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.