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A Partnership with China to Avoid World War

George Soros July 9, 2015 Issue           You can bet whatever George Soros says is complete bullshit, He's an Illuminati NWO bastard!
soros_1-070915.jpg Pete Souza/White House President Barack Obama and Chinese President Xi Jinping, Beijing, November 2014

International cooperation is in decline both in the political and financial spheres. The UN has failed to address any of the major conflicts since the end of the cold war; the 2009 Copenhagen Climate Change Conference left a sour aftertaste; the World Trade Organization hasn’t concluded a major trade round since 1994. The International Monetary Fund’s legitimacy is increasingly questioned because of its outdated governance, and the G20, which emerged during the financial crisis of 2008 as a potentially powerful instrument of international cooperation, seems to have lost its way. In all areas, national, sectarian, business, and other special interests take precedence over the common interest. This trend has now reached a point where instead of a global order we have to speak of global disorder.

In the political sphere local conflicts fester and multiply. Taken individually these conflicts could possibly be solved but they tend to be interconnected and the losers in one conflict tend to become the spoilers in others. For instance, the Syrian crisis deteriorated when Putin’s Russia and the Iranian government came to Bashar al-Assad’s rescue, each for its own reasons. Saudi Arabia provided the seed money for ISIS and Iran instigated the Houthi rebellion in Yemen to retaliate against Saudi Arabia. Bibi Netanyahu tried to turn the US Congress against the nuclear treaty the US was negotiating with Iran. There are just too many conflicts for international public opinion to exert a positive influence.

In the financial sphere the Bretton Woods institutions—the IMF and the World Bank—have lost their monopoly position. Under Chinese leadership, a parallel set of institutions is emerging. Will they be in conflict or will they find a way to cooperate? Since the financial and the political spheres are also interconnected, the future course of history will greatly depend on how China tackles its economic transition from investment and export-led growth to greater dependence on domestic demand, and how the US reacts to it. A strategic partnership between the US and China could prevent the evolution of two power blocks that may be drawn into military conflict.

How did we reach this point of global disorder? During the cold war the world was dominated by two superpowers. Each maintained some degree of control over its allies and satellites, and avoided direct military confrontation with the other because of the danger of Mutually Assured Destruction. It was a MAD system but it worked: it produced a number of local military conflicts but it avoided a world war.

When the Soviet empire fell apart the United States had an opportunity to become the sole superpower and the guarantor of peace in the world, but it did not rise to the occasion. The US was founded on the principle of individual freedom and it was not predisposed to become the policeman of the world. Indeed, it did not have a coherent view of the meaning of leadership in international affairs. During the cold war it had a bipartisan foreign policy, on which Democrats and Republicans largely agreed; but after the cold war ended the partnership broke up. Both parties continued to emphasize American sovereignty but they rarely agreed on subordinating it to international obligations.

Then in 1997, a group of neoconservatives argued that the US should use its military supremacy to impose its national interests, and established a think tank called the Project for the New American Century, “to promote American global leadership.” But that was a false approach: military force cannot be used to rule the world. After the terrorist attack of September 11, the neocons persuaded President George W. Bush to attack Iraq on dubious grounds that turned out to be false, and the US lost its supremacy. The Project for the New American Century had approximately the same lifespan as Hitler’s Thousand-Year Reich: around ten years.

On the financial side, by contrast, there was a clear consensus—the so-called Washington Consensus—on America’s role in the world. It became dominant in the 1980s under the leadership of Ronald Reagan and Margaret Thatcher. It had strong ideological support from market fundamentalists; it had a supposedly scientific foundation in the Efficient Market Hypothesis and Rational Choice Theory; and it was efficiently administered by the International Monetary Fund (IMF). The consensus was a much more subtle compromise between international governance and national self-interest than the neocons’ view that military power is supreme.

Indeed, the Washington Consensus had its roots in the original compromise on which the Bretton Woods institutions were founded. John Maynard Keynes proposed a truly international currency, the bancor, but the US insisted on the dollar as the world’s reserve currency and it prevailed. In the memorable words of George Orwell’s Animal Farm, “all animals are equal, but some animals are more equal than others.” The Washington Consensus promoted free trade and the globalization of financial markets. In the late 1990s, market fundamentalists even tried to modify the articles of agreement of the IMF so as to impose capital account convertibility, the free exchange of currencies. That attempt failed, but by allowing financial capital to move around freely the Washington Consensus also allowed capital to escape taxation and regulation. That was a triumph for market fundamentalism.

Unfortunately, the scientific foundations of this approach proved to be ill conceived. Unregulated financial markets are inherently unstable: instead of a general equilibrium that assures the optimum allocation of resources, they produce financial crises. This was dramatically demonstrated by the crash of 2008. By coincidence, 2008 marked both the end of America’s political supremacy and the demise of the Washington Consensus. It was also the beginning of a process of financial and political disintegration that first manifested itself in the microcosm of the European Union, but then spread to the world at large.

The crash of 2008 had a lasting negative effect on all the economies of the world, with the notable exception of China’s. The Chinese banking system was relatively isolated from the rest of the world and largely government-owned. As a consequence, the Chinese banks could, at the government’s behest, offset the collapse of external demand by flooding the economy with credit. The Chinese economy replaced the American consumer as the motor of the global economy, largely by selling to the American consumer on credit. It has been a rather weak motor, reflecting the relative size of the Chinese and American economies, so that the global economy has grown rather slowly since the emergence of China’s international economic power.

The main reason why the world avoided a global depression is that economists have learned some lessons from the experience of the 1930s. The heavy load of debt and lingering political prejudices limited the scale of fiscal stimulus globally (again with the exception of China); but the Federal Reserve under the leadership of its chairman, Ben Bernanke, embarked on unorthodox monetary policies including quantitative easing—large-scale injection of money into the economy through the purchase of bonds by the Federal Reserve. This prevented the reduction in effective demand from deteriorating into a global depression.

The crash of 2008 was also indirectly responsible for the euro crisis. The euro was an incomplete currency: it had a common central bank but it did not have a common treasury. The architects of the euro were aware of this defect but believed that when the deficiency became apparent the political will could be summoned to correct it. After all, that is how the European Union was brought into existence—taking one step at a time, knowing full well that it was insufficient but that when the need arose it would lead to further steps.

Unfortunately, political conditions changed between 1999, when the euro was adopted, and 2008, when the need arose. Germany under the leadership of Helmut Kohl led the process of European integration in order to facilitate the reunification of Germany. But reunification proved expensive and the German public became unwilling to take on any additional expenses. When, after the bankruptcy of Lehman Brothers in 2008, the European finance ministers declared that no systemically important financial institution would be allowed to fail, Chancellor Angela Merkel, as a politician in touch with the prevailing public opinion, insisted that the responsibility should fall on each country separately, not on the European Union collectively. That ruled out the possibility of a common treasury just when it was needed. That was the beginning of the euro crisis. Crises in individual countries like Greece, Italy, or Ireland are essentially variants of the euro crisis.

Subsequently, the financial crisis has morphed into a series of political crises. The differences between creditor countries and debtor countries have transformed the European Union from a voluntary association of equals into a relationship between creditors, such as Germany, and debtors, such as Greece, that is neither voluntary nor equal and arouses increasing political tensions.

The European Union started out as a valiant attempt at international governance on a regional scale. In the aftermath of 2008, the EU became preoccupied with its internal problems and failed to pull its weight in the international economy. The United States also became inward-looking but by a somewhat different route. The inward turn of the EU and US led to a decline in international cooperation on a global scale.

Since the Western powers are the mainstay of the prevailing world order, their declining influence has created a power vacuum in international governance. Aspiring regional powers and nonstate actors, which are willing to use military force, have rushed to fill the vacuum. Armed conflicts have proliferated and spread from the Middle East to other parts of Asia, Africa, and even Europe.

By annexing Crimea and establishing separatist enclaves in Ukraine, Putin’s Russia has challenged both the prevailing world order, which depends on the Western powers for support, and the values and principles on which the EU was founded. Neither the European nor the American public is fully aware of the severity of the challenge. President Vladimir Putin wants to destabilize all of Ukraine by precipitating a financial and political collapse for which he can disclaim responsibility, while avoiding occupation of a part of eastern Ukraine, which would then depend on Russia for economic support. He has demonstrated his preference by twice converting an assured military victory into a cease-fire that threatened to destabilize all of Ukraine. Unfortunately, Putin is succeeding, as can be seen by comparing the “Minsk Two” cease-fire with “Minsk One,” even if his success is purely temporary. Putin now seeks to use Ukraine to sow dissension and gain political influence within the European Union.

The severity of the Russian threat is directly correlated with the weakness of the European Union. The EU has excelled at muddling through financial and political crises but now it is confronted with not one but five crises: Russia, Ukraine, Greece, immigration, and the coming British referendum on EU membership—and that may be too much. The very survival of the EU is at risk.

Vladimir Putin; drawing by John Springs

International governance on a global scale is equally fragile. The world may break up into rival camps both financially and politically. China has begun to build a parallel set of financial institutions, including the Asian Infrastructure Investment Bank (AIIB); the Asian Bond Fund Initiative; the New Development Bank (formerly the BRICS Bank); and the Chiang Mai Initiative, which is an Asian regional multilateral arrangement to swap currencies. Whether the two camps will be able to keep their rivalry within bounds will depend on how China manages its economic transition and on how the US reacts to it.

The International Monetary Fund could play a positive part in this. It has abandoned its commitment to the Washington Consensus but the controlling shareholders of the Bretton Woods institutions—the US, the UK, France, and Germany among them—are unwilling to relinquish their voting control by increasing the representation of the developing world. This is very shortsighted on their part because it does not recognize changes in the relative weight of various economies and particularly the rise of China.

The controlling shareholders are unlikely to abandon their control, however tenuous; but the IMF has an opportunity to build a binding connection between the two camps. The opportunity arises from the fact that the composition of the IMF’s Special Drawing Rights (SDR) basket will be up for its five-yearly review at the end of 2015.

The SDR is an international reserve asset, created by the IMF in 1969 to supplement the existing official reserves of member countries. The Chinese renminbi is not fully qualified to be included in the SDR basket, but the qualifications to be included are not as rigorously defined as is generally believed. The Japanese yen was introduced when it was not yet widely traded; the franc entered the basket when the French capital account was heavily controlled; and the Saudi riyal was introduced when it was completely pegged to the US currency. The criteria for inclusion have changed over the years but now call for (1) a large exporter country and (2) a “freely usable” currency. This term is often misconstrued as imposing complete convertibility of capital accounts and flexibility of exchange rates; but that is not the case. Indeed, the basket of Special Drawing Rights formerly included currencies with no or little capital account convertibility.

