The Financial Crisis
The New York Review of Books, December 4, 2008
Edited by Andy Ross
The current financial crisis was generated by the financial system itself.
The financial system melted down. A large money market fund saw its asset
value fall below the dollar amount deposited. This started a run on money
market funds. The issuers of commercial paper were forced to draw down their
credit lines, bringing interbank lending to a standstill. The stock market
was overwhelmed by panic. All this happened in the space of a week.
American and European financial authorities committed themselves not to
allow any other major financial institution to fail. But guaranteeing that
the banks at the center of the global financial system will not fail has
precipitated a new crisis. Countries at the periphery could not offer
similarly credible guarantees, and financial capital started fleeing from
the periphery to the center. Currencies fell against the dollar and the yen.
Commodity prices dropped like a stone and interest rates in emerging markets
soared. So did premiums on insurance against credit default. Hedge funds and
other leveraged investors suffered enormous losses.
My new theory of
market behavior differs from the current one in two respects. First,
financial markets do not reflect prevailing conditions accurately. Second,
the distorted views expressed in market prices can affect the fundamentals
that the prices are supposed to reflect. This interaction between market
prices and the underlying reality I call reflexivity.
correct their own mistakes, but occasionally there is a misconception that
reinforces a real trend and thus reinforces itself. Such processes may carry
markets far from equilibrium. The interaction may persist until the
misconception becomes glaring and the trend becomes unsustainable. The
self-reinforcing process then starts working in the opposite direction.
The typical sequence of boom and bust has an asymmetric shape. The boom
develops slowly and accelerates gradually. The bust is short and sharp. The
asymmetry is due to the role of credit. As prices rise, the same collateral
can support a greater amount of credit. At the peak of the boom, both the
value of the collateral and the degree of leverage reach a peak. When the
price trend is reversed, participants are vulnerable to margin calls. The
forced liquidation of collateral leads to a catastrophic acceleration on the
Bubbles thus have two components: a trend that prevails in
reality and a misconception relating to that trend. For example, in real
estate, the trend consists of an increased willingness to lend and a rise in
prices. The misconception is that the value of the real estate is
independent of the willingness to lend. That misconception encourages
bankers to become more lax in their lending practices. The misconception
recurs despite a long history of real estate bubbles bursting.
Bubbles always involve the expansion and contraction of credit and they tend
to have catastrophic consequences. Since financial markets are prone to
produce bubbles, the markets are regulated by the financial authorities. In
the United States they include the Federal Reserve, the Treasury, the
Securities and Exchange Commission, and many other agencies.
Regulators base their decisions on a distorted view of reality just as much
as market participants, perhaps even more so because regulators are not only
human but also bureaucratic and subject to political influences. So the
interplay between regulators and market participants is also reflexive in
character. In contrast to bubbles, which occur only infrequently, the
cat-and-mouse game between regulators and markets goes on continuously.
The current crisis differs from the various financial crises that
preceded it. I base that assertion on the hypothesis that the explosion of
the US housing bubble acted as the detonator for a much larger
"super-bubble" that has been developing since the 1980s. The underlying
trend in the super-bubble has been the ever-increasing use of credit and
leverage. Credit has been growing at a much faster rate than the GDP ever
since 1945. But the rate of growth accelerated and took on the
characteristics of a bubble when it was reinforced by a misconception that
became dominant in 1980.
The misconception is that the pursuit of
self-interest should be given free rein and markets should be deregulated. I
call that belief market fundamentalism and claim that it employs false
logic. Just because regulations and all other forms of governmental
interventions have proven to be faulty, it does not follow that markets are
Although market fundamentalism is based on false premises,
it has served well the interests of the owners and managers of financial
capital. The globalization of financial markets allowed financial capital to
move around freely and made it difficult for individual states to tax it or
regulate it. The financial industry grew to a point where it represented 25
percent of the stock market capitalization in the United States and an even
higher percentage in some other countries.
