The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means

Speaker: George Soros, Chairman, Soros Investment Fund Inc.

Moderator: Daniel Gros, Director, CEPS

Date: 17 April 2008

Before an audience of CEPS members and guests at the Club de Warande in Brussels, George Soros, the famously successful speculator, investor, author, philanthropist and political activist, presented his latest book, The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means, containing his views on the current financial crisis, its causes and solutions.   

According to Soros, the crisis emerged with the bursting of the US housing bubble and has its origins in the dominance of the current paradigm of ‘efficient markets', or so-called market fundamentalism or ideology. In his view, this assumption is incorrect from a philosophy of science standpoint. Market fundamentalism assumes that markets function efficiently, move to the equilibrium, and therefore work in everyone's best interest. However, contrary to the views of his mentor Karl Popper, Soros argues against the unity of science and considers economics a social science that cannot rely on natural science assumptions. Natural phenomena operate according to the law of cause and effect and humans use their cognitive abilities to understand. Yet, humans do not only observe but play a participative-manipulative role in social science phenomena. In terms of the market, the concept of equilibrium is a natural science theory that does not apply to economics. Specifically, Soros focuses on the concept of reflexivity, where individuals with their perception shape reality and create disequilibrium rather than equilibrium when they enter into market transactions. This leads to uncertainty. The evidence shows that contrary to the statistical assumption of normal distribution, reflexivity leads to ‘thick tails'.

In practical terms, the crisis started in the 1970s, when the oil crisis led to imbalances between oil importers and producers, which had to be covered by the banks. This resulted in a bank crisis in the early 1980s under Reagan and Thatcher, when banks were given greater freedom to cope, relying on the market to take care of it. According to Soros, the credit expansion trend towards a bubble was reinforced by the misperception of a self-correcting market, which in turn reinforced the bubble. Usually, when there are signs that a possible bubble if forming, there is a testing/twilight period. If this test is passed, the misperception prevails and the bubble grows. If this test is not passed, policy is adapted and there is no bubble. For the current crisis, the test would have had to be failed and the authorities would have been obliged to regulate the financial market. However, on the contrary, the test was passed and the housing bubble burst in August 2007, exposing all the accumulated weaknesses based on market fundamentalism. One of those weaknesses is that instead of financial regulation, moral hazard was created, whereby the institutions causing the financial risk were not the ones to fully bear it.

The current financial crisis, which is characterised by a situation of uncertainty, liquidity shortages and solvency problems (where counter-parties cannot deliver), offers a strong argument in favour of a paradigm shift away from market fundamentalism towards more financial market regulation. In Soros' opinion, an international financial regulation agreement, for example a Basel III Accord, would be suitable. He proposes to regulate every aspect of financial market, encompassing capital, derivatives and currency markets.
 
Soros suggests that the authorities have not understood the necessity of a paradigm shift and thereby deny any responsibility for this current crisis. Instead of regulating the financial market, for example, he expects the Fed to react in conventional ways: increase the money supply by lowering interest rates to counter the effects of the crisis until even this strategy fails. The United States might face a recession and inflation, which might have a global impact due to the globalisation of international financial markets. He observed that the ECB had limited its actions to keeping the interest rate at 2%. There will definitely be global effects but they will affect different sectors in different parts of the world to a different degree.
 
The prediction is that ‘everything will be fine, it is just a question of time'. Concerning the dollar as a strong or weak currency, Soros thinks that the euro will not replace the dollar as a global reserve currency and that the dollar will eventually recuperate. For the moment, there is a general flight from cash towards real assets until the dollar becomes the reserve currency again.
 
A Hungarian journalist proposed to Soros that he should fund the creation of modern think-tanks to research his theories and propose regulation. Soros replied that research can be like finance: the higher the risk, the higher the possible return. In other words, the more risky the theory defended, the higher the return when the theory turns out to render the best predictions.