“It’s the end of an era, as far as the United States is concerned, because the prosperity was built on a false foundation.” – George Soros
Ye Weiqiang, Caijing 16 March 2009
What are the economic realities behind and possible solutions for the crisis gripping U.S. banks, emerging markets and the entire financial world? Caijing finance editor Ye Weiqiang travelled to New York to pose this and other questions to U.S. billionaire investor George Soros. Their discussion follows:
CJ: How do you identify economic cycles?
Soros: I have developed a theory about the financial market -- it’s really a philosophy -- which is at variance with the general theory, and it has given me perhaps a certain ability to identify bubbles when they develop. The prevailing theory, which is called efficient market hypothesis, holds that the market always reflects adequately or accurately all available information. I think this is false. I have a different hypothesis, which consists of two principles. One is that the market always distorts the available information. First of all, the market has to deal with the future, and the future is not predictable, and it always has a biased view, in some way a distorted view from the reality -- that’s the first principle. The second principle is reflexibility, as I call it. It says that mispricing of financial prices can have a way of affecting or changing the fundamentals of prices they are supposed to reflect.
So the two-way connection between the markets and the underlying reality is that the markets not only passively reflect, but also affect reality, and I call it the principle of reflexibility. This crisis now, I think, has proven that the effective market hypothesis is wrong. I think my interpretation provides a better understanding of what is happening.
Based on this general of reflexibility, I have in particular talked about what is happening now. The theory of bubbles is that to have a bubble, you have to have some trend that actually prevails over the reality, and there has to be a misconception about the trend, and the reflective interaction between those two can give rise to these bubbles that both the trend and the misconception mutually reinforce, and then eventually it becomes unsustainable, and it bursts. That’s the character of a bubble. It’s not the only form of reflexibility, but it’s very dramatic form because bubbles can be very powerful.
I have a special theory hypothesis with regard to what’s happening now. I say that the housing bubble in the U.S. was a regular small bubble but it acted like an atomic bomb -- a super-bubble which has been growing since the 1980s. So that’s why this crisis is not like other crises.
CJ: Is it good to change the game?
Soros: It’s not something you can control. It’s out of control. This is the situation now. The global financial structure has collapsed, so private sector credit has collapsed, and the financial system is actually broken. There is now artificial life support from the authorities.
CJ: Is faith in the authorities failing?
Soros: Yes. It’s more than confidence because, in reality, the international banking system has become largely insolvent. So it’s not just the problem of liquidity but also solvency; bank assets are falling in value, and so their liability exceeds their assets, and that means they are effectively insolvent.
CJ: Is nationalization necessary at this point?
Soros: Nationalization is a false label. Since the banks lost a lot of capital, and the private sector is not willing to replace the capital, the government has to do it. And one case when they decided not to do it, Lehman Brothers, set in motion this collapse.
The governments have determined not to let any other institutions that could endanger this system fail, so they are keeping them artificially alive. But it’s not enough to keep them alive; you also have to recapitalize them, and has to be done by the government.
But there is a big problem in emerging markets on the periphery of the system, where governments are not strong enough to provide guarantees for the banking system. The capital is moving out, creating a worse crisis than in the United States.
CJ: What is the current debate?
Soros: It looks like the government is not willing or able to recapitalize the banks in a way that will give them adequate capital to lend; all they do is prevent the banks from collapsing.
CJ: What is the current political barrier?
Soros: Unfortunately, the previous administration spent US$ 700 billion in an ineffective way, and it’s now politically difficult to secure additional funds needed for proper recapitalization.
CJ: What’s the government’s best course?
Soros: I advocate separating the existing assets of the banks and leaving the existing capital to be responsible… to suffer first loss, if the value of the assets decline, and put new capital into the future business of the bank. So separate past businesses from future businesses, and create a clean bank within the bank, which is not weighed down by these toxic assets that are losing value. And then put the new capital either from the private sector and the government into this new bank. Then this new bank would have adequate capital and would be eager to lend. That would restart the economy.
CJ: What’s the government’s approach, in reality?
Soros: The government is examining the balance sheets of banks, and that’ll take until the end of April. Then the decision will have to be made what to do in the case of individual banks. So the government is on the way, but for the time being it takes time to prepare and decide.
CJ: What should we consider when banks privatize?
