[THS] The Financial Crisis: An Interview With George Soros

[Peter Webster]

http://www.truthout.org/docs_2006/050608H.shtml

The Financial Crisis: An Interview With George Soros
    By Judy Woodruff
    The New York Review of Books

    15 May 2008 Issue

    The following is an edited and expanded version of an interview with
George Soros, Chairman, Soros Fund Management, by Judy Woodruff on
Bloomberg TV on April 4.

    Judy Woodruff: You write in your new book, The New Paradigm for
Financial Markets,[1] that "we are in the midst of a financial crisis the likes
of which we haven't seen since the Great Depression." Was this crisis
avoidable?

    George Soros: I think it was, but it would have required recognition that
the system, as it currently operates, is built on false premises.
Unfortunately, we have an idea of market fundamentalism, which is now
the dominant ideology, holding that markets are self-correcting; and this is
false because it's generally the intervention of the authorities that saves the
markets when they get into trouble. Since 1980, we have had about five or
six crises: the international banking crisis in 1982, the bankruptcy of
Continental Illinois in 1984, and the failure of Long-Term Capital
Management in 1998, to name only three.

    Each time, it's the authorities that bail out the market, or organize
companies to do so. So the regulators have precedents they should be
aware of. But somehow this idea that markets tend to equilibrium and that
deviations are random has gained acceptance and all of these fancy
instruments for investment have been built on them.

    There are now, for example, complex forms of investment such as credit-
default swaps that make it possible for investors to bet on the possibility that
companies will default on repaying loans. Such bets on credit defaults now
make up a $45 trillion market that is entirely unregulated. It amounts to
more than five times the total of the US government bond market. The
large potential risks of such investments are not being acknowledged.

    Woodruff: How can so many smart people not realize this?

    Soros: In my new book I put forward a general theory of reflexivity,
emphasizing how important misconceptions are in shaping history. So it's
not really unusual; it's just that we don't recognize the misconceptions.

    Woodruff: Who could have? You said it would have been avoidable if
people had understood what's wrong with the current system. Who should
have recognized that?

    Soros: The authorities, the regulators—the Federal Reserve and the
Treasury—really failed to see what was happening. One Fed governor,
Edward Gramlich, warned of a coming crisis in subprime mortgages in a
speech published in 2004 and a book published in 2007, among other
statements. So a number of people could see it coming. And somehow, the
authorities didn't want to see it coming. So it came as a surprise.

    Woodruff: The chairman of the Fed, Mr. Bernanke? His predecessor, Mr.
Greenspan?

    Soros: All of the above. But I don't hold them personally responsible
because you have a whole establishment involved. The economics
profession has developed theories of "random walks" and "rational
expectations" that are supposed to account for market movements. That's
what you learn in college. Now, when you come into the market, you tend
to forget it because you realize that that's not how the markets work. But
nevertheless, it's in some way the basis of your thinking.

    Woodruff: How much worse do you anticipate things will get?

    Soros: Well, you see, as my theory argues, you can't make any
unconditional predictions because it very much depends on how the
authorities are going to respond now to the situation. But the situation is
definitely much worse than is currently recognized. You have had a general
disruption of the financial markets, much more pervasive than any we have
had so far. And on top of it, you have the housing crisis, which is likely to
get a lot worse than currently anticipated because markets do overshoot.
They overshot on the upside and now they are going to overshoot on the
downside.

    Woodruff: You say the housing crisis is going to get much worse. Do you
anticipate something like the government setting up an agency or a trust
corporation to buy these mortgages?

    Soros: I'm sure that it will be necessary to arrest the decline because the
decline, I think, will be much faster and much deeper than currently
anticipated. In February, the rate of decline in housing prices was 25
percent per annum, so it's accelerating. Now, foreclosures are going to add
to the supply of housing a very large number of properties because the
annual rate of new houses built is about 600,000. There are about six
million subprime mortgages outstanding, 40 percent of which will likely go
into default in the next two years. And then you have the adjustable-rate
mortgages and other flexible loans.

    Problems with such adjustable-rate mortgages are going to be of about
the same magnitude as with subprime mortgages. So you'll have maybe
five million more defaults facing you over the next several years. Now, it
takes time before a foreclosure actually is completed. So right now you have
perhaps no more than 10,000 to 20,000 houses coming into the supply on
the market. But that's going to build up. So the idea that somehow in the
second half of this year the economy is going to improve I find totally
unbelievable.

    Woodruff: So how long will this last?

    Soros: Well, it depends on when the authorities wake up, because you
need to reduce the number of foreclosures. You need to keep as many
people as possible in their houses so that they don't come onto the market.
You need to arrest the decline in house prices, but you also need to prevent
human suffering and social disruption because it's going to be very, very
severe. Certain communities are already hurting and it's going to get a lot
worse. So action will have to be taken, but I don't think it's going to happen
during this administration.

