Worst Financial Crisis since the 1930s

A Review of George Soros’s Crash of 2008

George Soros graduated from the London School of Economics and established Soros Fund Management Inc. He is a philanthropist and has established foundations around the world that have made great achievements in the protection of human rights and improving public access to education and health care. He currently lives in New York.

BY SNEHA SHARMA

“Normal rules do not apply and the abnormal becomes normal.”1 George Soros describes the current recession as abnormal resulting from people misunderstanding the financial market in The Crash of 2008. This misunderstanding results in ineffective handling of boom-bust cycles and housing crises. This “interference reflexivity” adversely affects the entire economy.2 Beginning his first chapter with a psychological rather than financial analysis, Soros writes that there are underlying mindsets that cause people to make bad decisions that can ultimately adversely affect the economy. Although Soros also offers an in depth financial analysis of the recession that explains why the recession occurred, he also builds support for his reflexivity theory pertaining to the misunderstanding mentioned above.

Although people “seek to understand the world in which they live in,” they also want to “make an impact on the world.”3 A reflexive situation involves these two elements interfering with one another. Today’s economic theory excludes such reflexivity; however, Soros argues that economists must take this theory seriously in order to better understand and resolve the recession. Theorists tout the rationalist theory which predicts how the economic situation will be in the future. Although this theory can be effective, it does not consider the element of uncertainty. After all, the future financial market is ever changing and cannot always be predicted mathematically with graphs and charts. Soros was more “interested in the real world” rather than mathematical models, which led him to develop his reflexive theory.4 Instead of focusing on just the numerical amounts that drive economics, Soros uses the first few chapter of his book to expound on the theory of reflexivity focusing on which elements should be taken into consideration when analyzing the recession. People must realize “there is always more to be understood” and should always looks to understand more about their situation.5 Soros reiterates that people should assume nothing about the economy, especially not the most popular assumption—markets tend towards equilibrium. If this equilibrium theory were true, the reflexivity theory could never exist, since the equilibrium theory assumes the predictability of the financial market. However, the current recession has proved that markets do not tend toward equilibrium and therefore almost unpredictable. Soros offers a wrong theory that “supply and demand curves are independent of market prices.”6 Obviously, this postulation is untrue but many commodity markets regard it as true. Basically, Soros wants to reiterate that market trends cannot always be predicted. He wants readers to understand the ever present element of uncertainty related to such financial markets. Indeed, the book’s purpose is build support for his unpopular reflexivity theory that takes into account such uncertainty.

Soros, a billionaire today, earned his first fortune as a hedge fund manager, a popular position during the conglomerate boom of the 1960s. During this time companies were valued for their “growth of reported per share earnings.”7 Soros classifies this prevailing thought as a misunderstanding from investors who did not understand reflexivity and equity leveraging and therefore sold stock at inflated valuations to generate income. This led to stock inflation. All participants continued investing without knowing where the financial market was headed. Soros contends that if the theory of reflexivity was applied, investors would generate more profit and stock prices would not be as inflated. The reflexivity theory can also be applied to the real estate investment trusts. Because of these trusts many people went bankrupt. The overvaluation of mortgage trusts allows people “to justify the overvaluation by issuing additional shares at inflated prices.”8 People then try to imitate this process and the whole situation ends up with wide spread bankruptcy. Another boom-bust process also caused by equity leveraging follows a pattern of “slow start, gradual acceleration, gradual acceleration in the boom phase and catastrophic collapse,” which is also the pattern of bubbles that occur in the financial markets.9 However, the reflexive theory does not just manifest itself as a bubble but also as a floating exchange rate with regimes and market valuations. Therefore, market participants must always understand the principal of uncertainty and the whole reflexive process. It is because of this uncertainty that market prices reflect the thoughts and reactions of people more than just numerical data. Thus, Soros relates all of his financial analysis to his reflexive theory. Since the financial market can be unpredictable authorities must set regulations on it. Many market fundamentalists blame market fallibilities on the market regulators. However, Soros argues against the fundamentalist thought that “regulations should be abolished” because this will lead to an utter collapse of the market.10 Rather, people need to reexamine market regulations. Soros does not blame market regulations for the fallibility of market, since some form of “credit or leverage or some misconception or misrepresentation “is usually involved.11 Although the financial crisis today is as major as that of the Great Depression, it will not be as terrible since the banking system will prevent it from collapsing as it did before.

