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BIBLIOGRAPHY REVIEW Books

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Nothing proves better that events are acceleratingand that the world is becoming a village than whatcan be read on the second page of the book

reviewed here and of its Hungarian translation(Soros 2008a, 2008b). The two books were pub-lished in the same year. The Hungarian publiccould not only read the book in Hungarianalready in the year of its publication in the UnitedStates and the United Kingdom but this review,too, has followed shortly afterwards, in the firstmonths of the following year.

INTRODUCTION, BACKGROUND

What is stated above proves not only the greatand increasing rapidity with which ideas can be

spread but also the enormous importance ofthe events dealt with and the ideas pre-sentedin this book. The importance of these cannot

be better described than by the author in thefirst sentences of theIntroduction of his book.We are in the midst of the worst financial cri-sis since the 1930s1. In some way it resemblesother crises that have occurred in the last twen-ty-five years, but there is a profound differ-ence: the current crisis marks the end of an eraof credit expansion based on the dollar as theinternational reserve currency. The periodiccrises were part of a larger boom-bust process;the current crisis is the culmination of a super-boom that has lasted for more than twenty-five

years. To understand what is going on we needa new paradigm. The currently prevailing para-digm, namely that financial markets tendtowards equilibrium, is both false and mislead-ing; our current troubles can largely be attrib-uted to the fact that the international financial

George Soros

The credit crisisof 2008 and whatit means*

SCOLARKIAD, 2008

* This reviewer is indebted with the usual reserva-tions to Lszl Csaba and Dra Gyrffy for theirvaluable comments and help

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system has been developed on the basis of thatparadigm. The new paradigm I am proposing isnot confined to the financial markets. It deals

with the relationship between thinking andreality, and it claims that misconceptions andmisinterpretations play a major role in shapingthe course of history (p. 7).

In the further parts of the Introduction theauthor describes his subjective reason for writ-ing this book. Already in his first book, TheAlchemy of Finance (1987), he expounded thetheory of reflexivity, but it was not takenseriously in academic circles (p. 8). It is diffi-cult to gain attention for an abstract theory, but[] the current situation provides an excellent

opportunity to demonstrate its relevance andimportance. This consideration was whatweighted most heavily in [his] decision topublish his book (pp. 910). The reasoningexpounded already in the former book is sim-ple. Contrary to classical economic theory,which assumes perfect knowledge, neither mar-ket participants nor the monetary and fiscalauthorities can base their decisions purely onknowledge. Their misjudgments and miscon-ceptions affect market prices, and, more impor-

tantly, market prices affect the socalled funda-mentals that they are supposed to reflect.Market prices do not deviate from a theoreticalequilibrium in a random manner, as the currentparadigm holds. [] There is a two-way reflex-ive connection between perception and realitywhich can give rise to initially self-reinforcingbut eventually self-defeating boom-bustprocesses, or bubbles. (p. 10) The attempt toevaluate the book will follow at the end of thisreview, but these few sentences seem enough tosupport the statement that the approach pre-

sented in these few sentences is realistic.The Introduction is followed by a second

introduction bearing the title Setting the Stageand describing the course of events beginningAugust 6, 2007 when American HomeMortgage, one of the largest U.S. independent

home loan providers, filed of bankruptcy afterlaying off the majority of its staff (p. 13),which is considered generally as the setting off

of the crisis. The crisis was slow in coming,but it could have been anticipated several yearsin advance. [] For thirty-one consecutivemonths, the base inflation-adjusted short-terminterest rate was negative. [] When money isfree, the rational lender will keep on lendinguntil there is no one else to lend to. []Investment banks on Wall Street developed avariety of new techniques to hive credit risksoff to other investors. [] From 2000 untilmid-2005, the market value of existing homesgrew by more than 50 percent, and there was a

frenzy of new construction. [] Credit stan-dards collapsed. [] The bankers and the rat-ing agencies grossly underestimated the risks.[] Securitization2 became a mania. [] Itwas bound to end badly. [] Once the crisiserupted, financial markets unraveled withremarkable rapidity. Everything that could gowrong did. [] Distress spread from residen-tial real estate to credit card debt, auto debt,and commercial real estate. [] Over the pastseveral decades the United States has weath-

ered several major financial crises, [] but thecurrent crisis is of an entirely different charac-ter. It has spread from one segment of the mar-ket to others, particularly those that employthe newly created structured and syntheticinstruments3. [] Both the financial marketsand the financial authorities have been veryslow to recognize that the real economy isbound to be affected. [] One cannot escapethe conclusion that both the financial authori-ties and market participants harbor fundamen-tal misconceptions about the way financial

market functions. [] I shall argue that theglobal financial system has been built on falsepremises. [] In Part 1, I shall lay out the con-ceptual framework. [] In part 2, I shall applythat framework to the present moment in his-tory. (pp. 1528)