    Woodruff: You said the Federal Reserve had to step in to engineer the
buyout by J.P. Morgan of Bear Stearns to prevent a much bigger
catastrophe. You've also said that to do this, the Fed had to take on
considerable risk. Is this an unhealthy amount of risk that the Fed has taken
on?

    Soros: This is their job, whether unhealthy or not; I don't think it's
actually so severe. But that is their job, to save the system when it is in
danger. However, because that is their job, it ought to be their job also to
prevent asset bubbles from developing. And that task has not been
recognized. Greenspan once spoke about the "irrational exuberance" of the
market. It had a bad echo and he stopped talking about it. And it's
generally accepted that the Fed tries to control core inflation, but not asset
prices. I think that control of asset prices has to be an objective in order to
prevent asset bubbles because they are so frequent.

    Woodruff: And that's more than what the Fed is doing.

    Soros: It's more than what it's doing now. You have to recognize that
just controlling money doesn't control credit. You see, money and credit
don't go hand in hand. The monetarist doctrine doesn't stand up. So you
have to take into account the willingness to lend. And if it's too great—if
borrowers can obtain large loans on the basis of inadequate security—you
really have to introduce margin requirements for such borrowing and try to
discourage it.

    Woodruff: When you talk about currency you have more than a little
expertise. You were described as the man who broke the Bank of England
back in the 1990s. But what is your sense of where the dollar is going?
We've seen it declining. Do you think the central banks are going to have to
step in?

    Soros: Well, we are close to a tipping point where, in my view, the
willingness of banks and countries to hold dollars is definitely impaired. But
there is no suitable alternative so central banks are diversifying into other
currencies; but there is a general flight from these currencies. So the
countries with big surpluses—Abu Dhabi, China, Norway, and Saudi Arabia,
for example—have all set up sovereign wealth funds, state-owned
investment funds held by central banks that aim to diversify their assets
from monetary assets to real assets. That's one of the major developments
currently and those sovereign wealth funds are growing. They're already
equal in size to all of the hedge funds in the world combined. Of course,
they don't use their capital as intensively as hedge funds, but they are
going to grow to about five times the size of hedge funds in the next twenty
years.

    Woodruff: How low do you think the dollar will go?

    Soros: Well, that I don't know. I can see the trend, but I don't know its
extent, and I don't know when something might happen to turn it around.
Once the economy stabilizes, probably the overshoot on the currencies
would also be corrected.

    Woodruff: Few people know more about hedge funds than you do.
You've been enormously successful with your own hedge fund. Should
hedge funds be more regulated by Washington?

    Soros: I think hedge funds should be regulated like everything else. In
other words, you have to control leverage—credit obtained for investment
purposes—somewhere. Excessive use of leverage is at the bottom of this
problem. And there have been hedge funds that have been using leverage
excessively and some of those have gone broke. The amount of leverage
that people are allowed to use has to be regulated. I think it's best done
through the banks. In other words, the banks' reserve requirements—the
amounts of money they are obliged to hold—should be tailored to the
riskiness of their customers. So investment funds that use a lot of leverage
ought to be seen as very risky; and therefore they would not get the
amount of leverage they seek because the banks wouldn't give it to them.

    Woodruff: New regulation, though: Could that impede the ability of
hedge funds to be the big players that they have been in these markets?

    Soros: Yes, I think that there has been excessive use of credit and it
does have to be limited. So we are now in a period of very rapid
deleveraging and I think that in the future we ought not to allow leverage
to be used to the extent that it has been in the past.

    Woodruff: You write, "We are at the end of an era." When this current
credit crisis ends, will the US still be, no doubt about it, the world
superpower when it comes to the economy?

    Soros: Not at all. This is now in question. And you now have entered a
period of really considerable uncertainty and turmoil because of the general
flight from currencies, which manifests itself in the commodities bubble that
has developed. The price of gold hasn't yet gone as high as it might. So
what comes out of this turmoil is very open to question. I think that you will
have to somehow reconstruct the global financial architecture because you
have recognized that, in effect, the economic weight has changed
considerably among the different countries. China has become much more
important and also India, and so on. What kind of system will evolve from
this is, I think, a very open question.

    Woodruff: What about China? How much of an economic competitor
could it end up being?

    Soros: Well, China is rising. It's been the main beneficiary of
globalization. Their currency is significantly undervalued and for various
reasons they have to allow it to appreciate, recently at a rate of 10 percent.
And it's been accelerating now to 15, 20 percent, which makes the situation
more difficult for the Fed because you now have the prospect of core
inflation in the US accelerating because if our imports coming from China
go up in price by 15 percent, it will come through in core inflation. The
price of goods at Wal-Mart is rising and will probably continue to rise and
then accelerate.

    Woodruff: So while people are thinking that goods are cheaper from
China, you're saying the prices go up. It affects so many things that we buy
in this country. What of Russia and how its economy is doing?

    Soros: Basically, the country is benefiting from the high price of oil, but,
at the same time, it is reestablishing a very authoritarian regime where the
rights of investors are not respected. Now it is British Petroleum that is
being chased out. So you invest at your own risk. I've done it and I'm not
going to do it again.

