| viability.
The threat of a recession remains, but there
appears to be no fear of a financial implosion
that could spell a systemic crisis. What is
more, international finance seems to have regained
the confidence to start opposing any effort
at more stringent regulation of an industry
that had clearly run amok.
In the midst of this pretence of calm bordering
on nonchalance, there are a few voices of dissent.
Some are from the outside, and are likely to
be dismissed as the rant of scaremongers. But
there are many voices from the inside which
are calling for more attention to the nature
of this crisis and for a more disinterested
view of the need for state intervention. An
influential voice among them is that of George
Soros, chairman of the highly successful Soros
Fund Management and the guru of investors and
fund managers. Even in the worst of times, where
Soros goes, much of the herd follows.
In recent speeches, interviews and his just
released book The New Paradigm for Financial
Markets: The Credit Crash of 2008 and What it
Means (Public Affairs, New York), Soros has
challenged the prevailing sanguine view on the
intensity and implications of the crisis. As
he puts it, this "is not business as usual,
but the end of an era", because: "We
are in the midst of a financial crisis the likes
of which has not been seen since the Great Depression
of the 1930s."
This is no alarmist shriek or attempt at sensationalising
the issue. It is based on evidence that does
suggest that things are different this time.
At one level, the ongoing crisis which broke
in August last year is typical of the boom-bust
cycles to which markets, especially financially
markets are prone. But, Soros argues, things
are different and the implications grave because
it is not one but two crises that capitalism
is experiencing now. One is the housing crisis,
which has been much analysed. Soros' analysis
is along expected lines. The housing boom was
triggered by easy money and low interest rates.
As he notes, for more than two and a half years
the base inflation-adjusted short term interest
rate was negative. "When money is cheap,
the rational lender will keep on lending till
there is no one else to lend to." Standards
are relaxed and sub-prime borrowers entertained
because the Wall Street banks who bought into
these mortgages had found ways to transfer the
credit risk to investors like pension funds
and mutual funds. This process increased house
prices, encouraging further housing investments
because, "when the value of property is
going to rise more than the cost of borrowing,
it makes sense to own more property." It
also increased home equity, encouraging home
owners to borrow against property to spend elsewhere.
Between 1996 and 2007 consumers reportedly drew
$9 trillion in cash out of their home equity.
So the economy's performance was linked to the
housing boom. When the bust occurred it would
have effects elsewhere.
The bust did come because of a feature of the
boom that Soros draws attention to and provides
as one of many illustrations of his theory of
"reflexivity", which, simply put,
takes account of the facts that business decisions
are never based on complete knowledge and that
these decisions themselves affect the environment
which has been taken into account in making
them. The housing bubble resulted from the "reflexive"
connection between the value of the collateral
on the basis of which lending decisions were
made and the lending decisions themselves. It
is not just because collateral of a certain
value is available (in this case in the form
of the housing assets against which credit is
provided) that loans are on offer, but the willingness
to lend also influences the value of the collateral.
This connection which is ignored or not cognised
by most analysts triggered and sustained the
boom till it reached its cross-over point and
went bust. In this sense, the recent housing
boom and bust was similar to other boom-bust
cycles in financial markets in the past.
But, the recent cycle is also different from
those from the past, even if not completely
unique. This difference arises from a second
crisis that has occurred simultaneously, which
he calls the longer-term super bubble. This
super bubble too comes from the "reflexive
interaction between a prevailing trend and a
prevailing misconception". The trend underlying
the super bubble is the same, credit creation,
even if of more sophisticated types that lead
to instruments like collateralised debt obligations
(CDOs) and Credit Default Swaps (CDSs) and to
institutions like the Special Investment Vehicles
(SIVs) created by banks. This trend gains momentum
and goes the distance it does because of the
basic misconception that underlies the super
bubble, that markets are perfect and should
be left to themselves. Market fundamentalism
which can be dated to the 1980s, argues Soros,
is what generates the super bubble.
Soros' views sound like excerpts from a heterodox
tract. Consider this: "The super-bubble
combines three major trends, each containing
at least one defect. First is the long-term
trend towards ever increasing credit expansion
as indicated by rising loan-to-value ratios
in housing and consumer loans, and rising volume
of credit to gross national product ratios.
