Looking Towards the London G-20 Global Growth Summit: George Soros

George Soros, Chairman of Soros Fund Management and the Open Society Institute, spoke at New America's March 26 Economic Symposium, entitled "Looking Towards the London G-20 Global Growth Summit."

A full transcript of Soros' remarks, as well as his introduction by American Strategy Program Director Steven Clemons, is provided below.

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Steve Clemons: OK, folks! Folks, if I can have your attention. Clyde, Norm, Martin Hutchinson. We're really going to move into the next session, if you can take folks outside for a moment. Clyde. Folks, we're really going to begin so I need folks to move. Robert, Clyde, out. Quiet!

Give yourselves a round of applause for making it so far today. This has been great. I also want to thank all of those people who are watching online. For those who've come on, I'm Steve Clemons. I direct the American Strategy Program here at the New American Foundation.

It's great to see Martin Bailey up here -- my good friend.

We've had a very robust day. Our task has been to focus on this question of what the benchmarks of performance for the London G20 economic summit should be. How should we think about the global crisis? What are the levers we should be thinking about?

Thinking about domestic drivers of Japan, the jobs issues in America, the social contract in this country, but also thinking through the international implications. And I've asked George Soros, a good friend, who is a well-known philanthropist and, of course, the head of Soros Fund Management.

The interesting thing about George Soros is, he writes about his decisions very transparently, and there was a piece, I guess it was in "The New York Times, " looking at how various financiers did, and whether they put their money behind what they were saying. And George did rather well last year, I should say.

Others have done well. Many of us have been listening to George at the New America Foundation events in the past, so we're doing fine. But on the process, what I find interesting about George Soros, he gave a talk at the Council on Foreign Relations not too long ago, on an earlier version of this book, which is not officially out -- it comes out March 30th.

It's called "The Crash of 2008 and What it Means: The New Paradigm for Financial Markets," which includes four new chapters in this one. When he originally wrote this book he left us hanging about how his accounts had done. They largely floundered along, and I think now we've seen how they've done better.

But, what he's basically said is that also, as you look at credit-default swaps, as you looked at the role of central bankers, about whom he made the comment, at the Council of Foreign Relations, all central bankers are doomed to fail, which was an interesting comment, but also looking at the fact that his investment needs a response.

As you begin looking around the world, you look at regulation and you look at what a healthy global financial market is. Soros has been writing about this for some time.

And as I mentioned at a dinner we had last night, I found my notes from a senior economic summit in Hakone, Japan, in 1999, right in the wake of the 1997 -- 1998 East Asian economic shocks.

And many of George Soros' comments, which were widely discussed at that forum 10 years ago, are not dissimilar from the kind of comments that he's been making today.

I think it's important for us not to look at this as something, as Vice President Cheney said not too long ago, that people didn't see coming. In fact, many people in this room did see this coming. So, I do want to recommend George's book.

I'm grateful to him for sharing his thoughts today. We'll have a discussion with all of you and then we'll proceed with closing thoughts and comments. But, thank you, George.

[applause]

George Soros: Well, you've been exposed for four hours to various aspects of the financial crisis, so I think you've been softened up, sufficiently. I will now attempt the impossible, which is to try to bring the whole situation into a conceptual framework, in which it can be understood. What we have is a pretty complete breakdown. The financial system has broken down. This crisis is different from any crisis we have experienced in our lifetimes, because in the past, whenever we came close to a breakdown the authorities got their act together and did something to prevent it from really going over the brink. This time, it did go over the brink.

Actually, it was really the failure of Lehman Brothers that changed the game, and what had been purely a financial crisis really, then, affected the real economy in a very large way and we've been in a freefall since then.

With this pretty complete collapse, I think you need to do some pretty profound rethinking of the framework, in which we look at the world, and that's what I would like to put before you.

I will start, of course, with the financial markets, the economic theory. One of the salient features of this crisis was that it really originated in the financial system itself. And that contradicts the prevailing view of financial markets -- the paradigm that has been guiding us.

Namely that financial markets, basically, tend towards equilibrium and they are self-correcting, and deviations occur in a random fashion, and they are always caused by some exogenous factor that affects the markets and the markets have difficulty in adjusting to it, and so you have these dislocations, these deviations.

But this is contradicted by the fact that here the crisis started with the subprime market that collapsed, and then it sped with remarkable speed, to all kinds of other markets, seemingly unrelated, until the entire market collapsed. And in this case, the authorities failed to prevent it. So, the prevailing paradigm has failed.

