| The New Paradigm for Financial Markets, by George Soros |
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| General Book Reviews | |
| By Carol White | |
| Saturday, 28 June 2008 10:37 | |
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In his testimony before the Senate Commerce Committee, George Soros warned about the danger of a new speculative bubble in oil and gasoline, one that is driving up prices and threatening to push the U.S. economy into severe recession. He contended that this latest bubble is an outgrowth of a prolonged “super-bubble” that has been propelling the U.S. economy forward for the past 25 years. As the chairman of Soros Fund Management and someone who accumulated a fortune on the markets by placing winning bets that the British pound would collapse in 1992 and that the Thai currency would do the same in 1997, Soros is worth listening to when he warns of allowing U.S. financial markets tofunction without effective regulation. Soros’ new book, The New Paradigm for Financial Marekts: The Credit Crisis of 2008 and What It Means is of value to everyone who is struggling to make sense of the present economic debacle, and a must read for progressive policy-makers. Although Soros has written a number of books on the fallacies of the bubble economy, (The Bubble of American Supremacy, Underwriting Democracy and The Age of Fallibility, in his latest, he reports three considerations compelled him to write the current book: First, a new paradigm was urgently needed for a better understanding of what is going on. Second, engaging in a serious study could help me in my investment decisions. Third, by providing a timely insight in the financial markets, I would ensure that the theory of reflexivity would finally receive serious consideration. In the book, he makes a persuasive case of the need for a decisive change in the trend toward increasing autonomy of financial power that has become the economic direction of this country since Ronald Reagan was president. Soros begins with a philosophical theory that he has worked on for over fifty years. He writes: My starting point is that our understanding of the world in which we live is inherently imperfect because we are part of the world we seek to understand. There may be other factors that interfere with our ability to acquire knowledge of the natural world, but the fact that we are part of the world poses a formidable obstacle to the understanding of human affairs. This “obstacle” he calls the theory of reflexivity. (He also argues that there is a difference in kind between knowledge provided by natural science and that by the social sciences. The proof structures of the former are not available for the latter. An individual’s activities can always be different by choice.) Soros contends that a new paradigm is needed in order to understand the current global crisis, one that recognizes the deeper implications than just those of the immediate situation. He challenges the prevailing paradigm, insisting instead that the belief in financial markets tending toward equilibrium is both “false and misleading.” Equilibrium theory has been used to justify deregulation (which has arguably disastrous results, see response to Hurricane Katrina), as well as ignores the reflexive relationship between thinking and reality. He denies the assumption that the intentions of individual players counterbalance each other --, the fundamental belief underpinning laissez faire economic theory which assumesthe market is regulated by objective forces and works most efficiently when given free rein.While the antecedents of laissez faire theory go back to Adam Smith, the modern version is what Ronald Reagan liked to call the “magic of the market place.” The super bubble was based upon the theory of “market fundamentalism” that was popularized by Margaret Thatcher and Reagan which preached that “state intervention is always flawed.” According to the theory the fundamentals of the market are the objective relations between supply and demand and regulation is not only not necessary but detrimental. But deregulating financial markets had just the opposite effect. Rather than the markets oscillating around an equilibrium point an upward trend was built into the system through speculation. Soros uses the example of the housing market to show how the housing market and the super bubble were connected. The housing bubble was supported by the introduction of new financial instruments. While traditionally when granting a mortgage the lending had to consider the risk of the borrower not being able to repay, now he could quickly resell the loan which would be pooled with other mortgages and reissued as a mortgaged-backed security which could be traded on the open market. Its value was based upon the buyer’s expectation that the security would increase in value. Similarly households became increasingly dependant on the double-digit appreciation in house prices and their ability to cash out on their home equity. “The savings rate dropped below zero and households withdrew equity by refinancing their mortgages at an ever increasing rate.” While the outcome of the current financial crisis can be dated to the unraveling of the home mortgage market, Soros sees it as just the latest in a series of bubbles since the internet bubble burst in 2000—before 9/11/2001. In 2000, the Fed cut federal funds rates from 6.5 % to 3.5% in the space of a few months. By 2003, the rates were down to 1%. These low rates created the ready availability of cheap money which was a major factor -- along with the proliferation of new financial instruments that encouraged the extension of credit to dubious borrowers because of lower risk to the lender -- in the housing boom. Soros calls this proliferation a mania of “securitization” which exploded in 2005. During his tenure as chairman of the Federal Reserve, Alan Greenspan, who is a market fundamentalist, encouraged policy that caused a succession of bubbles, but Soros traces the severity of the present crisis, which he describes as “a financial crisis the likes of which has not been seen since the Great Depression of the 1930s,” to the emergence of something he dubs a “super bubble” that started during the Reagan administration. The trend toward deregulation which started in the 1980s created the conditions for the super bubble that is the root case of our economic problems today: Financial markets do not necessarily tend toward equilibrium; left to their own devices they are liable to go to extremes of euphoria and despair. For that reason they are not left to their own devices; they have been put in the charge of financial authorities whose job it is to supervise them and regulate them. Soros’ theory of reflexivity -- based upon the interplay between human cognition and human action -- relates directly to market economics. Those who participate in financial markets simultaneously try to understand the market and interact with it to their own profit. These two functions, cognition and manipulation, interfere with each other. In other words, the intentions and expectations of market players as based on their understanding and interpretation of what’s occurring the markets introduce “an element of contingency or uncertainty” into the market behavior itself. Because of this uncertainty, markets are not necessarily self-correcting nor do they necessarily tend to balance supply and demand. Despite his rejection of Thatcher and Reagan era market fundamentals, when it comes to policy recommendations Soros takes a cautious stance. As he explains at the beginning of the book, he himself is a market player and therefore any advice that he offers is tainted by his own potential interest. That said, he rejects a return to the strict regulatory climate that prevailed after WW II because credit creation should not be straitjacketed, “Credit availability fosters not only productivity but also flexibility and innovation.” And he also faults today’s regulators for not doing enough, even though they have less control over markets now since they have become increasingly deregulated. In his view, regulators have not tried to control the introduction of derivatives and other new financial instruments and methods into the markets. One reason for the hands-off approach is that financial transactions have become increasingly complex. Another reason is the unwillingness of the financial institutions involved to provide clear information, and their subterfuge in hiding their extended operations. Soros agrees with Fed intervention to bail out potentially bankrupt institutions because of the danger of a disastrous global blow-out, but he also believes that the scope accorded such institutions should be restricted. They must be brought under control: Regulators ought to be held accountable if they allow matters to get out of hand so that an institution has to be rescued. Soros does not claim to have answers to the problems that beset us, but he does provide invaluable tools to help us understand them. In his opinion, because of the impossibility of applying the scientific method to social affairs due to the indeterminacy introduced by reflexivity, there is always room for manipulation. Nonetheless, despite the impossibility of applying scientific rigor and standards of proof to social affairs, he believes that there can and must be a standard of truthfulness in economic and political relations, a standard which prevents financiers or politicians from hijacking our economy and the U.S. government. But sustaining a standard of truthfulness requires that there be an educated population. Because “reality” can be manipulated, it is much more difficult to make a commitment to the pursuit of truth. The primary purpose of political discourse is to gain power and to stay in power. Those who fail to recognize this are unlikely to be in power. The only way in which politicians can be persuaded to pay more respect to reality is by the electorate insisting on it, rewarding those whom it considers truthful and insightful, and punishing those who engage in deliberate deception. In other words, the electorate needs to be more committed to the pursuit of truth than it is at present. Soros’ latest book brings us, the populace, a step forward in that educational process.
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The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means by George Soros