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PERSPECTIVE

THE CORE IDEA The first chapter of Part I,

Perspective, Chapter 1 describes The coreidea presented already in the earlier works ofthis author. We are part of the world we seekto understand, and the fact that we are partof the world poses a formidable obstacle to theunderstanding of human affairs (p. 3). He dis-tinguishes the cognitive function, our attemptto understand the world in which we live andthe participating function, our attempt tomake impact on the world and change [it toour] advantage, which latter may be moreappropriate to call the manipulative function

(id.). The obvious consequence of this is thatthe phenomena do not consist only of factsbut also of intentions and expectations aboutthe future. The past may be uniquely deter-mined, but the future is contingent on the par-ticipants' decisions. Consequently the partici-pants cannot base their decisions on knowledgebecause they have to deal not only with presentand past facts but also with contingencies con-cerning the future (p. 4) This leads to thenotion of reflexivity to be dealt with in more

detail later on: In reflexive situations eachfunction deprives the other of the independentvariable which it would need to produce deter-minate result (p. 5). The demand and supplycurves are not independently given but inter-fere with each other and therefore they are notpredetermined facts. Take the stock market,for example. People buy and sell stocks inanticipation of future stock prices but thoseprices are contingent on the investors' expecta-tions. The expectations cannot qualify as knowl-edge (id., italics added by reviewer).

This leads to sharp criticism against conven-tional economic theory. Classical economistssimply assumed that market participants basetheir decisions on perfect knowledge (id.). Icontend that rational expectations theorytotally misinterprets how financial markets

work and therefore is no longer taken seri-ously outside academic circles (p. 6). This isfollowed by philosophical argumentation lead-

ing to the conclusion that humans are obligedto form a view of the world, but the view can-not possibly correspond to the actual state ofaffairs (p. 11).

AUTOBIOGRAPHY OF A FAILED PHILOSOPHERChapter 2, Autobiography of a failed philoso-pher deals with the personal experiences ofthe author and his father and also with theauthor's contact in Vienna with Karl Popperand his views. The reason for the inclusion ofthis chapter, which cannot be dealt with here in

de-tail for lack of space, is indicated in the lastsentence of Chapter 1. I learned at an early agehow ideologies based on false premises cantransform reality (p. 11). Europeans and par-ticularly Eastern Europeans can best under-stand the inherent validity and also the impor-tance of this statement that underpins, veryobviously, the author's ideas. This chapter,however, is not a digression of personal charac-ter inserted into the text of this book but adescription of the origin and development of

his ideas.

THE THEORY OF REFLEXIVITY Chapter 3expounding the author's views on The theoryof reflexivity can also be dealt with here only inlesser detail, emphasizing only what thisreviewer considers the most impor-tant. Theauthor himself introduces it with the followingremark: Readers may find this chap-ter some-what repetitive and hard going. Those who areonly interested in the financial mar-kets mayskip it (p. 25).

In this reviewer's view, the most interest-ing element of this chapter is the paralleldrawn between Enlightenment and postmod-ern thinking. The philosophers of theEnlightenment put their faith in reason; theysaw reality as something separate and inde-



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pendent of reason, and they expected to pro-vide a full and accurate picture of reality (p.32). The postmodern thinking sees the fallacies

of this reasoning, but the postmodern attitudetowards reality is much more dangerous. Whileit has stolen a march on the Enlightenment bydiscovering that reality can be manipulated, itdoes not recognize the pursuit of truth as arequirement. Consequently, it allows themanipulation of reality go unhindered (p. 38).This statement leads him to a frontal attack onhis archenemy, the Bush administration: I nowsee a direct connection between the postmod-ern idiom and the Bush administrations' ideol-ogy (p. 41). One of this administration's sen-

ior advisers (and, consequently, the administra-tion itself) did not merely recognize that thetruth can be manipulated, he promoted themanipulation of truth as a superior approach(pp. 4243). This leads to the paradoxical con-clusion that the higher standards in politicswere based on an illusion, and they were under-mined by the discovery of truth, namely thatreality can be manipulated (pp. 4546). This,in my opinion most important part of thischapter is closed with the following statements

of moral character: I believe political dis-course used to abide by much higher standardsof truthfulness and respect for the opponents'opinion in the first two hundred years ofdemocracy in America than it does today (p.45). To reestablish those higher standards thatused to prevail, people must come to realizethat reality matters even if it can be manipulat-ed (p. 46).

REFLEXIVITY OF FINANCIAL MARKETS In Chapter4, Reflexivity of financial markets the author

leaves the realm of abstractions in which hehas delved (p. 51), and begins to deal withrealities, the veritable problems of financialmarkets, problems in which the readers areprobably more interested than in the philo-sophical speculations of the first three chapters.