We need a new paradigm, and I would like to propose one. The prevailing paradigm says that financial markets basically reflect, accurately, all the available knowledge, and give us as accurate a reflection of the underlying reality as you can have.

I suggest that that is not the case; that, in fact, financial markets always distort reality. The degree to which they distort it is various -- sometimes a distortion is very big, sometimes it is small, but there is always a distortion.

There is always a bias, partly because financial markets deal with the future, and the future is not a matter of knowledge. It is a contingency that you have to guess at, so you have to have some bias, you have to introduce some judgment.

So, the whole discussion about information: information is not enough. You can't base decisions on information. You have to apply judgment or bias. Whether the information is complete or incomplete, you always have this distortion. So, that's the first: always there is a bias in the market. Some of this pricing is not an accurate reflection of an underlying reality.

The second proposal is that the mispricing in the financial markets can have ways of affecting the so-called fundamentals that prices are supposed to reflect.

So instead of a one-way relationship, where the prices are a passive reflection of conditions of supply and demand, effectively there is a two-way connection, a circular connection, a two way feedback mechanism, where the prices, the mispricing, can affect the conditions of supply and demand.

So, I call that principle reflexivity, and I propose that that is the new paradigm that ought to guide us in understanding markets.

Markets, instead of being passive reflections, are active agents in shaping the future. So, when you talk about how markets are prescient -- they anticipate what happens in the future -- actually, they are not so prescient.

They actually shape the future, so that's why market prices very often reflect what is going to happen in the months to come. But, they don't always reflect it, accurately. Very often they do, and because you have this two-way connection, that's why you have this impression those markets are prescient.

They are that way because they actually actively bring about what happens in the future.

So, that's the general theory, which then allows me to propose a theory of bubbles, because if markets don't tend towards equilibrium, you have this two-way feedback.

Then you can have an initially self-reinforcing, but eventually self-defeating process, which is very far from random, because it can go very far in one direction; much further than if you don't have this reflexive connection working.

So, in every bubble, you have basically two components. One is a trend which actually prevails in reality. There is always a foundation, and it doesn't come out of thin air. The second thing: that there is some kind of misconception, a [inaudible 13:47] misinterpretation of that trend, which very often, is corrected by markets, most often it is corrected.

The misconception is eliminated by markets correcting it. But occasionally, this reflexive connection can actually reinforce both the trend and the misconception.

The simplest and most common bubbles occur in real estate. The underlying trend is an easy availability of money -- a willingness to lend. The misconception is that the prices of real estate are independent of that willingness to lend, so that they can serve as collateral on which you can lend.

But effectively, since the prices are influenced by the willingness to lend, the ease of credit can generate a self-reinforcing process where you have housing prices or real estate prices rising. And because the loss experience is very favorable, there's also a relaxation of the conditions under which you are willing to lend.

And that goes on, where eventually people buy or hold houses or real estate, not because they need them or because they want them, but because they expect them to appreciate in value, so they hold more than they need.

And that goes on, self-reinforcing, until it becomes unsustainable, and then you have a reversal and prices fall, willingness to lend stops, collateral loses its value, and you have forced liquidation, and that reinforces the decline.

So, boom/bust sequences tend to have an asymmetric shape. They develop slowly, arise slowly, and then you have forced liquidation and you have the crash. So, that's the most common form. It happens in real estate, but it also happens, of course, in the stock market: for instance, the IT bubble, and so on. So that's the theory of bubbles: the importance of misconceptions.

Then I would propose a specific hypothesis with the situation that we are in, currently. And I contend that it's not a simple bubble. It's what I call a super-bubble that's composed of other bubbles which have developed over a period.

On the one hand you have the housing bubble, which acted as a simple bubble that acted as a detonator of the super-bubble, which has been growing for the last 25 years.

And that super-bubble is a much more complex, much more difficult structure to understand. It has, as its base, as its trend in reality, the increased use of leverage and credit, which has actually been prevailing ever since the end of the Second World War. If you look at the figures, you see that credit as a percentage of the GNP, has been growing ever since 1945.

The misconception is what I call market fundamentalism: the belief, in fact, this prevailing paradigm that the markets tend towards equilibrium, deviations are random, and markets are self-correcting, and therefore, they should be deregulated. Regulations are unnecessary or should be reduced, the state should pay a minimal role in the economy.

Of course globalization; so you put deregulation, globalization. Globalization was a market fundamentalist project that really took off in the 1980's with Ronald Reagan, President of the United States, and Margaret Thatcher, Prime Minister in the U.K., both believers in the magic of the marketplace.

