New York Review of Books

Volume 55, Number 16 · October 23, 2008
He Foresaw the End of an Era
By John Cassidy
The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means
by George Soros

PublicAffairs, 162 pp.,$22.95

George Soros has been an active investor for more than half a century. In the mid-1980s, when I started writing about Wall Street, he was already a leading hedge fund manager. Not many people understood hedge funds back then, but for those in the know Soros's Quantum Fund, which he founded in 1973, was the model: year after year, it had achieved returns in excess of the broader market. After weathering the 1987 stock market crash, Quantum, since 1989 under the day-to-day management of Stanley Druckenmiller, 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 has never publicly confirmed the exact figure. The British newspapers put it at $1.1 billion.)

Thereafter, Soros spent an increasing amount of his time on philanthropic activities throughout the world, including many laudable efforts to promote the spread of democracy in his native Eastern Europe. (He was born in Budapest in 1930.) After 2001, he also involved himself in domestic politics. A vocal critic of the Bush administration, in the run-up to the 2004 election he donated considerable sums to MoveOn.org, the liberal Internet organization. More recently, he and his family have contributed to Barack Obama's presidential campaign.

But Soros remains first and foremost a speculator. In 2007, after the subprime crisis erupted, he returned, at the age of seventy-seven, to directing Quantum's investments, with results suggesting he hadn't lost his touch. Alpha magazine, a glossy publication that covers hedge funds, estimates that he made $2.9 billion in 2007, placing him second on its list of mega-speculators, behind only John Paulson, of Paulson & Co., who raked in an even more astonishing $3.7 billion.
Harvard / Financial Crisis Books

At the start of this year, Soros, convinced (correctly) that the financial crisis was far from over, adopted a bearish investment strategy, which he describes thus: "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." Initially, some of these positions didn't pay off. Between January and March, US bonds rallied and Indian stocks tumbled, wiping out gains in other parts of Quantum's portfolio. Just how Soros has fared in the past few months of market turmoil may be known only to investors in Quantum, but it would be foolhardy to bet against him.

Forbes magazine recently estimated Soros's net worth at $9 billion. For all his worldly success, though, he still has an unfulfilled ambition: to be taken seriously not just as a financial practitioner but also as a theoretician. In 1987, Simon and Schuster published his first book, The Alchemy of Finance, in which he revisited some of his investments and expounded his theory of "reflexivity," which claims that major market movements, such as the recent rise in commodity prices, sometimes take on lives of their own, entrapping investors in illusions and imparting a fundamental instability to the economic system.

The book proved popular with other investors. Paul Tudor Jones II writes: "When I enter the inevitable losing streak that befalls every investor, I pick up The Alchemy and revisit Mr. Soros's campaigns." But many professional economists, who tend to take a more sanguine view of financial markets, dismissed it out of hand. Writing in The New Republic, MIT's Robert Solow, one of the most respected macroeconomists of the twentieth century, doubted that Soros understood "simultaneous" equations, i.e., systems of equations that involve more than one dependent variable. (For those unfamiliar with economics, this was a bit like accusing a carpenter of not knowing how to use a chisel.)

Solow had a point—he usually does. Soros's presentation of his ideas was a bit garbled. The suspicion lingers, however, that his principal offense was challenging professional economists on their own ground. Now he is at it again—in a much shorter and more digestible book entitled The New Paradigm for Financial Markets—and this time around he and his pet theory cannot be so easily dismissed. Since the publication of The Alchemy of Finance, the global economy has witnessed a long and geographically dispersed series of boom-and-bust cycles, the latest of which is currently ravaging the US economy. While episodes such as these would be perfectly recognizable to Victorian economists such as John Stuart Mill or Alfred Marshall, who referred to them as "trade cycles," they defy modern orthodoxy, which depicts the economy in general, and financial markets in particular, as effective, stable, and self-correcting mechanisms.

As of mid-September, the credit crunch was showing no sign of letting up, indeed it was getting more severe. One big Wall Street investment bank, Lehman Brothers, went bankrupt; another, Merrill Lynch, averted a similar fate by merging with a big commercial bank, Bank of America; AIG, the biggest insurance company in the country, got into such a perilous state that the Federal Reserve, fearful its collapse would bring down a number of other financial institutions, agreed to lend the firm $85 billion, while acquiring 80 percent ownership of the company. Finally, amid signs that despite the AIG bailout the markets were on the verge of a complete breakdown, Treasury Secretary Hank Paulson unveiled a plan for the federal government to buy from the banks up to $700 billion in distressed mortgage securities.