The first few pages discuss equilibrium theo-ry and rational expectations theory and addonly some details to what has been written pre-

viously. The fundamental theorem is presentedrather bluntly in the first sentences of the sec-tion on A contradictory theory. I contend thatfinancial markets are always wrong(italics addedby reviewer) in the sense that they operate witha prevailing bias, but in the normal course ofevents they tend to correct their own excesses.Occasionally the prevailing bias can actually val-idate itself by influencing not only marketprices but also the so-called fundamentals thatmarket prices are supposed to reflect. [] Thechange in the fundamentals may then reinforce

the biased expectations in an initially self-rein-forcing but eventually self-defeating process.Of course such boom-bust sequences do notoccur all the time. Most often the prevailingbias corrects itself before it can affect the fun-damentals. But [] they can occur []. Whenthey occur, boom-bust processes can take onhistoric significance. That is what happened inthe Great Depression, and that is what isunfolding now, although it is taking differentshape (pp. 5758). As we can see, in this analy-

sis already, a reference is made to the currentproblems to be dealt with later on, in Chapters58, while this chapter primarily focuses on pastevents rather than current problems.

The first such past event was the conglomer-ate boom of the 1960s. At this time companiescould attain a higher multiple simply by goingon an acquisition spree (p. 59), i.e. buyingother companies. The misconception [] wasthe belief that companies should be valuedaccording to the growth of their reported pershare earnings no matter how the growth was

achieved, i.e. by assuming that equity lever-aging4, that is, selling stock at inflated valua-tions can generate earning growth (p. 60).When stock prices started to fall, the declinefed on itself (id.). This was therefore a classi-cal boom-bust process: the boom was built on



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the increase of stock prices that, eventually, hadto come to a stop and at this point the collapseof the boom was unavoidable. The second such

event was the case of the real estate investmenttrusts. The shares of the first such trusts near-ly doubled in price in the space of a month orso. Demand generated supply, and a host ofnew issues came to the market. When it becameclear that the supply [] was inexhaustible,prices fell (p. 62), and the boom collapsed.

The most important was, however, theinternational banking crisis of the 1980s (p.64). The author's fundamental contention isthat in case of private loans bubbles arise whenbanks treat the value of [the collateral, of] the

real estate as if it were independent of thebanks' willingness to lend against it (pp.6465). The value of the real estate, however, isnot given, as conventional theory and alsobanks assume, but the willingness of the banksto lend against it increases its value. This istherefore a process that feeds on itself andmust come to a stop; the stop, however, leadsto collapse. When the debtors were sovereigncountries, [banks] pledged no collateral (p.65), and credits were given on the basis of the

creditworthiness of the countries. The coun-tries' creditworthiness was, however, increasedby the banks' willingness to give credit, whichwas therefore again a process that fed on itselfand had to come to a stop and collapse. Thethesis is therefore clear: the banks' activityinfluences fundamentals, the valuation of realestates and the economic state of the countries;credits are given because the banks' activityincreases the value of the real estate andimproves the position of the countries. Thisprocess must, however, come to a halt sooner

or later, followed by a collapse, if this self-rein-forcing process surpasses a certain limit or anadverse outside shock occurs.

BOOM/BUST MODEL Theboom-bust modelpre-sented in the next section is a generalization of

what has been written above and, according toit, the drama unfolds in eight stages (p. 65).It has a pecu-liarly asymmetric shape. It tends

to start slowly, accelerate gradually and thenfall steeper than it has risen (p. 66). A theo-retical and three empirical charts are presentedand the empirical ones are obviously conformto the theory and the theoretical charts. Otherforms of reflexivity are also possible, and infree-floating exchange rate regimes the reflex-ive relationship tends to generate large multi-year waves (p. 70).

The economic policy consequences of theabove considerations and of the empirical evi-dence are straightforward and farreaching.Because financial markets do not tend towards

equilibrium, they cannot be left to their own

devices (italics added by reviewer). Periodic cri-ses bring forth regulatory reforms (p. 71). Insharp contrast to the above, the prevailing par-adigm asserts that financial markets tend towards

equilibrium. That has led to the notion thatactual prices deviate from a theoretical equilib-rium in a random manner. While it is possible toconstruct theoretical models along these lines,the claim that those models apply to the real world

is both false and misleading. It leaves out ofaccount the possibility that the deviations maybe self-reinforcing in the sense that they mayalter the theoretical equilibrium. When thathappens,risk calculations and trading techniquesbased on these models are liable to break down.

[] This is at the root of the current financial cri-sis (italics added by reviewer, pp. 7374.)

A new paradigm is therefore needed, andits theoretical point of departure, as has beenstated before, is that by applying the postulateof radical fallibility to financial markets, one

can assert that instead of being always right,financial markets are always wrong. [] To bespecific: financial markets cannot predict eco-nomic downturns accurately, but they can cause

them. [] Bubbles often lead to financialcrises. Crises, in turn, lead to the regulation of



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financial markets. That is how the financialmarkets are best interpreted as a historical pro-

cess, and that is why this process cannot be under-

stood without taking into account the role of theregulators. In the absence of regulatory author-ities financial markets would be bound to breakdown, but in reality breakdowns rarely occurbecause markets operate under constant super-vision. [] Most of the reflexive processesinvolve an interplay between markets and regu-lators, [but] it is important to remember thatregulators are just as fallible as the partici-pants. [] That alone is sufficient to justifymy claim that the behavior of markets is bestregarded as a historical process (pp. 7677,

italics added by reviewer).This is something fundamentally different

from traditional theory and it is easy to under-stand that the author's criticism of the classicaltheory is annihilating. Market fundamental-istsblame market failures on the fallibility of theregulators, and they are half right: Both marketsand regulators are fallible. Where market funda-mentalists are totally wrong is claim-ing thatregulations ought to be abolished on account oftheir fallibility. That happens to be the inverse of

the Communist claim that markets ought to beabolished on account of their fallibility. [] Itwill advance our understanding of reality if werecognize the ideological character of marketfundamentalism. The fact that regulators are fal-lible does not prove that markets are perfect. Itmerely justifies re-examining and improving theregulatory environment (p. 77).