The Chinese leadership has now embarked on a major effort to have the renminbi included in the SDR basket, and the IMF staff is sympathetic. For instance, it has announced that the renminbi is “no longer undervalued,” and it doesn’t seek full and precipitous capital account liberalization, but rather a cautious and gradual pace of reform in order to ensure the smooth functioning of the SDR and the preservation of financial stability in China.

Much now depends on the attitude of the US government, which holds veto rights in the IMF—even if the decision regarding the SDR basket requires only a 70 percent majority of the IMF’s board. The US would be making a major concession if it opened the door to allowing the renminbi to become a potential rival to the dollar. It could demand similar concessions from China in return, but that would be the wrong approach. The relationship between two great powers is not a zero-sum game: one party’s gain is not necessarily a loss for the other.

China is seeking SDR status for the renminbi not to please or hurt the US but for reasons of its own that are only indirectly connected with China’s ultimate ambition of replacing the US dollar as the dominant currency in the world. China seeks to use financial liberalization as an engine of growth for the Chinese economy. China wants to deepen the government bond market and open it up to international investors in order to enable the central government to clean up the bad debts of insolvent local authorities; it also wants to reduce the excessive leverage in the economy by promoting conversions of debt to equity. Inclusion of the renminbi in the IMF basket would facilitate the process, and success would automatically advance the renminbi’s weight and influence in the world.

The US government has little to gain and much to lose by treating the relationship with China as a zero-sum game. In other words it has little bargaining power. It could, of course, obstruct China’s progress, but that would be very dangerous. President Xi Jinping has taken personal responsibility for the economy and national security. If his market-oriented reforms fail, he may foster some external conflicts to keep the country united and maintain himself in power. This could lead China to align itself with Russia not only financially but also politically and militarily. In that case, should the external conflict escalate into a military confrontation with an ally of the United States such as Japan, it is not an exaggeration to say that we would be on the threshold of a third world war.

Indeed, military budgets are rapidly increasing both in Russia and in China, and they remain at a very high level in the United States. For China, rearmament would be a surefire way to boost domestic demand. China is already flexing its military muscle in the South China Sea, operating in a unilateral and often quite belligerent manner, which is causing justifiable concern in Washington. Nevertheless, it may take a decade or more until a Russian–Chinese military alliance would be ready to confront the US directly. Until then, we may expect a continuation of hybrid warfare and the proliferation of proxy wars.

Both the US and China have a vital interest in reaching an understanding because the alternative is so unpalatable. The benefits of an eventual agreement between China and the US could be equally far-reaching. Recently there has been a real breakthrough on climate policy on a bilateral basis. By taking the nonbinding representations and promises made by the two countries at face value, the agreement has made more credible some recent efforts to bring climate change under control. If this approach could be extended to other aspects of energy policy and to the financial and economic spheres, the threat of a military alignment between China and Russia would be removed and the prospect of a global conflict would be greatly diminished. That is worth trying.

On his last state visit to the US in 2013, President Xi spoke of a “new type of great power relationship.” The subject has been widely discussed in China since then. President Obama should outline his own vision by drawing a distinction between Putin’s Russia, which has replaced the rule of law with the rule of force, and today’s China, which does not always abide by the rule of law but respects its treaty obligations. Russian aggression needs to be firmly resisted; by contrast China needs to be encouraged—by offering a more constructive alternative—to avoid the route of military aggression. This kind of offer may elicit a favorable response. Rivalry between the US and China is inevitable but it needs to be kept within bounds that would preclude the use of military force.

It does not follow that a far-reaching agreement amounting to a strategic partnership between the US and China would be easy to accomplish. The two countries have fundamentally different political systems. While the US is founded on the principle of individual freedom, China has no significant tradition of such freedom. It has had a hierarchical structure since time immemorial and it has been an empire throughout most of its history. In recent years the US has led the world in the innovative development of social media, while China has led the world in finding means to control it. Since the end of the cold war, China has been much more successful than Russia in creating a successful hierarchical system.

This is best seen by looking at the way information is distributed. Since the rise of social media, information increasingly travels along horizontal lines, but China is different: information is distributed vertically. Within the party–state apparatus, the closer one is to the top, the better one is informed and the more latitude one enjoys in expressing an opinion. This means that the party–state apparatus offers not only an opportunity for personal enrichment but also a semblance of individual freedom. No wonder that the apparatus has been able to attract much of China’s best talent. The degree of latitude it allows is, however, strictly circumscribed by red lines. People have to walk within a grid; those who transgress the red lines may fall into the hands of the security apparatus and disappear without a trace.

The stranglehold of the security apparatus was gradually diminishing but recently there has been an ominous reversal: under the leadership of President Xi the informal rules defining the rights and status of NGOs, for instance, are now in the process of being significantly tightened.*

Comparing President Xi’s “Chinese dream” with the American dream highlights the difference between the two political and social systems. Xi extols China’s success in “rejuvenating the nation” by harnessing the talents and energies of its people in service of the state. By contrast, the American dream extols the success of the rugged individual who achieves upward social mobility and material prosperity by overcoming obstacles posed by social conventions or prejudices or authorities abusing their power, or sheer bad luck. The US would like China to adopt its values but the Chinese leadership considers them subversive.

In this respect China has more in common with Russia than with the US. Both Russia and China consider themselves victims of America’s aspiration to world domination. From the US point of view, there is much to disapprove of in China’s behavior. There is no independent judiciary and multinational companies are often mistreated and replaced by domestic favorites. And there are conflicts with the US and other nations in the South China Sea and over cyberwarfare and human rights. These are not matters on which cooperation will be easy to achieve.

Fully recognizing these difficulties, the US government should nevertheless make a bona fide attempt at forging a strategic partnership with China. This would involve identifying areas of common interest as well as areas of rivalry. The former would invite cooperation, the latter tit-for-tat bargaining. The US needs to develop a two-pronged strategy that offers incentives for cooperation and deterrents that render tit-for-tat bargaining less attractive.

The areas for cooperation may prove to be wider than is obvious at first sight. Cooperating with China in making President Xi’s financial reforms successful is definitely in the common interest. Success would fulfill the aspirations of the ever-increasing Chinese middle class. It may also allow Xi to relax some of the restrictions he has recently introduced and that would, in turn, increase the probability that his reforms will succeed and improve global financial stability. The weak point of his current approach is that both implementing and monitoring the reform process are in the same hands. Opening up the process to criticism by the media and civil society would greatly improve the efficacy of his reforms. This is particularly true of Xi’s anticorruption campaign. And if China followed this path, it would become increasingly attractive to the US as a strategic partner.

Negotiations between the US and China could not possibly be completed by October 2015, when the board of the IMF is scheduled to consider the composition of the SDR basket. Realistically it would take until President Xi’s state visit to Washington in September to complete the preparations. But there is much to be gained by extending the SDR deadline to 2016. China will then host the meeting of the G20, and 2016 will also be the last year of the Obama administration. The prospect of a strategic partnership between the US and China would mobilize all political forces in favor of international cooperation on both sides.

If a bona fide attempt fails, the US would then be fully justified in developing a strong enough partnership with China’s neighbors that a Chinese–Russian alliance would not dare to challenge it by military force. That would be clearly inferior to a strategic partnership between the US and China. A partnership with China’s neighbors would return us to a cold war, but that would still be preferable to a third world war.

The Trans-Pacific and Trans-Atlantic Partnerships, which are currently being negotiated, could offer an excellent opportunity for a two-pronged strategy but the current approach is all wrong. At present China is excluded; indeed the partnerships are conceived as an anti-Chinese alliance under US leadership. The president has asked Congress to give him and his successor authority for up to six years to negotiate trade agreements under fast-track rules that would deprive Congress of its right to introduce amendments. The bill has passed the Senate and at this writing is before the House. If the House approves, President Xi may be presented with an apparent threat on his visit in September. This is an appropriate response to China’s aggressive behavior in the South China Sea and elsewhere, but it leaves little room for an alternative approach. It would, as a result, be difficult for President Obama to make a bona fide offer of strategic partnership.

It is to be hoped that the House will not authorize putting the bill on a fast track. Instead of railroading the bill through Congress, it ought to be taken off the fast track. In that case, Congress would have plenty of time to correct the fundamental flaws in the proposed treaties that make them unacceptable as they are currently written. And that would also allow President Obama to make President Xi a genuine offer of a strategic partnership with China when he visits Washington in September.

http://www.nybooks.com/articles/archives/2015/jul/09/partnership-china-avoid-world-war/

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The Future of Europe: An Interview with George Soros

Parts of the following interview with George Soros by the Spiegel correspondent Gregor Peter Schmitz appear in their book, The Tragedy of the European Union: Disintegration or Revival?, just published by PublicAffairs.


soros_1-042414 Maxim Shemetov/Reuters Supporters of the Russian annexation of Crimea at a rally in Red Square, Moscow, March 18, 2014

Gregor Peter Schmitz: The conflict in Crimea and Ukraine has changed the shape of European and world politics, and we will come to it. But let us first talk about a subject on which you’ve taken a critical position over the years: the crisis of the European Union: With regard to the euro, isn’t the worst over?

George Soros: If you mean that the euro is here to stay, you are right. That was confirmed by the German elections, where the subject was hardly discussed, and by the coalition negotiations, where it was relegated to Subcommittee 2A. Chancellor Angela Merkel is satisfied with the way she handled the crisis and so is the German public. They reelected her with an increased majority. She has always done the absolute minimum necessary to preserve the euro. This has earned her the allegiance of both the pro- Europeans and those who count on her to protect German national interests. That is no mean feat.

So the euro is here to stay, and the arrangements that evolved in response to the crisis have become established as the new order governing the eurozone. This confirms my worst fears. It’s the nightmare I’ve been talking about. I’m hopeful that the Russian invasion of Crimea may serve as a wake-up call. Germany is the only country in a position to change the prevailing order. No debtor country can challenge it; any that might try would be immediately punished by the financial markets and the European authorities.

Schmitz: If you said that to Germans, they would say: Well, we have already evolved a lot. We are more generous now and have modified our policy of austerity.

Soros: I acknowledge that Germany has stopped pushing the debtor countries underwater. They are getting a little bit of oxygen now and are beginning to breathe. Some, particularly Italy, are still declining, but at a greatly diminished pace. This has given a lift to the financial markets because the economies are hitting bottom and that almost automatically brings about a rebound.

