[OPE] The Financial Crisis: An Interview with George Soros

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The Financial Crisis: An Interview with George Soros

 By George Soros, Judy Woodruff

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.

 ----------------------
Doğan Göçmen
Author of The Adam Smith Problem:
Reconciling Human Nature and Society in
The Theory of Moral Sentiments and Wealth of Nations,
I. B. Tauris, London&New York 2007

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