After these considerations of mostly theo-retical character let us now turn to Part II: Thecurrent crisis and beyond.

THE CURRENT CRISIS AND BEYOND

THE SUPER-BUBBLE HYPOTHESIS Chapter 5: Thesuper-bubble hypothesis, which may be consid-ered as the central chap-ter of this book, tries

to apply the theoretical apparatus shown aboveto the present situation and also to point tofuture developments that may be expected. It is

therefore of necessity to review it in a verydetailed form.The chapter begins with very important and

very explicit statements: We are in the midstof a financial crisis the likes of which have notbeen seen since the Great Depression of the1930s. To be sure, it is not the prelude toanother Great Depression. History does notrepeat itself. The banking system will not beallowed to collapse as it did in 1932 (p. 81).Nevertheless, this [crisis] will have farreach-ing consequences. It is not business as usual

but the end of an era (id.). This is followed bythe concept to be developed in this chapter, i.e.that in the present situation there is not justone boom-bust process or bubble but two: thehousing bubble and what I shall call a longer-term super-bubble. [] The two bubbles didnot develop in isolation: they are deeply imbed-ded in the history of the period (p. 82).Finally, the statement that no new GreatDepression will develop is supported by thefollowing considerations: The current situa-

tion cannot be understood without taking intoaccount the economic strength of China, India,and some oil- and raw material-producingcountries; the commodities boom; an exchangerate system that is partly floating, partly tied tothe dollar and partly in between; and theincreasing unwillingness of the rest of theworld to hold dollars (p. 82). These views willbe expounded in a more detailed form later, inChapter 7.

The emergence of the U.S. housing bubble(p. 82), according to the views of the author,

can be traced back to a number of longer termdevelopments that are shown in Charts 1 to 7.The U.S. saving rate declined to practicallyzero and housing prices increased enormously.The growth of U.S. household debt and theratio of structured finance within total rated



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revenue was also enormous. Credit qualitydeclined, which can best be shown by thegrowing share of subprime and Alt-A origina-

tion5 (p. 83). Toward the end, houses couldbe bought with no money down, no questionsasked (id.). Under such conditions the crisiswas foreseeable and practically unavoidable asalready stated in the second introductionSetting the stage; the details can be found inthe book.

As to the super-bubble hypothesis, superim-posed on the U.S. housing bubble there is amuch larger boom-bust sequence which hasfinally reached its inflection, or crossover,point. It consists of an excessive reliance on the

market mechanism. President Ronald Reagancalled it the magic of the marketplace. I call itmarket fundamentalism. It became the domi-nant creed in 1980 when Reagan became presi-dent in the United States andMargaret Thatcherprime minister in the United Kingdom,although its antecedents go back much further.It was called laissez-faire in the nineteenth cen-tury. Market fundamentalism has its roots in thetheory of perfect competition. [] In the postWorld War II period it received a powerful fillip

from the failures of communism, socialism, andother forms of state intervention. That impetus,however, rests on false premises. [] Financialmarkets do not necessarily tend towards equilibrium; left to their own devices they are liableto go to extremes of euphoria and despair. Forthat reason they are not left to their owndevices; they have been put in the charge offinancial authorities whose job is to supervisethem and regulate them. Ever since the GreatDepression, the authorities have been remark-ably successful in avoiding any major break-

down in the international financial system.Ironically, it is their success that has allowedmarket fundamentalism to revive. When I stud-ied at the London School of Economics in the1950s, laissez-faire seemed to have been buriedfor good. Yet it came back in the 1980s. Under

its influence the financial authorities lost con-trol of financial markets and the super-bubbledeveloped (p. 92).

The super-bubble combines three majortrends, each containing at least one defect. Firstis the longterm trend towards everincreasingcredit expansion. [] This trend is the resultof the countercyclical policies developed inresponse to the Great Depression. Every timethe banking system is endangered, or a reces-sion looms, the financial authorities intervene,bailing out the endangered institutions andstimulating the economy. Their interventionintroduces an asymmetric incentive for creditexpansion also known as the moral hazard6.