If you have global markets, it means that financial capital is extremely difficult to regulate or to tax, because it can go somewhere else where it is better treated. So it is very favorable to financial capital. So globalization then became the dominant creed, and spread throughout the world.

The third factor was of course, financial innovation, financial engineering. That was based on this false paradigm that deviations are random, and so the risk calculations were based on that. You have Value at Risk, VAR, which was the sort of dominant calculation that was used, and generally became very sophisticated.

The idea was that risk can be quantified, and it can be calculated, and you can actually reduce it through financial engineering. So it invented various instruments like CDOs, where you felt that by dividing geographically or diversifying geographically, you reduce the risk. Then you could slice it and dice it, and you could again provide people the kind of risks they want.

Now, these instruments were as I say, were built on false premises, which only took into account the risks that could in fact be quantified and manipulated.

It left out of account the uncertainty, which actually cannot be quantified and has to do with this basic imperfection of human understanding, our inability to predict the future, and the influence that our imperfect understanding has on the course of events.

So, actually that general theory has an implication far beyond the financial markets, because I would contend that human events have a fundamentally different structure from natural events, because this imperfect understanding doesn't enter into natural phenomena, there you only observe the phenomena, and you have an independent criteria in the phenomena.

If your statement corresponds to the facts, then that statement is true. That's the correspondence theory of truth.

In natural science, that has produced tremendous insights, and a real deep understanding how nature functions, but in human affairs, our own understanding, imperfect understanding, enters into the puzzle chain and it introduces an element of uncertainty that is missing in the natural phenomena.

So even natural phenomena, you have this uncertainty principal, Heisenberg's uncertainty principal. That principal applies, I call it the "Social uncertainty principal," applies to human affairs much more strongly, with a much bigger force.

Because, when Heisenberg discovered the uncertainty principal, it didn't alter the behavior of the quantum particles or waves that he was dealing with.

Whereas in human affairs when you introduce a theory that is generally believed, be it Marxist theory of history or Equilibrium theory in economics, it changes the behavior of the subject to which the theory reflects.

So as a result, as an illustration; the medieval alchemists barked up the wrong tree when they tried to change the base metals into gold through incantation, it didn't work. But in stock market, in financial markets, it does work.

Audience: [laughter]

Soros: So, I've been practicing it and it works.

Audience: [laughter]

Soros: So this is a pretty fundamental thing. It means that human contracts have a different structure from natural contracts. So, when we look at let's say an automobile, it wouldn't exist if it didn't actually carry you from one place to the other. In human affairs you can have contracts like; states, markets, institutions, for instance that exist, they last, but they don't actually fulfill the purpose for which they are designed. So, there is this fundamental imperfection in human affairs.

Now, that's very important because it applies to markets, but it also applies to regulators. One of the mistakes that we make, a very common mistake, that just because one set of arrangements is flawed and is proven to be flawed, you then take the opposite of it and say, "That's perfect."

That's actually how market fundamentalism came to the foyer, because of the failure of socialism.

We might now have to be very careful, because that has proven false, and obviously markets are imperfect. They do need regulation, but we have to remember that regulations are also flawed.

In fact, they are more flawed then markets because regulators are not only human, but they are also bureaucratic, and they are also subject to political influences. So, actually markets on the whole, functions better than the governments.

Nevertheless, this idea that we would let markets function without government intervention failed. We do now have to have government intervention, and regulation.

So that's I think the perceptual frame work in which we have to look at this situation. Now, the problem that we have now is actually not one problem. It is very important to distinguish between the two.

One is we have a collapse. And it is a pretty profound collapse. I mean some thing as powerful as the financial system has actually collapsed. Credit has collapsed. And it has affected various elements of our lives. The real economy has been in free fall since September. And we must stop the collapse. We have to arrest it and reverse it. So that's one problem.

And second, we have to recognize that the system that has collapsed was obviously flawed. And therefore, it cannot be reconstituted the way it was. It has to be rethought and a new system. A modified system developed.

And it is very important to distinguish between the two. Because it turns out that what we need to do to stop the collapse, what we need to do in the short term is almost exactly the opposite of what we need to do to rebuild a sound, near equilibrium, stable system.

So that makes the whole task extremely difficult. And I think one has to have some idea of what that stable system ought to look like. In navigating this course where you face a collapse of credit, so what do you do? You have to actually increase the money supply to try to make up for the shrinkage of credit.

You have to recapitalize the banks, in order to restart the credit flow, and you also have to do your realty, housing situation which is at the approximate course of the collapse.