Soros: You now have conditional collapsing credit; that’s very far from normal. You can’t get back to normal in a simple way; you have to first replace the credit with government credit, which means effectively creating money, increasing the balance sheet of the Federal Reserve Bank. But that’s too technical; it really means creating money. But when credit is restarted, and you put this very big base of money, suddenly the danger of deflation would be replaced by the danger of inflation, and then you have to shrink the money supply as far as credit is increased. So you have two steps: First you have to increase the money supply to replace shrinking credit, and then you have to reduce the money supply to offset the growth of credit.
CJ: After recapitalization, should the government control bank system decision-making?
Soros: No. The governments should regulate, but government is not suited to make economic decisions. It should regulate the amount of credit available, but how the credit is used should be determined by economic actors. Of course, the government is an economic actor itself responsible for a very large part of economic activity. But it’s not the only actor; it needs counterparties to balance.
CJ: How do you value toxic assets?
Soros: You don’t value it; you avoid the valuation problem. If you separate and auction it, then you will have to value it. But if you just keep it in the bank, and you keep the capital of the bank, the equity, and the subordinated debt to cover those assets, then you can wait and allow assets to be gradually liquidated. Then you will determine whether there is anything left for shareholders. What are values? It depends on the asset. Probably the asset will recover some value, especially over a long period.
CJ: How about the Obama administration’s stimulus plan?
Soros: It’s certain to help moderate the decline. It’ll be a counter-cyclical force. It’s just starting now. You need to recapitalize the banks, and you have to stabilizing the housing industry. By reducing foreclosures, and modifying the mortgages so that people can pay them to stay their houses, you reduce forced selling.
And then you have to, most important, do something about the rest of the world because the emerging market is more severely affected than the United States. Here, the government has credibility and government credit is accepted. But in other countries, the governments don’t have the means to guarantee, so you have to provide them with the means, somehow, lend them the money or make money available enabling them to protect their banking industry in a way we protect ours. A lot of their banks are actually owned by multinational American or European banks. Those American or European banks are taking money back. And loans are maturing without measures enabling those countries to roll over the debt. If they are not able to pay, the crisis will get worse. So we really place a serious problem on the rest of the world. And that can only be solved by international cooperation. It is very important that the United States and China, as the most important countries now, work together.
CJ: Our readers are interested in how the financial crisis will evolve.
Soros: I think China is much better situated than the United States to come out of the crisis. I expect China to be growing by the end of the year, because the crisis hit China hard and suddenly, and exports came to a standstill. That also affected production for domestic demand, so domestic demand also declined. It takes time for the government to respond, but it did put together a stimulus package that’s quite significant. And if it’s not enough, they will, I think, increase it. They are in a position to do it and they know what is expected. So they are determined to bring about growth. Now you can’t make exports grow, because the demand is not there. But you can stimulate domestic demand, and especially you can engage in infrastructure projects. The main push will come from the infrastructure. And that will stimulate domestic consumer demand as well.
Hopefully, China will cooperate with the rest of the world, will provide enough credit to the rest of the world. Then they can also engage in domestic stimulus and re-open the market for Chinese exports. By the end of the year, they may probably still decline, and then they may begin to recover. I think China is situated relatively above the United States. It will take longer for the United States and Europe to get out of the crisis.
CJ: Maybe next year?
Soros: I also don’t think we’ll ever get back to where we came from. In other words, it’s the end of an era, as far as the United States is concerned, because the prosperity was built on a false foundation. It has now collapsed, and you cannot rebuild it. So we have to be major changes in the United States and the global financial system. And I hope we will be able to reconstruct the financial system on sounder grounds than they were until now. So it’ll be a different situation.
It is not back to normal because what was considered normal was actually not sustainable. So I hope that we can reconstruct a better system.
CJ: So it’s not just a simple economic cycle.
Soros: Fundamental change.
CJ: China’s stimulus plan, do you think it’s good?
Soros: Probably you’ll need to do more, and it’ll be relatively easier to stimulate GDP than provide employment. Because exports are very labour intensive, and infrastructure projects are more material intensive, and so they provide less employment. A big problem is to generate employment and whether to find work for people in the countryside.
The biggest task of all is for China is to fit in to the global economic system and to play a constructive role in shaping the new financial system. China cannot live in isolation, just as the United States cannot. I think China has to play a more important role in reconstructing the financial system than in the past.
CJ: What’s your view on regulation?
Soros: If you want to have a global financial system, you have to have global regulation, which we don’t have now. All the regulators are national. So you will need to strengthen them, the international financial institutions. That is a big task ahead.