This trend is the result of the countercyclical
policies developed in response to the Great
Depression. Every time the banking system is
endangered, or a recession looms, the financial
authorities intervene, bailing out the endangered
institutions and stimulating the economy. Their
intervention introduces an asymmetric incentive
for credit expansion also known as the moral
hazard. The second trend is the globalisation
of financial markets, and the third is the progressive
removal of financial regulations and the accelerating
pace of financial innovations."
Globalisation matters because it has an asymmetric
structure. "It favours the United States
and the other developed countries at the centre
of the financial system and penalizes the less-developed
economies at the periphery." The resulting
unequal relationship between the centre and
the periphery allows for the flow of capital
from the less developed to the developed, which
supported the credit financed investment and
consumption boom in the centre and played an
important role in the development of the super-bubble.
Soros' super-bubble is somewhat akin to the
boom in a long-wave that is superimposed on
shorter boom-bust cycles. In fact, the phase
of bust in these shorter cycles triggers government
responses that serve to reinforce the super-bubble.
But at some point even the long wave must, because
of its inner contradictions, its own reflexivities,
find its downturn. This it has in the course
of the current short boom-bust cycle. That is,
the current housing bust is different because
the subprime crisis is "the trigger that
has released the unwinding super-bubble".
This of course is a contention. But there are
in his view many bits of evidence that support
this conjecture. The most important of these
is that the crisis this time is not restricted
to particular segments of the financial system
but is systemic. Moreover, the ability of the
central banks to adopt successful countercyclical
measures is constrained by three factors. First,
the fact that financial innovation run amok
has created instruments that are difficult to
salvage. Second, growing evidence that the world
is reticent to hold the dollar and pump liquidity
into the US. Third, the fact that the capital
base of the banks is impaired so that they are
forced to themselves absorb the liquidity pumped
in by the central banks to reduce their own
exposure to doubtful assets.
Where do we go from here? Soros makes clear
whom he is not with: the market fundamentalists.
State intervention was inevitable in the past
and is unavoidable today. To shy away from that
is to ignore the factors that generated the
crisis in the first place. Having said that,
Soros is quick to hold himself back, influenced
by his notion of reflexivity. To quote: "Most
of the reflexive processes involve an interplay
between market participants and regulators.
To understand that interplay it is important
to remember that regulators are just as fallible
as the participants.Market fundamentalists blame
marker failures on the fallibility of regulators,
and they are half right: Both markets and regulators
are fallible. Where market fundamentalists are
totally wrong is claiming that regulations have
to be abolished on account of their fallibility.
That happens to be the inverse of the Communist
claim that markets have to be abolished on account
of their fallibility."
So Soros' policy recommendations are a case
for intervention in moderation. Thus he sees
the need for regulation, and the need for the
authorities to exercise vigilance and control
during the expansionary phase that "will
undoubtedly limit profitability". He is
even specific on certain counts, as when he
suggests that "Monetary authorities have
to be concerned not only with wage inflation
but avoiding asset bubbles". He is also
critical of regulators such as Alan Greenspan,
whom he sees as too much of a market fundamentalist.
There are many proposals for dealing with foreclosure
using state assistance that he supports. But
these are just partial measures of intervention
which leaves the overall framework of regulation
inadequately defined. As he put it in a recent
interview to the New York Review of Books (15
May 2008): "Because of the failures of
socialism, communism, we have come to believe
in market fundamentalism, that markets are perfect;
everything will be taken care of by markets.
And markets are not perfect. And this time we
have to recognize that, because we are facing
a very serious economic disruption. Now, we
should not go back to a very highly regulated
economy because the regulators are imperfect.
They're only human and what is worse, they are
bureaucratic. So you have to find the right
kind of balance between allowing the markets
to do their work, while recognizing that they
are imperfect. You need authorities that keep
the market under scrutiny and some degree of
control."
In today's world moderation of this kind may
be welcomed. The problem is that it leaves the
direction of movement ill-defined. It does not
make clear where the line dividing the province
of markets and that of the state should be drawn.
Leaving that poorly defined is perhaps also
leaving the disease that has been well diagnosed
untreated.
April 29, 2008.
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