George Soros is a financial titan. He beat the Bank of England in 1992, and has since cemented his billionaire status with his financial dealings. Yet he also lays claim to the status of societal thinker: He has written several books critiquing the workings of financial markets. He departs from the academic consensus of efficient markets, instead arguing in a December article: “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.”
Reflexivity, in Soros’ analysis, leads to bubbles and crashes in markets. Soros argues that the current crash is the end of a superbubble that had been developing since the 1980s. The superbubble was created by a combination of financial innovation and regulatory negligence. Soros favours more active regulation, using a variety of policy tools, to control bubbles. At the same time, he warns against “punitive reregulation”.
Soros contrasts his views with the idea that markets always tend to be in equilibrium. In fact, the notion of market equilibrium, as developed by economists, is quite broad, and includes the idea that the equilibrium state can be influenced by market participants’ expectations. At any time, there can be more than one equilibrium, depending on whether people are pessimistic or optimistic. In some cases, small external shocks can lead to dramatic changes in the equilibrium, as both expectations and actions follow an upward or downward spiral. The shortcoming of the equilibrium view of the world is that it does not give us a clear understanding of the process of adjustment from one equilibrium to another. Often, there is no model of how people’s expectations are formed, making it impossible to understand how expectations adjust. Another weakness of the equilibrium perspective is that often the term is used in a narrow sense, referring to a lack of short-term incentives for any individual to deviate from what he or she is doing, rather than a long-term alignment of actions with underlying fundamentals.
But it is hard to be sure what the fundamentals really are. Much of the prevailing thinking during the long boom was that the fundamentals had changed: The collapse of Communism, the rise of emerging economies in Asia, the impact of information technology, and the increase in international flows of goods, services and capital, all could be adduced as factors supporting higher global growth. One could argue that this was a virtuous cycle that could have continued without the severe collapse we are now seeing.
What went wrong then? Soros identifies inadequate models of risk assessment and risk management, and financial innovations that outstripped the capacity of regulators to regulate effectively. These are different reasons than his argument that there is a natural tendency for financial markets to bubble and crash, but they explain why neither the financial industry nor the government controlled the bubble in time to prevent the crash. Soros also blames “deregulation”, but that is a somewhat different cause than lack of regulatory implementation. In any case, the heart of the argument is that markets are not inherently stable and do not self-correct without pain. But as I have suggested, Soros’ view on this is not something that the vast majority of economists would argue with.
However, there are four things that Soros misses. First, sufficient regulatory authority with respect to commercial bank supervision and regulation of investment banks was clearly available to Alan Greenspan of the US Federal Reserve and Christopher Cox of the Securities and Exchange Commission. Neither did his job properly: That is different from deregulation. Second, ideology and politics interfered, beyond a simple market fundamentalism. The same processes and attitudes in the Bush administration that distorted economic policy led to a disastrous foreign policy that had its own high costs. Leadership matters, and poor leadership can be calamitous. Third, markets are not abstractions. The design of market institutions matters, and the regulatory problem was not just deregulation or lack of enforcement, but an abdication of regulators’ responsibility to update the design of market institutions to keep up with innovations in financial instruments. One could call this lack of regulation, but it is a different enough issue to deserve separate treatment.
The fourth additional point deserves emphasis. Soros focuses on the failings of financial markets in describing the cycling of the world economy. He notes that lower risk tolerance is going to affect future growth negatively. But, despite the chaos in the world economy caused by high-level greed, incomprehension and incompetence in the US, the world is fundamentally different since the 1980s, in a way that has not been the case since before the Industrial Revolution. Asia can still drive the world’s economic growth if it follows the right policies.
Nirvikar Singh is professor of economics at the University of California, Santa Cruz. Your comments are welcome at email@example.com