Three days ago we brought attention to Soros' most recent outburst of negativity in a speech presented during a conference in Vienna, in which he said that "The collapse of the financial system as we know it is real, and the crisis is far from over. Indeed, we have just entered Act II of the drama." Below is the full text of Soros' speech.
In the week following the bankruptcy of Lehman Brothers on September
15, 2008 – global financial markets actually broke down and by the end
of the week they had to be put on artificial life support. The life
support consisted of substituting sovereign credit for the credit of
financial institutions which ceased to be acceptable to counter parties.
As Mervyn King of the Bank of England brilliantly explained, the
authorities had to do in the short-term the exact opposite of what was
needed in the long-term: they had to pump in a lot of credit to make up
for the credit that disappeared and thereby reinforce the excess credit
and leverage that had caused the crisis in the first place. Only in the
longer term, when the crisis had subsided, could they drain the credit
and reestablish macro-economic balance. This required a delicate two
phase maneuver just as when a car is skidding, first you have to turn
the car into the direction of the skid and only when you have regained
control can you correct course.
The first phase of the maneuver has been successfully accomplished –
a collapse has been averted. In retrospect, the temporary breakdown of
the financial system seems like a bad dream. There are people in the
financial institutions that survived who would like nothing better than
to forget it and carry on with business as usual. This was evident in
their massive lobbying effort to protect their interests in the
Financial Reform Act that just came out of Congress. But the collapse
of the financial system as we know it is real and the crisis is far
Indeed, we have just entered Act II of the drama, when financial
markets started losing confidence in the credibility of sovereign debt.
Greece and the euro have taken center stage but the effects are liable
to be felt worldwide. Doubts about sovereign credit are forcing
reductions in budget deficits at a time when the banks and the economy
may not be strong enough to permit the pursuit of fiscal rectitude. We
find ourselves in a situation eerily reminiscent of the 1930’s. Keynes
has taught us that budget deficits are essential for counter cyclical
policies yet many governments have to reduce them under pressure from
financial markets. This is liable to push the global economy into a
It is important to realize that the crisis in which we find
ourselves is not just a market failure but also a regulatory failure
and even more importantly a failure of the prevailing dogma about
financial markets. I have in mind the Efficient Market Hypothesis and
Rational Expectation Theory. These economic theories guided, or more
exactly misguided, both the regulators and the financial engineers who
designed the derivatives and other synthetic financial instruments and
quantitative risk management systems which have played such an
important part in the collapse. To gain a proper understanding of the
current situation and how we got to where we are, we need to go back to
basics and reexamine the foundation of economic theory.
I have developed an alternative theory about financial markets which
asserts that financial markets do not necessarily tend towards
equilibrium; they can just as easily produce asset bubbles. Nor are
markets capable of correcting their own excesses. Keeping asset bubbles
within bounds have to be an objective of public policy. I propounded
this theory in my first book, The Alchemy of Finance, in 1987. It was
generally dismissed at the time but the current financial crisis has
proven, not necessarily its validity, but certainly its superiority to
the prevailing dogma.
Let me briefly recapitulate my theory for those who are not familiar
with it. It can be summed up in two propositions. First, financial
markets, far from accurately reflecting all the available knowledge,
always provide a distorted view of reality. This is the principle of
fallibility. The degree of distortion may vary from time to time.
Sometimes it’s quite insignificant, at other times it is quite
pronounced. When there is a significant divergence between market
prices and the underlying reality I speak of far from equilibrium
conditions. That is where we are now.
Second, financial markets do not play a purely passive role; they can also affect
the so called fundamentals they are supposed to reflect. These two
functions that financial markets perform work in opposite directions.
In the passive or cognitive function the fundamentals are supposed to
determine market prices. In the active or manipulative function market
prices find ways of influencing the fundamentals. When both functions
operate at the same time they interfere with each other. The supposedly
independent variable of one function is the dependent variable of the
other so that neither function has a truly independent variable. As a
result neither market prices nor the underlying reality is fully
determined. Both suffer from an element of uncertainty that cannot be
quantified. I call the interaction between the two functions
reflexivity. Frank Knight recognized and explicated this element of
unquantifiable uncertainty in a book published in 1921 but the
Efficient Market Hypothesis and Rational Expectation Theory have
deliberately ignored it. That is what made them so misleading.
