I am no fan of "market fundamentalism" but as Soros points out government policy has not relied on markets per se but on stimulating demand artificially by lowering interest rates etc. The article ignores the role of military Keynesianism in U.S. economic growth as well. What is interesting to me is that supposed market fundamentalists are intervening big time with market forces. Market fundamentalism might have its rhetorical purposes in defending capitalism but democracy requires the purchase of votes. Loss of jobs, houses, and creative destruction during crashes does not buy many votes. Lock up the fundamentalist theologians in economic departments until times improve.
Financial Times, Jan. 23, 2008
The worst market crisis in 60 years
By George Soros
Published: January 22 2008 19:57 | Last updated: January 22 2008 19:57
The current financial crisis was precipitated by a bubble in the US
housing market. In some ways it resembles other crises that have
occurred since the end of the second world war at intervals ranging
from
four to 10 years.
However, there is a profound difference: the current crisis marks the
end of an era of credit expansion based on the dollar as the
international reserve currency. The periodic crises were part of a
larger boom-bust process. The current crisis is the culmination of a
super-boom that has lasted for more than 60 years.
Boom-bust processes usually revolve around credit and always involve a
bias or misconception. This is usually a failure to recognise a
reflexive, circular connection between the willingness to lend and the
value of the collateral. Ease of credit generates demand that pushes up
the value of property, which in turn increases the amount of credit
available. A bubble starts when people buy houses in the expectation
that they can refinance their mortgages at a profit. The recent US
housing boom is a case in point. The 60-year super-boom is a more
complicated case.
Every time the credit expansion ran into trouble the financial
authorities intervened, injecting liquidity and finding other ways to
stimulate the economy. That created a system of asymmetric incentives
also known as moral hazard, which encouraged ever greater credit
expansion. The system was so successful that people came to believe in
what former US president Ronald Reagan called the magic of the
marketplace and I call market fundamentalism. Fundamentalists believe
that markets tend towards equilibrium and the common interest is best
served by allowing participants to pursue their self-interest. It is an
obvious misconception, because it was the intervention of the
authorities that prevented financial markets from breaking down, not
the
markets themselves. Nevertheless, market fundamentalism emerged as the
dominant ideology in the 1980s, when financial markets started to
become
globalised and the US started to run a current account deficit.
Globalisation allowed the US to suck up the savings of the rest of the
world and consume more than it produced. The US current account deficit
reached 6.2 per cent of gross national product in 2006. The financial
markets encouraged consumers to borrow by introducing ever more
sophisticated instruments and more generous terms. The authorities
aided
and abetted the process by intervening whenever the global financial
system was at risk. Since 1980, regulations have been progressively
relaxed until they have practically disappeared.
The super-boom got out of hand when the new products became so
complicated that the authorities could no longer calculate the risks
and
started relying on the risk management methods of the banks themselves.
Similarly, the rating agencies relied on the information provided by
the
originators of synthetic products. It was a shocking abdication of
responsibility.
Everything that could go wrong did. What started with subprime
mortgages
spread to all collateralised debt obligations, endangered municipal and
mortgage insurance and reinsurance companies and threatened to unravel
the multi-trillion-dollar credit default swap market. Investment
banks’
commitments to leveraged buyouts became liabilities. Market-neutral
hedge funds turned out not to be market-neutral and had to be unwound.
The asset-backed commercial paper market came to a standstill and the
special investment vehicles set up by banks to get mortgages off their
balance sheets could no longer get outside financing. The final blow
came when interbank lending, which is at the heart of the financial
system, was disrupted because banks had to husband their resources and
could not trust their counterparties. The central banks had to inject
an
unprecedented amount of money and extend credit on an unprecedented
range of securities to a broader range of institutions than ever
before.
That made the crisis more severe than any since the second world war.
Credit expansion must now be followed by a period of contraction,
because some of the new credit instruments and practices are unsound
and
unsustainable. The ability of the financial authorities to stimulate
the
economy is constrained by the unwillingness of the rest of the world to
accumulate additional dollar reserves. Until recently, investors were
hoping that the US Federal Reserve would do whatever it takes to avoid
a
recession, because that is what it did on previous occasions. Now they
will have to realise that the Fed may no longer be in a position to do
so. With oil, food and other commodities firm, and the renminbi
appreciating somewhat faster, the Fed also has to worry about
inflation.
If federal funds were lowered beyond a certain point, the dollar would
come under renewed pressure and long-term bonds would actually go up in
yield. Where that point is, is impossible to determine. When it is
reached, the ability of the Fed to stimulate the economy comes to an
end.
Although a recession in the developed world is now more or less
inevitable, China, India and some of the oil-producing countries are in
a very strong countertrend. So, the current financial crisis is less
likely to cause a global recession than a radical realignment of the
global economy, with a relative decline of the US and the rise of China
and other countries in the developing world.
The danger is that the resulting political tensions, including US
protectionism, may disrupt the global economy and plunge the world into
recession or worse.
The writer is chairman of Soros Fund Management
Copyright The Financial Times Limited 2008
