Information Processing

Soros' central observation is that markets do not necessarily function properly, even when left to themselves. He is not referring to the usual causes cited for market failure, such as imperfect competition, externalities, information asymmetry, etc. Instead, he is attacking the fundamental assumption that markets are reliable processors of information, that they can be depended on to generate price signals which indicate how resources should be allocated within society.

New York Review of Books: ...This remarkable sequence of events can be understood only if we abandon the prevailing theory of market behavior. As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.

More excerpts below.

...the current crisis differs from the various financial crises that preceded it. I base that assertion on the hypothesis that the explosion of the US housing bubble acted as the detonator for a much larger "super-bubble" that has been developing since the 1980s. The underlying trend in the super-bubble has been the ever-increasing use of credit and leverage. Credit—whether extended to consumers or speculators or banks—has been growing at a much faster rate than the GDP ever since the end of World War II. But the rate of growth accelerated and took on the characteristics of a bubble when it was reinforced by a misconception that became dominant in 1980 when Ronald Reagan became president and Margaret Thatcher was prime minister in the United Kingdom.

The misconception is derived from the prevailing theory of financial markets, which, as mentioned earlier, holds that financial markets tend toward equilibrium and that deviations are random and can be attributed to external causes. This theory has been used to justify the belief that the pursuit of self-interest should be given free rein and markets should be deregulated. I call that belief market fundamentalism and claim that it employs false logic. Just because regulations and all other forms of governmental interventions have proven to be faulty, it does not follow that markets are perfect.

Although market fundamentalism is based on false premises, it has served well the interests of the owners and managers of financial capital. The globalization of financial markets allowed financial capital to move around freely and made it difficult for individual states to tax it or regulate it. Deregulation of financial transactions also served the interests of the managers of financial capital; and the freedom to innovate enhanced the profitability of financial enterprises. The financial industry grew to a point where it represented 25 percent of the stock market capitalization in the United States and an even higher percentage in some other countries.

Since market fundamentalism is built on false assumptions, its adoption in the 1980s as the guiding principle of economic policy was bound to have negative consequences. Indeed, we have experienced a series of financial crises since then, but the adverse consequences were suffered principally by the countries that lie on the periphery of the global financial system, not by those at the center. The system is under the control of the developed countries, especially the United States, which enjoys veto rights in the International Monetary Fund.

Whenever a crisis endangered the prosperity of the United States—as for example the savings and loan crisis in the late 1980s, or the collapse of the hedge fund Long Term Capital Management in 1998—the authorities intervened, finding ways for the failing institutions to merge with others and providing monetary and fiscal stimulus when the pace of economic activity was endangered. Thus the periodic crises served, in effect, as successful tests that reinforced both the underlying trend of ever-greater credit expansion and the prevailing misconception that financial markets should be left to their own devices.

It was of course the intervention of the financial authorities that made the tests successful, not the ability of financial markets to correct their own excesses. But it was convenient for investors and governments to deceive themselves. The relative safety and stability of the United States, compared to the countries at the periphery, allowed the United States to suck up the savings of the rest of the world and run a current account deficit that reached nearly 7 percent of GNP at its peak in the first quarter of 2006. Eventually even the Federal Reserve and other regulators succumbed to the market fundamentalist ideology and abdicated their responsibility to regulate. ...

Financial engineering involved the creation of increasingly sophisticated instruments, or derivatives, for leveraging credit and "managing" risk in order to increase potential profit. An alphabet soup of synthetic financial instruments was concocted: CDOs, CDO squareds, CDSs, ABXs, CMBXs, etc. This engineering reached such heights of complexity that the regulators could no longer calculate the risks and came to rely on the risk management models of the financial institutions themselves. The rating companies followed a similar path in rating synthetic financial instruments, deriving considerable additional revenues from their proliferation. The esoteric financial instruments and techniques for risk management were based on the false premise that, in the behavior of the market, deviations from the mean occur in a random fashion. But the increased use of financial engineering set in motion a process of boom and bust. ...

It should be emphasized that this interpretation of the current situation does not necessarily follow from my model of boom and bust. Had the financial authorities succeeded in containing the subprime crisis—as they thought at the time they would be able to do—this would have been seen as just another successful test instead of the reversal point.