The second trend is the globalization of finan-cial markets, and the third is the progressiveremoval of financial regulations and the accel-erating pace of financial innovations. []Globalization also has an asymmetric structure.It favors the United States and other developedcountries at the center of the financial systemand penalizes the less developed economies atthe periphery. The disparity between the centerand the periphery is not widely recognized, butit has played an important role in the develop-

ment of the super-bubble. And [] bothderegulation and many of the recent innova-tions were based on the false assumption thatmarkets tend towards equilibrium and devia-tions are random. The super-bubble tiestogether the three trends and the three defects(p. 93).

If what has been told until now on marketfundamentalism is a dethronement, what istold on globalization is a blasphemy. Theglobalization of financial markets was a verysuccessful market fundamentalist project. If

financial capital is free to move about, itbecomes difficult for any state to tax it or toregulate it because it can move somewhere else.This puts financial capital into a privilegedposition. Governments often have to pay moreheed to the requirements of international capi-



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tal than to the aspirations of their own people.That is why the globalizations of financial mar-kets served the objectives of the market funda-

mentalists so well. [] Globalization did notbring about the level playing field that freemarkets were supposed to provide according tothe market fundamentalist doctrine. [] Theway the system works, the United States,which enjoy veto power in the Bretton Woodsinstitutions, [] is 'more equal' than the oth-ers. [] As the barriers to capital movementswere removed the savings of the world weresucked up to the center and redistributed fromthere (pp. 9596).

The above statements may appear as populist

utterances but they are followed by thorough-going analysis. The gradual lifting of restric-tions and the asymmetry of the system des-cribed above combined with the asymmetricincentive for credit expansion in the developedworld, sucked up the savings of the world fromthe periphery to the center and allowed theUnited States to develop a chronic currentaccount deficit. [] This was a perverse situa-tion because capital was flowing from the less-developed world to the United States and both

the current account and the budget deficits ofthe United States served as major sources ofcredit expansion. Another major source was theintroduction of new financial instruments andthe increased use of leverage by the banks andsome of their customers, notably hedge fundsand private equity funds. Yet another source ofcredit expansion was Japan. [] These imbal-ances could have continued to grow indefinite-ly because willing lenders and willing borrowerswere well matched. There was a symbiotic rela-tionship between the United States, which was

happy to consume more than it produced, andChina and other Asian exporters, which werehappy to produce more than they consumed.The United States accumulated external debt,China and the others accumulated currencyreserves. The United States had low saving

rates, the others high ones (pp. 9697). Thissituation became unsustainable with the devel-opment of a housing bubble in the U.S. and the

introduction of financial innovations based on afalse paradigm. [The housing bubble] is follow-ing the classic boom-bust pattern, but, in addi-tion, it has also set in motion a flight from thedollar and an unwinding of the other excessesintroduced in the financial system by recentinnovations. That is how the housing bubble andthe super-bubble are connected (p. 98, italicsadded by reviewer).

There is therefore the fundamental differ-ence between this crisis and the periodic crisesthat have punctuated finical history since the

1980s. [] Those who kept insisting that thesubprime crisis was an isolated phenomenonlacked a proper understanding of the situation.The subprime crisis was merely a trigger thatreleased the unwinding of the super-bubble(pp. 9899). This is followed by a longer argu-mentation posing the question whether the au-thor's thesis is valid or not, but the author,returning to the three major trends (p. 93)shown above, comes to the conclusion thatthese three factors render an economic slow-

down virtually inevitable and turn [what hashappened now] into the end of an era (p. 101).Nevertheless, he adds that we must beware oflaying too much emphasis on the super-bubble.We must not endow it with magical powers theway President Reagan did with the market-place. There is nothing predetermined or com-pulsory with the boom-bust pattern. []I want to caution against the pitfalls that awaitthose who seek to fit the course of events intoa predetermined pattern. [] The right way toproceed is to fit the pattern to the actual course

of events (pp. 101102). The author empha-sizes therefore that the future is not predeter-mined and human foresight is limited butleaves no doubt that, in his opinion, we are atthe end of an era and at a turning point ofhuman history.



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This chapter is closed with similar statements.I believe that the theory of reflexivity canexplain the current state of affairs better than

the prevailing paradigm, but I have to admit thatit cannot do what the old paradigm did. It can-not offer generalizations in the mold of naturalscience. It contends that social events are funda-mentally different from natural phenomena,they have thinking participants whose biasedviews and misconceptions introduce an elementof uncertainty into the course of events (p.103). It can therefore be assumed that we are atthe end of an era and at a turning point of humanhistory, but it cannot be assumed that we canforesee the future with certainty.

