My Interview with George Soros: End of Financial Crisis Could Be in Sight

George Soros, the financier and philanthropist, is author most recently of The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means. He spoke with me in Washington, D.C., where the IMF and World Bank are meeting, on Sunday.

Nathan Gardels: Let's talk first about the nature of the crisis. Thanks to low interest rates, global liquidity and deregulation, we have had a 25-year, self-reinforcing credit expansion bubble, leading to "irrational exuberance," as it was once said, in financial markets. Now we have the self-reinforcing crash of the stock and credit markets --"irrational despair" -- not justified by the economic fundamentals in the real economy.

How does this pattern fit your theory of reflexivity and your new paradigm for understanding finance?

George Soros: The key to understanding this crisis -- the worst since the 1930s -- is to see that it was generated within the financial system itself. What we are witnessing is not the result of some exogenous shock that knocked things off balance, as the prevailing paradigm, which believes markets are self-correcting, would suggest. The reality is that financial markets are self-destabilizing; occasionally they tend toward disequilibrium, not equilibrium.

The paradigm I'm proposing differs from the conventional wisdom in two respects. First, financial markets don't reflect the actual economic fundamentals. Expectations by traders and investors are always distorting them. Second, these distortions in the financial markets can affect the fundamentals -- as we see in both bubbles and crashes. Euphoria can lift housing and dot.com prices; panic can send sound banks tumbling.

That two-way connection -- that you affect what you reflect -- is what I call "reflexivity." That is how financial markets really work. Their instability is now spreading to the real economy, not the other way around. In short, the boom-bust sequences, the bubbles, are endemic to the financial system.

The current situation is not just about the housing bubble. The housing bubble was merely the trigger that detonated a much larger bubble. That super-bubble, created by the ever-increasing use of credit and debt leverage, combined with the conviction that markets are self-correcting, took more than 25 years to grow. Now it is exploding.

Gardels: What ought to be the "circuit breaker" that short-circuits the distortions that inevitably destabilize financial markets?

Soros: If bubbles are endemic in the system, then government regulators have to intervene to prevent bubbles from getting too big. Governments have to recognize that markets are not self-correcting. It is not enough to pick up the pieces after the crisis.

Gardels: Does the presence of the 24-hour global financial news cycle amplify and exaggerate distortions in the financial markets?

Soros: Without question, they accelerate the process. At the same time, I wouldn't overstate it. At the end of the 19th century, you didn't have 24-hour cable, but nevertheless you had the same kind of bubbles. Throughout the 19th century, when there was a laissez-faire mentality and insufficient regulation, you had one crisis after another. Each crisis brought about some reform. That is how central banking developed.

Gardels: How come all the efforts of the U.S. government so far -- the $700 billion rescue package, low Federal interest rates, backstopping deposits and commercial paper -- have not stemmed the crisis?

Soros: The U.S. authorities bought into market fundamentalist ideology. They thought that the markets would ultimately correct themselves. U.S. Treasury Secretary Henry Paulson epitomized this. He thought that six months after the Bear Stearns crisis the market would have adjusted and, "Well, if Lehman (Brothers) goes bust, the system can take it." Instead, everything fell apart.
Since they did not understand the nature of the problem -- that the market would not correct itself -- they did not see the need for government intervention. They did not prepare a Plan B.
As the shock of the Lehman failure set in, he had to change his mind and rescue AIG. The next day there was a run on the money markets and commercial paper markets, so he turned around again and said we need a $700 billion bailout. But he wanted to put the money in the wrong place -- taking the toxic securities out of the hands of the banks.

They have finally now come around -- with the government buying equity in banks -- because they see the financial system is on the verge of collapse.

Gardels: Now that the U.S. authorities are at last on the right track, what are the key components of resolving the crisis?

Soros: The outlines are clear. There are five major elements.
-- First, the government needs to recapitalize the banking system by buying equity stakes in banks.
-- Second, interbank lending needs to be restarted with guarantees and bringing LIBOR (London Interbank Offered Rate) in line with Fed funds. This is in the works. It is going to happen.
-- Third, we must reform the mortgage system in the U.S., minimizing foreclosures and renegotiating loans so that mortgages are not worth more than houses. Stemming foreclosures will cushion the fall of housing prices.
-- Fourth, Europe has to fix a weakness of the Euro by creating a safety net for its banks. While initially resisting this, they have now found religion and done it at their meeting in Paris on Sunday.
-- Fifth, the IMF must deal with the vulnerability of countries at the periphery of the global financial system by providing a financial safety net. This is also in the works. The Japanese have already offered $200 billion for this purpose.
These five steps will start the healing process. If we implement these measures effectively, we will have passed through the worst of the financial crisis.

But then, I'm afraid, there is the fallout in the real economy, which is now gathering momentum. At this point, repairing the financial system will not stop a severe worldwide recession. Since, under this circumstance the U.S. consumer can no longer serve as the motor of the world economy, the U.S. government must stimulate demand. Because we face the menacing challenges of global warming and energy dependence, the next administration should direct any stimulus plan toward energy savings, developing alternative energy sources and building green infrastructure. This stimulus can be the new motor for the world economy.

Gardels: At the end of the day, won't we be looking at a vastly different global financial landscape? The U.S. will decline as the top power. It will have, along with parts of Europe, socialized banks and loads of debt. Communist China will be the new financial power globally, flush with capital and a major investor in the West.

Soros: U.S. influence will wane. It has already declined. For the past 25 years, we have been running a constant current account deficit. The Chinese and the oil-producing countries have been running a surplus. We have consumed more than we produced. While we have run up debt, they have acquired wealth with their savings. Increasingly, the Chinese will own a lot more of the world because they will be converting their dollar reserves and U.S. government bonds into real assets.