Market fundamentalism is
built on false assumptions. The adverse consequences were suffered
principally by the countries that lie on the periphery of the global
financial system. The system is under the control of the developed
countries, especially the United States. Whenever a crisis endangered the
prosperity of the United States, the authorities intervened. The United
States sucked up the savings of the rest of the world and ran a current
account deficit. Regulators abdicated their responsibility to regulate.
Financial engineering involved the creation of increasingly
sophisticated instruments, or derivatives, for leveraging credit and
"managing" risk in order to increase potential profit. The regulators could
no longer calculate the risks and came to rely on the risk management models
of the financial institutions themselves. The models were based on the false
premise that deviations from the mean occur in a random fashion. But the
increased use of financial engineering set in motion a process of boom and
My interpretation of financial markets based on reflexivity can
explain events but it does not claim to determine the outcome as equilibrium
theory does. It can assert that a boom must eventually lead to a bust, but
it cannot determine either the extent or the duration of a boom. Indeed,
those of us who saw the housing bubble expected it to burst much sooner. Had
it done so, the damage would have been much smaller and the super-bubble may
have remained intact.
Reflexivity introduces an element of
uncertainty into financial markets that the previous theory left out of
account. That theory was used to establish mathematical models for
calculating risk and converting bundles of debt into tradable securities.
Uncertainty by definition cannot be quantified. Excessive reliance on those
mathematical models did untold harm.
The new paradigm has
far-reaching implications for the regulation of financial markets.
The End of an Era
The New York Review of Books, October 23, 2008
Edited by Andy Ross
George Soros has been an active investor for more than half a century. He
founded the Quantum Fund in 1973, which year after year achieved returns in
excess of the broader market. After weathering the 1987 stock market crash,
Quantum racked up more big gains, culminating in a huge bet against the
pound sterling in 1992, which reportedly netted more than a billion dollars.
Soros then spent an increasing amount of his time on philanthropic
activities throughout the world.
remains first and foremost a speculator. Alpha magazine estimates that he made $2.9 billion in 2007. Forbes magazine
recently estimated his net worth at $9 billion. But Soros also wants to be taken seriously
as a theoretician.
Financial markets perform two essential
roles in the economy. They take money from those with no immediate use for
it and put it into the hands of those with productive investment ideas, and
they allow individuals and institutions to reapportion risk to those more
willing to bear it. For financial markets to work correctly, the price
signals they send must be the right ones day after day after day.
benign view of markets owes much to three Chicago economists: Milton
Friedman, Eugene Fama, and Robert Lucas. Friedman
played a key part in developing the efficient markets hypothesis, which
states that prices of stocks, bonds, and other speculative assets
necessarily reflect everything that is known about economic fundamentals.
Fama applied the efficient markets hypothesis to the
stock market: investors cannot hope to outperform the market using trading
strategies based on publicly available information.
Lucas extended the methodology
to invent the rational expectations approach, which enshrined in higher
mathematics the stabilizing properties of unfettered markets driven by
had neither the inclination nor the technical ability to challenge the
formal arguments. He says he got poor grades at the London
School of Economics, where he studied in the late 1940s. But he has a lot of
firsthand knowledge gained in the financial markets.
Soros: "Reflexivity can be interpreted as a circularity, or two-way feedback
loop, between the participants' views and the actual state of affairs.
People base their decisions not on the actual situation that confronts them
but on their perception or interpretation of that situation. Their decisions
make an impact on the situation (the manipulative function), and changes in
the situation are liable to change their perceptions (the cognitive
Soros says the recent
housing bubble in the United States fits the historic pattern. As house
prices shot up between 2001 and 2005, credit standards deteriorated sharply.
It was only when borrowers who had taken out loans they couldn't afford
started to default in large numbers that the housing bubble finally burst.