AUTOBIOGRAPHY OF A SUCCESSFUL SPECULA-TOR Chapter 6, Autobiography of a successful

speculator is even less a digression of personalcharacter inserted into the text of this bookthan Chapter 2, Autobiography of a failedphilosopher was. It is a description of thedevelopment of the banking sector in theauthor's active lifetime, since 1950. At the endof World War II [] banks and markets werestrictly regulated. [] International financial

transactions were subject to strict regulation bymost countries and there was very little inter-national capital movement. [] Banks at thetime were considered the stodgiest of institu-tions. Managements had been traumatized bythe failures of the 1930s, and safety was theparamount consideration, overshadowing prof-it and growth (pp. 106109). This is followedby the description of the two oil shocks, ofthe technology bubble that burst in 2000 andof the terrorist attack of September 11, 2001(p. 116) and their consequences, as well as the

shocking abdication of responsibility on thepart of the regulators (p. 117). Even the activ-ities of FED presidents Alan Greenspan (p.118) and Ben Bernanke (p. 119) are evaluated,and the chapter ends with the author's follow-ing revelation: when the crisis erupted in

August 2007, I considered the situation graveenough that I did not feel comfortable leavingthe management of my fortune to others, [and]

I resumed control (p. 121). In my opinionthis chapter does not explicitly state butimplies if other parts of the book are alsotaken into consideration that the bankingindustry will be led in a much more conserva-tive way in future and it will be put under effec-tive control once again.

MY OUTLOOK FOR 2008 Chapter 7 bearing thetitleMy outlook for 2008 is subdivided into sec-tions headed by the dates when these sectionswere presumably written.

The most important statements can be readin the first section datedJanuary 1, 2008, and itseems reasonable to cite them.

1. A sixty-year period of credit expansionbased on the United States exploiting its posi-tion at the center of the global financial systemto control over the international reserve cur-rency has come to an end (p. 122).

2. One can expect some longerlastingchanges in the character of banking and invest-ment banking (p. 123).

3. There are no grounds, however, for pre-dicting a prolonged period of credit contrac-tion or economic decline in the world as awhole because there are countervailing forcesat work. China, India and some of the oil-pro-ducing countries are experiencing dynamicdevelopments which may not be significantlydisrupted (p. 124).

4. The United States during the Bushadministration failed to exercise proper politi-cal leadership (id.).

These statements are followed by the

author's conjectures about the state and futureof the most important participants and deter-minants of the world economy. As to theUnited States, both investors and the generalpublic suffer from a misconception. Theybelieve that the financial authorities [] will



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do whatever it takes to avoid a recession.I believe that they are not in a position to do sopartly because of the commodity boom and

partly because of the vulnerability of the dollar(the two are mutually self-reinforcing) (p.125). The obvious consequence of this is thatI believe that the renminbi will be allowed toappreciate at a faster rate (id.). Europe isliable to be affected almost as badly as theUnited States (p. 128). China is undergoing aradical structural transformation, and the assetbubble engendered by negative real interestrates is facilitating the process. [] No doubta bubble is in formation, but it is in a relativelyearly stage, and there are powerful interests at

work to keep the bubble going (p. 129).Nevertheless, China will sail through the cur-rent financial crisis and subsequent recessionwith flying colors and gain considerable relativestrength. [] China is likely to challenge thesupremacy of the United States much soonerthan could have been expected when George W.Bush was elected president (p. 131). Ofcourse an utterance against this archenemy isnot spared: What an ironic outcome for theProject for a New American Century! (Id.) In

India the growth rate has now more than dou-bled. [] The discovery of offshore natural gaspromises to make India energy self-sufficientwithin the next few years (pp. 131132).Another source of strength for the worldeconomy is to be found in some of the oil-pro-ducing countries of the Middle East (p. 133),[because] these states are accumulatingreserves at an impressive rate, [] [and] arelikely to favor investing in the developingworld [] [which] is likely to reinforce thepositive performance of the developing

economies (pp. 133135). The ensuing sec-tions do not modify this picture in any sub-stantial way.

SOME POLICY RECOMMENDATIONS Chapter 8presents Some policy recommendations which

follow directly from what has been written pre-viously. We must not be surprised that the firststatement and the first rec-ommendation are

the following: Only a Democratic presidentcan be expected to turn things around and leadthe nation in a new direction, and, respective-ly: Clearly an unleashed and unhinged finan-cial industry is wreaking havoc with the econo-my. It needs to be reined in. Credit creation byits nature is a reflexive process. It needs to beregulated in order to prevent excesses (p.142). This does not mean, however, any exces-sive state interference: Markets should begiven the greatest possible scope compatiblewith maintaining economic stability (p. 143).

As a specific measure that could help relievethe credit crisis is the establishment of a clear-ing house or exchange for credit default swapsthat seems necessary as forty-five trillion dol-lars (!!!) worth of contracts are outstanding(p. 145). The next question is: What is to bedone about the mess created by the bursting ofthe housing bubble, considering that about40 percent (!!!) of the 7 million (!!!) subprimeloans outstanding will default in the next twoyears and that the human suffering caused by

the housing crisis will be enormous (pp.146147). The detailed discussion of the con-crete proposals is impossible here but it can beseen that the mess is extreme and the way outis far from being obvious.

CONCLUSION

The Conclusion repeats the most importantelements of the previous argumentation and itslast paragraph shows best the veritable prob-

lem. I should like to end with a plea. Let thisnot be the conclusion but the beginning of aconcerted effort at better understanding thehuman condition. Given our increased controlover the forces of nature, how can we governourselves better? How is the new paradigm for



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financial markets to be reconciled with the oldone? How should financial markets be regulat-ed? How can we deal with global warming and

nuclear proliferation? How can we bring abouta better world order? These are the questionsfor which we have to find answers. I hope toparticipate in a lively debate (pp. 159160.)