And you have to prevent housing prices from over shooting on the down side the way we over shot on the up side. So we have to bring some relief on mortgages to reorganize the market. So what you need to do, all those things as I say, is the opposite of what you need in the long term.

But it is important to think of what the long term ought to look like when you are reorganizing, when you are dealing with the short term.

To give you an example, in the mortgage market, I believe the system has actually, completely broken down. Therefore, it would be worth while to introduce a better system that wouldn't break down so easily.

So I've been proposing the Danish model. It's the Danish model, because that's where it was introduced. It's a system of mortgages where the mortgages are actually converted into securities so that the connection between the mortgage and the securities is never broken.

Each mortgage automatically becomes a security. And the securities are uniform, they can be issued by any number of mortgage originators that are regulated and meet the conditions that regulators set.

Not like here, where we had Fannie Mae and Freddie Mac, sort of government monopolies. So it's an open system and the house holder can repurchase or redeem his mortgage by buying a security of equal amount.

So for instance, if interest rates go up, the securities fall in value. So he can refinance and therefore, by buying the security at the discount, and so the value of the houses, generally doesn't exceed the value of the mortgages. I could go on, but I'm told not to.

[laughter]

I've some ideas about what we need to do. I have some ideas on the G-20, I've been pushing the idea of special drawing rights, which would bring great relief to the developing world. But I'd rather explain those things and answer questions than to keep on talking.

Clemons: Well, George. Thank you so much for walking through the system of reflexivity and thank you very much. [applause]

Clemons: Let me, before we move to the audience, let me ask you to share your thoughts, as you did yesterday in the Senate Foreign Relations Committee, and you have recently both in the Wall Street Journal and The Financial Times, shared your thoughts and your concern about these periphery countries, developing countries. How important they are to get them right. And your conception of SDR's, and frankly I would like to hear just a bit more on this tension on what we need to do in the near term and, which I think Bernard Schwartz and a lot of other people have said, keeping people in their homes. Developing the real economy, getting jobs going.

But then what mistakes don't you want to see, in the longer term horizon we have?

Soros: Well, the G-20. It's important to realize that the periphery countries, the developing world is facing an even more serious crisis than we do. Because in the after math of the Lehman default, basically European countries, the United States and Japan, any other country that could, guaranteed the banking system against default. Basically, said that, no financial institution, of systemic importance, would be allowed to go bust.

And the countries in the periphery cannot give guaranties that would be equally convincing. So the result was that capital took flight from the periphery back to the center. And that's when Eastern Europe went into crisis.

Then Brazil, which had been doing very well, suddenly had a financial crisis. And the currency dropped 40% and so on. So looking forward, the periphery countries are not in a position to spend money the way we can.

And therefore, we must help them to be able to protect their banking systems and to engage in counter-cyclical policies because it's a global problem where you need to reinforce global demand.

Therefore, it is in our enlightened self interest to help them, to effectively print money. And special drawing rights, which are very complicated arcane instruments effectively is an international creation of money.

And it can be used. The periphery countries need them. And we don't because we can print our own. Therefore, the rich countries should lend their allocations to the poorer countries and it doesn't cost them anything, so this is a rather costless, effective way.

It has indirect costs of course, because they will use that money and buy our goods. I think we want them to buy our goods, because that will help our exports.

So the SDRs are as I say, it's a complicated instrument, difficult to understand. I can't contend that I understand it fully, but it works, it exists, it has been issued already. It should now be issued on a larger scale. So, I think that would make a big difference.

Clemons: Let me open the floor, but as I do I would like to ask George one thing. You are well-known to have applauded the Obama Administration coming in. How do you think the Obama Administration-do you think they get this? Are they prepared to own this? Are they moving in the direction you think is constructive, in terms of both achieving, not necessarily an equilibrium at home?

We have had a lot of talk as we did last night with Bernard Schwartz and others, who are very worried about the deterioration of the real economy and the larger macro economic issues as well. Are you pleased with the way the Obama Administration is going? Do you think that they need to read your book more carefully?

Soros: I think, actually I give them very high marks in every area except one, and that's recapitalization of the banks. It's a good excuse that talk was proposed by the previous administration and applied the wrong way, but unfortunately they should have said, "That was the wrong way, we are going to do it right. We need additional funds to do it," and I think at that moment of enthusiasm, fresh out of the gate, he would have got that money.

Then we could have recapitalized the banks the right way, which would be to draw a line over the existing, the past accumulated bad assets, and cleared new banks on top of these old banks.

