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He Foresaw the End of an Era

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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