Reflexivity sets up a feedback loop between market valuations and
the so-called fundamentals which are being valued. The feedback can be
either positive or negative. Negative feedback brings market prices and
the underlying reality closer together. In other words, negative
feedback is self-correcting. It can go on forever and if the underlying
reality remains unchanged it may eventually lead to an equilibrium in
which market prices accurately reflect the fundamentals. By contrast, a
positive feedback is self-reinforcing. It cannot go on forever because
eventually market prices would become so far removed from reality that
market participants would have to recognize them as unrealistic. When
that tipping point is reached, the process becomes self-reinforcing in
the opposite direction. That is how financial markets produce boom-bust
phenomena or bubbles. Bubbles are not the only manifestations of
reflexivity but they are the most spectacular.
In my interpretation equilibrium, which is the central case in economic theory, turns out to be a limiting
case where negative feedback is carried to its ultimate limit. Positive
feedback has been largely assumed away by the prevailing dogma and it
deserves a lot more attention.
I have developed a rudimentary theory of bubbles along these lines.
Every bubble has two components: an underlying trend that prevails in
reality and a misconception relating to that trend. When a positive
feedback develops between the trend and the misconception a boom-bust
process is set in motion. The process is liable to be tested by
negative feedback along the way and if it is strong enough to survive
these tests, both the trend and the misconception will be reinforced.
Eventually, market expectations become so far removed from reality that
people are forced to recognize that a misconception is involved. A
twilight period ensues during which doubts grow and more and more
people lose faith but the prevailing trend is sustained by inertia. As
Chuck Prince former head of Citigroup said, “As long as the music is
playing you’ve got to get up and dance. We are still dancing.”
Eventually a tipping point is reached when the trend is reversed; it
then becomes self-reinforcing in the opposite direction.
Typically bubbles have an asymmetric shape. The boom is long and
slow to start. It accelerates gradually until it flattens out again
during the twilight period. The bust is short and steep because it
involves the forced liquidation of unsound positions. Disillusionment
turns into panic, reaching its climax in a financial crisis.
The simplest case of a purely financial bubble can be found in real
estate. The trend that precipitates it is the availability of credit;
the misconception that continues to recur in various forms is that the
value of the collateral is independent of the availability of credit.
As a matter of fact, the relationship is reflexive. When credit becomes
cheaper activity picks up and real estate values rise. There are fewer
defaults, credit performance improves, and lending standards are
relaxed. So at the height of the boom, the amount of credit outstanding
is at its peak and a reversal precipitates false liquidation,
depressing real estate values.
The bubble that led to the current financial crisis is much more
complicated. The collapse of the sub-prime bubble in 2007 set off a
chain reaction, much as an ordinary bomb sets off a nuclear explosion.
I call it a super-bubble. It has developed over a longer period of time
and it is composed of a number of simpler bubbles. What makes the
super-bubble so interesting is the role that the smaller bubbles have
played in its development.
The prevailing trend in the super-bubble was the ever increasing use
of credit and leverage. The prevailing misconception was the believe
that financial markets are self-correcting and should be left to their
own devices. President Reagan called it the “magic of the marketplace”
and I call it market fundamentalism. It became the dominant creed in
the 1980s. Since market fundamentalism was based on false premises its
adoption led to a series of financial crises. Each time, the
authorities intervened, merged away, or otherwise took care of the
failing financial institutions, and applied monetary and fiscal stimuli
to protect the economy. These measures reinforced the prevailing trend
of ever increasing credit and leverage and as long as they worked they
also reinforced the prevailing misconception that markets can be safely
left to their own devices. The intervention of the authorities is
generally recognized as creating amoral hazard; more accurately it
served as a successful test of a false belief, thereby inflating the
super-bubble even further.
It should be emphasized that my theories of bubbles cannot predict
whether a test will be successful or not. This holds for ordinary
bubbles as well as the super-bubble. For instance I thought the
emerging market crisis of 1997-1998 would constitute the tipping point
for the super-bubble, but I was wrong. The authorities managed to save
the system and the super-bubble continued growing. That made the bust
that eventually came in 2007-2008 all the more devastating.
What are the implications of my theory for the regulation of the financial system?
First and foremost, since markets are bubble-prone, the financial
authorities have to accept responsibility for preventing bubbles from
growing too big. Alan Greenspan and other regulators have expressly
refused to accept that responsibility. If markets can’t recognize
bubbles, Greenspan argued, neither can regulators—and he was right.
Nevertheless, the financial authorities have to accept the assignment,
knowing full well that they will not be able to meet it without making
mistakes. They will, however, have the benefit of receiving feedback
from the markets, which will tell them whether they have done too much
or too little. They can then correct their mistakes.
Second, in order to control asset bubbles it is not enough to
control the money supply; you must also control the availability of
credit. This cannot be done by using only monetary tools; you must also
use credit controls. The best-known tools are margin requirements and
minimum capital requirements. Currently they are fixed irrespective of
the market’s mood, because markets are not supposed to have moods. Yet
they do, and the financial authorities need to vary margin and minimum
capital requirements in order to control asset bubbles.
