others, of injecting public money directly into the banks, through government purchases of preferred stock.)

From an economic perspective, what matters is whether the Paulson plan, or one close to it, will work: Are the planned purchases of assets big enough to make a difference? What about all the other increasingly toxic assets that financial institutions have on their books, including roughly $950 billion of securities linked to risky “alt-A” mortgages; hundreds of billions of dollars in securitized auto loans and credit card debts; and countless dubious credits that were extended during the boom to commercial real estate developers and leveraged buyout firms? Would it have been cheaper and more effective for the government to have recapitalized the big banks by taking equity stakes in many of them?

Even if the Paulson plan, or some variation of it, restores some degree of normalcy to the credit markets, it is far from certain that a modest fall in mortgage rates and a greater willingness to lend on the part of financial institutions will be sufficient to break the self-reinforcing impetus toward recession that has taken hold in other parts of the economy. Much depends on what happens to the housing market and to the global economy, which, in providing a ready market for US exports—and in providing cash by buying US government bonds—has helped to prevent a much sharper downturn in output and employment.

One of Soros’s points is that the behavior in markets he defines as reflexivity adds a fundamental indeterminacy to economic events, which makes prediction very tricky. Still, given 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. The Bush administration and most economic forecasters do not understand that markets can be self-reinforcing on the downside as well as the upside. They are waiting for the housing market to find a bottom on its own, but it is further away than they think.

Soros wasn’t all gloom and doom. He said rapid growth in the developing world, particularly China, would continue, and he brushed aside fears that the international banking system would collapse, as it did in the 1930s. After observing the pathologies the financial system had exhibited since the summer of 2007, he called for more regulation, including stricter limits on leverage, the amounts borrowed for investment. But Soros’s main conclusion went beyond specific forecasts of 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.

Since 1971, when the Nixon administration abandoned the dollar’s link to gold, many commentators have predicted the demise of the American currency and an end to US economic hegemony, only to be proved wrong, or, at least, premature. Soros could well end up joining this group—he freely admits he has been too pessimistic on previous occasions. (A decade ago, he underestimated the global economy’s ability to rebound from the Asian financial crisis.) If the Paulson bailout succeeds in excising from the US banking system the distressed mortgage securities that have caused so much trouble; if there is a recovery of confidence on Wall Street; if the housing market stabilizes; if the recent fall in the oil price is sustained—then the US economy and currency could yet display their Houdini-like qualities one more time. Conversely, Soros’s reading of the financial omens has enriched him oftentimes before: betting against him now could be unwise.

Print Friendly, PDF & Email


  1. walt

    The problem is that none of Soros’ ideas are new. It’s not that no one ever thought of the idea that prices could be systematically wrong because of a bubble, but that the possibility was deliberately downplayed for ideological reasons.

  2. viking

    soros simply understands that the markets have a psychlogical component, something that ivory tower types often underlook

    Alchemy is a GREAT BOOK

  3. Anonymous

    “The problem is that none of Soros’ ideas are new. “

    Yeah, I read “a new paradigm..” and was disappointed. The best part of the book was his describing his father’s escaping a gulag in Siberia.

    Basically, he rehashes many of the phenomena that led to the current crisis.

    Heck I was ready to jump into a bomb shelter in 2005, given the insanity I saw in the housing and credit markets.

    Yes, he’s right to point out the ’emotional’ component to the markets, but I’m not sure why he gets the attention he does (perhaps because, for a financial manager he seems somewhat human?)

    I placed down his book with my world-view unchanged.

  4. Anonymous

    Soros is an intellectual in the true sense of the word. Hence, we tend to distrust him. In investing, we distrust “big ideas” players and admire people like Peter Lynch for his hard work, simple ideas, and always optimistic attitude.

    Arianna got it right in huffingtonpost, today: “It’s in our DNA to fear the evil genius. But we still have to be trained to recognize the dangers of the clueless mediocrity.”

  5. doc holiday

    I’m currently re-learning and re-thinking the Treasury yield curve and remain confused as what happens if a tsunami of foreign currency is dropped into Treasuries or money markets, which are backed by bonds that are becoming more and more worthless in terms of having value for future U.S. obligations, It is a complicated puzzle — made more challenging by Treasury being in the global commercial banking business and Treasury buying synthetic derivative assets that are worthless! Very weird that people may just seek a safe haven in the eye of the storm!