...Sophisticated financial engineering of the kind I have mentioned can render the calculation of margin and capital requirements extremely difficult if not impossible. In order to activate such requirements, financial engineering must also be regulated and new products must be registered and approved by the appropriate authorities before they can be used. Such regulation should be a high priority of the new Obama administration. It is all the more necessary because financial engineering often aims at circumventing regulations.

Take for example credit default swaps (CDSs), instruments intended to insure against the possibility of bonds and other forms of debt going into default, and whose price captures the perceived risk of such a possibility occurring. These instruments grew like Topsy because they required much less capital than owning or shorting the underlying bonds. Eventually they grew to more than $50 trillion in nominal size, which is a many-fold multiple of the underlying bonds and five times the entire US national debt. Yet the market in credit default swaps has remained entirely unregulated. AIG, the insurance company, lost a fortune selling credit default swaps as a form of insurance and had to be bailed out, costing the Treasury $126 billion so far. Although the CDS market may be eventually saved from the meltdown that has occurred in many other markets, the sheer existence of an unregulated market of this size has been a major factor in increasing risk throughout the entire financial system.

Since the risk management models used until now ignored the uncertainties inherent in reflexivity, limits on credit and leverage will have to be set substantially lower than those that were tolerated in the recent past. This means that financial institutions in the aggregate will be less profitable than they have been during the super-bubble and some business models that depended on excessive leverage will become uneconomical. The financial industry has already dropped from 25 percent of total market capitalization to 16 percent. This ratio is unlikely to recover to anywhere near its previous high; indeed, it is likely to end lower. This may be considered a healthy adjustment, but not by those who are losing their jobs.

In view of the tremendous losses suffered by the general public, there is a real danger that excessive deregulation will be succeeded by punitive reregulation. That would be unfortunate because regulations are liable to be even more deficient than the market mechanism. As I have suggested, regulators are not only human but also bureaucratic and susceptible to lobbying and corruption. It is to be hoped that the reforms outlined here will preempt a regulatory overkill.

Bill Moyers' Journal is usually pretty boring, but of late he's been quite good. Two weeks ago he interviewed George Soros, who said the following:

GEORGE SOROS: ...this belief that everybody pursuing his self-interests will maximize the common interests or will take care of the common interests is a false idea. It's a suitable idea for those who are rich, who are successful, who are powerful. It suits them to justify you know, enjoying the fruits without paying taxes.

Yesterday he interviewed (thanks to Mark Thoma for the link) heterodox economist James Galbraith (UT Austin; son of John Kenneth Galbraith). Moyers led into the Galbraith interview by first quoting from Alan Greenspan's recent congressional testimony.

ALAN GREENSPAN: I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.

CHAIRMAN WAXMAN: In other words, you found that your view of the world, your ideology, was not right, it was not working.

ALAN GREENSPAN: Absolutely, precisely. You know, that's precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.

Now on to the heterodoxy:

BILL MOYERS: With his ideological blinders stripped away by reality, Alan Greenspan might well do penance by curling up this weekend not with THE FOUNTAINHEAD and ATLAS SHRUGGED but with James K. Galbraith's new book THE PREDATOR STATE: HOW CONSERVATIVES ABANDONED THE FREE MARKET AND WHY LIBERALS SHOULD TOO. In it, the author asks: "Why not build a new economic policy based on what is really happening?" ...

BILL MOYERS: What scares you most right now?

JAMES GALBRAITH: Well, a week ago or two weeks ago I would have said the possibility that [McCain economic advisor] Phil Gramm might become Secretary of the Treasury. ...Gramm himself was the architect, a deep architect of the speculative markets that have just collapsed. ...

BILL MOYERS: You call your book THE PREDATOR STATE, what do you mean predator?

JAMES GALBRAITH: What I mean is the people who took over the government were not interested in reducing the government and having a small government, the conservative principle. They were interested in using these great institutions for private benefit, to place them in the control of their friends and to put them to the use of their clients. They wanted to privatize Social Security. They created a Medicare drug benefit in such a way as to create the maximum profit for pharmaceutical companies.

They used trade agreements to extend patent protections for various interests or to promote the expansion of the corporate agriculture's markets in the third world. A whole range of things that were basically political and clientelistic. That's the predator state.