It hardly needs saying that these events were without precedent in postwar history, although students of the Great Depression, such as Fed chairman Ben Bernanke, saw much that was frighteningly familiar. And yet, despite all this, the economists who promulgated the reassuring orthodoxy about financial markets and force-fed it to generations of graduate students have been notably quiet about what went wrong with their theories.

Soros doesn't have all the answers, not by any means. But unlike some of the professors who dismissed him as an overremunerated gadfly, he has something to say. (In recent years, it should be noted, a number of theorists, some rallying under the banner of "behavioral finance," have created more realistic models in which financial markets can depart from economic fundamentals, speculation can be destabilizing, and boom-and-bust cycles can persist. Until very recently, however, these new theories had little or no impact on economic policymaking.[*])

Financial markets perform two essential roles in the economy: (1) they take money from those with no immediate use for it, such as people saving for retirement and the hereditary rich, and put it into the hands of firms and entrepreneurial individuals with productive investment ideas but a shortage of cash to finance them; (2) they allow individuals and institutions to reapportion risk to those more willing to bear it. If Wall Street didn't exist, another method of allocating savings and risks would have to be found. One alternative is diktat, but the history of the Soviet Union and other Communist countries amply demonstrated the difficulties involved in centralizing economic decisions.

The great advantage of a market system is that it draws on information from throughout the economy and translates it into public signals—prices—that investors and firms can react to. Earlier this year, investors woke up to the fact that Detroit had ignored the threat of dwindling oil stocks and had bet its future on gas-guzzling SUVs: the stock prices of American car companies plummeted, making it much more expensive for them to sell equity in their corporations. Toyota and Honda, which had invested heavily in smaller, more fuel-efficient vehicles, have seen their stocks hold up much better, enabling them to raise funds cheaply. Nobody planned it, but in this instance the market rewarded foresight and innovation.

For financial markets to allocate resources to their most productive uses on an ongoing basis, the price signals they send must be the right ones day after day after day. Is this a realistic goal? A typical investor following the Dow's gyrations on CNBC or Yahoo Finance might be tempted to say no, but then the typical investor doesn't have the benefit of an economics Ph.D. from the University of Chicago.

The benign view of markets owes much to three Chicago economists: Milton Friedman, Eugene Fama, and Robert Lucas. Although best known for his work on monetary theory and his enthusiastic espousal of capitalism, early in his career Friedman had played a key part in developing the "efficient markets hypothesis," which, together with its younger sibling the "rational expectation hypothesis"—see below—provided the intellectual underpinning for more than two decades of financial deregulation. Briefly put, the efficient markets hypothesis states that prices of stocks, bonds, and other speculative assets necessarily reflect everything that is known about economic fundamentals, such as inflation, exports, and corporate profitability. The proof proceeds by contradiction. Suppose stock prices have risen above levels justified by the fundamentals. Then clever speculators, such as Soros, will step in and sell them, thereby restoring prices to their proper levels. If stocks fall below their fundamental value, speculators will step in and buy them.

Friedman actually formulated the efficient markets hypothesis in an analysis of currencies. It was Fama, one of his students, who applied it to the stock market and pointed out an interesting corollary: if stock prices already reflect everything that is known and knowable, then investors can't hope to outperform the market using trading strategies based on publicly available information. Rather than wasting time and effort trying to pick individual stocks, they would be well advised to place their savings in a broadly diversified mutual fund that tracks the daily movement of the market. Largely thanks to Fama and his followers, so-called index funds today have a central part in many Americans' retirement planning.

Lucas, the third member of the Chicago triumvirate, was arguably more influential even than Friedman. In a series of ingenious papers published in the 1960s and 1970s, he and several colleagues extended the hyperrational methodology underpinning the efficient markets hypothesis to other parts of the economy, such as the job market, the output decisions of firms, and the formulation of economic policy. By the time they were done, Lucas et al. had invented a new way of doing macroeconomics, known as the rational expectations approach, which enshrined in higher mathematics the stabilizing properties of unfettered markets. You don't have to spend much time on Wall Street to recognize that expectations are what drive the markets. If investors anticipate good news, they buy; if they expect bad news, they sell.