1 comment:
A Soros Solution for the Global Meltdown
“It’s the end of an era, as far as the United States is concerned, because the prosperity was built on a false foundation.” – George Soros
Ye Weiqiang, Caijing
16 March 2009
What are the economic realities behind and possible solutions for the crisis gripping U.S. banks, emerging markets and the entire financial world? Caijing finance editor Ye Weiqiang travelled to New York to pose this and other questions to U.S. billionaire investor George Soros. Their discussion follows:
CJ: How do you identify economic cycles?
Soros: I have developed a theory about the financial market -- it’s really a philosophy -- which is at variance with the general theory, and it has given me perhaps a certain ability to identify bubbles when they develop. The prevailing theory, which is called efficient market hypothesis, holds that the market always reflects adequately or accurately all available information. I think this is false. I have a different hypothesis, which consists of two principles. One is that the market always distorts the available information. First of all, the market has to deal with the future, and the future is not predictable, and it always has a biased view, in some way a distorted view from the reality -- that’s the first principle. The second principle is reflexibility, as I call it. It says that mispricing of financial prices can have a way of affecting or changing the fundamentals of prices they are supposed to reflect.
So the two-way connection between the markets and the underlying reality is that the markets not only passively reflect, but also affect reality, and I call it the principle of reflexibility. This crisis now, I think, has proven that the effective market hypothesis is wrong. I think my interpretation provides a better understanding of what is happening.
Based on this general of reflexibility, I have in particular talked about what is happening now. The theory of bubbles is that to have a bubble, you have to have some trend that actually prevails over the reality, and there has to be a misconception about the trend, and the reflective interaction between those two can give rise to these bubbles that both the trend and the misconception mutually reinforce, and then eventually it becomes unsustainable, and it bursts. That’s the character of a bubble. It’s not the only form of reflexibility, but it’s very dramatic form because bubbles can be very powerful.
I have a special theory hypothesis with regard to what’s happening now. I say that the housing bubble in the U.S. was a regular small bubble but it acted like an atomic bomb -- a super-bubble which has been growing since the 1980s. So that’s why this crisis is not like other crises.
CJ: Is it good to change the game?
Soros: It’s not something you can control. It’s out of control. This is the situation now. The global financial structure has collapsed, so private sector credit has collapsed, and the financial system is actually broken. There is now artificial life support from the authorities.
CJ: Is faith in the authorities failing?
Soros: Yes. It’s more than confidence because, in reality, the international banking system has become largely insolvent. So it’s not just the problem of liquidity but also solvency; bank assets are falling in value, and so their liability exceeds their assets, and that means they are effectively insolvent.
CJ: Is nationalization necessary at this point?
Soros: Nationalization is a false label. Since the banks lost a lot of capital, and the private sector is not willing to replace the capital, the government has to do it. And one case when they decided not to do it, Lehman Brothers, set in motion this collapse.
The governments have determined not to let any other institutions that could endanger this system fail, so they are keeping them artificially alive. But it’s not enough to keep them alive; you also have to recapitalize them, and has to be done by the government.
But there is a big problem in emerging markets on the periphery of the system, where governments are not strong enough to provide guarantees for the banking system. The capital is moving out, creating a worse crisis than in the United States.
CJ: What is the current debate?
Soros: It looks like the government is not willing or able to recapitalize the banks in a way that will give them adequate capital to lend; all they do is prevent the banks from collapsing.
CJ: What is the current political barrier?
Soros: Unfortunately, the previous administration spent US$ 700 billion in an ineffective way, and it’s now politically difficult to secure additional funds needed for proper recapitalization.
CJ: What’s the government’s best course?
Soros: I advocate separating the existing assets of the banks and leaving the existing capital to be responsible… to suffer first loss, if the value of the assets decline, and put new capital into the future business of the bank. So separate past businesses from future businesses, and create a clean bank within the bank, which is not weighed down by these toxic assets that are losing value. And then put the new capital either from the private sector and the government into this new bank. Then this new bank would have adequate capital and would be eager to lend. That would restart the economy.
CJ: What’s the government’s approach, in reality?
Soros: The government is examining the balance sheets of banks, and that’ll take until the end of April. Then the decision will have to be made what to do in the case of individual banks. So the government is on the way, but for the time being it takes time to prepare and decide.
CJ: What should we consider when banks privatize?