But the prospect of a long period of stagnation has not been removed. It’s generally agreed that the eurozone is threatened by deflation but opposition from the German Constitutional Court and its own legal departments will prevent the European Central Bank (ECB) from successfully overcoming the deflationary pressures the way other central banks, notably the Federal Reserve, have done.

The prospect of stagnation has set in motion a negative political dynamic. Anybody who finds the prevailing arrangements intolerable is pushed into an anti-European posture. This leads me to expect the process of disintegration to gather momentum. During the acute phase of the euro crisis we had one financial crisis after another. Now there should be a series of political rather than financial crises, although the latter cannot be excluded.

Schmitz: You say that current arrangements are intolerable. What exactly needs to change? What needs to be reformed?

Soros: At the height of the euro crisis, Germany agreed to a number of systemic reforms, the most important of which was a banking union. But as the financial pressures abated, Germany whittled down the concessions it had made. That led to the current arrangements, which confirm my worst fears.

Schmitz: As we speak, European finance ministers are in the process of concluding an agreement on the banking union. What do you think of it?

Soros: In the process of negotiations, the so-called banking union has been transformed into something that is almost the exact opposite: the reestablishment of national “silos,” or separately run banks. This is a victory for Orwellian newspeak.

Schmitz: What’s wrong with it?

Soros: The incestuous relationship between national authorities and bank managements. France in particular is famous for its inspecteurs de finance, who end up running its major banks. Germany has its Landesbanken and Spain its caixas, which have unhealthy connections with provincial politicians. These relationships were a major source of weakness in the European banking system and played an important part in the banking crisis that is still weighing on the eurozone. The proposed banking union should have eliminated them, but they were largely preserved, mainly at German insistence.

Schmitz: That is a pretty drastic condemnation. How do you justify it?

Soros: In effect, the banking union will leave the banking system without a lender of last resort. The proposed resolution authority is so complicated, with so many decision-making entities involved, that it is practically useless in an emergency. Even worse, the ECB is legally prohibited from undertaking actions for which it is not expressly authorized. That sets it apart from other central banks, which are expected to use their discretion in an emergency.

But Germany was determined to limit the liabilities that it could incur through the ECB. As a result, member countries remain vulnerable to financial pressures from which other developed countries are exempt. That is what I meant when I said that over-indebted members of the EU are in the position of third-world countries that are overindebted in a foreign currency. The banking union does not correct that defect. On the contrary, it perpetuates it.

Schmitz: You sound disappointed.

Soros: I am. I left no stone unturned trying to prevent this outcome, but now that it has happened, I don’t want to keep knocking my head against the wall. I accept that Germany has succeeded in imposing a new order on Europe, although I consider it unacceptable. But I still believe in the European Union and the principles of the open society that originally inspired it, and I should like to recapture that spirit. I want to arrest the process of disintegration, not accelerate it. So I am no longer advocating that Germany should “lead or leave the euro.” The window of opportunity to bring about radical change in the rules governing the euro has closed.

Schmitz: So, basically, you are giving up on Europe?

Soros: No. I am giving up on changing the financial arrangements, the creditor–debtor relationship that has now turned into a permanent system. I will continue to focus on politics, because that is where I expect dramatic developments.

Schmitz: I see. Obviously, people are concerned about the rise of populist movements in Europe. Do you see any opportunity to push for more political integration, when the trend is toward disintegration?

Soros: I do believe in finding European solutions for the problems of Europe; national solutions make matters worse.

Schmitz: It seems the pro-Europeans are often silent on important issues because they are afraid that speaking up might increase support for the extremists—for example, in the case of the many refugees from the Middle East and Africa who hoped to reach Europe and were detained on the Italian island of Lampedusa.

Soros: Like it or not, migration policy will be a central issue in the elections. We must find some alternative to xenophobia.

Schmitz: What do you propose to do about it?

Soros: I have established an Open Society Initiative for Europe—OSIFE for short. One of its first initiatives is Solidarity Now, in Greece. The original idea was to generate European solidarity with the plight of the Greek population that is suffering from the euro crisis and Greek solidarity with the plight of the migrants, who experience inhuman conditions and are persecuted by the ultranationalist Golden Dawn party. It took us some time to get the project off the ground, and by the time we did, it was too late to generate European solidarity with the Greeks because other heavily indebted countries were also in need of support. So we missed that boat, but our initiative has had the useful by-product of giving us a better insight into the migration problem.

Schmitz: What have you learned?

Soros: That there is an unbridgeable conflict between North and South on the political asylum issue. The countries in the North, basically the creditors, have been generous in their treatment of asylum seekers. So all the asylum seekers want to go there, particularly to Germany. But that is more than they can absorb, so they have put in place a European agreement called Dublin III, which requires asylum seekers to register in the country where they first enter the EU. That tends to be the South, namely, Italy, Spain, and Greece. All three are heavily indebted and subject to fiscal austerity. They don’t have proper facilities for asylum seekers, and they have developed xenophobic, anti-immigrant, populist political movements.

Asylum seekers are caught in a trap. If they register in the country where they arrive, they can never ask for asylum in Germany. So, many prefer to remain illegal, hoping to make their way to Germany. They are condemned to illegality for an indefinite period. The miserable conditions in which they live feed into the anti-immigrant sentiment.

Schmitz: Looking at other European issues, aren’t your foundations also very involved in the problems of the Roma (Gypsies)?

Soros: Yes, we have been engaged in those issues for more than twenty-five years. The Roma Education Fund has developed effective methods of educating Roma children and strengthening their Roma identity at the same time. If this were done on a large-enough scale it would destroy the hostile stereotype that stands in the way of the successful integration of the Roma. As it is, educated Roma can blend into the majority because they don’t fit the stereotype but the stereotype remains intact.

This is another instance where the European Commission is having a positive effect. I look to the European Structural funds to scale up the programs that work.

Schmitz: What do you think of Vladimir Putin’s recent policies with respect to Ukraine, Crimea, and Europe?

Soros: Now you are coming to the crux of the matter. Russia is emerging as a big geopolitical player, and the European Union needs to realize that it has a resurgent rival on its east. Russia badly needs Europe as a partner, but Putin is positioning it as a rival. There are significant political forces within the Russian regime that are critical of Putin’s policy on that score.

Schmitz: Can you be more specific?

Soros: The important thing to remember is that Putin is leading from a position of weakness. He was quite popular in Russia because he restored some order out of the chaos. The new order is not all that different from the old one, but the fact that it is open to the outside world is a definite improvement, an important element in its stability. But then the prearranged switch with Dmitry Medvedev from prime minister to president deeply upset the people. Putin felt existentially threatened by the protest movement. He became repressive at home and aggressive abroad.

That is when Russia started shipping armaments to the Assad regime in Syria on a massive scale and helped turn the tide against the rebels. The gamble paid off because of the preoccupation of the Western powers—the United States and the EU—with their internal problems. Barack Obama wanted to retaliate against Syria’s use of chemical weapons. He asked for congressional approval and was about to be rebuffed when Putin came to the rescue and persuaded Assad to voluntarily surrender his chemical weapons.

That was a resounding diplomatic victory for him. Yet the spontaneous uprising of the Ukrainian people must have taught Putin that his dream of reconstituting what is left of the Russian Empire is unattainable. He is now facing a choice between persevering or changing course and becoming more cooperative abroad and less repressive at home. His current course has already proved to be self-defeating, but he appears to be persevering.

Schmitz: Is Russia a credible threat to Europe if its economy is as weak as you say?

Soros: The oligarchs who control much of the Russian economy don’t have any confidence in the regime. They send their children and money abroad. That is what makes the economy so weak. Even with oil over $100 a barrel, which is the minimum Russia needs to balance its budget, it is not growing. Putin turned aggressive out of weakness. He is acting in self-defense. He has no scruples, he can be ruthless, but he is a judo expert, not a sadist—so the economic weakness and the aggressive behavior are entirely self-consistent.

Schmitz: How should Europe respond to it?

Soros: It needs to be more united, especially in response to Russian aggression in Ukraine. Putin prides himself on being a geopolitical realist. He respects strength and is emboldened by weakness. Yet there is no need to be permanently adversarial. Notwithstanding the current situation in Ukraine, the European Union and Russia are in many ways complementary; they both need each other. There is plenty of room for Russia to play a constructive role in the world, exactly because both Europe and the United States are so preoccupied with their internal problems.

Schmitz: How does that translate into practice, particularly in the Middle East?

Soros: It has totally transformed the geopolitical situation. I have some specific ideas on this subject, but it is very complicated. I can’t possibly explain it in full because there are too many countries involved and they are all interconnected.

Schmitz: Give it a try.

Soros: I should start with a general observation. There are a growing number of unresolved political crises in the world. That is a symptom of a breakdown in global governance. We have a very rudimentary system in place. Basically, there is only one international institution of hard power: the UN Security Council. If the five permanent members agree, they can impose their will on any part of the world. But there are many sovereign states with armies; and there are failed states that are unable to protect their monopoly over the use of lethal force or hard power.

The cold war was a stable system. The two superpowers were stalemated by the threat of mutually assured destruction, and they had to restrain their satellites. So wars were fought mainly at the edges. After the collapse of the Soviet Union, there was a brief moment when the United States emerged as the undisputed leader of the world. But it abused its power. Under the influence of the neocons, who argued that the United States should use its power to impose its will on the world, President George W. Bush declared “war on terror” and invaded Iraq under false pretenses.

Angela Merkel; drawing by James Ferguson

That was a tragic misinterpretation of the proper role of hegemonic or imperial power. It is the power of attraction—soft power—that ensures the stability of empires. Hard power may be needed for conquest and self-protection, but the hegemon must look after the interests of those who depend on it in order to secure their allegiance instead of promoting only its own interests. The United States did that very well after World War II, when it established the United Nations and embarked on the Marshall Plan. But President Bush forgot that lesson and destroyed American supremacy in no time. The neocons’ dream of a “new American century” lasted less than ten years. President Obama then brought American policy back to reality. His record in foreign policy is better than generally recognized. He accepted the tremendous loss of power and influence and tried to “lead from behind.” In any case, he is more preoccupied with domestic than foreign policy. In that respect America is in the same position as Europe, although for different reasons. People are inward-looking and tired of war. This has created a power vacuum, which has allowed conflicts to fester unresolved all over the world.

Recently, Russia has moved into this power vacuum, trying to reassert itself as a geopolitical player. That was a bold maneuver, inspired by Putin’s internal weakness, and it has paid off in Syria because of the weakness of the West. Russia could do what the Western powers couldn’t: persuade Assad to “voluntarily” surrender his chemical weapons. That has radically changed the geopolitical landscape. Suddenly, the prospect of a solution has emerged for the three major unresolved conflicts in the Middle East—Palestine, Iran, and Syria—when one would have least expected it.