This conclusion shows best that the sub-prime crisis, which first appeared to be an iso-lated problem the likes of which could besolved in the past with no major consequences,triggered a US credit crisis which, in turn, trig-gered an international financial crisis thatbrought to the fore a number of fundamentalproblems which were known but were shelved

for fear of facing them. We must suppose thatthe world order of the years before this crisiswill never return, it will take a long time untilthe new a new world order is shaped, and thatthis time will be hard for all of us. The greatestmerit of this book is to show the depth of theproblems before us and the weight of the taskfacing us.

This looks like the end of this review but Ihave some remaining tasks to solve and somequestions to answer.

Thefirst question is whether the author's fun-damental theses that financial markets do nottend towards equilibrium, they cannot be left to

their own devices (p. 71, italics added byreviewer), and that financial markets arealways wrong (p. 76, italics added by reviewer)are valid, considering that traditional economictheory and the practice built on it hold thatspeculation is beneficial and even unavoidable.My contention is that these theses of Soros arenot only valid but they can be supported bymeans of neoclassical analysis, and that finan-

cial markets are wrong not only in the sensethat they bring disruptive forces to the fore butalso in the sense that they distort prices. Thisclaim can be backed in the most simple way byreferring to a book published sixty years ago,Abba P. Lerner's Economics of control (1947).

This book draws all its conclusions from thethesis that the general prevalence of perfectcompetition is the best possible state of affairs,

and devotes a whole chapter to competitivespeculation.The summary of this Chapter is the follow-

ing: The social utility of competitive specula-tion is more certain than that of simple pro-duction. It is beneficial for the rest of societyeven if the speculator is mistaken and incurs aloss, and even when he sells short. Hostility tospeculation is mistaken and arises in part fromidentifying productive or competitive specula-tors with aggressive or monopolisticSpeculators [written in this case with capital S].

The profits from speculation are best eliminat-ed by increasing the amount of speculation (p.13). This is, obviously, the classical and neo-classical view on which the prevalent system ofstock and merchandise exchanges are built.

In Lerner's book, the title and the first para-graph of the first Section of the ChapterCompetitive speculation are the following:The social utility of competitive speculation is

more certain than that of simple production (p.88). All perfectly competitive speculation is in

the social interest whether the optimum divi-sion of each factor between the different prod-ucts is reached or not. It always improves onthe situation, bringing it nearer to the opti-mum. It is strange that this should be more cer-tainly so in the case of speculation than on thecase of production in the ordinary sense whichusually receives much grater social approba-tion. Simple production of a particular goodmay be perfectly competitive and yet not con-tribute at the margin to bringing out the bestuse of the factor. It may be harmful socially

because there is an aberration from the opti-mum in the production of the alternative prod-ucts. [] But perfectly competitive specula-tion cannot have its good works nullified bywhat gets on anywhere in the economy becauseit completes the whole cycle by itself in taking



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goods from points where they are cheaper toothers where they are dearer and so frompoints where the value of the alternative use,

the marginal social cost, is lower than the valueof the actual use, the marginal social benefit.Thus it always tends to bring marginal socialcost closer to marginal social benefit (id.).

To express this argumentation in a moreconcise way, in the case of ordinary production,marginal social cost is equal to marginal socialbenefit only if this condition is fulfilled eve-rywhere, as a price distortion anywhere maycause distortion everywhere. This problemdoes not arise in the case of speculation asspeculation involves only a single piece of

goods in some place at some time and is there-fore unaffected by distortions related to othergoods. Speculation can be harmful only ifspeculators are able, because they are very richor because they can organize many people intocombinations, to affect the price and thus tofrustrate any attempts to bring about an opti-mum allocation of goods. [] We may call thisaggressive or monopolistic Speculation (p.69). The moral is simple and it is in full con-formity with or is even the best expression of

the teachings of classical economics: perfectcompetition is good and monopolies are badbecause they distort prices. Monopolies are notbad because they exist but because they distortprices.

This is where the Soros theory enters the pic-ture. Speculators can affect prices not only ifthey are very rich or if they organize them-selves into combinations but if they behave in auniform way, led by the Keynesian animal spir-it, without organizing themselves into combi-nations. A large unorganized group led by the

same misconception distorts prices just as wellas organized monopolies do. As a result, thetheses of Soros that financial markets do nottend towards equilibrium, they cannot be left to

their own devices (p. 71, italics added by re-viewer), and that financial markets are always

wrong (p. 76, italics added by reviewer) aretherefore valid even within the context of clas-sical economics as unorganized groups led by

the same misconception act and distort pricesin the same way as monopolies do. This meansthat speculation is not only wrong because itinvolves excesses of exuberance and despairand consequently leads to crises but alsobecause it distorts prices.

