Feature Stories | Jan 25 2008
By Greg Peel
”The current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.” – George Soros
Thus legendary hedge fund trader George Soros suggested, in an article written for London’s Financial Times on Tuesday, ahead of the annual World Economic Forum in Davos, Switzerland, that the world was now possibly facing the worst recession it has seen in 60 years. This has proven the hottest article on the net this week, picked up by newspapers and wire services from Sydney to Shanghai.
“I got it wrong”, said Soros. “I have always felt fallible and I have always acted fallible. If I have a bit of an edge it is because I know what I know. I did make the mistake predicting a serious calamity. I got a bit carried away. I do not normally do that.” – George Soros
The above quote appeared in London’s Daily Telegraph. However, it actually appeared on March 23, 2001. At the time, the world was suffering from the bursting of the dotcom bubble. But Soros was making reference to his 1998 book entitled “The Crisis of Global Capitalism”, which he wrote following the historic collapse of hedge fund LTCM that year and the subsequent bail-out of the world financial system by central banks. While Soros then suggested he got a bit carried away in predicting the end of the world as we know it, and that he doesn’t normally do that, it seems Soros is back for another swing. The sky may not have fallen in 1998, but perhaps it will in 2008.
Hungarian-born George Soros was well known in financial circles in the mid-nineties as the world’s most influential hedge fund trader and guru. His was a classic American tale of the rags-to-riches immigrant. Hedge funds were fairly scarce in the nineties, and held in some degree of awe, which is why the collapse of the biggest one – LTCM – was of such significance. That LTCM only lost US$6 billion seems almost inconsequential in the context of today’s credit crisis, where in excess of US$100 billion has already been written down across the globe.
But the name Soros was soon to become a household one when he was credited in 1997 of actually causing the great Asian Currency Crisis of that year. Famously recalcitrant Malaysian president Mohamad Mahathir called the crisis a “Jewish conspiracy” in a thinly veiled attack on the hedge fund trader. Soros’ only crime was to understand that the Little Tiger economies were allowing their currencies to appreciate at an unsubstantiated rate while building up huge current account deficits. So he began heavily shorting them against the US dollar. The rest is history.
After every global financial crisis, the grey-beards of the economic world gather to figure out just what regulations they should put in place to stop it happening again. As you can probably gather from today’s crisis, nothing much ever eventuates. But in 1998 the grey-beards found an ally in Soros. Despite being himself an iconic manifestation of free market capitalism, Soros was keen to argue the case for the regulation of derivative instruments in the wake of LTCM. This was part of his argument in his doomsaying book, so the grey-beards were keen to hear what he had to say. As far as they were concerned, Soros had passed back from the Dark Side.
And so it is that the regulators have turned once again to the guru to address the annual World Economic Forum. Soros wrote the 60-year recession letter to the Financial Times as a precursor. Famous ex-Salomon Bros trainee and author of “Liar’s Poker”, Michael Lewis, last year described the meeting in Davos as such:
“It’s become almost obligatory for the world’s most important economic people, at the beginning of each year, to travel joylessly to the base of a Swiss ski slope and worry. And to worry not privately, with dignity, but publicly, to anyone who will listen. Davos is where people with no talent for risk-taking gather to imagine what actual risk-takers might do.” (“Davos is for Wimps”; FYI; 01/02/07).
Unfortunately for Lewis, his cheeky attack on the value of the World Economic Forum at the time has come back to bite him on the backside. The grey-beards made a general statement last January that “The surging demand for derivatives is making financial markets more vulnerable to any slowdown in the global economy”. On reflection (and this was just before the Shanghai Surprise which brought subprime mortgages to the attention of the world), this has proved to be one of the most glowingly prescient statements made in history. The only problem is, it was pretty much the same statement as was dusted off at Davos every year previously. But Lewis concluded:
“None of them seemed to understand that when you create a derivative you don’t add to the sum total of risk in the financial world; you merely create a means for redistributing that risk. They have no evidence that financial risk is being redistributed in ways we should all worry about. They’re just – worried.”
Lewis was last seen consuming his fedora.
So if Soros was wrong in ’98, why should we listen to him this time? Why, indeed, should he be invited back to Davos once more when he last described himself in 2001 as an “over-aged prima donna”?
The truth is that Soros’ letter makes for compelling reading. He may be a prima donna, but he is a lucid one. As a stand-alone argument, it is hard to fault. But then not everyone agrees with it. A summary of the argument is appropriate at this point.