Soros: You now have conditional collapsing credit; that’s very far from normal. You can’t get back to normal in a simple way; you have to first replace the credit with government credit, which means effectively creating money, increasing the balance sheet of the Federal Reserve Bank. But that’s too technical; it really means creating money. But when credit is restarted, and you put this very big base of money, suddenly the danger of deflation would be replaced by the danger of inflation, and then you have to shrink the money supply as far as credit is increased. So you have two steps: First you have to increase the money supply to replace shrinking credit, and then you have to reduce the money supply to offset the growth of credit.
CJ: After recapitalization, should the government control bank system decision-making?
Soros: No. The governments should regulate, but government is not suited to make economic decisions. It should regulate the amount of credit available, but how the credit is used should be determined by economic actors. Of course, the government is an economic actor itself responsible for a very large part of economic activity. But it’s not the only actor; it needs counterparties to balance.
CJ: How do you value toxic assets?
Soros: You don’t value it; you avoid the valuation problem. If you separate and auction it, then you will have to value it. But if you just keep it in the bank, and you keep the capital of the bank, the equity, and the subordinated debt to cover those assets, then you can wait and allow assets to be gradually liquidated. Then you will determine whether there is anything left for shareholders. What are values? It depends on the asset. Probably the asset will recover some value, especially over a long period.
CJ: How about the Obama administration’s stimulus plan?
Soros: It’s certain to help moderate the decline. It’ll be a counter-cyclical force. It’s just starting now. You need to recapitalize the banks, and you have to stabilizing the housing industry. By reducing foreclosures, and modifying the mortgages so that people can pay them to stay their houses, you reduce forced selling.
And then you have to, most important, do something about the rest of the world because the emerging market is more severely affected than the United States. Here, the government has credibility and government credit is accepted. But in other countries, the governments don’t have the means to guarantee, so you have to provide them with the means, somehow, lend them the money or make money available enabling them to protect their banking industry in a way we protect ours. A lot of their banks are actually owned by multinational American or European banks. Those American or European banks are taking money back. And loans are maturing without measures enabling those countries to roll over the debt. If they are not able to pay, the crisis will get worse. So we really place a serious problem on the rest of the world. And that can only be solved by international cooperation. It is very important that the United States and China, as the most important countries now, work together.
CJ: Our readers are interested in how the financial crisis will evolve.
Soros: I think China is much better situated than the United States to come out of the crisis. I expect China to be growing by the end of the year, because the crisis hit China hard and suddenly, and exports came to a standstill. That also affected production for domestic demand, so domestic demand also declined. It takes time for the government to respond, but it did put together a stimulus package that’s quite significant. And if it’s not enough, they will, I think, increase it. They are in a position to do it and they know what is expected. So they are determined to bring about growth. Now you can’t make exports grow, because the demand is not there. But you can stimulate domestic demand, and especially you can engage in infrastructure projects. The main push will come from the infrastructure. And that will stimulate domestic consumer demand as well.
Hopefully, China will cooperate with the rest of the world, will provide enough credit to the rest of the world. Then they can also engage in domestic stimulus and re-open the market for Chinese exports. By the end of the year, they may probably still decline, and then they may begin to recover. I think China is situated relatively above the United States. It will take longer for the United States and Europe to get out of the crisis.
CJ: Maybe next year?
Soros: I also don’t think we’ll ever get back to where we came from. In other words, it’s the end of an era, as far as the United States is concerned, because the prosperity was built on a false foundation. It has now collapsed, and you cannot rebuild it. So we have to be major changes in the United States and the global financial system. And I hope we will be able to reconstruct the financial system on sounder grounds than they were until now. So it’ll be a different situation.
It is not back to normal because what was considered normal was actually not sustainable. So I hope that we can reconstruct a better system.
CJ: So it’s not just a simple economic cycle.
Soros: Fundamental change.
CJ: China’s stimulus plan, do you think it’s good?
Soros: Probably you’ll need to do more, and it’ll be relatively easier to stimulate GDP than provide employment. Because exports are very labour intensive, and infrastructure projects are more material intensive, and so they provide less employment. A big problem is to generate employment and whether to find work for people in the countryside.
The biggest task of all is for China is to fit in to the global economic system and to play a constructive role in shaping the new financial system. China cannot live in isolation, just as the United States cannot. I think China has to play a more important role in reconstructing the financial system than in the past.
CJ: What’s your view on regulation?
Soros: If you want to have a global financial system, you have to have global regulation, which we don’t have now. All the regulators are national. So you will need to strengthen them, the international financial institutions. That is a big task ahead.
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