This contention is very similar to theKeynesian thesis that free markets do not nec-essarily bring about full employment, and, ifthey do not, state intervention is necessary.This raises, however, the second question. Ifstate intervention is necessary when financial

markets run amok, how is this state interven-tion to be effectuated? The answer that can begiven is also very similar to the Keynesian case.In a closed economy both countercyclical fiscaland monetary policies and the regulation of thefinancial markets are rather simple. In closedeconomies, taxes and interest rates can beraised or lowered by well-known methods rela-tively easily. Similarly, financial markets canalso be regulated in closed economies relativelyeasily and without damaging consequences. If

some financial inventions as structured andsynthetic instruments are too complicated tobe controlled, they can be prohibited.Problems arise in open economies, and they arethe greater the more the economy is open.

This leads to the favorite topic of Soros: thelack of political leadership in the United States.Even now when the relative power of the U.S.is much smaller than it used to be in the previ-ous, post World War II. decades, only thedomestic problems of the United States cancause world-wide problems, the domestic

problems of the other countries remain isolat-ed problems which can be solved by themselvesor by the international agencies. The theoreti-cal problems of the control of internationalfinances are difficult or perhaps impossible tosolve if the partners are equal. The fact that the



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U.S. is more equal makes the problem man-ageable, because the problems of internationalfinances can be reduced to the problem of U.S.

domestic finances as it is obviously true now.The international financial crisis is thereforethe consequence of the U.S. domestic financialcrisis. This reasoning can also be extended tothe fundamental imbalances of the world econ-omy, the origin of which can also be tracedback to U.S. domestic problems: the lack ofdomestic savings, etc.

The historical analogy is obvious. Lack ofpolitical leadership under President HerbertHoover led to the Great Depression. Lack ofpolitical leadership under President Bush led to

the present turmoil. This is not my analysis;this is the logical extension of the Soros analy-sis. This reasoning leads to the obvious conclu-sion. Worldwide financial problems are theconsequence of U.S. domestic financial prob-

lems and if the latter could be solved, world-wide financial problems would cease to existand financial problems appearing elsewhere

would be reduced to local problems. This, inthis form, is obviously a simplification but asimplification that facilitates the grasping ofthe core of the problem and pointing to itssolution.

This reasoning goes against the current trendof decreasing the role of politics because of theobvious deficiencies of politicians. RudigerDornbusch stated that money is somethingtoo serious to be left to politicians, to which itis added now that budget is also too serious tobe left to them. This, however, deprives society

from the means to control the economy, whichleads to crises like the present one. The way outtherefore is not undoing the role but raising thelevel of politics and politicians.

Gyrgy Szakolczai

NOTES

1 An excellent description of the crisis can be found inGyrffy (2008).

2

Securitization means the creation of tradable securi-ties from the nontradable assets of the banks bybundling, unbundling and rebundling the differentfinancial assets. This allows the separation ofexchange rate, interest rate and most recently alsocredits risks. The risks connected with the individualand non.tradable assets can be concealed by usingthis technique and this technique can thereforeincrease the value of the combined assets created inthis way above the value of the original nontradableassets. See also note 3

3 Structured and synthetic instruments are the securi-ties created in the way described in footnote 2. Thesenew derivatives reduced or seemed to reduce the

overall risk of the whole system.

4 Equity leveraging means buying stock and othersecurities for speculative purposes from credittaken up to finance this activity. If the value of thestocks and other securities increases, as it wasassumed, the credits taken up can be paid back eas-

ily. If the speculator's expectations are not fulfilledand he incurs losses and particularly heavy losses,the credits cannot be repaid and the loss of the

bank is unavoidable.5 According to Gyrffy (2008): Highrisk, subprime

borrowers can be classified into two groups: Alt-Aand subprime. In the Alt-A category, risk derivesfrom the fact that loans were taken out at a very lowlevel of documentation, e.g. the income certificatewas missing or no declaration was submitted on anyother mortgage that may have encumbered the prop-erty. In the subprime category, risks were signalled bya poor credit history or the complete failure to repaya former loan. In 2000, the aggregate ratio of thesetwo categories within total mortgage loans repre-sented 4 per cent only. This figure rose to 25 per centby early 2007 and nearly 40 per cent of mortgages

issued in 2006 fell in these categories.

6 Moral hazard appears when the person or institutionbearing the risk differs from those ob-taining theprofit expected from the transaction. Such a situa-tion certainly involves excessive risk-taking and maylead to heavy losses.



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GYRFFY, D. (2008): Szp j vilg Amerikban: Azllam lmai s a vlsg valsga (Brave new world in

America: The dreams of the state and the reality of thecrisis). Pnzgyi Szemle Public Finance Quarterly,current issue

LERNER, A. P. (1997): The economics of control,Macmillan, New York, 1947

SOROS, G. (2008a): The new paradigm for financialmarkets. The credit crisis of 2008 and what is means,Public Affairs Ltd., London

SOROS, GY. (2008b): A 2008-as hitelvlsg skvetkezmnyei, Scolar Kiad, Budapest

LITERATURE


Documents

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