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The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means | 
 enlarge | Author: George Soros
Publisher: PublicAffairs
Category: Book
List Price: $22.95
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Rating:  65 reviews
Sales Rank: 1858
Media: Hardcover
Pages: 208
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Dimensions (in): 7.6 x 5.4 x 0.8
ISBN: 1586486837
Dewey Decimal Number: 332.0973
EAN: 9781586486839
ASIN: 1586486837
Publication Date: May 5, 2008
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Product Description
In the midst of the most serious financial upheaval since the Great Depression, legendary financier George Soros explores the origins of the crisis and its implications for the future. Soros, whose breadth of experience in financial markets is unrivaled, places the current crisis in the context of decades of study of how individuals and institutions handle the boom and bust cycles that now dominate global economic activity. “This is the worst financial crisis since the 1930s,” writes Soros in characterizing the scale of financial distress spreading across Wall Street and other financial centers around the world. In a concise essay that combines practical insight with philosophical depth, Soros makes an invaluable contribution to our understanding of the great credit crisis and its implications for our nation and the world.
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 Yet another reflexivity theory promotion April 4, 2008
Read and think (Canada)
228 out of 320 found this review helpful
I had bought this book based on a magazine article which indicated that the authors was giving his opinion on what is to be expected in the coming year.
Who wouldn't pay a few dollars to know what a highly successful billionaire (and philantropist) trader thinks of a situation that has perplexed all economists and instilled fear in anybody who wasn't vacationing in the space station in the last year?
I quickly bought and jumped straight to chapter 7: "My outlook for 2008".
In that chapter, the author only describes a few short-term trades done in the first 3 months of 2008 that more or less went nowhere. For most of us, these are of little interest especially that most of them are hedge-fund style and involving shorting stocks, an activity likely to lead to the quick bankruptcy of most people (and including, in the past, a few well known high-flying traders, numerous hedge funds, and even two nobel-prize winners demonstrating to the world the practical monetary value of the actual theory for which they had won their nobel-price!)
Well maybe I'll get more in the "Conclusion" chapter...
Ah ah! There it is (p 158), I found it! :
"Near panic conditions prevail in financial markets. People want to know what lies ahead."
Yes, that's me! I want to know what lies ahead! ... That surely will be worth $10...! Y...e....s....!!!
Now, here it is revealed to the world (Skip it if you don't want the punch line before reading the book):
"I cannot tell them because I don't know" (p.159) !
That's it!
And that's the penultimate page and the actual conclusion.
So what is the point of the book?
"What I want to tell them (the readers) is something different. I want to explain the human condition."
... with a title like "A new paradigm of the financial markets" released in a hurry in the middle of the crisis! Yah sure...
Of course that is not true. The book is yet another attempt to describe his "reflexivity" theory (fully explained in previous books). The author only use the current crisis as a bait and switch teaser.
And if you haven't read his previous books and don't know anything about that theory (and would like to know about it) I can tell you all there is to know virtually in a single paragraph:
The author claims that economic classical theory is wrong because the classic demand/supply curve are considered as a given pre-existant independant entity while in reality the economic actors by their actions influence those curve and therefore those curve are not independant. Hence the term "reflexivity" to describe that reaction.
A typical example is that if you have 2 company A and B with identical balance sheet and prospects and people believe (without "evidence") that company A will do better than company B and bid its share much higher, then A far from being overvalued, by the mere fact of the bidding up of its shares, is more likely to succeed as it will be able to raise more and cheaper money than B, and therefore the fact that the company is now more apt to succeed merits its higher price vs the other, a sort of virtuous cycle, a case of "reflexivity". The author actually does give similar example such as conglomerates and a few others.
Well, while this observation is important, this is hardly a new concept. That is the whole idea of stock promotion and the like. Anybody in the market knows the game very well.
And the same concept is well known in a lot of other field under different names: it is the "self-fulfilling prophecy" convenient to explain the paranoid self-inducted reinforcing view of the world in psychology, it is the "bio-feedback" mechanism in biology, it is the "chain reaction" in physics, it is the "recursion" programming paradigm, etc... All variation of the same underlying idea.