Regulators may also have to invent new tools or revive others that
have fallen into disuse. For instance, in my early days in finance,
many years ago, central banks used to instruct commercial banks to
limit their lending to a particular sector of the economy, such as real
estate or consumer loans, because they felt that the sector was
overheating. Market fundamentalists consider that kind of intervention
unacceptable but they are wrong. When our central banks used to do it
we had no financial crises to speak of. The Chinese authorities do it
today, and they have much better control over their banking system. The
deposits that Chinese commercial banks have to maintain at the People’s
Bank of China were increased seventeen times during the boom, and when
the authorities reversed course the banks obeyed them with alacrity.
Third, since markets are potentially unstable, there are systemic
risks in addition to the risks affecting individual market
participants. Participants may ignore these systemic risks in the
belief that they can always dispose of their positions, but regulators
cannot ignore them because if too many participants are on the same
side, positions cannot be liquidated without causing a discontinuity or
a collapse. They have to monitor the positions of participants in order
to detect potential imbalances. That means that the positions of all
major market participants, including hedge funds and sovereign wealth
funds, need to be monitored. The drafters of the Basel Accords made a
mistake when they gave securities held by banks substantially lower
risk ratings than regular loans: they ignored the systemic risks
attached to concentrated positions in securities. This was an important
factor aggravating the crisis. It has to be corrected by raising the
risk ratings of securities held by banks. That will probably discourage
loans, which is not such a bad thing.
Fourth, derivatives and synthetic financial instruments perform many
useful functions but they also carry hidden dangers. For instance, the
securitization of mortgages was supposed to reduce risk thru
geographical diversification. In fact it introduced a new risk by
separating the interest of the agents from the interest of the owners.
Regulators need to fully understand how these instruments work before
they allow them to be used and they ought to impose restrictions guard
against those hidden dangers. For instance, agents packaging mortgages
into securities ought to be obliged to retain sufficient ownership to
guard against the agency problem.
Credit default swaps (CDS) are particularly dangerous they allow
people to buy insurance on the survival of a company or a country while
handing them a license to kill. CDS ought to be available to buyers
only to the extent that they have a legitimate insurable interest.
Generally speaking, derivatives ought to be registered with a
regulatory agency just as regular securities have to be registered with
the SEC or its equivalent. Derivatives traded on exchanges would be
registered as a class; those traded over-the-counter would have to be
registered individually. This would provide a powerful inducement to
use exchange traded derivatives whenever possible.
Finally, we must recognize that financial markets evolve in a
one-directional, nonreversible manner. The financial authorities, in
carrying out their duty of preventing the system from collapsing, have
extended an implicit guarantee to all institutions that are “too big to
fail.” Now they cannot credibly withdraw that guarantee. Therefore,
they must impose regulations that will ensure that the guarantee will
not be invoked. Too-big-to-fail banks must use less leverage and accept
various restrictions on how they invest the depositors’ money. Deposits
should not be used to finance proprietary trading. But regulators have
to go even further. They must regulate the compensation packages of
proprietary traders to ensure that risks and rewards are properly
aligned. This may push proprietary traders out of banks into hedge
funds where they properly belong. Just as oil tankers are
compartmentalized in order to keep them stable, there ought to be
firewalls between different markets. It is probably impractical to
separate investment banking from commercial banking as the
Glass-Steagall Act of 1933 did. But there have to be internal
compartments keeping proprietary trading in various markets separate
from each other. Some banks that have come to occupy quasi-monopolistic
positions may have to be broken up.
While I have a high degree of conviction on these five points, there
are many questions to which my theory does not provide an unequivocal
answer. For instance, is a high degree of liquidity always desirable?
To what extent should securities be marked to market? Many answers
that followed automatically from the Efficient Market Hypothesis need
to be reexamined.
It is clear that the reforms currently under consideration do not
fully satisfy the five points I have made but I want to emphasize that
these five points apply only in the long run. As Mervyn King explained
the authorities had to do in the short run the exact opposite of what
was required in the long run. And as I said earlier the financial
crisis is far from over. We have just ended Act Two. The euro has taken
center stage and Germany has become the lead actor. The European
authorities face a daunting task: they must help the countries that
have fallen far behind the Maastricht criteria to regain their
equilibrium while they must also correct the deficinies of the
Maastricht Treaty which have allowed the imbalances to develop. The
euro is in what I call a far-from-equilibrium situation. But I prefer
to discuss this subject in Germany, which is the lead actor, and I plan
to do so at the Humboldt University in Berlin on June 23rd. I hope you will forgive me if I avoid the subject until then.