The Syrian crisis is by far the worst, especially in humanitarian consequences. Russia’s entry as a major supplier of arms, coupled with Hezbollah’s entry as a supplier of troops, has turned the tables in favor of Assad. The fighting can be brought to an end only by a political settlement imposed and guaranteed by the international community. Without it, the two sides will continue to fight indefinitely with the help of their outside supporters. But a political settlement will take months or years to negotiate. In the meantime, Assad is following a deliberate policy of denying food and destroying the medical system as a way of subduing the civilian population. “Starve or surrender” is his motto.

This raises the specter of a human catastrophe. Unless humanitarian assistance can be delivered across battle lines, more people will have died from illness and starvation during the winter than from actual fighting.

Schmitz: What about Iran?

Soros: There has been an actual breakthrough in the Iranian crisis in the form of a temporary agreement on nuclear weapons with the new president Hassan Rouhani. The sanctions imposed by the Western powers have been very effective. The Iranian revolution itself advanced to the point where it fell into the hands of a narrow clique, the Revolutionary Guard; the mullahs were largely pushed out of power. As head of the mullahs, the Supreme Leader could not have been pleased. He must also be aware that the large majority of the population has been profoundly dissatisfied with the regime. In contrast with previous attempts at negotiations, he seems to be in favor of reaching an accommodation with the United States. That improves the prospects for a final agreement. We must take into account, as Vali Nasr recently wrote, that Iran has, after Russia, the world’s second-largest reserves of natural gas; and it potentially might compete with Russia in supplying gas to Europe.

Schmitz: That leaves the longest-lasting crisis, Palestine.

Soros: Recent developments in Egypt have improved the chances of progress in the long-festering Palestinian crisis. The army, with the active support of Saudi Arabia and the Gulf states, has removed the legally elected president and is engaged in the brutal suppression of the Muslim Brotherhood. This otherwise disturbing development has a potentially benign side effect: it raises the possibility of a peace settlement between the Palestinian Authority and Israel, to the exclusion of Hamas. This would have been inconceivable a few months ago. Secretary of State John Kerry became engaged in the Palestinian negotiations well before this window of opportunity opened, so he is ahead of the game. Prime Minister Benjamin Netanyahu is very suspicious but, for all his intransigence, cannot openly oppose negotiations because, having openly supported Mitt Romney in the American elections, he holds a relatively weak hand. Negotiations are making progress, but very slowly indeed.

If all three crises were resolved, a new order would emerge in the Middle East. There is a long way to go because the various conflicts are interconnected, and the potential losers in one conflict may act as spoilers in another. Netanyahu, for instance, is dead set against a deal with Iran because peace with Palestine would end his political career in Israel. Nevertheless, the broad outlines of a potential new order can already be discerned, although we cannot know the effects of the current crisis in Ukraine. Russia could become more influential, relations between Saudi Arabia and the United States may become strained, and Iran may emerge as America’s closest ally, second only to Israel. But the situation remains fluid and may change from one day to the next.

Schmitz: Recently the crisis in Ukraine has overshadowed all the others.

Soros: Indeed. Ukraine and in particular Crimea are of much greater interest to Russia than anything in the Middle East. Putin woefully misjudged the situation. Last autumn he had no difficulty in outmaneuvering the European Union, which was hamstrung by its internal political and financial problems. Under German leadership it offered too little and demanded too much. Putin could easily offer a better deal to Ukrainian President Yanukovych. But the Ukrainian people rebelled, upsetting the calculations of both sides.

The rebellion wounded Putin in his Achilles heel. The idea of a spontaneous rebellion simply did not enter into his calculations. In his view the world is ruled by power and those in power can easily manipulate public opinion. Failure to control the people is a sign of weakness.

Accordingly, he made it a condition of his assistance that Yanukovych should repress the rebellion. But the use of force aroused the public and eventually Yanukovych was forced to capitulate. This could have resulted in a stalemate and the preservation of the status quo with Ukraine precariously balanced between Russia and Europe, and a corrupt and inept government pitted against civil society. It would have been an inferior equilibrium with the costs exceeding the benefits for all parties concerned.

But Putin persisted in his counterproductive approach. Yanukovych was first hospitalized and then sent to Sochi to be dressed down by Putin. Putin’s instructions brought the confrontation to a climax. Contrary to all rational expectations, a group of citizens armed with not much more than sticks and shields made of cardboard boxes and metal garbage can lids overwhelmed a police force firing live ammunition. There were many casualties, but the citizens prevailed. It was a veritable miracle.

Schmitz: How could such a thing happen? How do you explain it?

Soros: It fits right into my human uncertainty principle, but it also reveals a remarkable similarity between human affairs and quantum physics of which I was previously unaware. According to Max Planck, among others, subatomic phenomena have a dual character: they can manifest themselves as particles or waves. Something similar applies to human beings: they are partly freestanding individuals or particles and partly components of larger entities that behave like waves. The impact they make on reality depends on which alternative dominates their behavior. There are potential tipping points from one alternative to the other but it is uncertain when they will occur and the uncertainty can be resolved only in retrospect.

On February 20 a tipping point was reached when the people on Maidan Square were so determined to defend Ukraine that they forgot about their individual mortality. What gave their suicidal stand historic significance is that it succeeded. A deeply divided society was moved from the verge of civil war to an unprecedented unity. Revolutions usually fail. The Orange Revolution of 2004 deteriorated into a squabble between its leaders. It would be a mistake to conclude that this revolution is doomed to suffer the same fate. Indeed the parties participating in the interim government are determined to avoid it. In retrospect the resistance of Maidan may turn out to be the birth of a nation. This promising domestic development was a direct response to foreign oppression. Unfortunately it is liable to provoke further pressure from abroad because successful resistance by Ukraine would present an existential threat to Putin’s continued dominance in Russia.

Schmitz: You are referring to the Russian invasion of Crimea. How do you see it playing out?

Soros: If it is confined to Crimea it will serve as a further impetus to greater national cohesion in Ukraine. Crimea is not an integral part of Ukraine. Khrushchev transferred Crimea to Ukraine in 1954 by an administrative decree. The majority of its population is Russian and it is the base of the Russian Black Sea Fleet. That is exactly why Putin is liable to put military and economic pressure on Ukraine directly and they are not in a position to resist it on their own. They need the support of the Western powers. So Ukraine’s future depends on how the Western powers, particularly Germany, respond.

Schmitz: What should the Western powers do?

Soros: They should focus on strengthening Ukraine rather than on punishing Russia. They cannot prevent or reverse the annexation of Crimea. They are bound to protest it of course because it violates the Budapest Memorandum of 1994 that guaranteed the territorial integrity of Ukraine, including Crimea, but they are not in a position to oppose it by military means. Even sanctions ought to be used sparingly in order to preserve them as a deterrent against the real danger, namely of direct military or economic assault on Ukraine. Russian forces have already occupied a gas plant in Ukraine supplying Crimea and may take more territory unless they are stopped.

Fortunately economic sanctions would be a potent deterrent provided they are used judiciously. Freezing the foreign assets of Russian oligarchs is the opposite of smart sanctions. Oligarchs sending their profits and their children abroad weaken the Russian economy. Until now capital flight was more or less offset by foreign direct investment. Effective sanctions would discourage the inflow of funds, whether in the form of direct investments or bank loans. Moreover, the US could release oil from its strategic reserve and allow its sale abroad. That could put the Russian economy into deficit. The Russian economy is fragile enough to be vulnerable to smart sanctions.

Schmitz: Wouldn’t that be cutting off your nose to spite your face? Germany has a lot of investments in Russia, which are equally vulnerable.

Soros: Effective sanctions against Russia should be threatened at first only as a deterrent. If the threat is effective, they wouldn’t be applied. But Chancellor Merkel faces a fundamental choice: should Germany be guided by its narrow national self-interests or should it assert its leadership position within the European Union and forge a unified European response? On her choice hinges not only the fate of Ukraine but also the future of the European Union. Her passionate speech to the German Parliament on March 13 gives me hope that she is going to make the right choice.

Schmitz: What is your idea of the right choice?

Soros: A large-scale technical and financial assistance program for Ukraine. The EU and the US, under the leadership of the International Monetary Fund, are putting together a multibillion-dollar rescue package that will save the country from financial collapse. But that is not enough: Ukraine also needs outside assistance that only the EU can provide: management expertise and access to markets.

Ukraine is a potentially attractive investment destination. But realizing this potential requires improving the business climate by addressing the endemic corruption and weak rule of law. The new regime in Ukraine is eager to confront that task. But only the EU can open up its domestic market and provide political risk insurance for investing in Ukraine. Ukraine in turn would encourage its companies to improve their management by finding European partners. Thus Ukraine would become increasingly integrated in the European common market. That could also provide a much-needed fiscal stimulus for the European economy and, even more importantly, help to recapture the spirit that originally inspired the European Union.

http://www.nybooks.com/articles/archives/2014/apr/24/future-europe-interview-george-soros/

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The Crisis and How to Deal with It

—The Editors

Jeff Madrick: It was six months ago now that the Lehman debacle occurred, that AIG was rescued, that Bank of America bought Merrill Lynch; it was about six months ago that the TARP funds started being distributed. The economy was doing fairly poorly in much of 2008, and then fell off a cliff in the last quarter of 2008 and into 2009, shrinking at a 6 percent annual rate—an extraordinary drop in our national income. It is now by some very important measures the worst economic recession in the post–World War II era. Employment has dropped faster than ever before in this space of time.

We have a three-front problem: a housing market that went crazy as the housing bubble burst; a credit crisis, the most severe we’ve known since the early 1930s; and now a sharp drop in demand for goods and services and capital investment, leading to a severe recession. What gives us the jitters is that all of these are related. We have seen some deceleration in the rate of economic decline, and many people are saying that “green shoots” are showing. What is the actual state of the economy, and do we need a serious mid-course correction on the part of the Obama administration?

Bill Bradley: How far are we along in a recovery? When the market price of Citicorp drops from 60 to 1, and then comes back to 3, I don’t think that’s a recovery. Warren Buffett buys Goldman Sachs, and after he buys, the price drops 45 to 50 percent, and if he’s going to break even on the investment he’s got to earn 9 percent for the next twelve years, I don’t think that’s a recovery. The administration has put in place measures that, if they were to work, could offer some hope.

