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Reports
of losses that range between a few hundred million to
a few billion dollars due to the ripple effects of the
mortgage crisis in the US and elsewhere have now become
routine and passé. The almost stoic acceptance
of such losses being reported by the world’s leading
banks and financial firms makes it appear that they
only skim the fat off the huge profits these entities
were making, without damaging their 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.
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