BILL MOYERS: You call it a corporate republic.

JAMES GALBRAITH: It is a corporate republic.

BILL MOYERS: Which means that the purpose of government is to divert funds from the public sector to the private sector?

JAMES GALBRAITH: I think it's very clear. They also turned over the regulatory apparatus to the regulated industries. They turned over the henhouse to the foxes in every single case. And that is the source of the decline in, the abandonment of environmental responsibility, the source of the collapse of consumer protection, and the source of the collapse of the financial system, all trace back to a common root, which is the failure to maintain a public sector that works in the public interest, that provides discipline and standards, a framework within which the private sector can operate and compete. That's been abandoned.

BILL MOYERS: We saw what Alan Greenspan said yesterday. But did you see what the chairman of the Securities and Exchange Commission, Christopher Cox, said? I mean, it was one of the great recantings in modern American history. Quote, "The last six months have made it abundantly clear that voluntary regulation does not work."

Now to my heterodox heterodoxy: always estimate costs and benefits when making a decision. A little calculation is in order: suppose unfettered markets lead to systemic crises every 20 years that cost 15% of GDP to clean up. I think that's an upper bound: a $2 trillion (current dollars) crisis every 20 years.

Easy Question: What growth rate advantage (additional GDP growth rate per annum) would savage, unfettered markets need to generate to justify these occasional disasters?

Answer: an additional 0.1 percent annual GDP growth would be more than enough. That is, an unregulated economy whose growth rate was 0.1 percent higher would, even after paying for each 20 year crisis, be richer than the heavily regulated comparator which avoided the crises but had a lower growth rate.

Hard Question: would additional regulation decrease economic growth rates by that amount or more?

Unless you think you can evaluate the relative GDP growth effects of two different policy regimes with accuracy of better than 0.1 percent, then the intellectually honest answer to the policy question is: I don't know. No shouting, no shaking your fist, no lecturing other people, no writing op eds, just I don't know. Correct the things that are obviously stupid, but don't overstate your confidence level about additional policy changes.

(Note I'm aware that distributional issues are also important. In the most recent era gains went mostly to a small number of top earners whereas the cost of the bailout will be spread over the whole tax base.)

The bottom line from George Soros, from this interview with Bill Moyers (via Barry Ritholtz). Read the whole transcript, or watch the interview -- there's much more about the credit crisis, modern finance, etc.

GEORGE SOROS: ...this belief that everybody pursuing his self-interests will maximize the common interests or will take care of the common interests is a false idea. It's a suitable idea for those who are rich, who are successful, who are powerful. It suits them to justify you know, enjoying the fruits without paying taxes.

It would be much easier for Soros to wax eloquent about how greed is good, greed works, markets are efficient optimizers, etc. He is, after all, a huge winner in the capitalist system. But he's seen too much to buy everything that Ayn Rand and market fundamentalists are selling.

Longer NYBooks article on Soros by John Cassidy, who covers business and finance for the New Yorker.

In 2007, after the subprime crisis erupted, he returned, at the age of seventy-seven, to directing Quantum's investments, with results suggesting he hadn't lost his touch. Alpha magazine, a glossy publication that covers hedge funds, estimates that he made $2.9 billion in 2007, placing him second on its list of mega-speculators, behind only John Paulson, of Paulson & Co., who raked in an even more astonishing $3.7 billion.

Earlier post on investor John Paulson, who made $15B for his fund betting against the credit bubble.

The Financial Crisis: An Interview with George Soros with Judy Woodruff on Bloomberg TV.

According to his estimates (see below), housing starts would have to go to zero (he gives a normal value of 600k per annum, but I think the correct number is about twice that) for several years to compensate for the inventory that will flood the market due to foreclosures. So, no recovery in the near future, and continued pressure on the dollar. He also has some nice things to say about academic economics :-)

Judy Woodruff: You write in your new book, The New Paradigm for Financial Markets,[1] that "we are in the midst of a financial crisis the likes of which we haven't seen since the Great Depression." Was this crisis avoidable?

George Soros: I think it was, but it would have required recognition that the system, as it currently operates, is built on false premises. Unfortunately, we have an idea of market fundamentalism, which is now the dominant ideology, holding that markets are self-correcting; and this is false because it's generally the intervention of the authorities that saves the markets when they get into trouble. Since 1980, we have had about five or six crises: the international banking crisis in 1982, the bankruptcy of Continental Illinois in 1984, and the failure of Long-Term Capital Management in 1998, to name only three.

