Themes > Current Issues

29.04.2008

C.P. Chandrasekhar

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.