“The current financial crisis was precipitated by a bubble in the US housing market. In some ways it resembles other crises that have occurred since the end of the second world war at intervals ranging from four to 10 years.”
This statement is then followed by that appearing at the top of this article – Soros has decided this is the big one – the credit crisis to end all crises. Boom-bust cycles usually occur as a result of a failure to recognise the “reflexive” connection between the willingness to lend and the value of the collateral, says Soros. In the case of this housing crisis, easy credit generated demand that pushed up property prices, which in turn increased the amount of credit available. The boom was soon feeding itself. When people buy houses in the expectation they can refinance their mortgages at a profit, a bubble has formed. But this recent boom-bust cycle is only a part of a greater and more complex 60-year (ie post-war) cycle .
“Market fundamentalists believe that markets tend towards equilibrium and the common interest is best served by allowing participants to pursue their self-interest.”
This statement is no better illustrated than by the mantra chanted each day on one CNBC business program in the US: “Free market capitalism is the best path to prosperity”. But as Soros rightly points out (and the program in question tends to gloss over, or even contradicts itself on this point), every time credit expansions run into trouble financial authorities have had to intervene, and have injected liquidity or found other ways to stimulate the economy. That is exactly, of course, what is happening right now. This is the “moral hazard”.
Thus fundamentalism is an “obvious misconception”, notes Soros, as it has always been the intervention of the authorities which has prevented financial markets from breaking down, not the markets themselves. But since the 1980s, the point at which financial markets began to become globalised and the US began running a current account deficit, fundamentalists have dominated. “Globalisation allowed the US to suck up the savings of the rest of the world and consume more than it produced”.
It was the financial markets themselves which encouraged US consumers to borrow more by introducing ever more sophisticated instruments and more generous terms, notes Soros. But rather than restraining this practice, the authorities actually “aided and abetted” by intervening whenever the global financial system was at risk (eg, 1998). Since the eighties, “regulations have been relaxed as to practically disappear”, which is an observation that supports the cynicism Michael Lewis displayed over Davos.
“The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility.”
This is a clear reference to the now famous collateralised debt obligation (CDO), among other exotics. So complex are these instruments, and so effectively clandestine, that the US Federal Accounting Standards Board simply capitulated and allowed for them to be valued for reporting purposes by the holders themselves – on a best guess basis. This is the now legendary method of “mark to myth”.
The ratings agencies also played their part, similarly sacrificing independence, and thus integrity, as a result. Rather than evaluating credit risk from arm’s length, as they had always done in the past, the ratings agencies actually became complicit in the creation of the CDOs in the first place. The whole exercise was to find away to legally turn junk into AAA, and now the creators, the issuers and the agencies have all been found out. (And yes, there’s all sorts of legal action in the offing).
As Soros has suggested, “Everything that could go wrong did.”
What started with simple subprime mortgages spread to CDOs, mortgage insurance, and credit default swaps. The final blow came when banks could no longer trust their counterparties and stopped lending. “The central banks had to inject an unprecedented amount of money and extend credit on an unprecedented range of securities to a broader range of institutions than ever before. That made the crisis more severe than any since the second world war.”
Soros states the obvious in suggesting credit expansion must now be followed by a period of contraction. However, this time there’s a problem. In the past, the world has always turned to the US as the saviour, as the US Federal Reserve is the keeper of the global reserve currency. But the capacity for the Fed to save the day is now constrained by the unwillingness of the rest of the world to absorb additional dollar reserves. Indeed, the world has been trying to move away from the US dollar ever since it was felt by all and sundry that the US current account (reflecting US profligacy) was getting out of hand.
“Until recently, investors were hoping that the US Federal Reserve would do whatever it takes to avoid a recession, because that is what it did on previous occasions. Now they will have to realise that the Fed may no longer be in a position to do so.”
The ability of the Fed to stimulate the economy will come to an end, says Soros, when the yields on US long-term bonds begin to rise despite massive cuts of the cash rate. This would reflect a collapse of the US dollar due to inflation – inflation that is already being driven by the rapid rise of global oil and food prices. “Where that point is, is impossible to determine”, says Soros. (US bond yields have risen sharply these past two sessions, ever since the emergency cash rate cut. But then yields have been very volatile ever since the crisis began.)
And here comes the clincher.
Although Soros suggests a recession in the “developed world” is more or less inevitable, he notes China, India and the Middle East are in a “very strong counter-trend”. Hence the whole world will not fall into recession – there will simply be “a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.” Soros is predicting the end of US hegemony.