What I’d like to suggest is that if they don’t work, there’s an alternative. The national government has now made about $12.7 trillion in guarantees and commitments to the US financial sector, and we’ve already spent a little over $4 trillion in this crisis. Some institutions such as Citicorp, for example, received about $60 billion in direct assistance, and $340 billion in guarantees. So US taxpayers are into Citicorp for around $400 billion. If we look out to June, July, and if we see that the PPIP [Public-Private Investment Program, created by Treasury Secretary Timothy Geithner] is not succeeding, that the bank assets aren’t being bought at levels that they should be bought from the books of banks, then there is an alternative.

Think back to Citicorp. I looked at the ticker today: the market capitalization of Citicorp is $17 billion. So the government could buy Citicorp for a fraction of what we’ve already obligated the taxpayer for. And in buying Citicorp, as an example—there could be one or two others—the government would announce in four to six months that it is going to sell the good assets of the bank back to the public. If the government bought Citicorp for, let’s say, $20 billion, what would it be worth if the government sold the good assets back to the public? Surely, several times what it paid for it.

I don’t mean selling these assets to hedge funds, although they can participate; but I would propose offering them to any American who wants to invest in this good bank the opportunity to do so.

The prospect of that happening would bring very strong, positive influence on the development of the whole economy. And what would the government then be left with? The bad bank—that is, the bad assets that we’re going through hoops now to try to get off the bank books. Instead the government would have those assets and it could take fifteen to twenty years to clean them up. So I say I would like to see the existing program work. But if it doesn’t work, there is an alternative, and it’s an alternative in the long run in which the average guy in America could participate.

Niall Ferguson: This is the end of the age of leverage, which began, I guess, in the late 1970s, and saw an explosive rise in the ratio of debt to gross domestic product, not only in this country, but in many, many other countries. Once you end up with public and private debts in excess of three and a half times the size of your annual output, you are Argentina. You know, it’s funny that people refer all the time back to the collapse of Lehman last September. Let’s remember that this crisis actually began in June 2007. It fully became clear in August of 2007 that major financial institutions were almost certainly on the brink of insolvency to anybody who bothered to think about the impact of subprime mortgage defaults on their balance sheets.

But we were in denial. And we stayed in denial until September, more than a year later, of last year. Then we had the breakdown. Notice how psychological terms are very helpful when economics fails as a discipline. After the breakdown, we came out of denial and we realized that probably more than one major bank was insolvent. Then in September and October the world went into shock. It was deeply traumatic.

Now we’re in the therapy phase. And what therapy are we using? Well, it’s very interesting because we’re using two quite contradictory courses of therapy. One is the prescription of Dr. Friedman—Milton Friedman, that is —which is being administered by the Federal Reserve: massive injections of liquidity to avert the kind of banking crisis that caused the Great Depression of the early 1930s. I’m fine with that. That’s the right thing to do. But there is another course of therapy that is simultaneously being administered, which is the therapy prescribed by Dr. Keynes—John Maynard Keynes—and that therapy involves the running of massive fiscal deficits in excess of 12 percent of gross domestic product this year, and the issuance therefore of vast quantities of freshly minted bonds.

There is a clear contradiction between these two policies, and we’re trying to have it both ways. You can’t be a monetarist and a Keynesian simultaneously—at least I can’t see how you can, because if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.

After all, $1.75 trillion is an awful lot of freshly minted treasuries to land on the bond market at a time of recession, and I still don’t quite know who is going to buy them. It’s certainly not going to be the Chinese. That worked fine in the good times, but what I call “Chimerica,” the marriage between China and America, is coming to an end. Maybe it’s going to end in a messy divorce.

No, the problem is that only the Fed can buy these freshly minted treasuries, and there is going to be, I predict, in the weeks and months ahead, a very painful tug-of-war between our monetary policy and our fiscal policy as the markets realize just what a vast quantity of bonds are going to have to be absorbed by the financial system this year. That will tend to drive the price of the bonds down, and drive up interest rates, which will also have an effect on mortgage rates—the precise opposite of what Ben Bernanke is trying to achieve at the Fed.

One final thought: Let’s not think of this as a purely American phenomenon. This is a crisis of the global economy. I’d go so far as to say it’s a crisis of globalization itself. The US economy is not going to contract the most this year, even if the worst projections at the International Monetary Fund turn out to be right; a 2.6 percent contraction is far, far less than the shock already being inflicted on Japan, on South Korea, on Taiwan, to say nothing of the shock being inflicted on Europe. Germany is contracting at something close to 5 or 6 percent. So we are faced not just with a problem to be dealt with by American policy, we are faced with a crisis of global proportions, and it’s far from clear to me that the prescriptions of Dr. Friedman and Dr. Keynes together can solve that massive global crisis.

Paul Krugman: Let me respond to that a bit. Let’s think about what is actually happening to the global economy right now. On the one side there has been an abrupt realization by many people that they have too much debt, that they are not as rich as they thought. US households have seen their net worth decline abruptly by $13 trillion, and there are similar blows occurring around the world. So the people, individual households, want to save again. The United States has gone from approximately a zero savings rate two years ago up to about 4 percent right now, which is still below historical norms; but suddenly saving is occurring.

That saving ought to be translated into investment, but the investment demand is not there. Housing is flat on its back because it was overbuilt; housing bubbles collapsed not only in the United States, but across much of Europe. Many businesses cannot get access to capital because of the breakdown of the financial system. But even those that do have access to capital don’t want to invest because consumer demand is not there. Between the housing bust and the sudden decision of consumers to save, after all, we have a world with lots of excess capacity. The GDP report that just came out says that business-fixed investment, non-residential fixed investment, essentially business investment, is falling at a 40 percent annual rate.

This causes a problem. There are lots of people who want to save, creating a vast increase in savings, not only in the US but around the world, combined with a sharp decline in the amount that the private sector is willing to invest, even at a zero interest rate, or rather even at a zero interest rate for US government debt, which is what the Federal Reserve has the most direct impact on.

One way to think about the global crisis is a vast excess of desired savings over willing investment. We have a global savings glut. Another way to say it is we have a global shortage of demand. Those are equivalent ways of saying the same thing. So we have this global savings glut, which is why there is, in fact, no upward pressure on interest rates. There are more savings than we know what to do with. If we ask the question “Where will the savings come from to finance the large US government deficits?,” the answer is “From ourselves.” The Chinese are not contributing at all.

Now, the great concern I have is that although we understand these things fairly well, there are thirty-eight Republican senators who say that the answer for the crisis is another round of Bush-style tax cuts that will reduce revenues by $3 trillion over the next decade.

This crisis has been so large and the political process has been so sluggish that the difficulties have been greater than expected. And yes, there are some green shoots. Things are getting worse more slowly, but we have not managed to head off a crisis that could turn out to be self-reinforcing, and leave us in this trap for many, many years.

Nouriel Roubini: It’s pretty clear by now that this is the worst financial crisis, economic crisis and recession since the Great Depression. A number of us were worrying about it a while ago. At this point it’s becoming conventional wisdom.

The good news is probably that six months ago there was a risk of a near depression, but we have seen very aggressive actions by US policymakers, and around the world. I think the policymakers finally looked into the abyss: they saw that the economy was contracting at a rate of 6 percent–plus in the US and around the world, and decided to use almost all of the weapons in their arsenals. Because of that I think that the risk of a near depression has been somewhat reduced. I don’t think that there is zero probability, but most likely we are not going to end up in a near depression.

However, the consensus is now becoming optimistic again and says that we are going to go from minus 6 percent growth to positive growth in the second half of this year, meaning that the recession is going to be over by June. By the fourth quarter of 2009, the consensus estimates that growth is going to be positive, by 2 percent, and next year more than 2 percent. Now, compared to that new consensus among macro forecasters, who got it wrong in the past, my views are much more bearish.

I would agree that the rate of economic contraction is slowing down. But we’re still contracting at a pretty fast rate. I see the economy contracting all the way through the end of the year, going from minus 6 to minus 2, not plus 2. And next year the growth of the economy is going to be very slow, 0.5 percent as opposed to the 2 percent–plus predicted by the consensus. Also, the unemployment rate this year is going to be above 10 percent, and is likely to be close to 11 percent next year. Thus, next year is still going to feel like a recession, even if we’re technically out of the recession.

The outlook for Europe and Japan, both this year and next year, is even worse. Most of the advanced economies are going to do worse than the United States for a number of reasons, including structural factors in Japan and weak policy response in the case of the Euro zone.

The problems of the financial system are severe. Many banks are still insolvent. If you don’t want to end up like Japan with zombie banks, it’s better, as Bill Bradley suggested, to do what Sweden did: take over the insolvent banks, clean them up, separate good and bad assets, and sell them back in short order to the private sector.

Now, on the question of policy responses, there is no inconsistency between monetary easing and fiscal easing. Both of them should be stimulating demand, and the monetary easing should be leading also to restoration of credit. Of course, in a situation in which the economy is suffering not just from a lack of liquidity but also problems of solvency and a lack of credit, traditional monetary policy doesn’t work as well. You also have to take unconventional monetary actions, and you have to fix the banks. And we need a fiscal stimulus because every component of our economy is sharply falling: consumption, residential investment, nonresidential construction, capital spending, inventories, exports. The only thing that can go up and sustain the economy for the time being is the fiscal spending of the government.

However, fiscal policy cannot resolve problems of credit, and it is not without cost. Over the next few years it’s going to add about $9 trillion to the US public debt. Niall Ferguson said it’s the end of the age of leverage. It’s not really. There is not deleveraging. We have all the liabilities of the household sector, of the banks and financial institutions, of the corporate sectors; and now we’ve decided to socialize these bad debts and to put them on the balance sheet of the government. That’s why the public debt is rising. Instead, when you have an excessive debt problem, you have to convert such debt into equity. That’s what you do with corporate restructuring—it converts unsecured debt into equity. That’s what you should do with the banks: induce the unsecured creditors to convert their claims into equity. You could do the same thing with the housing market. But we’re not doing the debt-into-equity conversion. What we’re doing is piling public debt on top of private debt to socialize the losses; and at some point the back of some governments’ balance sheet is going to break, and if that happens, it’s going to be a disaster. So we need fiscal stimulus in the short run, but we have to worry about the long-run fiscal sustainability, too.

George Soros: There are two features that I think deserve to be pointed out. One is that the financial system as we know it actually collapsed. After the bankruptcy of Lehman Brothers on September 15, the financial system really ceased to function. It had to be put on artificial life support. At the same time, the financial shock had a tremendous effect on the real economy, and the real economy went into a free fall, and that was global.