Where, though, do these economic expectations come from? According to Lucas, they reflect a predefined, externally grounded, and commonly agreed upon reality. In his models, the economy's equations of motion are well defined and known to all—from Ph.D. economists at the University of Chicago to nurses and cab drivers. Utilizing this common knowledge, people form "rational expectations" of things like inflation and interest rates. They don't always get things right—a certain amount of randomness is allowed for—but they are precluded from making systematic errors. If in one period the economy gets out of sync, in the next period it jumps back to the "equilibrium" defined by the model.

Not content to create new models, Lucas also disparaged older theories that viewed financial capitalism more skeptically. Keynesianism wasn't merely wrong, he declared at one point: it was no longer intellectually respectable.

Soros had neither the inclination nor the technical ability to challenge the Chicago school's formal arguments. (In a charming passage, he reveals that he wasn't very good at math, and that he achieved poor grades at the London School of Economics, where he studied in the late 1940s.) What he does possess, however, is voluminous amounts of firsthand knowledge gained in the financial markets, together with a keen interest in formulating a theory on the basis of his observations. Academic criticism of The Alchemy of Finance didn't put him off that effort. "My conceptual framework remained something very important for me personally," he writes. "It guided me both in making money as a hedge fund manager and in spending it as a philanthropist: and it became an integral part of my identity."

Outside the idealized world of Lucas's theory, knowledge is imperfect, people stick to wrongheaded ideas, and there is no agreed version of how the economy works. In these circumstances, Soros rightly points out, economic expectations, even biased ones, can help to determine economic fundamentals. One way to grasp what Soros is getting at is to look at the diagram on this page, in which the arrows indicate the directions of causation. Soros doesn't refer to this diagram, which I drew up myself, but he spells out the relations it illustrates:

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 function).

A simple hypothetical example—for which I also take responsibility—may help to illustrate what can happen in such a reflexive system.

Imagine that ABC Corp. makes profits of $W per share, pays dividends of $X a share, and is growing at Y percent per annum. If you assume that this rate of earnings growth will persist indefinitely, it is a matter of high school arithmetic to figure out what ABC Corp.'s stock is worth on a fundamental basis, an amount I will call $Z. In the world of the Chicago economists, well-informed investors bid the price up to $Z and stop there. If prices rise above that level, they step in and sell; if prices fall below $Z, they buy. All is rational: all is efficient.

Now imagine that a group of irrationally exuberant investors come to believe that ABC Corp.'s growth rate is about to accelerate to 2Y percent, and, as a result, they bid up its stock up $2Z and keep it there for a while. What happens next? One possibility is that ABC Corp. could issue more of its highly rated shares and use them to purchase a rival, DEF Corp., whose stock price has been lagging—hence presenting a relative bargain. Thanks to the magic of acquisition accounting, the mere act of ABC Corp. buying DEF Corp. would make it appear that its earnings per share were growing rapidly. Voilà, the inflated earnings expectations that drove up ABC Corp.'s stock would have turned out to be justified. Most likely, the stock would rise even further—for a while, anyway.

If the previous discussion seemed a bit abstract, don't lose heart. In the second half of his book, Soros applies his theoretical frame to events he has lived through, beginning with the conglomerates boom of the late 1960s and ending with today's credit crunch. Reflecting on the harsh reception afforded to his earlier book, he writes:

Many critics of reflexivity claimed that I was belaboring the obvious, namely that the participants' biased perceptions influence market prices. But the crux of reflexivity is not so obvious; it asserts that market prices can influence the fundamentals. The illusion that markets manage to be always right is caused by their ability to affect the fundamentals they are supposed to reflect. The change in the fundamentals may then reinforce the biased expectations in an initially self-reinforcing but eventually self-defeating process.

Of course, such boom-bust sequences do not happen all the time. More often the prevailing bias corrects itself before it can affect the fundamentals. But the fact that [such sequences] can occur invalidates the theory of rational expectations. When they occur, boom-bust processes can take on historic significance. That is what happened in the Great Depression, and that is what is unfolding now, although it is taking a very different shape.

One of Soros's earliest professional coups was investing in fast-growing industrial conglomerates, such as Textron, LTV, and Teledyne, which during the early days of the Nixon administration used their inflated stocks to buy out a succession of other companies. Just as in the example of ABC Corp., simply combining a lower-rated company with a higher-rated one boosted reported earnings per share for the lower-rated company. Even though investors such as Soros knew full well that much of this growth was an accounting illusion, they continued to bid up the conglomerates' stocks, thereby keeping the game going.

