財經觀察 1548 ---George Soros\' Speech at CICC Forum

George Soros' Speech at CICC Forum

November 21 in Beijing, China

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.  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.