It is a very important principle, and congratulation to Soros to put it in the limelight again. But should the title be more truthfully... be something like: "Reflexivity - The Important Economic Principle Too Often Ignored"
The author does nevertheless write an excellent chapter on the genesis of the current "super-bubble". It will be nothing new to anyone who has read any newspaper, magazine or the internet on the subject in the last year. However, the author believes this bubble marks the end of a more important decades-old credit "superbuble" and therefore is more ominous.
There is also a chapter on "policy recommendation". After accusing the Bush administration of being afflicted with "market fundamentalism" and the Fed of mismanagement ("The Federal Reserve has the legal authority to regulate the mortgage industry, which it failed to exercice" p 119) he supports the measures proposed by Representative Barney Frank: modifying the bankruptcy law to permit the bankruptcy judge to rewrite loan terms on a principle residence and empowering the Federal Housing Administration to provide guarantees that would help refinance subprime borrowers into affordable mortgages and do everything to avoid foreclosures.
Now the summum of irony is that Soros's proposal of rewriting the term of the mortgage and preventing foreclosure is a flabbergasting case of a real life case of "reflexivity" at work that Soros appears to completely have failed to spot!
Indeed! Let's figure it together. Citizen A and B are in the same middle-class situation with similar job, asset and income. Citizen A purchase a million dollar home and a few year later refinance it to pay for a brand-new jaguar car. Citizen B continues to rent and avoid debt.
Normal "classical economy theory": citizen A is wrecklees, citizen B is more prudent and ultimately will be more successful and rich. How wrong!
In a "reflexivity economy theory": citizen A is obviously much smarter and responsible because his behavior will "act" on the situation and therefore change the terms of the deal! Sooner than later he will become a "victim" about to loose his home, quickly becoming sought-after video material to a heart-breaking newsreport on a pathetic epidemic situation about to convulse America! So economic philosopher Soros and populist represensatives band together with their great ideas: change the deal, erase the debt (in part or completely), and in any case let the poor fellow drive home from his tv interview in his comfortable jaguar and have a needed restful sleep in his million-dollar home. Of course the government won't stop there. The Feds will allso lowers interest, debase the currency and the congress will increase tax to pay for it.
Now Citizen A is obviously the huge winner. He gets "relief" with lower interest on his loan, he is ecstatic about the dollar debasement and the resulting inflation (which continues to increase the value of his home relative to his loan). He keeps his home. He keeps his car. Life is good!
Meanwhile the stone-age "neo-classical" citizen B is now in a dire situation: his income has been reduced further by new taxes at the same time as his dollar assets has lost 30%-50% of their value relative to virtually all other currencies, fuel, home or any hard assets; his money market fund now provides him an even higher NEGATIVE after-inflation and after-rax interest rate (lowered nominal interest rate MINUS highered inflation MINUS highered tax= outrageously negative real after-tax interest rate) and therefore he is every year getting poorer and poorer. He is receiving little sympathy and certainly no TV appointment to talk about his situation. After all he is the "lucky" who is debt-free! He obviously must lose any dream to ever buy a home since they are now worth 50%-100% higher than when citizen A purchased them (and will remain at ridiculously inflated level relative to median income rate if Soros gets his way). And while his interest t-bill income has collapsed (thanks to Bernanke) and while his net salary was reduced by his increased income tax (soon to come...) his rent is already shooting up due to the increaing inflation.
You can also apply reflexivity to the situation of the meager salary of CEO in a prudent and sound bank (if there still exist one, perhaps somewhere in a small town in Alaska, who hasn't yet disappeard in the new "reflexive" economy) and the $200 million bonus of a CEO of a "victim" hyper-leveraged bank rescued by the government
Of course reflexivity can work both ways and in the end citizen B could become the big winner given appropriate measures to reverse the momentum. Soros does recognise that reflexivity can go in both direction and even overshoot. Unfortunalety Soros didn't seem to realise that the measures he is championing (ironically by the actual effect of "reflexivity"!), would ultimately reward irresponsibility and severely sanction virtuous citizen.
