The Soros Nose Knows

I met George Soros twice in recent months. The first encounter was last October at the International Monetary Fund Annual Meeting in Istanbul. We were both invited to a close-door symposium chaired by the fund's managing director, Dominique Strauss-Kahn. I'm slow at matching faces with names, but not in the case of Soros. He looked exactly like the man featured in mountains of media pictures, except for a small patch on his nose. He might have hurt it somehow.

After small talk, I asked for his views on the world economy. He said he wasn't upbeat about the United States but had confidence in China. In addition, he said he liked the idea highlighted in a widely read paper written by China's central bank governor, Zhou Xiaochuan, calling for a broader use of IMF's Special Drawing Rights as an alternative reserve currency.

Later at Davos, Soros held a luncheon at the Hotel Seehof. I was surprised to find so many familiar faces; Soros mainly invited media people. I enjoyed seeing old friends and acquaintances, including the 79-year-old "financial crocodile," as Soros is described in China. He is energetic and fast-thinking. This time, though, the plaster on his nose was gone.

Soros gave a brief speech and invited questions from the floor. Here is what he said:

"Now I think the weight is all about financial regulation, and what went wrong and what needs to be done to put it right. And that's what the second lecture is about. And to appreciate the second lecture, you may want to read the first one, which lays the groundwork.

"Now the crucial factor in the crash of 2008 is that it was not due to some exogenous event or extraneous shock that the prevailing paradigm would tell you. But it was generated by the system itself. And that means that the prevailing paradigm, the efficient market hypothesis, the rational expectations, basically has been proven wrong by the crash of 2008.

"I have proposed an alternative paradigm which recognizes that rational people base their decisions not on reality but on their perception of reality. And there is always a gap between perception and what actually happens in the world. It can be greater or lesser gap, but there is some divergence. And the really interesting thing is that that divergence, the false perceptions, can in turn influence the actual course of events. So there's a feedback mechanism between the participants' thinking and the course of events. A two-way feedback which I call 'reflexivity.'

"Now feedback can be negative, which then brings you closer to equilibrium. By equilibrium we mean an actual correspondence between the participants' perception and reality. Or we can have a positive feedback, and that takes you away from an equilibrium. And that is how bubbles are formed.

"And so the fact is, financial markets, instead of tending towards equilibrium, are just as easily moving away from it. And you can move far from equilibrium conditions, and bubbles, of course, are innate in financial markets. And if you look at history, you've had them as long as you've had financial markets.

"So I think one has to revise one's idea about how financial markets operate, and therefore you also have to recognize and accept the responsibility that you have to prevent bubbles from getting out of hand. When they become this positive reinforcement, something has to be done from going too far.

"Now that's a responsibility that Alan Greenspan and the regulators generally explicitly refuse to accept. Alan Greenspan said if markets can't recognize a bubble, how can you expect the regulators to do so? He spoke of irrational exuberance, but there is nothing irrational about bubbles. As a participant, when I recognize a bubble, I rush out and buy. And that's the rational thing to do. Therefore you can't expect markets to correct their own excesses. There is a need to maintain stability, and the authorities have to accept that responsibility.

"Now they will then say, we don't have the instruments to do it. And they're right. Because just to control the money supply, doesn't control credit. So credit needs to be controlled separately from the money supply. And there are instruments, if they exist, they used to be used, they are used very aggressively and I would say, up to recently, quite successfully by the Chinese. So there has to be a radical rethinking of how markets have to be regulated.

"Now this Theory of Reflexivity, a theory of bubbles, which is that every bubble has a basis in reality, it doesn't come out of thin air. There is a trend in reality that actually prevails, and then there is a misconception relating to that trend which reinforces the trend and reinforces the misconception as well. The simplest case is usually in real estate, where the trend is easy availability of money, credit, and credit extension. That is the trend that causes the bubble. And then there is a misconception that the value of the real estate is independent from the availability of credit. And that misconception comes up time and time again in different guises, the most recent case was of course with the use of CDOs, but I don't want to go into details on that.

"But what happened in the recent financial crisis was not an ordinary bubble, it was what I call a super bubble. It was actually composed of little bubbles that kept cropping up. And it's very interesting to see the relationship between the little bubbles and the big one. The super bubble had a basic underlying trend: which is the ever-increasing use of credit and leverage. And in that there was a misconception, which was the efficient market hypothesis, the rational expectations theory, the view of the market that has proven wrong, and the set of political beliefs that went with it, namely, that the markets should be deregulated.