The other feature is that the financial system collapsed of its own weight. That contradicted the prevailing view about financial markets, namely that they tend toward equilibrium, and that equilibrium is disturbed by extraneous forces, outside shocks. Those disturbances were supposed to occur in a random fashion. Markets were seen basically as self-correcting. That paradigm has proven to be false. So we are dealing not only with the collapse of a financial system, but also with the collapse of a worldview.

That’s the situation that President Obama inherited. He’s faced with two objectives. One, he must arrest the collapse and, if possible, reverse it. Second, he has to reconstruct the financial system because it cannot be restored to what it was. This is a new situation. When people see this crisis as being the same as previous financial crises, they’re making a mistake.

The interesting thing is that what needs to be done in the short term is almost exactly the opposite of what needs to be done in the long term. Obviously the problem was excessive leverage. But when you have a collapse of credit there’s only one source of credit that is still credible, and that’s the state: the Federal Reserve and the Treasury. Then you have actually to inject a lot more leverage and money into the economy; you have to print money as fast as you can, expand the balance sheet of the Federal Reserve, increase the national debt. And that is, in fact, what has been done, which is the right thing to do. But then once this policy is successful, you have to rein in the money supply as fast as you can.

I would say that policy has generally lagged behind events. We were behind the curve. Now that the free fall is moderating, and the collapse has more or less occurred, I think there is hope that policy will, in fact, catch up with events. The outcome of the stress test of the banks will be important, because that’s basically where the policy has been lagging behind—in recapitalizing the banks. And that’s where most of the confusion comes from.

Robin Wells: I want to go back to what Paul said about the global savings glut. The global savings glut is what drove interest rates down to historically low levels. Housing is very sensitive to the interest rate, and therefore a housing bubble was practically foreordained by an extended period of low interest rates. But you’ll also notice that the bubble in housing hasn’t occurred just in the United States, it’s also occurred in Spain, Eastern Europe, and the UK; it’s been in Ireland, it’s been in Iceland. In order to prevent us from reexperiencing this catastrophe in another, say, ten years, we need to look at the origins of the global savings glut. Yes, there are some differences in how the bubbles were actually manifested in the different countries, and those manifestations are important; but let’s look for a moment at the global savings glut in its entirety.

I think this story starts really in the Eighties. During the Reagan years, we experienced chronic fiscal deficits, and we began to abdicate our responsibility to raise tax revenue that could sustainably finance government. In order to do that, we had to borrow, and who did we borrow from? We borrowed from countries that were running persistent trade surpluses. And as we continued to run these deficits with these countries, there grew to be a symbiotic relationship, as Niall Ferguson says, this Chimerica.

But it was on several different fronts. There were the net exporters, such as China, Japan, and Germany, and the net importers of capital, the largest, of course, being the United States. This import of capital allowed us to consistently live beyond our means, first by running fiscal deficits, not raising enough tax revenue to finance the government, and then also through, ultimately, the leverage that we used in housing, and in commercial real estate, and in leverage buyouts. And this continued; it grew because there was no point anywhere along the line at which anyone would say “halt.”

The persistent imbalances led us to pretend that we could keep borrowing without having sufficient tax revenue to pay for the government. And if your house prices are rising, if the stock market is going up—which of course is going to happen if you have cheap money—it puffs up the value of the assets, and disguises a lot of other structural problems such as rising inequality and corruption.

With this inflow of capital from abroad, the financial sector in the United States also became larger and larger relative to the rest of the economy, with GDP tilted disproportionately toward the financial sector.

How do we start to get out of this? In many ways we’re almost adverse to bringing up the situation in which we find ourselves with the net exporting countries. I thought it was quite interesting a few weeks ago when many Chinese officials were saying that it was proper, and it was good economically, that the US continue to run persistent trade imbalances with China, that the Chinese yuan did not need to be appreciated, that we should continue doing the things we always have, and that the US should make sure that the value of Chinese assets were not diminished by any change in the value of the dollar. It should have been clear that this was not a sustainable relationship, but no one was willing to say that.

So I think we’re going to have to address these chronic global trade imbalances. You might very well see a shift toward more protectionism. We’re going to have to actually do something about raising taxes so that we can sustain government from our own resources rather than depending upon borrowing abroad. And we’re going to have to start stepping back into our former role, one that we abdicated, as managers and guardians in the global economy.

J.M.: I think most people think the US government did what it had to in adopting a serious stimulus, despite the debt. Niall, why don’t you respond to the comments, and then we’ll have a little discussion on that.

N.F.: Well, if you listened carefully to what Paul Krugman said, he actually agreed with me. Because what he said was that everything is just fine as long as the financial credibility of the United States isn’t called into question, but my point is that it will be called into question. Of course it will. According to the administration’s crazily optimistic forecast for a recovery, it’s going to be a 3 percent growth rate next year, 4 percent the year after that, 4.6 percent the year after that. If you believe those numbers, you’ll believe absolutely anything, but they are there in the administration’s budget document. Even if those numbers turn out to be true, the federal debt will rise over the next five to ten years to around 100 percent of gross domestic product.

But since those numbers are clearly wrong, and the trend growth rate of the US will be much closer to 1 percent than to 4, it seems reasonable to anticipate a much more rapid explosion of federal debt to somewhere in the region of 140 or 150 percent of gross domestic product. Even if the private savings rate rebounded to its highest point in the postwar period, it would still account for no more than 5 percent of gross domestic product. But this year’s deficit, as I said earlier, is likely to be north of 12 percent of gross domestic product. So it doesn’t quite add up.

The Fed has committed itself to buying $300 billion worth of treasuries this year, but clearly it will have to buy a great many more than that. Remember, $1.7 trillion or so are coming onto the market. And you assume that the credibility of the United States in the eyes of Americans, as well as foreign investors, is going to withstand this? At some point the United States does start to look like a Latin American economy, not only to people abroad but maybe to people at home. If the Fed’s balance sheet explodes to up to $3 or $4 trillion, who knows how big it could get. At what point do people stop believing in the US dollar as a reserve currency, or even as a store of value for their own savings?

J.M.: Let’s allow Paul and others to respond.

P.K.: The essence of this kind of recession is precisely that the amount that collectively we want to save is greater than the amount that collectively we want to invest. That is the problem. You can’t get around that.

There is a very different question, which is the long-run solvency of the US government, and I do worry about that. I would disagree very much with Niall about those numbers, but this is a factor that should be taken into account. We are currently in debt about 60 percent of GDP. We have in the past been as high as 100 percent of GDP at the end of World War II without having a crisis, but your ability to go that high does depend upon people’s belief that you will behave responsibly, and that is somewhat in question. I hope it is less in question than it was in the past, now that we’ve had some regime changes, but it is a problem.

N.R.: I think that the debate here is about what needs to be done in the short term versus the long term. The lesson of the Great Depression is pretty clear: it started with the stock market crash of 1929, and it actually became the Great Depression by 1933 for four reasons. One, we didn’t believe in a counter-cyclical monetary policy. The money supply contracted rather than being eased. Interest rates were not falling, and that made the credit crunch worse. Two, nobody believed in counter-cyclical fiscal policy. The general theory of Keynes was written only in 1936; in the early 1930s, the government was raising taxes and cutting spending in order to maintain a balanced budget. That made the recession even more severe.

Three, there was a belief that banks should be allowed to collapse. Thousands of them collapsed, the credit crunch became even worse. And four, by 1933, 75 percent of households had defaulted on their mortgages; they couldn’t pay them. So a stock market crash became a Great Depression. Then you add currency wars internationally, trade wars, protectionism, and capital controls; then you had default by countries and the rise of totalitarian regimens in Germany and in Italy, in Japan, and Spain, and we ended up in World War II. So those are the consequences of not taking the right policy actions in the short run.

I agree, however, that we have to worry about the long run. If we’re going to finance budget deficits by printing money, we may have high inflation, even risk of hyperinflation in some countries. That’s what happened in Germany in the 1920s during the Weimar Republic. We are having large budget deficits and increasing the public debt, we don’t know whether it’s going to be $5 trillion or $10 trillion of more debt. But there are only a few ways of resolving that debt problem: either you default on it as countries like Argentina did; or you use the inflation tax to wipe out the real value of the debt; or you have to raise taxes and cut government spending. And given the size of the deficits, over time that’s going to be a painful political choice to make. So we need the stimulus in the short run, but we need to restore medium-term fiscal sustainability.

G.S.: Let’s face it, for twenty-five years we have been consuming more than we have been producing. This living beyond our means accumulated mainly in the housing sector and the financial sector, and now those liabilities are being nationalized. It’s a bit unfortunate that so far we have only nationalized the liabilities of the banks, and not their assets. I think it’s right that we are extending a government credit to replace the collapsing credit, and we are currently in a deflationary situation. When the flow of credit restarts, suddenly there will be a flip-flop where the fear of deflation will be replaced by the fear of inflation. The pressure for interest rates to rise will be very, very strong, and the rise in interest rates could choke off the recovery. And so we are facing a period of stop-go, or stagflation similar to but more severe than what we faced in the Seventies. But that is a favorable outcome compared to what would have happened if we hadn’t done what we are doing.

About regulation, we have to start by recognizing that the prevailing view is false, that markets actually are bubble-prone. They create bubbles. Therefore, they have to be regulated. The authorities have to accept responsibility for preventing asset bubbles from growing too big. They’ve expressly rejected that, saying that if the markets don’t know, how can the regulators know? And, of course, they can’t. They’re bound to be wrong, but they get feedback from the market, and then they can make adjustments. Now, it is not enough to regulate the money supply. You have to regulate credit. And that means using tools that have largely fallen into disuse. Of course you have margin requirements, minimum capital requirements; but you actually have to vary them to counteract the prevailing mood of the market, because markets do have moods. It should be recognized that exuberance actually is quite rational. When I see a bubble beginning, forming, I jump on it because that’s how I make money. So it’s perfectly rational.

It’s the job of the regulators to regulate. However, we should try not to go overboard. While markets are imperfect, regulators are even more imperfect: not only are they human, they’re also bureaucratic and subject to political influences. So we want to keep regulation to a minimum, but we have to recognize that markets are inherently unstable.

N.R.: On this question of regulation, of course, we go into cycles, you know. We had the Great Depression, and then we imposed many actually useful regulations, both on the financial system and on the real economy. Some of them became excessive, and even before Reagan and Thatcher, Jimmy Carter started deregulating some parts of the economy. Eventually policy makers started believing that self-regulation is best; but that means no regulation. We believed in market discipline; but there is no discipline when there is irrational exuberance. We relied on internal risk management models; but nobody listened to risk managers when the risk takers were making all the profits in the banks; and we relied on rating agencies which had massive conflicts of interest since they were being paid by those that they were supposed to be rating. So the entire model of self-regulation and market discipline now has collapsed.