More troublesome is Soros's silences. Nowhere does Soros propose nor even consider the possibility that, in such dire times, it might make sense that a law would retro-actively (or at least starting today) force immoral CEO to disgorge the proceed of their theft.... euh , I mean, their huge bonus given to them for bankrupting their companies. (However Soros do suggest to implement IN THE FUTURE some (vague) regulation of the mortgage (and derivatives) industry).
So in essence Soros measures (or absence of measures) boils down to: for whoever already robbed the bank wether it be the mortgagee or the mortgagor or the CEO (or actually all of them since they were all acomplices) the government must step in and make sure they keep their spoil (wether it be their home or bonus). None of them should be forced to give anything back. And ALL of the cost should happily be beared by all the other taxpayers because it is apparently in their best interest to continue renting and paying for the home and the bonus of the others. Outrageous.
End of reflexivity discussion. Let's now study a smarter proposal from Soros.
Soros propose a clearing house or exchange for credit default swap that would enforce adequate margins requirement. But while this is a great idea for future contracts, what do you do with the existing contract which now, today, DON'T have that "adequate" margin? Do you really want to let the entire world know, all at once, what is the percentage of those contract that are worthless (creating in all certainty a panic that will lead almost certainly to the bankruptcy of many pension funds) or do you want to leave some fuzziness so that people can digest the news over a period of time (years or a least months as it is currently now done) and find ways to spread the pain over years?
This is an especially crucial and important question when, as Soros points out, the actual value of those Credit Default Swap ($42 trillion) is equalt to the ENTIRE household wealth of the USA, and is 2.3 x times the capitalisation of the ENTIRE stock market in the Usa!
I humbly proposed what I believe is a better variation, at least for the mortgage part (but it can be easily extended to commercial debt):
- the current difficulty is that nobody knows the value of the products because they represent tranche of pooled mortgage and nobody knows what the value of each mortgage is, nevermind the value of the pooled one or the tranche.
- we need a drastic dramatic measure because the situation is clearly dire and this permits revolutionary emergency measures
- we should pass a law that all existing and future MORTGAGE and FINANCIAL INSTRUMENT based on mortgage will need to be registered in a new governement MORTAGE TITLE REGISTRATION AND CLEARING AGENCY with an independant status (to prevent political interference). That agency would have to value each existing mortgage. This could be done by various statistical method based on current price in neighborhood, size of home, obtaining information from institutions and property tax assesment, assessing the value of mortagee information emanating from specific institution based on previous experience with those institution, sampling, new interviews, obligation for each mortgagor and mortgagee to resubmit (on a regular basis) information on his financial situation (including obligation to notify when significant change occured, like losing a job or having a significant raise) with severe penalty (similar to false income tax declaration) if not truthful
- you also require by law the registration of all mortage derivative instruments indicating for each which exact tranche of which exact mortgage it is linked to and who owns it
- you put all the data in a computer. In a few minutes it will be able to deduct the value of each mortgage derivative because it will know what the instrument is structured (mandatory mortgage financial instrument registration) and what is the underlying value of the mortgages are (mandatory mortgage registration and actual agency valuation of each)
- each institution must mandatory use the value emanating from that agency in their financial statement and each institution is also required to indicate the approximate market value of its mortgage financial instrument obtained as described below.
- the agency creates a mortgage and mortgage financial instrument market to let anyone one in the world bid on any morgage financial instrument put on sale by anyone. The computer keeps track of the exact composition of each instrument and owners could automatically reslice and repackage them to sell only what they want (same thing for bidders proposal).This will permit bank in need to rapidly get rid of some mortgage to raise quick liquidity. Any owner of instrument could accept a bid of someone wanting part of his modified instrument and the registration agency computer would automatically change it
- the mortgage payments could be collected by the agency, just like we now do with income tax and remitted immediately to the registered owner account.