"As such, you had one financial crisis after another. And each time, when the system failed, the authorities intervened and saved the system. The way they did it was merging away the failing institutions and, if necessary, deregulating further and increasing money supply – reinforcing the underlying trend of increasing use of credit. And reinforcing this false belief of what I call market fundamentalism.

"So the individual crisis that we have experienced in the last 75 years were successful tests of a false hypothesis. And actually, they reinforced and made the bubble grow bigger. I made the mistake of thinking in the emerging market crisis of '97 that the system would not be able to take it, and I was wrong. And after that you have the internet bubble, and then the long period of very low interest rates which allows the housing bubble to develop.

"So then, 10 years later, because of that, the super bubble has grown much bigger. And it started of course in the subprime crisis, which Bernanke famously said, "Well, it cost us a few hundred billion, but the system can easily take it."

"However, there was contagion, and the crisis spread from one market to another at an alarming and amazing speed, and that's how it eventually became too big to contain. And with the mistake of allowing Lehman to go bust, actually the system did break down, and within a week had to be put on artificial life support. And that life support involved an implicit guarantee that no other institution would be allowed to fail. And of course, the spigot was turned down, and tremendous injections of liquidity, and effectively the collapsing credit was replaced by the only source of credit that was still credible: the credit of the state, both in the form of one, the balance sheet of the Federal Reserve, which blew from US$ 600 billion to US$ 2 trillion, with about US$ 8 trillion in guarantees on top of it. So it really did replace a very large part of the credit that had collapsed. And of course, two, in the form of the stimulus to get the economy going again.

"Now the other shoe I supported actually works. And the markets have stabilized, and the concerted international stimulus got the world economy going again. And there is a great desire to carry on as before, having survived this crisis, feted as another successful test, where we can say we survived and we are here, and we want to return to normal. Especially for those financial institutions that survived have now a stronger competitive position. So they really see no reason to interfere.

"But the way the rescue was organized, I am afraid it created a lot of political resentment. Because instead of injecting the capital into the banks at the equity level, the decision was made that this would be somewhat politically unacceptable, and instead of that, the banks were allowed to earn their way out of a hole. And in fact, they are doing it at a really remarkable rapidity. Of course, this was the Japanese approach as opposed to the Scandinavian approach of injecting capital. And the repair is making great progress, when you have a very steep huge gap, and you have access to capital at zero, and you can invest it in, let's say, 10-year government bonds at three and a half, that's a lot more than the Japanese banks were able to earn when the 10-year bonds sell at one and a half. So it's a much faster process.

"But the fact that the burden has been carried by the taxpayers, and that most of the shareholders and bankers basically came through free and clear, and that the banks' management treated this windfall profit as something that has been earned (and therefore people had to be rewarded for it with bonuses), all created a political storm. And that has actually led to the Obama administration imposing taxes and talking about the reorganization of the system as necessary.

"Now this development came too soon, because we are not out of the woods. The operation of re-establishing equilibrium consisted of two parts: One was to actually reinforce the dis-equilibrium, the excesses. If a car is skidding, first you have to turn the wheel in the same direction as the skid, and then you can establish and gain control. So the first operation actually reinforces the imbalances that were caused by the bubble, and the process has not yet been completed. Now you have to start for political reasons on the second, which is to tax banks and regulate them more closely.

"From an economic point of view, this is coming too soon because even the first part of the maneuver has not been quite completed. To tax the banks when you are doing everything to help them to earn their way out of a hole is directly against the policies that you're currently pursuing.

"Now the second part of the maneuver is perhaps going to be more difficult than the first part. The political tensions that have been created, I think, will make it even more difficult. The task ahead – and I don't think this is fully recognized – is not to restart the economy and the financial system. You actually have to create a new system because the old system has broken down.

"Globalization has been pursued very successfully on false premises: on the premise that markets don't have to be regulated. And deregulation is very contagious, because once the United States and the UK led the way, every country had to follow, otherwise capital would flee that country. And since you can't exist without capital, you had to do the deregulation that is necessary to affect the capital. So deregulation and globalization was contagious. But now that you realized that markets can't be left without regulation, you need global regulation. And that's not contagious: on the contrary, the regulatory authority still remains the state, which is led by national interests, to forge a consensus will be extremely difficult. So this is the challenge. And I'm afraid that the current confusion is making it very difficult to get there.

"And that probably gives you a general idea of where I stand, in case you didn't know it already.