The housing bubble faithfully followed the pattern described above. This bubble, one of the many causes for the current recession, was sustained by speculation and aggressive lending practices. The bubble finally burst in 2007 as housing prices rapidly fell. Although the government intervened, Soros argues that the government cannot continuously intervene because it has done it too often and this “financial crisis is not like others.”12 Market fundamentalists also tried globalizing the financial markets, which makes these markets harder to regulate. This globalization did not “bring about the level playing field” it was supposed to provide to participants.13 Developed countries had a greater influence over the entire process. The United States gradually gained more external debt while other countries gained currency reserves. Households gradually became more dependent on double digit appreciation on their houses but when housing prices stopped rising this trend had to reverse and a “flight from the dollar ensued.”14 Therefore another cause for the recession was created The flow of credit from the banks to the economy is disrupted and a meltdown of the entire financial system almost occurred.

The new paradigm of reflexivity that Soros proposed cannot predict the future state of the economy like the equilibrium theory. It cannot provide any generalization but does let participants understand what decisions to make in the prevailing economic situation and profit. By writing this book Soros hopes to get others engaged in his theory. Later on “newly introduced trading and financial techniques were offered.15 However, all of these new ideas and strategies were based on the theory of equilibrium therefore having a fatal flaw. The inception of globalization began in 1980 with Ronald Reagan and Margaret Thatcher. Then came a technology bubble in 2000 and with lowered interest rates this bubble burst. Soros finds that at this time “there was a shocking abdication of responsibility” by regulators.16 Alan Greenson was the chairman of the Federal Reserve at the time. “Responsibility for the real estate bubble” can be justly given to him. He supported Bush tax cuts, cutting on discretionary spending and social spending.17 Soros predict that the ability of the Federal Reserve to hold long-term obligations and dollars will be constrained. However the United States’ recession will be helped by a current account deficit improvement. A little inflation for the economy might be a good thing but it is necessary that regulators that they keep a close eye on the value of the money. Soros finds that the “financial markets are more occupied with the liquidity crisis” than with the long term effects. All participants in the market must look ahead more instead of just creating policies that will resolve current problems. In China the “real cost of capital is already negative.”18 This will create an asset bubble. This may happen to the US if it does not prepare more for the future. The Federal Reserve also cut rates on stocks which surprised most people. Soros believes that the U.S. government will “eventually have to use taxpayers’ money to arrest the decline of housing prices.”19 More financial solutions will become insolvent. The financial industry must also not be so big that it cannot be controlled by the government. Soros suggests that the “establishment of a clearing house of exchange for credit default swaps” could work to help control the financial crisis.20 Foreclosures have destabilized entire neighborhoods as well. Pooling and service agreements would allow greater flexibility. The financial authorities did not help stop the current financial crisis before it began. The value of the dollar decreased at the end of 2008. When the financial system collapsed after the bubble ended, the treasury secretary was unprepared. The bursting of bubbles creates credit contractions and forces people to liquidate their assets and destroys the personal wealth of many. Only the creation of money can balance this contraction of credit. Soros believes that three methods—recapitalizing the banking system, writing off or down accumulated debt, and “creating money to offset the contraction of credit- could prevent a severe depression.”21 What Soros suggests the government do is radical, unorthodox. Soros believes the financial crisis was handled badly by the Bush administration which pushed the economy into an even deeper slump—to remedy this, he suggests that Obama create a fiscal stimulus package, a thorough overhaul of the mortgage system, recapitalization of the banking system, an innovative energy policy, and a reform of the international finance system.22 Soros obviously believes that the financial market should be regulated and without any regulation the financial market could get any worse.