The huge advantage are
- there will be no costly bailout by the taxapayer (undemocratically forced on them)
- some imprudent bank will deservedly fail
- some prudent bank and indiviuals who saved their money will be highly rewarded with good values,
- other countries liquidity (sovereign funds, pensions funds, individuals, oil money) will be able to reliquidify the Usa therefore ...
- the collapse of the dollar will possibly be averted,
- a level playing field: this put an end to the "play favorite" where this bank or that bank "too big to fail" or "run by a good friend of ours or with who I work before or will give me a great job in the future", or "a friend that has contributed a lot to our party" gets deals that make a very few super-rich at the expense of taxpayer's money ... of course this always being presented altruisticly as 'having saved our citizen from the worse"
- in the all we will all be better then before the crisis with a new evolutionary (if not revolutionary) easy and super-versatile way to issue and manage mortgage and create a world market out of it.
I could easily see Google propose to make this happen in record time...
 Hmmm... April 5, 2008
Me (United States)
165 out of 213 found this review helpful
About the previous review, I find it interesting that you say the subprime issue is: "a situation that has perplexed all economists" and then you proceed to give your own solution at the end of what you wrote. Are you saying that you alone have the solution to something that has "perplexed all economists?" Anyway, not all economists are "perplexed" by the issue...they merely speak in technical terms so most people don't understand the gravity of what they are saying. They have known of this issue for a long time. In fact, Bernanke wrote a book on what he is about to do with interest rates. It is called "Inflation Targeting." He will seek to maintain a certain "core inflation rate." Note that *food* and *fuel* are NOT included in the "core rate." They are part of what he is calling "headline inflation." The FED will not react to changes in food and fuel (headline) inflation directly...only after they have affected the "core inflation rate." This lag in control will likely create oscillations in the system. Great for stock traders, but tough for the average person with a life. The FED will have tough times politically.
Further, you say that it has "instilled fear in anybody who wasn't vacationing in the space station in the last year." Perhaps you have forgotten that Soros fought hard during the last election (longer than a year ago) for a change in these very policies. Buffett spoke out against derivatives long ago. Jim Rogers (co-founder of Quantum Fund with Soros) wrote about the commodities boom in 2004 in his book "Hot Commodities." Implicit in the view that commodities will boom is the view that there will be hyper-inflation, since everything is made of commodities and the hyper-inflated prices will be passed along or the companies will go out of business. Greenspan also alluded to hyper-inflation in his book.
Anyway, Soros is an expert in this field and has been quite prescient on this topic for years. Following advice such as his (as well as that of Rodgers, Buffett, Graham, and other notables) has permitted me to position my portfolio defensively for these times. I started years ago (hence my knowledge of what was known more than a year ago.) I sold my home at the peak of housing and bought a home in an area that did not have the same unrealistic home inflation. The remaining cashed-out home equity was invested in other defensive things. My home value has not fallen nearly as much as it would have had I kept my other home, thanks to Mr. Soros' foresight. I look forward to what he has to say about the coming financial winds so I can plot my next step in capital preservation/expansion.
Don't judge the book based on theoretical criticisms. Look at the reality of the track record of the man himself. Also, consider the fundamental fact that most "bubbles" occur because of over leveraging and greed. Years ago there was the LBO bust and today, we have a bust from over leveraged banks and improperly leveraged homeowners. I say "improperly" because the way those contracts were written practically assures a bust...prepayment penalties that are really refinance penalties, interest rates dependent on LIBOR (London Inter-Bank Offerring Rate) instead of US rates, etc.
In short, if the FED can't use its tools to avoid the foreclosures, it will cause a depression in the housing market. In fact, the housing market is already in depression by definition. That is, interest rate changes cannot be used to avoid the harm...therefore, severe price deflation (i.e., "depression") and job losses result. Since 78% of the US economy is housing related (e.g., furniture sales, appliance sales, insurance, lawn care, carpeting, mortgage banking, etc.) the situation is clearly serious.
