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He Foresaw the End of an Era

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.

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.

  1. *

    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).

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