George Soros's New Paradigm: Behind and Beyond the Superbubble

Steve Clemons, director of the American Strategy Program here at the New America Foundation held a media conference call Friday with George Soros to discuss his new book, New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means. The book is available in electronic form, here. To listen to the MP3 of the call, click here.

In the book, Soros examines the financial roots of the current financial crisis and what to do about it. After the call on Friday, my colleague Sam Sherraden looked at Soros' market analysis and policy prescriptions in this special edition of Global Economic Snapshot. I will take a little more time to examine the geopolitical roots of the crisis, focusing on his concept of the Superbubble and extracting some strategic lessons for the United States.

Bubble of Damocles

According to Soros, the Superbubble is the product of a 25-year feedback loop. That loop involves market fundamentalists, who rose to power in the Reagan administration, acting on their belief that markets generally tend toward equilibrium if left alone by the government. In the process, over-deregulating markets and producing a long series of speculative bubbles.

Ironically, those fundamentalists pioneered a new cocktail of government intervention--usually some combination of monetary policy, Keynesian fiscal stimulus, targeted re-regulation, and some kind of geopolitical adjustment, to stabilize the markets and correct for "minor" busts like the 1987 crash, Long-Term Capital Management, the Internet bubble and now the housing bubble.

According to Soros, each succeeding bailout, instead of calling into question the wisdom of continued de-regulation, further entrenched market fundamentalists in their belief. The Fed, led for most of this period by Alan Greenspan, a market fundamentalist himself, became the trusted steward of not only banks, but of market stability more broadly. Without a regulator supervising these new markets and assuring investors that some minimum standards necessary for stability were being met, markets began to securitize risk at a dramatic rate in the mid-1990s. With Greenspan at the Fed, market institutions knew they were playing with an implicit government safety net and it led to signficant excesses. Nevertheless, until a few months ago, many believed that they had tamed the beast of risk in a voluntary, market-based way.

The subprime bubble was part of this hedging of risk. With loads of offshore dollars looking to invest in the rock-solid American housing market, institutions turned to collateralized debt obligations as a means to mitigate the risk incurred by expanding the mortgage market to home buyers with below-standard credit ratings. With no regulation, however, CDOs became untethered from the actual risk in the U.S. housing market, making it impossible to accurately value the securities once the underlying mortgages started defaulting at unexpected rates. Without a way to value the security, institutions are now in the process of simply having to write off billions of dollars of securities, creating a solvency question that is freezing up corporate lending, and impacting the real economy.

Leo Hindery, speaking here at New America last week, believes there is approximately $850 billion in bad subprime mortgages out there, and only a little more than $200 billion have been written off so far. Large though that is, there is an even larger bubble, the ultimate product of twenty-five years of market fundamentalism, looming on the horizon.

Called credit-default swaps, this unregulated derivative market has a total estimated value of $45 trillion dollars. Soros calls this a "Damocles sword" hanging over the global markets. Writing in the New York Times about similar concerns, Gretchen Morgenson observed that, "JPMorgan Chase, with $7.8 trillion, is the largest player; Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively." If that Superbubble bursts, the financial system really could collapse.

Roots in Cold War Grand Strategy

For the American grand strategist, this is clearly a major concern. American economic vitality is essential in any conception of U.S. grand strategy and this kind of risk cannot be allowed to continue. But, large though it is, the Superbubble is still a symptom of a larger strategic dysfunction. To understand that, it is essential to recognize that the Superbubble, which Soros argues was started in the early 1980s by Reagan's economic policies, was a product of the final stage of the Cold War.

At the end of the Carter Administration, our Cold War grand strategy was fraying. Containment, of course, established that since America could not win a military confrontation with the Soviet Union, we must keep the East-West struggle primarily one of economic and political systems. In effect, we said our economy would do the strategic heavy lifting.

In 1980, our economy was in significant trouble, and Containment was at risk. We found ourselves in a perfect storm of two oil shocks, the arrival of Europe and Japan as economic competitors, the end of the Baby Boom, and the massive deficits incurred during the Vietnam War. In short, the post-war economic engine that produced the halcyon decades of the 50s and 60s had run out of fuel--before America had won the economic contest with the Eastern bloc. Jimmy Carter's new Federal Reserve Chairman, Paul Volcker, had to raise interest rates to tame inflation. Combined with Carter's well-intentioned but incomplete efforts at energy conservation, the American economy went into a deep recession.