    Woodruff: So what you see in Russia tells us that political freedom and
economic freedom are separable after all?

    Soros: Well, the lack of political freedom also impinges on the rights of
shareholders. So it's not a suitable area for investing exactly because you
don't have the rule of law. China is improving a great deal. The rule of law
is getting stronger in China, even though you don't have democracy.

    Woodruff: The most attractive emerging market?

    Soros: At this time, the outlook for India is also very good.

    Woodruff: Let me mention two other points because they are so much
on the minds of our leaders today. One is fighting the war on terror. Should
the next president be prepared to sit down with the leaders of organizations
like Hamas, like Hezbollah, countries like Iran?

    Soros: Absolutely. I wrote another book arguing that the entire idea of a
"war on terror" is a misleading concept that has got this country off on the
wrong track.[2] It is responsible for our invading Iraq under the wrong
pretenses and for a decline of our political influence and military power that
has no precedent.

    Woodruff: Where do you see the "war on terror" ten years down the
road?

    Soros: I hope that we will put it behind us. If you think in terms of
human security and you say that the role of governments is to make the
people secure, then it leads you to a completely different line of action. And
even in Iraq, the surge, which was quite successful militarily, tried to
provide protection for civilians, instead of just chasing terrorists whom we
couldn't find after breaking into houses and terrifying the people. Concern
for human security, making us feel safe and making the people in other
countries feel safe: I think that would get you to a totally different line of
action.

    Woodruff: Bringing us back to this country in the midst of this economic
credit crisis that you write about and that you've been describing, we are
also in the middle of a presidential election. You endorsed Barack Obama
the day he announced. Why him rather than your home state senator,
Senator Clinton?

    Soros: Well, I have very high regard for Hillary Clinton, but I think
Obama has the charisma and the vision to radically reorient America in the
world. And that is what we need because I'm afraid we have gotten off the
right track and we need to have a greater discontinuity than Hillary Clinton
would bring.

    Woodruff: You have no concern that he lacks the experience to lead in
this dangerous time that we live in?

    Soros: I think that he has shown himself to be a really unusual person.
And I think this emphasis on experience is way overdone because he will
have exactly the same advisers available as Hillary Clinton, and it will be a
matter of judgment whom he chooses. And actually, he is more likely to
bring in new blood, which is what we need.

    Woodruff: Recently, Senator Obama has endorsed some of the things
we've been talking about: greater financial regulation, having for example
the Federal Housing Administration insure unaffordable mortgages against
default. Do you think this goes far enough, what he's talking about? Did he
talk with you at all?

    Soros: No, I've had absolutely no contact with him or any of the
Democratic leadership on this issue. Now that my book is out, maybe I will
in the future. But these are my ideas and they are not responsible for them.

    Woodruff: From what you know about what he's saying about the
housing crisis, do you think he goes far enough?

    Soros: No, nothing right now goes far enough and Representative
Barney Frank, who really understands the issues, is not pushing that far
because, in order to get bipartisan support, you can't. So if you want
something done, you have to set your sights lower. And that is what he has
done and I think he is getting a few things through. But they are not
enough.

    Woodruff: A larger question on the campaign—you gave, I believe,
something like $23 million in 2004 to various Democratic efforts:
MoveOn.org and candidates. Far less than that so far this year—why the
change?

    Soros: Well, because I think that was a unique time when not having
President Bush reelected would have made the situation of this country and
of the world much better. I think now it's less important. And, in any case, I
don't feel terribly comfortable being a partisan person because I look
forward to being critical of the next Democratic administration.

    Woodruff: What of your book and the philosophy that comes of it?

    Soros: In human affairs, as distinguished from natural science, I argue
that our understanding is imperfect. And our imperfect understanding
introduces an element of uncertainty that's not there in natural
phenomena. So therefore you can't predict human affairs in the same way
as you can natural phenomena. And we have to come to terms with the
implication of our own misunderstandings, that it's very hard to make
decisions when you know you may be wrong. You have to learn to
recognize that we in fact may be wrong. And, even worse than that, it's
almost inevitable that all of our constructs will have some kind of a flaw in
them. So when it comes to currencies, no currency system is perfect.

    So you have to recognize that all of our constructions are imperfect. We
have to improve them. But just because something is imperfect, the
opposite is not perfect. So because of the failures of socialism, communism,
we have come to believe in market fundamentalism, that markets are
perfect; everything will be taken care of by markets. And markets are not
perfect. And this time we have to recognize that, because we are facing a
very serious economic disruption.

    Now, we should not go back to a very highly regulated economy because
the regulators are imperfect. They're only human and what is worse, they
are bureaucratic. So you have to find the right kind of balance between
allowing the markets to do their work, while recognizing that they are
imperfect. You need authorities that keep the market under scrutiny and
some degree of control. That's the message that I'm trying to get across.

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