Now...all of this has a deeper level. There is a larger case of over-leveraging that is starting to unwind right as you read this review: The National Debt. Yes, deficits *do* matter. They are obligated taxes...with interest. The payment of the trillion dollar national debt will be painful and require a type of tax that noone voted for: Inflation. Why? Well, how is one going to get people to vote for a tax to pay off the debt when they were already voting against the taxes they already had? The only solution is an involuntary, hidden tax: Inflation. Over time, Inflation makes debts look smaller and more managable. The hidden inflation tax is *already* here because of the current interest rate cuts and will grow to a size people haven't yet imagined. Buy gold, oil, or any other commodity. This will be about a ten year cycle, overall, so inflation has a long time to run.
Since inflation has already started, it will be difficult to stop. Like a fire, it will continue to burn until susceptible assets are destroyed. The remaining assets will be helped by it though.
Buffett warned of this years ago. He recently said that more and more deficit spending and rate cuts would eventually make the dollar "worthless" (a statement he later "corrected" under some pressure to "worth less".) Anyway, the situation is serious. Don't trust any particular review of the book...not even this one. Look at the book yourself and make your OWN judgement regarding Soros' acumen.
 Short but interesting May 9, 2008
Dr. Lee D. Carlson (Saint Louis, Missouri USA)
130 out of 145 found this review helpful
In August 2006 the risk manager of the home equity division of one of the largest banks in the United States collected his staff together and told them that the portfolio they manage had begun to exhibit dramatic losses. All the other banking institutions were beginning to exhibit similar losses he said, but that policies to be put in place will mitigate these losses and therefore "not to worry." He resigned his position only six months later, and at the time the mortgage losses throughout the nation were accelerating dramatically, forcing layoffs, resignations, panic in the financial markets, and aggressive action from the Federal Reserve.
Theories abound on why this turmoil is occurring, one of these being discussed in this book, which is written by one of most well-known financial speculators of all time. The tone of the book is general and philosophical, and the author refrains from indulging in mathematical considerations, but there are many concepts in the book that are interesting and merit further investigation. The author's intellectual honesty is refreshing, in that he admits the job he has taken on is a formidable one. Describing the workings of the financial markets is challenging, and has occupied the time of countless researchers and financial analysts.
The author wants to get rid of the "market equilibrium" paradigm in traditional economics and replace it with one that he has called "reflexivity". This concept is similar to a few that have been discussed in recent months, one holding that investor analysis and modeling activities actually serve to change the markets, rather than just "mirror" them. The author's idea is that humans have both a cognitive function and a "manipulative" one when they approach the financial markets. This has the implication that social phenomena cannot be described or studied in the same way as natural phenomena. They are separate areas of study, he argues, and he attempts to justify their separation on the pages of this very short book.
His analysis is interesting and provocative, and certainly worthy of attention, but to put it on a firm quantitative foundation would require a large amount of work. The theory of reflexivity is not the only proposal to be put forward that differs from the classical one. There have been many in recent years due to the increasing importance of financial engineering, the latter of which has been applied on a massive scale. But the author proposed this theory almost two decades ago, when derivatives trading and financial modeling were beginning to ramp up. He therefore foresaw the need for alternative points of view when dealing with financial instruments and market activities that cannot be captured by the classical paradigm.
The book is part autobiographical and could probably be better appreciated if the reader was familiar with the author's earlier works. But anyone interested in making sense out of the current news reports will find an interesting read here, even though at times the author's political affiliation comes out a bit heavy-handed. In addition, his attitude about free markets and "laissez faire" is somewhat puzzling since a purely "laissez faire" economy has not been realized historically. Any arguments against its efficacy are therefore misplaced. Those who still believe in "laissez faire" may therefore object strongly to many of the author's assertions and his recommendations at the end of the book for fixing the current "credit crisis." Whatever your world view though it is perhaps fair to say that the increasing complexity of the financial markets demands new ideas and approaches.If anything a good understanding of financial dynamics is a matter of survival. The financial markets of the twenty-first century take no prisoners.