    See Also Me Going: Moohahahahahaha

  6. Tim

    Nothing may be knew here now but keep in my he wrote the book back in January I think. Now if he could only explain his 11th hour Lehman brothers stock accumulation…

  7. Matt Dubuque

    Yves, thanks for posting this.

    I heard Soros give a one hour interview with Owen Bennett Jones on the BBC six weeks ago about the publication of this book.

    I think that if people state that Soros is not really adding anything new to the mix, that they do not fully understand some of the subtlety in his points.

    The article mentions how some of his ideas are now reflected in “behavioral economics”, for which Kahneman won a Nobel in Economics in 2002.

    Soros stated in the interview cited above that his acquisition of wealth was substantially attributable to two things: 1) the ability to recognize trends before the “efficient” market does and 2) to stay with that position even AFTER the “efficient” market learns he is correct because, according to Soros, the allegedly “efficient” markets ALWAYS overshoots by FAR more than anyone predicts, or is predicted by the pricing.

    This is what Soros said was the key to his acquisition of wealth.

    And indeed this view is deeply consonant with Kahneman’s recent Nobel work on “anchoring”, where market participants incorrectly assume that previous models are appropriate for new decision frames because they have an incorrect “anchor” upon which they frame their analysis.

    ADDITIONALLY, when the markets DO change their conceptual frameworks, they INSIST on overshooting, by failing to understand that the LIMITS of the new anchors are not bounded in the same way as the old anchors.

    Indeed, when Lucas spoke of the market seeking equilibrium using “higher mathematics”, (as the NY Times reporter describes it, Lucas STILL assumes that economic pricing shocks and equilibria occur and allegedly “stabilize” within Gaussian (bell-shaped) spaces.

    What Soros in lay terms and Kahneman and his contemporaries understand in more formal terms is that this so-called “higher mathematics” needs to go a level higher to more accurately describe systems behaving in Cauchy domains.

    What Lucas, Fama and Friedman’s “higher mathematics” fails to predict is the explosion of economic events we are having that were supposed to be five standard deviations from the norm under their Gaussian scenarios.

    Indeed, this shortcoming was the essence of Mandelbrot’s work, in its early stages of development, that he published in peer-reviewed journals decades ago about the Cauchy type price distributions of cotton.

    Matt Dubuque

  8. Anonymous

    I dunno, Mr. Dubuque, but I don’t think the “higher mathematics” can be fixed by simply using a different distribution. It may be time to entertain the heresy that (1) the “higher mathematics” was simply a smoke-screen for economic ideology, and (2) as per the behaviorists, there will be no quantitative, predictive, economic theory until there is such a model for a human brain.

  9. Anonymous

    I’ve always loved the idea of Lucas that Keynesian economics had become no longer intellectually respectable. It is to me like a warm blanket on a cold winter’s night. It was that one brief, wondrous break in the clouds in which the light shines down and the true intellectual insecurity of men like Lucas is bared before all. What a sad and insecure man, with such a preposterous hypothesis: markets made by humans are rational. Cognitive dissonance is so strong, so overwhelming, nary a man can survive its pull. Lucas certainly couldn’t.

  10. PrintFaster

    Soros is too wierd for me:
    “hopefully to be followed by the emergence of a new world order.”

    Here is a correlate quote:
    A national leader once said: “[Our party] will use its own revolution for the establishing of a new world order.”

    Is this what attracts Soros to the politicians that he supports? His reputation as a 14 year old collaborator in Budapest reeks of one who would plunder the earth for vanity. Not much has changed in 60 years.

    On to a new world order. What consummate arrogance that Soros knows that we need a new world order.

    Afraid it is impossible to scream over the internet.

  11. Owe Jessen

    Is it just me, or is the journalistic world – even the economic part of that world – lagging economics about 10 years? Just a couple of points:

    – prospect theory was developed in the 1970s.
    – behavioral finance became a fad at least 10 years ago.
    – CAPM has been discredited as the all-encompassing theory since early 1980s.

    But what’s more: I suppose any reasonable scientiest _knows_ that his models are only tools to explain a litle part of the world, and does not confuse this explanatory power with the idea, that reality would behave exactly like the model.