At the same time, in the wake of Vietnam and the failed hostage rescue mission, Desert One, American military capability and morale was at an historic nadir. In addition, the Soviets had invaded Afghanistan and the Shah, our agent in the Persian Gulf, had fallen to the Islamic Revolution.

At some level, Reagan and his advisors knew these complex geopolitical stakes. Their agenda, combining a feel-good domestic PR campaign, pressure on the Saudis to open the oil spigot, military spending, aggressive covert operations in Eastern Europe and Central Asia, and a shift toward market fundamentalism provided the social, economic and political lift that America needed to shore up Containment for long enough to let the Soviet system collapse -- first.

This was the geo-strategic context in which Soros' Superbubble was born. The prescription of market fundamentalism was part of a larger package to salvage Containment and finish off the Soviet Union. With no pathway to rebuild the asset-based and middle-class post-war economy, Reagan and his team chose the financial equivalent of steroids, debt. It was a gamble purpose-built for this finite strategic mission.

Strategic Drift

After the collapse of the Soviet Union, neither the George H.W. Bush administration nor the Clinton Administration could find a new grand strategy for America. Instead, Bush 41 dealt with Cold War clean-up issues like reuniting Germany, stopping Iraqi aggression in the Persian Gulf, and facilitating a peaceful transition of power in Moscow. The Clinton team remained in crisis management mode while trying to expand America's Cold War economic engine and balance the budget. Aided by a genuine increase in productivity driven by information technology, the combination appeared to work. Riding out the crashes in Mexico, Asia, and Russia, America, it seemed, had figured out how to tame a market economy and now our role was to expand that economy globally while defending its choke points.

It was a false positive that reinforces Soros's theory of reflexivity in both markets and geopolitics as well. In reality, Rubinomics allowed the Superbubble to continue its speculative ways with the rise of the internet bubble. The broader culture of laissez-faire also contributed to perfidy in corporate accounting houses and the spectacular collapse of Enron. Meanwhile, our fascination with the rise and fall of the Asian Tigers blinded us to the long-term implications of the slow but massive export- and urbanization-driven Chinese growth engine. Meanwhile, our stability policy in the Gulf gave new energy to a little-known band of extremists name al-Qaeda. When 9/11 hit, our economic and political myopia allowed a home-grown group of extremists known as neo-conservatives, allied with domestically-focused Karl Rove, to use another innaccurate set of narratives to push us into further economic and military distress.

Back to Basics

It is now time to get back to grand strategic basics--and the Soros narrative helps us get there. Despite the $45 trillion in credit default swaps, the rise of Asia, our overstretched military and the spectre of al-Qaeda, there is plenty of opportunity for the United States to find a new direction. We obviously have to fix the problem of the Superbubble--figuring out a way to stabilize the pool of credit default swaps and then creating a new generation of efficient market management institutions to ensure a prosperous and competitive balance of stability, assurance, agility and innovation.

But simply strapping a new set of regulations on the remnants of America's Cold War economic engine is the ultimate in futility. This no more than what Reagan did in the 1980s and what got us into the Superbubble in the first place--a collective inability or unwillingness to envision a new era of domestic growth based on something other than SUVs and Exurbs paid for with home equity loans or subprime mortgages.

Soros implicitly understands this when he said in the conference call that he believes America needs to turn to climate change to find a new source of economic growth. Climate change, of course, is just the tip of the iceberg, a leading symptom of our macroeconomic dysfunction.

Driving climate change but also our trade imbalances, energy insecurity, and myriad other major challenges, is the unavoidable reality that the world needs to bring 4 billion people into a global economy that is crashing with the 2 billion already in it. Indeed, the McKinsey Global Institute last month released a major report saying that the primary global economic opportunity of the coming era will be helping China's urban population grow to 1 billion, a project that requires massive investment and innovation in energy, transportation, land use and resource use. And behind the Chinese are another billion Indians and 2 billion other low- and medium-income people around the world whose needs and dreams are driving them into the global economy.

This is where our future lies. America is at its best when it sets out to address the driving challenge of the era. With five percent of the world's population and 25 percent of global GDP, we will always be stronger economically than militarily. So once again, our economy will have to do the heavy lifting. That means leading the innovation in energy, transportation, land use and resource use here at home, then exporting America's cutting-edge products, infrastructure, and services into increasingly compatible markets in Asia and around the world.

Soros' new book is a major contribution to our understanding of the financial system and the bubbles that threaten us. But the next administration needs to integrate strong sectoral recommendations such as these into a broader grand strategy for the present era. Then and only then will our economy will be on a sound, sustainable footing.