His psychological theory of reflexivity also supports the regulation because participants in a market without regulation would have nothing to base decisions on. Although Soros’s purpose in writing the book was to build support for his reflexive theory, he also provides valuable insight into how the system works—and since the natural flow of money is erratic, people must not try to define a pattern for the financial market. The theory of reflexivity basically provides a reason for the current recession: people assumed too much about the market and made decisions that ultimately led to the current economic decline. The 1930s crisis is a severe example of the current recession. Over investing in stocks and bad financial instruments contributed as well. All the problems of the current recession are well defined in the book; however, Soros also offered many solutions to the myriad problems the government is facing and how they must combat the deeper the slump the economy may go into. Soros thinks it is necessary to regulate all credit. Today, financial markets have completely collapsed and it is necessary to keep them alive to keep the economy from relapsing into depression. Like what the government did in the 1930s, Soros wants the government to take more control of the economy in order to help it. An innovative energy policy could also play a big part in resolving this financial crisis-some new policies would involve putting a tax in fossil fuels and taxing carbon emissions. This extra income would then be distributed to other households and help in resolving the recession. This distribution of money is what the economy needs rather than producing money and risking inflation. Today “exports suffer for the lack of trade finance” thus government regulators must protect the unstable condition of the economy.23 Therefore Congress will give away stimulus packages that they must implement with care in order to better the recession. Soros predicts that the government will play a huge role in financing since it will be the largest role in financing.

Although Congress will have to pump more and more money into the economy in the form of stimulus packages problems will arise in two areas: exchange rates and interest rates. Different nations hold different views of the problem and this causes wide swings in the values of the exchange rates. Soros maintains that the most important factor in the developing world is China all of these international forces that will play a big part on the global market; Soros emphasizes the need for international cooperation in order to reform this economic crisis. However, the financial institutions of Europe remain undeveloped. Soros hopes that this time will be a “period of development for the European Union.”24 Europe does not have a common fiscal policy or treasury. Throughout the book, Soros emphasizes the need for international cooperation and the fact that nations must unite in order to better their current economic situations and eventually help the global economy turn around. This thought is different because most countries are caught up in their own situations rather than trying to help each other. They key to solving the current crisis is to better individual economies in hopes of bettering the global economy. The book’s purpose is to persuade readers that the reflexive theory is the root cause of many of the causes of the recession. Although this was Soros’s only purpose in writing the book he also manages to give an in depth analysis of the cause of the recession, the actual events of the recession, and the way the government must go about in dealing with this recession. Also, Soros links the international recession to global economics by mentioning China and India as well as the oil exporting countries. He advocates international cooperation between these countries in order to work together to overcome this recession. Indeed it is Soros’s theory of reflexivity that distinguishes his book from many other about the recession. Through his work Soros is author, economist, and philosopher. In fact the regulation of banks is in the hand of national leaders instead of Europe wide ones which results in bad policies impeding Europe to be economically read for any sort of severe recession. Today the global financial system has collapsed and Europe must use its international relations constantly in dealing with the crisis. Soros feels the entire recession was not caused by some external factor but by the financial system. These complex causes can be traced back to the psychological theory that participants in the financial markets have misconceptions about the market as illustrated by the Soros’s reflexive theory. Indeed, reflexivity gives rise to this causes that cannot be quantified, rather they can only be examined and described as they are of the human mind. Soros is trying to discover if reflexivity can be modeled and whether quantitative models should be such a major factor in dealing with financial markets. Although Soros defines many reasons both quantitatively and logically that caused the current recession, he also writes a great deal about his reflexivity theory that dealt more with a psychological cause for this recession: the situation at hand and what the person wants to manipulate the situation. There is also an inherent misunderstanding between the individual and market he is trying to participate in. Although his theory is complex, Soros breaks the theory and offers real life examples to support his arguments. The theory is not accepted into most economic circles, but Soros argues that he made his great fortune on the basis of this theory and others can as well as long as they do not believe what many economic theorists believe: that the economy follows a general pattern and that investors can follow this pattern to financial success. Overall the economy must be based on decisions people are making now instead of perceived trends.

At first The Crash of 2008 appears similar to any other book of commentary on the recession. But readers soon discover George Soros is trying to support and argue for his reflexive theory and to ultimately banish a lot of the mistaken beliefs in patterns of the recession. He tries to make readers understand that they must make decisions in the market while understanding there will always be room for error no matter how carefully thought out the decision is. Because the theory is relatively simple readers will be able to understand the rest of Soros arguments and commentary on the recession easily because it will tie back into his reflexivity theory.

Endnotes

Student Bio

Sneha Sharma was born in Sri Lanka in 1993. She moved to America when she was five years old. Although she loves to learn about history, she enjoys her English classes more. She hopes to become a lawyer one day.