In order for it to continue indefinitely, however, the acquirers had to target bigger and bigger companies. Eventually, the Reliance Group, Saul Steinberg's outfit, launched a takeover bid for the venerable Chemical Bank that generated an establishment backlash. Steinberg's bid failed, and investors began to question the reported earnings growth of Reliance and other conglomerates. Knowing that the jig was almost up, Soros sold out and moved on to the next boom-bust cycle, which, in his case, turned out to be in real estate investment trusts.

Breaking up the narrative, Soros provides a handy eight-stage guide to the typical boom-bust cycle, together with a series of stock charts to help readers spot one in the making. Turning to the current situation, he says that, in large part, the recent housing bubble in the United States fit the historic pattern, except that in this case reflexivity was centered on the real estate rather than the stock market. As house prices shot up between 2001 and 2005, credit standards deteriorated sharply. Rather than restricting their lending, mortgage financiers deluded themselves into believing that the collateral for the loans they were making would continue to rise in value. The very act of extending more and more credit, on easier and easier terms, kept demand for real estate buoyant, which, in turn, ensured that for several years the lenders' optimistic expectations were validated. 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.

What distinguishes this process from earlier downturns, and what makes it so dangerous, is the historical and international economic situation in which it is taking place, Soros says. "Superimposed on the US housing bubble," he writes, "is a much larger boom-bust sequence which has finally reached its inflection, or crossover, point." The housing slump is following the normal historical pattern, he suggests,

but, in addition, it has also set in motion a flight from the dollar and unwinding of the other excesses introduced into the financial system by recent innovations. That is how the housing bubble and super-bubble are connected.

As described by Soros, the "super-bubble" developed over the past quarter-century and is the result of three underlying trends: globalization, credit expansion, and deregulation. By globalization, he means not just expansion of trade in goods and services, and the rise of China and India, but the US's emergence as the world's biggest debtor. In the past couple of years, he reminds us, the United States has been running a current account deficit of more than 6 percent of GDP—a level usually associated with a developing country about to suffer a foreign exchange crisis.

The US has been able to avoid that fate because of the dollar's status as the main international reserve currency, and because foreign governments, particularly the one in Beijing, have proved willing to purchase enormous quantities of Treasury bonds. "There was a symbiotic relationship between the United States, which was happy to consume more than it produced, and China and other Asian exporters, which were happy to produce more than they consumed," Soros notes. "The United States accumulated external debt: China and the others accumulated currency reserves."

The lending boom extended far beyond the housing market. Over the past generation, the overall expansion of the US economy has increasingly become an asset-driven phenomenon. In 1980, the total amount of credit market debt outstanding in the United States was roughly the same as the GDP: by 2007, it had risen to about 350 percent of GDP. The bundling of residential mortgages into widely traded securities—"securitization"—played a significant role in this transformation, but so did increased federal lending resulting from large-scale budget deficits, the securitization of credit card debt and auto loans, and an expansion in corporate debt issuance. Soros isn't the first to point out these trends, but his description of the changes he has witnessed since starting out on Wall Street is instructive, nonetheless. In the years after World War II, he points out:

The total amount of credit outstanding in relation to the size of the economy was much less than it is today, and the amounts that could be borrowed against different types of collateral were also much smaller. Mortgages required at least 20 percent down payment, and borrowing against stocks was subject to statutory margin requirements that restricted loans to 50 percent or less of the value of the collateral. Auto loans, which required down payment, have been largely replaced by leases, which do not. There were no credit cards and very little unsecured credit. Financial institutions represented only a small percentage of the capitalization of US stocks. Very few financial stocks were listed on the New York Stock Exchange. Most banks were traded over the counter, and many of them traded only by appointment.

Until last summer, the US economy was awash in easy credit. In one way or another, the banking system played an important part in issuing many of these loans, which is hardly surprising since that is how banks make money. Rather than criticizing his fellow investors on Wall Street, who created many of the newfangled debt instruments—such as mortgage-backed securities and collateral debt obligations—that have now imploded, Soros puts the blame on the regulators and central bankers who aided and abetted the financiers' incendiary activities. Under the system of "self-regulation" adopted by American and European banking regulators, many big financial institutions, such as Citigroup, Barclays, and Union Bank of Switzerland, were allowed to rely on their internal risk-management systems. The only outside check on their activities came from commercial ratings agencies, such as Moody's and Standard & Poor's, which depended on the banks' fees for business.

"I find this the most shocking abdication of responsibility on the part of the regulators," Soros writes.

