Pondering the crisis, and peddling a new paradigm
 

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CRISIS breeds opportunity, as the bottom-fishers starting to circle beaten-up mortgage bonds and leveraged loans can attest. For George Soros it offers a chance of a different sort: to revive his favourite intellectual theory. In his latest book, “The New Paradigm for Financial Markets”, published on April 3rd, he sets out to illuminate the credit crunch through the prism of “reflexivity.”

The 77-year-old hedge-fund supremo and slayer of sterling has nothing to prove financially (he is worth upwards of $8 billion). Intellectually, however, he has long been frustrated at not being taken seriously. Just as he was about to give up, along came a debacle that, he believes, validates his Weltanschauung.

The theory draws on thoughts first developed in his 1988 bestseller, “The Alchemy of Finance”, which was itself influenced by the work of Karl Popper, one of Mr Soros’s philosophical heroes. Essentially, it says that financial markets have built-in biases which have an impact not only on prices but also, in extreme times, the fundamentals themselves. In such moments, market events affect as well as reflect supply and demand.

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Reflecting on reflexivity

America’s housing crisis, he contends, exemplifies this. Lenders made more money available for home-buying in the 1990s. More people bought houses, increasing their prices. This boosted the value of the collateral on banks’ balance sheets, encouraging them to lend more. Prices rose further, prompting more lending and a relaxation of underwriting standards, and so on.

Financial history is dotted with booms and busts, as Mr Soros knows all too well; he first got his hands dirty in the conglomerate bubble of the 1960s. But this crisis is profoundly different from its predecessors, he argues—at least, all those since the Depression—because two bubbles are coinciding: a “straightforward” one in housing, pumped up by low interest rates in the wake of the dotcom collapse; and a longer-term, more complicated “super-bubble” fed by globalisation, deregulation and decades of credit expansion, which is taking in commodities, currencies and more besides. As a result, investors are fleeing the dollar and are unlikely to return soon. Its days as the world’s reserve currency are numbered.

The subprime-mortgage crisis exposed the cracks in financial innovation, especially synthetic structured products. But it was “merely the trigger that released the unwinding of the super-bubble,” reckons Mr Soros.

His prognosis is grim. America will pay for its “market fundamentalism”, which was “no better than Marxist dogma”. Thanks to a general inability or unwillingness to factor in reflexivity, he says, the entire system has been brought to the point of breakdown. As central banks struggle to contain the damage, they face new demons. The giant market for credit-default swaps, overrun by hedge funds acting essentially as unlicensed insurers, hangs like a Damocles sword that will fall when corporate defaults rise.

The economic impact on America will be hard. Just as the financial bubble lifted the economy, so the credit contraction will drag it down. The flow of credit has already been disrupted more severely and for a longer period than ever before, he contends. The Fed’s hands are largely tied because of the vulnerable dollar and the spectre of inflation.

Strong exports will help offset the pain, but only for a while. The wider picture is less depressing. Thanks to enduring strength in the developing world, a global recession can be avoided. But China is in the middle of an asset bubble that will, eventually, cause a financial crisis.

The new paradigm that Mr Soros advocates is the financial equivalent of the political third way. We need markets—how else do you make a few billion? But we must accept that, left to their own devices, they will lurch dangerously in both directions.

Regulators need to regain the control they happily ceded in the 1980s, particularly over excessive borrowing. The idea that risk management can be left to the moneymen is an “aberration”. After three decades of stellar growth, the financial-services industry needs to shrink and become less profitable. The last two chapters are peppered with smaller suggestions, such as the creation of a clearing house with proper margin requirements to ease counterparty fears in derivatives markets.

But all this raises as many questions as it answers. Mr Soros admits that while more regulation is needed, regulators themselves tend to mess things up. Indeed, he pours scorn on American supervisors: waving through Byzantine products that they could not have understood—since even their clever creators did not—was a “shocking abdication of responsibility”.

Is he really giving markets a fair hearing? True, the situation is ugly. But all crises look worse than the last when you are in the middle of them—even to greybeards. Prices may have a lot further to fall, as he contends. Or they may not. (Once the bottom-fishers start to nibble, expect a feeding frenzy.) Innovation clearly went too far. But who wants to go back to the 1970s, when banking was all but frozen by draconian regulation?

Ultimately the palindromic arch-speculator, lured by another chance to meld philosophy and finance, may be trying too hard to make reflexivity work. “I have always wanted to be a philosopher, and finally I may have become one,” he gurgles at one point.

In any case, if the past is a guide, most readers will be more interested in his latest investment strategy than his grand theories. They will find what they are looking for on page 135, where Mr Soros crisply points out that he is “short US and European stocks, US ten-year government bonds, and the US dollar; long Chinese, Indian and Gulf States stocks and non-US currencies.” Call your broker. Now.

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