A "super-bubble" developed over the past
quarter-century and is the result of three underlying trends: globalization,
credit expansion, and deregulation. Globalization includes the emergence of
the United States as the world's biggest debtor. In the past couple of
years, the United States has been running a current account deficit of more
than 6% of GDP.
risk models of the banks were based on the assumption that the system is
stable. But, contrary to market fundamentalist beliefs, the stability of
financial markets is not assured; it has to be actively maintained by the
authorities. By relying on the risk calculations of the market participants,
the regulators pulled up the anchor and unleashed a period of uncontrolled
History shows that ad hoc attempts to resolve banking crises seldom work.
The only thing that puts an end to the downward spiral is government
intervention on a grand scale, socializing the losses that have been
incurred, and freeing up the survivors to start again.
Soros points out that reflexivity adds a fundamental indeterminacy to
economic events, which makes prediction very tricky.
Soros: "So what does the end of an era really mean? I contend
that it means the end of a long period of relative stability based on the
United States as the dominant power and the dollar as the main international
reserve currency. I foresee a period of political and financial instability,
hopefully to be followed by the emergence of a new world order."
A Successful Prophet
By John Authers
Financial Times, May 19, 2008
Edited by Andy Ross
George Soros thinks the credit crisis marks the end of an era of credit
expansion based on the dollar. He devised his own theory to prove markets
were not efficient. He acted on this philosophy as an investor with
spectacularly successful results.
That philosophy derived from his
undergraduate studies at the London School of Economics under Karl Popper.
In the relationship between thinking and reality, Soros says, thinking plays
a dual role: participants in a market try to understand the situation (the
cognitive function), and to change it (the manipulative function). When the
two functions interfere with each other, the market displays reflexivity.
So an investor's misperception of reality can help to change that
reality, begetting further misperceptions. When market actors' decisions
affect outcomes, patterns emerge. If a lot of people are bullish about
internet stocks their price goes up. Soros used the theory to predict, and
profit from, a series of "initially self-reinforcing but eventually
self-defeating boom-bust processes, or bubbles".
A key implication of
this is that markets do not tend toward equilibrium. And they will not move
in the random walk promulgated by efficient markets theory, which holds that
prices always incorporate all known information and so move randomly in
response to new information. The architecture of modern capital markets
depends on these theories.
Soros believes that a "super-bubble" has
been formed as the result of a "long-term reflexive process" over the last
25 years. Its hallmarks include credit expansion (boosted by the belief that
inflation has been vanquished) and a prevailing misconception, which Soros
blames on Ronald Reagan and Margaret Thatcher, that markets should be given
Soros calls himself a "failed philosopher" — but he was a
AR George and I are entangled in intrigung ways.
I too studied philosophy in Karl Popper's department at the London School of
Economics, albeit a quarter of a century later, when Popper had
retired.George's speculation against the pound in 1992 cost me several
hundred pounds on the value of my British investments. But since George then
spent his gains on philanthropic ventures, that episode is forgiven.
As an economics student at Oxford, I denounced the efficient market and
rational expectations theories as based on a classic liberal philosophy that
failed to account for the deep irrationalism of human agents in economic
markets. I soon found a ready echo for my critique of the prescientific
fragments of psychology and sociology that are used to shore up economic
orthodoxy in the writings of Karl Popper, which led me away from economics
and toward the LSE, where I studied logic and scientific method.
Soros concept of reflexivity recalls my own envisaged repair of economic
theory. In economic life, thought and reality are coupled in an ongoing
feedback loop. At the time, I unpacked this in terms of the Hegelian concept
of a dialectic, which in effect means that thought and reality co-evolve in
reciprocal feedback cycles. In my gloss, these cycles form the stages of a
dialectic, which I then proceeded to model in axiomatic set theory, in order
to avoid the charge of fuzzy thinking that attends any appeal to dialectics
in the context of hard science. But all my theorizing deflected me from the
simple truths of economic life — and from the stern task of getting rich.