But this is not exactly the point that Soros began to argue at the outset. He has declared that the world indeed will be plunged into recession – the worst recession in 60 years. The fall of the US is not enough, in itself, to cause such a global calamity given the strength of emerging economies. What will affect such a calamity, suggests Soros, is the potential for resulting global political tensions, including US protectionism. This may “disrupt the global economy and plunge the world into recession or worse”.
Here endeth the lesson.
Speaking in Davos this week, Soros returned to his call of a decade ago for stringent regulation of the financial industry. The world needs a “new sheriff” for global finance. As Associated Press put it:
“It was stark and jarring message coming from one of the richest businessmen in the world – albeit one who is no stranger to controversy and politics, and has seemed to pride himself on being a maverick”.
And, by his own admission, a “prima donna”, and “fallible”, and one prone to getting carried away. George Soros clearly likes the spotlight. But what do other commentators think of Soros’ prediction?
GaveKal’s Anatole Kaletsky has been arguing since last year that the governments of the world would need to come up with a “Plan B” if the financial markets did not themselves resolve the credit crisis by the end of February. This would involve any or all of (a) central banks slashing rates, (b) governments offering tax incentives, or (c) regulators fudging accounting rules to ensure banks would keep lending. Well tick (a) and (b) and maybe (c) is loosely achieved if the regulators somehow save the bond insurers.
Kaletsky thus asks, rhetorically, does all this mean the world is on the brink of a catastrophic economic crisis? Or does it mean the credit crunch is now over?
Well we know which answer George Soros would give.
Kaletsky suggests Soros is “unequivocally wrong” in suggesting this crisis is the worst the world has seen since the war. A mortgage problem and a 20% fall in stock prices “cannot remotely compare” with the crises of the 70s and 80s, says Kaletsky, when inflation and interest rates soared to 20%, stock markets plunged by 80% in real terms, major banks “fell like nine-pins” and unemployment was double or triple what it is now. But having said that, Kaletsky qualifies his accusations by suggesting Soros “offers the clearest and most persuasive ‘case for the prosecution'” explaining how we got into this credit crisis mess in the first place. Kaletsky suggests Soros’ letter as required reading.
But he also suggests the letter may “nonetheless prove misleading” in anticipating just what might happen next.
Kaletsky agrees that Soros’ predictions of a global credit growth reversal, a slowdown in US consumption and a shift in economic power from the US to Asia “will all undoubtedly happen”. However, he does not believe there is anything to suggest that these shifts will be so abrupt as to cause a serious recession, particularly the greatest recession in 60 years.
Nor does Kaletsky disagree with Soros assessment of economic “fundamentalism” and its interventionary contradictions. But he does suggest Soros is wrong to believe the credit “super-cycle” has been the only “super-boom” driving the world economy. Three more powerful trends in recent decades have been the arrival of three billion new workers and consumers into the world economy (read the Chinese, the Indians et al), the global division of labour which results from almost universal free trade (call that another factor of “globalisation”), and the reduction of transport, communication and data processing costs to virtually zero (call that the internet). Says Kaletsky:
“These secular trends and their consequences are nowhere near exhausted even if turns out that Soros is right to argue that the credit super-cycle is now over.”
Soros makes the argument that financial markets are “reflexive”, suggesting there is no such thing as fundamental equilibrium as markets follow boom-bust cycles, constantly overshooting in each direction. Hence the 60-year super-boom will end with a super-bust. Part of the problem, says Soros, is that authorities always intervene in busts with some form of safety-net stimulation which then only makes the next boom-bust inevitable. While Kaletsky agrees with Soros’ appraisal of equilibrium, he also argues it will be exactly such intervention which will prevent a calamitous bust. For while markets might be “reflexive” they are also “rational”.
This rationality means that we all naturally attempt to create wealth rather than destroy it, and if it wasn’t for the occasional intervention of laissez-faire politicians overruling market forces – that is, crimping pure, free market capitalism – then we would truly descend into the sort of market mad-house Soros describes. “This is the main reason why the world economy has a natural bias towards long booms and short, shallow slow-downs”, says Kaletsky.
Of course, it is Soros’ argument that ultimately the US will fail in its intervention attempts because the world is now shying away from excess US dollars. Therein will follow the shift of power. Kaletsky does not dispute this, he only suggests it will not happen quite so quickly as to bring about Soros’ 60-year recession.
Which suggests it’s all a matter of timing. Soros was wrong in 1998. Will he be wrong again in 2008?”