We have to go to a world where there is greater prudential regulation and supervision of the financial system. I think the challenge for the US economy is, can we grow without excessive credit and leverage? Can we grow in a more sustainable way? And what are going to be the sectors of the economy that give us sustainable, long-term growth? I think that’s an open question.

P.K.: I think there are two big structural changes that we’d want to see. One is we need to reduce the role of the financial sector in the economy. We went from an economy in which about 4 percent of GDP came from the financial sector to an economy in which 8 percent of GDP come from the financial sector, and in which at its peak 41 percent of profits were being earned by the financial sector. And there is no reason to believe that anything productive happened as a result of all of that. These extremely highly compensated bankers were essentially just finding new ways to offload risks on to other people.

As I’ve written, we need a boring banking sector again. All of this high finance has turned out to be just destructive, and that’s partly a matter of regulation. But in the political economy there was also a vicious circle. Because as the financial sector got increasingly bloated its political clout also grew. So, in fact, deregulation bred bloated finance, which bred more deregulation, which bred this monster that ate the world economy.

The other thing not to miss is the importance of a strong social safety net. By most accounts, most projections say that the European Union is going to have a somewhat deeper recession this year than the United States. So in terms of macromanagement, they’re actually doing a poor job, and there are various reasons for that: the European Central Bank is too conservative, Europeans have been too slow to do fiscal stimulus. But the human suffering is going to be much greater on this side of the Atlantic because Europeans don’t lose their health care when they lose their jobs. They don’t find themselves with essentially no support once their trivial unemployment check has fallen off. We have nothing underneath. When Americans lose their jobs, they fall into the abyss. That does not happen in other advanced countries, it does not happen, I want to say, in civilized countries.

And there are people who say we should not be worrying about things like universal health care in the crisis, we need to solve the crisis. But this is exactly the time when the importance of having a decent social safety net is driven home to everybody, which makes it a very good time to actually move ahead on these other things.

N.F.: Well, I tell you what, I feel depressed after what I’ve heard tonight. We are now contemplating a massive expansion of the state to substitute for the private sector because that’s the only thing Paul thinks will deliver growth. We’re going to reregulate the markets, we’re going to go back to those good old days. Where were you in the 1970s when all these wonderful regulations were in place? I don’t remember that going too smoothly. But what else are we going to do? We’re going to print money. Almost limitlessly we’ll print money. That’s going to be fine, too. And when we’re done with that, we’re going to raise taxes. What a fabulous package we have in store for us. You know, back in late 2007, I was asked what my big concern was, and I said, “My concern is that we’re going to get the 1970s for fear of the 1930s.” It’s very easy to forget, in your iron indignation at the failure of the market, where the true mainsprings of economic growth lie. The lesson of economic history is very clear. Economic growth does not come from state-led infrastructure investment. It comes from technological innovation, and gains in productivity, and these things come from the private sector, not from the state.

B.B.: As we look at the future, we also have to look at the mistakes policymakers made in the last ten years. It’s not news that people are greedy. But we made conscious decisions not to put limits on that natural human impulse. What were the mistakes? In 1999, we allowed investment banks, banks, insurance companies to combine: we eliminated the Glass-Steagall Act, which prohibited commercial banks from operating as investment banks. Why was Glass-Steagall put into law? Because the last time we didn’t limit greed we got into trouble, the Great Depression.

The second mistake was in 1999, the explicit decision by the Clinton administration and Congress not to regulate derivatives, in particular credit default swaps. In 2002 they were worth $1 trillion and today they’re worth $33 trillion, and that decision not to regulate derivatives created the following sequence: you have mortgages; then a thousand mortgages are packaged and sold as a mortgage-backed security; a thousand mortgage-backed securities are packaged and sold as a collateral debt obligation [CDOs]; then a thousand collateral debt obligations are packaged and sold as a CDO squared; and insuring each one of those bundles are credit default swaps, which are a part of that $33 trillion. And our government deliberately decided not to regulate this chain of investments.

One result was that the 374 people in the London office of AIG who were responsible for AIG derivatives destroyed a company that had 116,000 employees in 120 countries. Why? Because there was no regulation at all.

The third decision was in 2004. The SEC allowed banks to go from 10 to 1 leverage to 30 to 1 leverage. And guess what? Once they were allowed to do it, they did it. So if we’re going to look at the future, we might think of undoing those three mistakes.

Finally, we might want to remember that the chairman of the Federal Reserve is supposed to remove the punch bowl from the party when the party gets out of control. And that did not happen in the Greenspan years. The opposite happened.

http://www.nybooks.com/articles/archives/2009/jun/11/the-crisis-and-how-to-deal-with-it/

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The Crisis & What to Do About It

1.

The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. This fact—that the defect was inherent in the system —contradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting. The severity and amplitude of the crisis provides convincing evidence that there is something fundamentally wrong with this prevailing theory and with the approach to market regulation that has gone with it. To understand what has happened, and what should be done to avoid such a catastrophic crisis in the future, will require a new way of thinking about how markets work.

Consider how the crisis has unfolded over the past eighteen months. The proximate cause is to be found in the housing bubble or more exactly in the excesses of the subprime mortgage market. The longer a double-digit rise in house prices lasted, the more lax the lending practices became. In the end, people could borrow 100 percent of inflated house prices with no money down. Insiders referred to subprime loans as ninja loans—no income, no job, no questions asked.

The excesses became evident after house prices peaked in 2006 and subprime mortgage lenders began declaring bankruptcy around March 2007. The problems reached crisis proportions in August 2007. The Federal Reserve and other financial authorities had believed that the subprime crisis was an isolated phenomenon that might cause losses of around $100 billion. Instead, the crisis spread with amazing rapidity to other markets. Some highly leveraged hedge funds collapsed and some lightly regulated financial institutions, notably the largest mortgage originator in the US, Countrywide Financial, had to be acquired by other institutions in order to survive.

Confidence in the creditworthiness of many financial institutions was shaken and interbank lending was disrupted. In quick succession, a variety of esoteric credit markets—ranging from collateralized debt obligations (CDOs) to auction-rated municipal bonds—broke down one after another. After periods of relative calm and partial recovery, crisis episodes recurred in January 2008, precipitated by a rogue trader at Société Générale; in March, associated with the demise of Bear Stearns; and then in July, when IndyMac Bank, the largest savings bank in the Los Angeles area, went into receivership, becoming the fourth-largest bank failure in US history. The deepest fall of all came in September, caused by the disorderly bankruptcy of Lehman Brothers in which holders of commercial paper—for example, short-term, unsecured promissory notes—issued by Lehman lost their money.

Then the inconceivable occurred: the financial system actually melted down. A large money market fund that had invested in commercial paper issued by Lehman Brothers “broke the buck,” i.e., its asset value fell below the dollar amount deposited, breaking an implicit promise that deposits in such funds are totally safe and liquid. This started a run on money market funds and the funds stopped buying commercial paper. Since they were the largest buyers, the commercial paper market ceased to function. The issuers of commercial paper were forced to draw down their credit lines, bringing interbank lending to a standstill. Credit spreads—i.e., the risk premium over and above the riskless rate of interest—widened to unprecedented levels and eventually the stock market was also overwhelmed by panic. All this happened in the space of a week.

With the financial system in cardiac arrest, resuscitating it took precedence over considerations of moral hazard—i.e., the danger that coming to the rescue of a financial institution in difficulties would reward and encourage reckless behavior in the future—and the authorities injected ever larger quantities of money. The balance sheet of the Federal Reserve ballooned from $800 billion to $1,800 billion in a couple of weeks. When that was not enough, the American and European financial authorities committed themselves not to allow any other major financial institution to fail.

These unprecedented measures have begun to have an effect: interbank lending has resumed and the London Interbank Offered Rate (LIBOR) has improved. The financial crisis has shown signs of abating. But guaranteeing that the banks at the center of the global financial system will not fail has precipitated a new crisis that caught the authorities unawares: countries at the periphery, whether in Eastern Europe, Asia, or Latin America, could not offer similarly credible guarantees, and financial capital started fleeing from the periphery to the center. All currencies fell against the dollar and the yen, some of them precipitously. Commodity prices dropped like a stone and interest rates in emerging markets soared. So did premiums on insurance against credit default. Hedge funds and other leveraged investors suffered enormous losses, precipitating margin calls and forced selling that have also spread to markets at the center.

Unfortunately the authorities are always lagging behind events. The International Monetary Fund is establishing a new credit facility that allows financially sound periphery countries to borrow without any conditions up to five times their annual quota, but that is too little too late. A much larger pool of money is needed to reassure markets. And if the top tier of periphery countries is saved, what happens to the lower-tier countries? The race to save the international financial system is still ongoing. Even if it is successful, consumers, investors, and businesses are undergoing a traumatic experience whose full impact on global economic activity is yet to be felt. A deep recession is now inevitable and the possibility of a depression cannot be ruled out. When I predicted earlier this year that we were facing the worst financial crisis since the 1930s, I did not anticipate that conditions would deteriorate so badly.

2.

This remarkable sequence of events can be understood only if we abandon the prevailing theory of market behavior. As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.

While the two-way connection is present at all times, it is only occasionally, and in special circumstances, that it gives rise to financial crises. Usually markets correct their own mistakes, but occasionally there is a misconception or misinterpretation that finds a way to reinforce a trend that is already present in reality and by doing so it also reinforces itself. Such self- reinforcing processes may carry markets into far-from-equilibrium territory. Unless something happens to abort the reflexive interaction sooner, it may persist until the misconception becomes so glaring that it has to be recognized as such. When that happens the trend becomes unsustainable and when it is reversed the self-reinforcing process starts working in the opposite direction, causing a sharp downward movement.

The typical sequence of boom and bust has an asymmetric shape. The boom develops slowly and accelerates gradually. The bust, when it occurs, tends to be short and sharp. The asymmetry is due to the role that credit plays. As prices rise, the same collateral can support a greater amount of credit. Rising prices also tend to generate optimism and encourage a greater use of leverage—borrowing for investment purposes. At the peak of the boom both the value of the collateral and the degree of leverage reach a peak. When the price trend is reversed participants are vulnerable to margin calls and, as we’ve seen in 2008, the forced liquidation of collateral leads to a catastrophic acceleration on the downside.