If they could not calculate the risk, they should not have allowed the institutions under their supervision to undertake them. The 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 credit expansion.

As long as credit was flowing freely, the three elements of the "super-bubble" reinforced one another. Now that the housing bubble has burst and economic growth has slowed dramatically, reflexivity is working in the opposite direction: market fundamentals are influencing investor perceptions. The global capital market that enabled the US to finance a huge trade deficit has proved equally adept at transferring the subprime shock to other parts of the world: after rushing in to capture the high yields offered by US subprime securities, big European banks have been forced to write off almost as much money as their American brethren. (Taking the United States and Europe together, banks and other financial institutions have, so far, written off roughly $450 billion in subprime-related charges. Many institutions are sitting on losses that they haven't yet declared. Estimates of the total losses that will eventually result range from $1 trillion to $2 trillion.)

As nerves fray and values of collateral plummet, many big financial institutions are desperately trying to eliminate the debt showing on their balance sheets. Individually, this may make sense. When banks do this collectively, it deprives worthwhile capital projects of funding and risks deepening the economic downturn, which, in turn, could well lead to more loans going bad. As Lawrence Summers, the Harvard economist and former Treasury secretary, recently noted in the Financial Times, this is but one of several vicious cycles operating simultaneously. Falling asset prices are forcing investors with heavy borrowings into distress sales, which is putting more downward pressure on prices. As GDP growth slows, firms are laying off workers. Higher unemployment leads households to cut back on their spending, which reduces economic growth. "Without active efforts to interfere with these mechanisms," Summers wrote in an article published on August 6, "there can be no basis for confidence that the American economy will recover even in the medium term."

Soros would surely agree with that statement. Finishing his manuscript earlier this year, he predicted that the economic slump would be prolonged, partly because problems in the financial system would make countercyclical policies—such as easing the money supply to stimulate investment—less effective than usual. During 2008, the Fed has cut short-term interest rates to 2 percent and established virtually unlimited borrowing lines to financial firms. Congress has voted through a refinancing scheme for many of the homeowners who fall behind on their mortgage payments.

In early September, in an effort to bring down mortgage rates and put an end to the housing slump, the Bush administration took the dramatic step of effectively nationalizing Fannie Mae and Freddie Mac, two giant mortgage lenders that the government originally set up but which had for many years operated as private companies. The federal takeover added more than $5 trillion to the national debt, and, especially coming from a Republican administration, it represented a historic extension of public intervention in the American economy; the Treasury Department then, without congressional approval, granted itself warrants to buy up to 80 percent of AIG's stock. (One Republican senator, Jim Bunning of Kentucky, lambasted the move as socialism and called on Treasury Secretary Hank Paulson to resign.) Yet despite all these moves, rates on jumbo mortgage loans—the type many home buyers have to take out if they live in places like New York, Boston, and Washington—remain close to 8 percent. Not surprisingly, house prices in most major markets are still falling.

Where will it end? Viewed from Soros's perspective, the dramatic events of mid-September demonstrated how reflexivity was working on the downside, to devastating effect: the slumping real estate market had wreaked havoc on banks and other financial institutions, which had reacted by tightening lending standards, and cutting back on the amount of credit, particularly mortgage finance, that they were willing to extend to households and firms. Tighter credit conditions, in turn, were hurting the economy and putting further downward pressure on property prices, shattering hopes that the credit markets would stabilize of their own accord, and that troubled firms would be able to recapitalize their balance sheets.

Some sort of recovery was what Richard S. Fuld, Lehman's former chief executive, and his colleagues had been hoping for. From the fall of 2007 onward, the firm, which was founded in 1850, was struggling to survive. Rather than selling out to a bigger, sounder institution, its managers gambled that the credit markets would rebound, arresting the fall in value of tens of billions of dubious real estate assets festering on the firm's balance sheet. The turnaround never came. By the time that Lehman was prepared to give up its independence, in mid-September, it was facing a funding crisis, and there were no purchasers interested. (The Treasury Department and the Federal Reserve didn't deem Lehman strategically important enough to save, so it went bust. AIG, on the other hand, was too big to be allowed to fail.)