That changes the power relations. The powershift toward Asia is a consequence of the sins of the last 25 years on the part of the United States.

Comments

[JBS]

Mr. Soros financial crisis may be nearing its end, but ours has just begun.

[drkazmd65]

I sure hope Mr. Soros is right about the end of the Financial Crisis being nearby,...

But I am darned sure he is also right about the pain for the economy,..­. and more importantly for the people living in it,.... is far from over.

I'm betting about 2-3 years of low-level economic agony and uncertainty for us 'peons',.. followed by a decade (or more) before things really start to get back on track.

And by then of course, the Chinese will have swayed to balance in their favor.

I wonder how hard it would be for me to start learning some Mandarin?

[archerlane]

Time to start lining up the traitors: corprorate, financial and government leaders who sold this country out.

Forget the bullshit about not pointing fingers, we need public display, prosecutions and disgorgement of the gains these traitors have accumulated at the expense of this country and its people.

[bobsmith]

Yep. Try them, strip the guilty of all assets, strip them of their citizenship, and deport them. And follow them around with cameras as they perform menial labor in an overseas sweatshop they used to own - now that's a reality TV show that the country would watch.

The point is - unless there's stiff, public retribution for their treason, it will happen again and again. I'm sick of seeing the poor and minorities harassed by our pathetic "justice" system for ridiculous drug charges and other nonsense. It's time for some REAL justice that might actually restore some faith in this country while announcing to the world that "we're back on track".

[boophus]

I remember in the 80's being concerned about the national debt and there were these supposed financial wizs who were saying it was irrelevant. That it would be minimized by our economies growth.
OOPS. All that happened is that my taxes went up, the taxes of the richest went down, the security net was unraveled, jobs were outsourced, unions were attacked and destroyed, ... oh yeah it has been a marvelous time, a great party where citizens copied the federal goverments weird money management and were encouraged to do so by low savings interest rates, low mortgage rates, all kinds of new credit offerings and mortgage products. Now the bums try to blame the little guy.

[TeddyRoosevelt]

Our leaders need to pay attention to Soros! He understands the global economy better than anyone else. The countries that are taking his advice will come out far better than those that refuse to come to terms of financial reality. Obama better be paying close attention.

[JimBullis]

(continued from previous)
I think the Miastrada is a better answer. However, these are just examples of products that could be a basis of a revitalized automobile industry. The miastrada site discusses putting the US industrial capacity to work on a war-like production effort. A range of possible vehicles can be seen at http://www.auto.xprize.org.

Then the economy of the country might really get revitalized. And we might be able to continue to live much like we do now.

If we were to take the innovative path I suggest, we would clearly be in the lead in fighting global warming, and that might make the world think of us as true leaders.

[schatsie]

I have always admired Soros' logic.... I just do not trust this administration to handle this bailout any better than the repugs handled the Savings and Loan Bailout or the WAR on Iraq....

[paixa3]

Mr. Soros, it is nice to read your ideas. I believe they are spot on. Will the USA government really do the right thing? I doubt it.

[jsarets]

This is hopelessly naive! If bubbles are endemic to the system, then the banks will always stay one step ahead of regulator innovating ways to inflate them. We have to determine why bubbles are endemic and then change the nature of the system itself.

Bubbles are endemic because every dollar in circulation represents a debt of one dollar plus interest. Since the interest isn't loaned into circulation with the dollar, we have to borrow in order to pay the interest, which then represents a debt of the interest on the dollar plus the interest on that. Therefore, we have to keep expanding credit at an exponential rate to prevent catastrophic monetary collapse.

Banks have to keep lending, even if the borrowers won't be able to pay back the loan, because otherwise they won't be able to service the debt on their own loans originating at the Federal Reserve. If regulators attempt to curb risky or excessive lending, they will force the banks into bankruptcy overnight. Asking the banks to lend responsibly is akin to asking them to commit suicide.

The banking crisis is a symptom of a money crisis, and the money crisis has been lurking in our financial system for over a century, biding its time before the physical limitations of natural resources rendered the exponential growth unsustainable. Stop blaming the banks! Stop blaming the regulators! It's the money, stupid!

[spartanmom]

Bubbles are endemic because the financial industry runs on testosterone

http://news.yahoo.com/s/afp/20080919/bs_afp/financesciencepsychology_080919015553

[zann]

While the markets run on fear and greed?

[cluesearch]

You are saying the same thing that Soros is saying. The money crisis HAS been happening for the last 30 years (ever since we stopped gold backing money) and that is why we are in a crash now. We continued to try to be one step ahead of the next bubble and continued to dance until the music stopped. The music stopped. It stopped at the most inopportune time, a time when we produce nothing, consume everything, and save nothing. We are a debtor nation and the new emerging market economies i.e., China, India and other South Asian countries are the new manufacturing society. We are in fact, Europe in the 1940s our only hope is to start producing something to make asset backed money. Unfortunately, while we are fumbling around with our preverbial condoms. Other emerging markets have become independent of us and are procreating at a rapid pace. We find ourselves in the akward position of being infertile and only praying in vitro works. We have leveled the global playing field (to our disadvantage) and once we emerge from the other side of this crisis we will be sad to find that our position in the global pecking order will be secondary.

How 'bout those mixed metaphors huh?

[cybervigilante]

Of course bubbles are endemic. All of reality is fluctuation. The thing is, we don't want Enormous bubbles that wreck the system. We do have to allow smaller and even medium-sized, and rarely, larger bubbles, in order to foster natural dynamism - but at a certain point the bubbles must be deflated befoe they grow too large. That's the job of Regulation.