Each time, it's the authorities that bail out the market, or organize companies to do so. So the regulators have precedents they should be aware of. But somehow this idea that markets tend to equilibrium and that deviations are random has gained acceptance and all of these fancy instruments for investment have been built on them.

There are now, for example, complex forms of investment such as credit-default swaps that make it possible for investors to bet on the possibility that companies will default on repaying loans. Such bets on credit defaults now make up a $45 trillion market that is entirely unregulated. It amounts to more than five times the total of the US government bond market. The large potential risks of such investments are not being acknowledged.

Woodruff: How can so many smart people not realize this?

Soros: In my new book I put forward a general theory of reflexivity, emphasizing how important misconceptions are in shaping history. So it's not really unusual; it's just that we don't recognize the misconceptions.

Woodruff: Who could have? You said it would have been avoidable if people had understood what's wrong with the current system. Who should have recognized that?

Soros: The authorities, the regulators—the Federal Reserve and the Treasury—really failed to see what was happening. One Fed governor, Edward Gramlich, warned of a coming crisis in subprime mortgages in a speech published in 2004 and a book published in 2007, among other statements. So a number of people could see it coming. And somehow, the authorities didn't want to see it coming. So it came as a surprise.

Woodruff: The chairman of the Fed, Mr. Bernanke? His predecessor, Mr. Greenspan?

Soros: All of the above. But I don't hold them personally responsible because you have a whole establishment involved. The economics profession has developed theories of "random walks" and "rational expectations" that are supposed to account for market movements. That's what you learn in college. Now, when you come into the market, you tend to forget it because you realize that that's not how the markets work. But nevertheless, it's in some way the basis of your thinking.

Woodruff: How much worse do you anticipate things will get?

Soros: Well, you see, as my theory argues, you can't make any unconditional predictions because it very much depends on how the authorities are going to respond now to the situation. But the situation is definitely much worse than is currently recognized. You have had a general disruption of the financial markets, much more pervasive than any we have had so far. And on top of it, you have the housing crisis, which is likely to get a lot worse than currently anticipated because markets do overshoot. They overshot on the upside and now they are going to overshoot on the downside.

Woodruff: You say the housing crisis is going to get much worse. Do you anticipate something like the government setting up an agency or a trust corporation to buy these mortgages?

Soros: I'm sure that it will be necessary to arrest the decline because the decline, I think, will be much faster and much deeper than currently anticipated. In February, the rate of decline in housing prices was 25 percent per annum, so it's accelerating. Now, foreclosures are going to add to the supply of housing a very large number of properties because the annual rate of new houses built is about 600,000. There are about six million subprime mortgages outstanding, 40 percent of which will likely go into default in the next two years. And then you have the adjustable-rate mortgages and other flexible loans.

Problems with such adjustable-rate mortgages are going to be of about the same magnitude as with subprime mortgages. So you'll have maybe five million more defaults facing you over the next several years. Now, it takes time before a foreclosure actually is completed. So right now you have perhaps no more than 10,000 to 20,000 houses coming into the supply on the market. But that's going to build up. So the idea that somehow in the second half of this year the economy is going to improve I find totally unbelievable.

...

Woodruff: When you talk about currency you have more than a little expertise. You were described as the man who broke the Bank of England back in the 1990s. But what is your sense of where the dollar is going? We've seen it declining. Do you think the central banks are going to have to step in?

Soros: Well, we are close to a tipping point where, in my view, the willingness of banks and countries to hold dollars is definitely impaired. But there is no suitable alternative so central banks are diversifying into other currencies; but there is a general flight from these currencies. So the countries with big surpluses—Abu Dhabi, China, Norway, and Saudi Arabia, for example—have all set up sovereign wealth funds, state-owned investment funds held by central banks that aim to diversify their assets from monetary assets to real assets. That's one of the major developments currently and those sovereign wealth funds are growing. They're already equal in size to all of the hedge funds in the world combined. Of course, they don't use their capital as intensively as hedge funds, but they are going to grow to about five times the size of hedge funds in the next twenty years.