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 surviving institutions to start lending again. With Hank Paulson's bailout plan, we have now reached that stage, where the taxpayer is called upon to rectify the bankers' mistakes. Although the plan comes with a $700 billion price tag, the eventual cost could be even larger. Some observers have compared what is happening now to the S&L crisis of the late 1980s, when the government set up the Resolution Trust Corporation to dispose of the assets of insolvent thrifts, but that was a relatively trivial exercise compared to what is ahead. A better analogy is the Japanese banking crisis of the 1990s, where the government initially refused to recognize the scale of the problem, but ended up, after almost a decade of economic stagnation, having to spend vast sums of public money on recapitalizing the country's financial sector. Even then, the Japanese economy failed to resume its previous growth rates: after a few years of modest expansion, it has once again slipped into near-recession.

It is to be hoped that the Paulson plan has a more invigorating effect on the US economy, but despite the recent celebrations on Wall Street a happy outcome is far from guaranteed. Critics have questioned the timing, ethics, politics, and efficacy of the proposal. The Treasury secretary is seeking absolute freedom to enact the plan as he sees fit. Under his proposed legislation, "decisions by the secretary pursuant to the authority of this act are nonreviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency"—a position rejected by members of the Senate Banking Committee who questioned Paulson on September 23. (Writing in the Financial Times on September 25, Soros proposed an alternative rescue plan, also suggested by Senator Charles Schumer and others, of injecting public money directly into the banks, through government purchases of preferred stock.)

From an economic perspective, what matters is whether the Paulson plan, or one close to it, will work: Are the planned purchases of assets big enough to make a difference? What about all the other increasingly toxic assets that financial institutions have on their books, including roughly $950 billion of securities linked to risky "alt-A" mortgages; hundreds of billions of dollars in securitized auto loans and credit card debts; and countless dubious credits that were extended during the boom to commercial real estate developers and leveraged buyout firms? Would it have been cheaper and more effective for the government to have recapitalized the big banks by taking equity stakes in many of them?

Even if the Paulson plan, or some variation of it, restores some degree of normalcy to the credit markets, it is far from certain that a modest fall in mortgage rates and a greater willingness to lend on the part of financial institutions will be sufficient to break the self-reinforcing impetus toward recession that has taken hold in other parts of the economy. Much depends on what happens to the housing market and to the global economy, which, in providing a ready market for US exports—and in providing cash by buying US government bonds—has helped to prevent a much sharper downturn in output and employment.

One of Soros's points is that the behavior in markets he defines as reflexivity adds a fundamental indeterminacy to economic events, which makes prediction very tricky. Still, given his taste for the grand philosophical statement, he couldn't resist imparting a few thoughts about the future. Writing well before the latest dramatic developments, he said:

Eventually, the US government will have to use taxpayers' money to arrest the decline in house prices. Until it does, the decline will be self-reinforcing, with people walking away from homes in which they have negative equity and more and more financial institutions becoming insolvent, thus reinforcing both the recession and the flight from the dollar. The Bush administration and most economic forecasters do not understand that markets can be self-reinforcing on the downside as well as the upside. They are waiting for the housing market to find a bottom on its own, but it is further away than they think.

Soros wasn't all gloom and doom. He said rapid growth in the developing world, particularly China, would continue, and he brushed aside fears that the international banking system would collapse, as it did in the 1930s. After observing the pathologies the financial system had exhibited since the summer of 2007, he called for more regulation, including stricter limits on leverage, the amounts borrowed for investment. But Soros's main conclusion went beyond specific forecasts of policy recommendations. The period of history that the elections of Margaret Thatcher and Ronald Reagan ushered in had come to an end, he said:

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.

Since 1971, when the Nixon administration abandoned the dollar's link to gold, many commentators have predicted the demise of the American currency and an end to US economic hegemony, only to be proved wrong, or, at least, premature. Soros could well end up joining this group—he freely admits he has been too pessimistic on previous occasions. (A decade ago, he underestimated the global economy's ability to rebound from the Asian financial crisis.) If the Paulson bailout succeeds in excising from the US banking system the distressed mortgage securities that have caused so much trouble; if there is a recovery of confidence on Wall Street; if the housing market stabilizes; if the recent fall in the oil price is sustained—then the US economy and currency could yet display their Houdini-like qualities one more time. Conversely, Soros's reading of the financial omens has enriched him oftentimes before: betting against him now could be unwise.

—September 25, 2008

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Notes

[*] See Andrei Shleifer, Inefficient Markets: An Introduction to Behavioral Finance (Oxford University Press, 2000), and Advances in Behavioral Finance, Vol. 2, edited by Richard H. Thaler (Russell Sage Foundation/Princeton University Press, 2005).