A Soros Solution for the Global Meltdown

03-16 08:31 Caijing comments( 0 )

"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

By staff reporter Ye Weiqiang

(Caijing Magazine) 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 traveled 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 -- itʼs 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 -- thatʼs 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. Thatʼs the
character of a bubble. Itʼs not the only form of reflexibility, but itʼs very dramatic form
because bubbles can be very powerful.

I have a special theory hypothesis with regard to whatʼs 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 thatʼs
why this crisis is not like other crises.
CJ: Is it good to change the game?

Soros: Itʼs not something you can control. Itʼs 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. Itʼs more than confidence because, in reality, the international banking
system has become largely insolvent. So itʼs 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 itʼs 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 itʼs now politically difficult to secure additional funds needed
for proper recapitalization.

CJ: Whatʼs the governmentʼs 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: Whatʼs the governmentʼs approach, in reality?

Soros: The government is examining the balance sheets of banks, and thatʼll 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; thatʼs very far from normal. You
canʼt get back to normal in a simple way; you have to fi rst replace the credit with
government credit, which means effectively creating money, increasing the balance
sheet of the Federal Reserve Bank. But thatʼs 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 itʼs not the only actor; it needs counterparties to balance.

CJ: How do you value toxic assets?

Soros: You donʼt 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 administrationʼs stimulus plan?

Soros: Itʼs certain to help moderate the decline. Itʼll be a counter-cyclical force. Itʼs
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 donʼt 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 thatʼs
quite significant. And if itʼs 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 canʼt 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 donʼt think weʼll ever get back to where we came from. In other words,
itʼs 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 itʼll 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 itʼs not just a simple economic cycle.

Soros: Fundamental change.

CJ: Chinaʼs stimulus plan, do you think itʼs good?

Soros: Probably youʼll need to do more, and itʼll be relatively easier to stimulate
GDP than provide employment. Because exports are very labor 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: Whatʼs your view on regulation?

Soros: If you want to have a global financial system, you have to have global
regulation, which we donʼt have now. All the regulators are national. So you will
need to strengthen them, the international financial institutions. That is a big task
ahead.

Full Article in Chinese: http://magazine.caijing.com.cn/2009-03-15/110120995.html