    Case in point: It should be obvious that rational expectations mainly are an efficient tool to make the mathematical modelling easier; and let’s not forget that the theory of rational bubbles was concieved about 1982.

  12. Juan

    Theoretic systems dependent upon interlocking axioms of assumed utility maximizing individuals and equilibrium, no matter their mathematical depth, have never been able to capture the capital system’s actual contradictions and motion.

    Or, as another native of Hungary, Istvan Mészáros, put it:

    Everything else is built around these two principles which are never established, but always assumed. They reciprocally and quasi-axiomatically support one another, constituting thereby the real armour of the theory. According to the believers in the ‘subjective revolution’, the irrepressible drive of the – by their ‘human nature’ so determined – individuals for maximising their utilities brings about the happy economic condition of equilibrium; and by the same token, economic equilibrium itself is the required condition under which the maximisation of the utilities of all individuals predestined for the purpose of selfish utility-maximisation can be – and for good measure actually is being – accomplished.

    This impregnable circular reasoning provides the theoretical framework in which assumptions can run riot, enabling the economists concerned to derive the desired conclusions from the earlier enunciated ‘assumptions’ and ‘suppositions’, without any need to subject them to the test of actuality.
    (Beyond Capital, 1995)

    Many (all?) neoclassical economists are confused because they know no better than what, for over a century, has been ideology. Objective value as understood by Smith, Ricardo, Sismondi, Marx, was tossed aside in favor of the subjectivities of needs while producers were transmogrified into consumers and labor into merely another ‘factor’ rather than the sole value creating moment. With labor value disappeared from ‘the equation’ so also the moving non-identity of value and price and other systemic contradictions until crises came to appear as (almost by definition exogenous) surprises.

    Why mention this? Because, last instance, paper claims are claims to a portion of just that labor value which neoclassic theory effectively ‘disappeared’. From this perspective, EMH was/is blind.

  13. David Galbraith

    The one thing that doesn’t make sense about Soros’ ideas is that even if you buy his thesis about psychology affecting fundamentals, you don’t need this to be the case for chaotic cycles.

    The Mandelbrot reference is correct, efficient markets aren’t smooth just like the weather isn’t. Thunder storms are not caused by psychology.

    And this is because the marketplace is fundamentally not a closed system.

  14. Anonymous

    Re: Printfaster

    “On to a new world order. What consummate arrogance that Soros knows that we need a new world order.”

    Soros is not the first person to believe a New World Order will emerge. It *has* to.

    What consumate arrogance to believe that the US will be able to retain its mantle? Remember, once upon a time … there was unprecedented global *change* and then the US became the global leader until…..

    Change – you cant fight against it. The change to so many important (domestic) fundamentals and so many changing global ones, can only mean the status quo will change.

    Chickens have come home to roost. A country that elects Bush *twice* and that has unravelled its financial system to this extent cannot expect to retain the global throne – this is all said regretfully.

  15. Francois

    “If you think the US is about to collapse I think you are very mistaken.”

    There are many shades of gray between absolute preeminence and collapse.

    Let’s try to go beyond binary pseudo-thinking, shall we?

    One thing is sure: the US is not at its best now, far from it. We got biiig problems but biiiig resources in material and people.

    The question is: Will we use them wisely to get out of this pickle, or are going to get stuck, denying there are fundamental problems that MUST be addressed?

  16. Anonymous

    Folks, please read this note very carefully. I am serious. I have read all books of soros(particularly the Alchemy and the recent book). I have also been following a blogger. And here is the main point.

    I have been thinking that the blogger in question IS George Soros, but after reading the NY times article, I now think that the blogger thinks exactly like Soros, but he is better than Soros because, for instance, back in May 08, he made a prediction/vision which he posted on his about the dollar, stocks and commodities. The price action has vindicated that prediction.

    What is interesting in that prediction is the WHOLE reasoning of why things would turn the way they did (A la Soros). And they turned exactly as explained. The the article is below.

    A FASCINATING and a MUST read.

    Could anyone help determine whether RFT is Soros. His behavior is similar to Soros (He has Napoleon’s picture on his profile, but he removed it).

Comments are closed.