 Rampaging Smart Guys June 11, 2008
G. D. Geiss (Harrisburg, Pa. USA)
48 out of 57 found this review helpful
I saw Mr. Soros testify before Washington State (home state of my favorite soccer goal keeper) Sen. Maria Cantwell's committee the other day (on TV, of course) concerning possible oil futures speculation. I was impressed with Senator Cantwell (although we'd agree on little, policy-wise) and with Mr. Soros (despite myself). So I picked up this book to see what he had to say on the central economic issue of the day.
I won't bash the book, exactly, but it was pretty rambling, pretty repetitive, and spent a considerably longer time trying to defend/explain his theory of "reflectivity" and bashing Republican politics than discussing the credit crisis. Still it offered some useful points and observations. It's personal account of worlwide historical financial events that Mr. Soros himself not only lived through but participated in as well as a concise account of the events that comprise the subprime mortgage meltdown were themselves worth, in my view, the price of admission.
In the end, though, the central theme of the book, it's overarching structure, is Mr. Soro's longstanding theorem about "reflectivity" in financial markets. He maintains that both the factual "reality" and the participants' resort to emotional facilities as a result of imperfect informational access interact with each other in a kind of feedback loop. As a result of this "reflectivity" serious degrees of uncertainty are injected into the marketplace that are not predicted by "classical" economic theories of "rationality" or "equilibrium". This, he says, invalidates market models based on those classic concepts. What to do about that, of course, he's not quite so clear about, except, perhaps, you should vote Democratic (his advice, not mine).
Unfortunately by his own analysis, this theorem is unsatisfactory as anything other than a cautionary alarm bell. By it's own definition and assertion it is untestable and (in the terms of one of Mr. Soros's own favorite philosophers, Karl Popper) incapable of falsification. Since it's prime tenent is that it's unpredictable and not even of consistent relevance in any given situation, it is roughly akin to the statement of Cretan philosopher, Epimenides, (quoted by Soros himself) that "all Cretans always lie". If, claiming unpredictablility, "reflectivity" yields accurate predictions, it is false.
Nassim Nicholas Taleb has called these same kind of events as said to be caused by "reflectivity" black swans. Inductive reasoning in financial markets has led to some frightening financial meltdowns. Having seen only white swans (even in their hundred thousands) and therefore betting the ranch there ARE only white ones is a sound foundation for disaster. Mr. Taleb helpfully also points out that somewhere downunder there are, in fact, black swans.
Benoit Mandelbrot has suggested that his fractile geometry, rather than bell curves, is a better financial model and, in fact, perhaps allows for better predictability. Don't know about that. The intersection between regulators and markets that Mr. Soros rather convincingly argues must be, at least in part, responsible for the subprime mortgage meltdown, doesn't strike me as a geometric intersection, fractile or otherwise. And besides, Herr Doktor Mandelbrot's math is WAY beyond my (or I'd postulate any other non genius math brain's) comprehension.
For me though, the persuasiveness of Mr. Soros's point about unpredictablity and odd shaped (non bell) curves can be found in the seminal work of William James, who demonstrated 100 years ago what every good salesman has always known (at least by instinct, if not overtly): that human beings ACT on feelings and use their intellectual reasoning to rationalize the result. I would accept, a priori, that no single individual actor in today's complex financial markets in our globally interwoven world can possibly know all the relevant facts about any one proposed action therein. Thus he must have imperfect information. And even as among the myriad of facts he does "know", he will use his experience, his intuition based on it and on the recounted experiences of those he has learned to trust, to value those various factual inputs.
I would submit (and I don't think Mr. Soros would raise too strenous an objection) that gernerally speaking, in a broad enough marketplace, all those individual "emotional" decisions ought to cancel each other out to a degree that would render them indistinguishable for practical purposes from randomness. Perhaps not perfect bell curves (some fat tails and modified kurtosis), but within acceptable (and perhaps hedgeable) limits.