Bubbles thus have two components: a trend that prevails in reality and a misconception relating to that trend. The simplest and most common example is to be found in real estate. The trend consists of an increased willingness to lend and a rise in prices. The misconception is that the value of the real estate is independent of the willingness to lend. That misconception encourages bankers to become more lax in their lending practices as prices rise and defaults on mortgage payments diminish. That is how real estate bubbles, including the recent housing bubble, are born. It is remarkable how the misconception continues to recur in various guises in spite of a long history of real estate bubbles bursting.

Bubbles are not the only manifestations of reflexivity in financial markets, but they are the most spectacular. Bubbles always involve the expansion and contraction of credit and they tend to have catastrophic consequences. Since financial markets are prone to produce bubbles and bubbles cause trouble, financial markets have become regulated by the financial authorities. In the United States they include the Federal Reserve, the Treasury, the Securities and Exchange Commission, and many other agencies.

It is important to recognize that regulators base their decisions on a distorted view of reality just as much as market participants—perhaps even more so because regulators are not only human but also bureaucratic and subject to political influences. So the interplay between regulators and market participants is also reflexive in character. In contrast to bubbles, which occur only infrequently, the cat-and-mouse game between regulators and markets goes on continuously. As a consequence reflexivity is at work at all times and it is a mistake to ignore its influence. Yet that is exactly what the prevailing theory of financial markets has done and that mistake is ultimately responsible for the severity of the current crisis.

3.

In my book The New Paradigm for Financial Markets,* I argue that the current crisis differs from the various financial crises that preceded it. I base that assertion on the hypothesis that the explosion of the US housing bubble acted as the detonator for a much larger “super-bubble” that has been developing since the 1980s. The underlying trend in the super-bubble has been the ever-increasing use of credit and leverage. Credit—whether extended to consumers or speculators or banks—has been growing at a much faster rate than the GDP ever since the end of World War II. But the rate of growth accelerated and took on the characteristics of a bubble when it was reinforced by a misconception that became dominant in 1980 when Ronald Reagan became president and Margaret Thatcher was prime minister in the United Kingdom.

The misconception is derived from the prevailing theory of financial markets, which, as mentioned earlier, holds that financial markets tend toward equilibrium and that deviations are random and can be attributed to external causes. This theory has been used to justify the belief that the pursuit of self-interest should be given free rein and markets should be deregulated. I call that belief market fundamentalism and claim that it employs false logic. Just because regulations and all other forms of governmental interventions have proven to be faulty, it does not follow that markets are perfect.

Although market fundamentalism is based on false premises, it has served well the interests of the owners and managers of financial capital. The globalization of financial markets allowed financial capital to move around freely and made it difficult for individual states to tax it or regulate it. Deregulation of financial transactions also served the interests of the managers of financial capital; and the freedom to innovate enhanced the profitability of financial enterprises. The financial industry grew to a point where it represented 25 percent of the stock market capitalization in the United States and an even higher percentage in some other countries.

Since market fundamentalism is built on false assumptions, its adoption in the 1980s as the guiding principle of economic policy was bound to have negative consequences. Indeed, we have experienced a series of financial crises since then, but the adverse consequences were suffered principally by the countries that lie on the periphery of the global financial system, not by those at the center. The system is under the control of the developed countries, especially the United States, which enjoys veto rights in the International Monetary Fund.

Whenever a crisis endangered the prosperity of the United States—as for example the savings and loan crisis in the late 1980s, or the collapse of the hedge fund Long Term Capital Management in 1998—the authorities intervened, finding ways for the failing institutions to merge with others and providing monetary and fiscal stimulus when the pace of economic activity was endangered. Thus the periodic crises served, in effect, as successful tests that reinforced both the underlying trend of ever-greater credit expansion and the prevailing misconception that financial markets should be left to their own devices.

It was of course the intervention of the financial authorities that made the tests successful, not the ability of financial markets to correct their own excesses. But it was convenient for investors and governments to deceive themselves. The relative safety and stability of the United States, compared to the countries at the periphery, allowed the United States to suck up the savings of the rest of the world and run a current account deficit that reached nearly 7 percent of GNP at its peak in the first quarter of 2006. Eventually even the Federal Reserve and other regulators succumbed to the market fundamentalist ideology and abdicated their responsibility to regulate. They ought to have known better since it was their actions that kept the United States economy on an even keel. Alan Greenspan, in particular, believed that giving users of financial innovations such as derivatives free rein brought such great benefits that having to clean up behind the occasional financial mishap was a small price to pay. And his analysis of the costs and benefits of his permissive policies was not totally wrong while the super-bubble lasted. Only now has he been forced to acknowledge that there was a flaw in his argument.

Financial engineering involved the creation of increasingly sophisticated instruments, or derivatives, for leveraging credit and “managing” risk in order to increase potential profit. An alphabet soup of synthetic financial instruments was concocted: CDOs, CDO squareds, CDSs, ABXs, CMBXs, etc. This engineering reached such heights of complexity that the regulators could no longer calculate the risks and came to rely on the risk management models of the financial institutions themselves. The rating companies followed a similar path in rating synthetic financial instruments, deriving considerable additional revenues from their proliferation. The esoteric financial instruments and techniques for risk management were based on the false premise that, in the behavior of the market, deviations from the mean occur in a random fashion. But the increased use of financial engineering set in motion a process of boom and bust. So eventually there was hell to pay. At first the occasional financial crises served as successful tests. But the subprime crisis came to play a different role: it served as the culmination or reversal point of the super-bubble.

It should be emphasized that this interpretation of the current situation does not necessarily follow from my model of boom and bust. Had the financial authorities succeeded in containing the subprime crisis—as they thought at the time they would be able to do—this would have been seen as just another successful test instead of the reversal point. I have cried wolf three times: first with The Alchemy of Finance in 1987, then with The Crisis of Global Capitalism in 1998, and now. Only now did the wolf arrive.

My interpretation of financial markets based on reflexivity can explain events better than it can predict them. It is less ambitious than the previous theory. It does not claim to determine the outcome as equilibrium theory does. It can assert that a boom must eventually lead to a bust, but it cannot determine either the extent or the duration of a boom. Indeed, those of us who recognized that there was a housing bubble expected it to burst much sooner. Had it done so, the damage would have been much smaller and the super-bubble may have remained intact. Most of the damage was caused by mortgage-related securities issued in the last two years of the housing boom.

The fact that the new paradigm does not claim to predict the future explains why it did not make any headway until now, but in the light of recent experience it can no longer be ignored. We must come to terms with the fact that reflexivity introduces an element of uncertainty into financial markets that the previous theory left out of account. That theory was used to establish mathematical models for calculating risk and converting bundles of subprime mortgages into tradable securities, as well as other forms of debt. Uncertainty by definition cannot be quantified. Excessive reliance on those mathematical models did untold harm.

4.

The new paradigm has far-reaching implications for the regulation of financial markets. Since they are prone to create asset bubbles, regulators such as the Fed, the Treasury, and the SEC must accept responsibility for preventing bubbles from growing too big. Until now financial authorities have explicitly rejected that responsibility.

It is impossible to prevent bubbles from forming, but it should be possible to keep them within tolerable bounds. It cannot be done by controlling only the money supply. Regulators must also take into account credit conditions because money and credit do not move in lockstep. Markets have moods and biases and it falls to regulators to counterbalance them. That requires the use of judgment and since regulators are also human, they are bound to make mistakes. They have the advantage, however, of getting feedback from the market and that should enable them to correct their mistakes. If a tightening of margin and minimum capital requirements does not deflate a bubble, they can tighten them some more. But the process is not foolproof because markets can also be wrong. The search for the optimum equilibrium has to be a never-ending process of trial and error.

The cat-and-mouse game between regulators and market participants is already ongoing, but its true nature has not yet been acknowledged. Alan Greenspan was a past master of manipulation with his Delphic utterances, but instead of acknowledging what he was doing he pretended that he was merely a passive observer of the facts. Reflexivity remained a state secret. That is why the super-bubble could develop so far during his tenure.

Since money and credit do not move in lockstep and asset bubbles cannot be controlled purely by monetary means, additional tools must be employed, or more accurately reactivated, since they were in active use in the 1950s and 1960s. I refer to variable margin requirements and minimal capital requirements, which are meant to control the amount of leverage market participants can employ. Central banks even used to issue guidance to banks about how they should allocate loans to specific sectors of the economy. Such directives may be preferable to the blunt instruments of monetary policy in combating “irrational exuberance” in particular sectors, such as information technology or real estate.

Sophisticated financial engineering of the kind I have mentioned can render the calculation of margin and capital requirements extremely difficult if not impossible. In order to activate such requirements, financial engineering must also be regulated and new products must be registered and approved by the appropriate authorities before they can be used. Such regulation should be a high priority of the new Obama administration. It is all the more necessary because financial engineering often aims at circumventing regulations.

Take for example credit default swaps (CDSs), instruments intended to insure against the possibility of bonds and other forms of debt going into default, and whose price captures the perceived risk of such a possibility occurring. These instruments grew like Topsy because they required much less capital than owning or shorting the underlying bonds. Eventually they grew to more than $50 trillion in nominal size, which is a many-fold multiple of the underlying bonds and five times the entire US national debt. Yet the market in credit default swaps has remained entirely unregulated. AIG, the insurance company, lost a fortune selling credit default swaps as a form of insurance and had to be bailed out, costing the Treasury $126 billion so far. Although the CDS market may be eventually saved from the meltdown that has occurred in many other markets, the sheer existence of an unregulated market of this size has been a major factor in increasing risk throughout the entire financial system.

Since the risk management models used until now ignored the uncertainties inherent in reflexivity, limits on credit and leverage will have to be set substantially lower than those that were tolerated in the recent past. This means that financial institutions in the aggregate will be less profitable than they have been during the super-bubble and some business models that depended on excessive leverage will become uneconomical. The financial industry has already dropped from 25 percent of total market capitalization to 16 percent. This ratio is unlikely to recover to anywhere near its previous high; indeed, it is likely to end lower. This may be considered a healthy adjustment, but not by those who are losing their jobs.

In view of the tremendous losses suffered by the general public, there is a real danger that excessive deregulation will be succeeded by punitive reregulation. That would be unfortunate because regulations are liable to be even more deficient than the market mechanism. As I have suggested, regulators are not only human but also bureaucratic and susceptible to lobbying and corruption. It is to be hoped that the reforms outlined here will preempt a regulatory overkill.

—November 6, 2008

http://www.nybooks.com/articles/archives/2008/dec/04/the-crisis-what-to-do-about-it/

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The Financial Crisis: An Interview with George Soros

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.

http://www.nybooks.com/articles/archives/2008/may/15/the-financial-crisis-an-interview-with-george-soro/


July 1st 2015  Rev - 4

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