But humans are also herd animals (we, however, call them tribes), and that instinct is a survival trait and still strong. One need only contemplate the blowing of a single car horn on a gridlocked highway that is inevitably followed in nanoseconds by hundreds more, to understand it's continued pervasive presence. When that happens in financial affairs, when smart guys get afraid of being left behind the "easy" money, when they can't stand the other tribe harvesting all that golden fleese or bear the thought of some young ambitious upstart taking over their hard won desk by merely following sombody else's playbook (what have you done for me lately says the boss), then homework vanishes. Smart guy follows smart guy in a kind of stampede. Risk of loss no longer matters or is outweighed by the risk of being stranded alone. Each of us (no I'm not a trader, but empathy demands the collective pronoun) falls all over ourselves to steal candy from the blind confectioner, never mind that we know that the poison pill is there in one of those jars on one of those shelves. It won't happen to me, we say. I'm too smart, I'll see it coming, I'll get away. This time it'll be different. We rationalize the emotional decision to chase after the leaders, to blow our horn, too.
This is far too long, let me try to wind up. In this crisis surely whole truckloads of the "smartest guys in the room" demonstrated levels of greed, arrogance, and impaired judgment that, despite being all too human (to borrow a phrase from Nietzsche, who seems particularly apt in this context) are still, in retrospect, shocking. Still, "free markets" provide efficiencies and multiplicities of choice that cannot be duplicated (or even approached) by any central planner or micromanaging regulator. But when these herd markets fail as spectacularly as they have here, the individualist free marketer along with the "reflectivist" (if I may be so bold as to lable Mr. Soros) are both left wanting a better way, a better regulatory system, for keeping these rampaging smart guys from trampling in their passing our own hard won little (in my case) or not so little (in Mr. Soros's) net eggs. This is a thoughtful book. Even just trying to "deconstruct" it may lead you down interesting thoughtways.
Putting Limits on Leverage July 20, 2008
Izaak VanGaalen (San Francisco, CA USA)
42 out of 47 found this review helpful
George Soros thinks that the current credit crunch is the most severe financial crisis since the 1930s and that it marks the end of an era of credit expansion based on the dollar. In this book he argues that a new paradigm is urgently needed to better understand what is going on. The paradigm used until now by most economists was based on false premises.
The existing paradigm, often referred to as free-market fundamentalism, holds that markets are self-correcting, that they naturally tend toward equilibrium. Economists as far back as Adam Smith have argued against regulation or government intervention of any kind since it would interfere with the natural forces of the market.
Soros correctly argues the contrary. In fact government intervention has repeatedly saved the market. A few examples are the bankruptcy of Continental Illinois in 1984, or the failure of Long Term Capital Management in 1998, or the current bolstering of Fannie Mae and Freddie Mac (my example). The notion that the market deviates from an orderly path is the rule rather than the exception.
The new paradigm that is needed, according to Soros, must incorporate the theory of reflexity. Developed in previous works by himself and his mentor Karl Popper, reflexivity examines the relationship between thinking and reality, between the cognitive function and the manipulative function. In the investment world, this means that when investors are bullish on, say, housing or mortgage backed securities their values go up, not because they become intrinsically more valuable, but because everyone else is thinking they are more valuable. This is basically old-fashioned market psychology dressed-up in theory. The mechanism that allows the market to go up is self-reinforcing but ultimately self-defeating. The market goes from euphoria to despair overshooting the top, and ultimately the bottom too. Witness today's housing market.
We are currently experiencing the consequences of unregulated credit markets and Soros argues that if more is not done the crisis could get much worse. He points out that moneterist doctrine in inadequate. Controlling the money supply is only half of the picture. The internet bubble, the housing bubble, and the current commodities bubble were created through excessive use of leverage. The amount of debt currently outstanding is unprecedented. Any new financial regulations will need to temper the use of credit to avoid future bubbles.
Soros argues that the US must come to grips with the new realities if it is to maintain its preeminent position in the world. If we are not careful the dollar will lose its standing as the reserve currency of choice. The task of regulating credit will now became even more precarious since the credit market is already tightening. Soros, as a former hedge fund manager, realizes that credit is the lifeblood of capitalism and any overregulation will also damage the economy. Reflexivity theory aside, this book is an excellent discussion of the challenges we are facing today.
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