Instead of good-bank bad-bank, have new-bank old-bank, and keep the old capital to cover the old assets which are still deteriorating, and will continue to deteriorate for several years, because the commercial loans, commercial real estate, has not yet fallen in value.

Clemons: But it is on its way, is that right?

Soros: It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it. So we know they'll drop at least 30%. Since they have basically borrowed up to 85%, we can see there is a significant hold there, right? If it's going to drop to at least 70% and you've lent 85%, you're going to be at least 15% out of money, but it is more than that.

That has not yet been recognized, because the loans only come due every five years. So you will get it in the next four years. It's already there, but it's ... So the existing capital should be kept to cover the existing assets, and the new capital should be injected and should not be affected, and should not be liable for the depreciation of those assets.

Then you would have these new banks, new growth with lots of deposits, because the deposits are very valuable, and newly raised fresh capital, without the commitment. Then those new growths would be out there eager to take advantage of these extremely high margins, which currently prevail.

So that would be the way to really solve the problem. It could have been done. It will now take a long time, and hopefully we will eventually move there. I haven't given up hope, but we are definitely not there.

Clemons: Well, we are told that some of them are watching you on TV right now. Robert, very quickly, brief.

Question.

Robert Sheretta: Robert Sheretta, with International Investor. Mr. Soros, first you were quite right when a year ago you predicted as many as 1/3 of the hedge funds might go under. I think we are now approaching 1, 500 that have been declared insolvent or have been merged in one way or another since then, so you were right on that one. My question has to do with you, 20 years ago the headlines read, "Soros Fund Breaks the Bank of England." How fearful are you that there is a young 'George Soros' out there at one of these hedge funds, that's going to put undue pressure on the Federal Reserve, the Central Bank of the United States?

Soros: It could happen, and in the automobile industry it is already happening, because it is hedge funds that own the auto companies. So, yes, but let's face it, the leverage in hedge funds is much, generally speaking, much, much lower then it is in the banks and in the investment banks.

Clemons: Right here. Question.

Dennis Debusschere: Hi, Dennis Debusschere from ISI. T-Bill's today traded negative on a one-month basis, first time since December. My question is, despite the huge amount of issuance of Treasury securities to soften the blow from the unwinding of this 'super' bubble. So my question is, are we on the verge for the lack of a better term, a 'super duper' bubble in U.S. Treasuries?

Soros: In a way, yes. Because in order to make up for the collapse of credit, we are effectively creating money, and that's what quantitative easing. That's what quantitative easing means. If and when credit is restarted, you will then have an incredibly swollen monetary base, which if it were leveraged you would have an explosion of inflation. So, right now we are in the period of deflation, but it could easily tip over where you are facing inflation. So you then are faced with the task of draining the money supply as fast as credit is created. So it's a two-step operation to regain balance-equilibrium, I don't want to use that word. So there is that danger, and it could easily get out of hand.

Clemons: Jeff, got to go quickly! Question.

Jeff: Mr. Soros, the Europeans for the G20, they want to regulate; the U.S. wants them to stimulate. Incidentally, it's interesting that the current EU President who maligned the mono plan as a way to hell, is about to lose his job as the Czech Prime Minister. Aside from that, what is going to happen if it goes bust? Are the answers instead of a Bretton Woods II, is it a Basel III? Can the governors of the fund do this on their own, along the lines of an earlier suggestion that just the top four do it?

Soros: Well, I think there are a number of questions there.

Clemons: Pick the one you like most.

Soros: I think you do need a Basel III, Basel II has failed. It put the owners of regulating risk, under risk-takers. There is a systemic risk, which is not just risks to the participants but to the system, the stability of the system, that has to be recognized. That means that it is not enough to regulate money. You also have to regulate credit. With a given amount of money supply, you can have an asset bubble and you can have it burst. So you need to go against the prevailing bias of the market. When a self-reinforcing market is developing, you then have to tighten margin requirements and minimum capital requirements.

In other words, you have to have variable capital requirements and Basel three should be based on that principle.

Clemons: Fred? The last question.

Fred Sweinger: Fred Sweinger. I wanted to follow up on Steve's question. You've properly focused on what must be the number one priority, the financial system and fixing it. Why does the White House insist on stating that they have three priorities: healthcare, education, and energy? It's confusing the public, it's confusing the Congress, and it is splitting his support. There's no problem with healthcare that can't wait for a few months or a year. Education isn't in a crisis. The Education Department was established by Reagan...

Clemons: Your question being America's....

Sweinger: There's no pressure on energy. There's no problem.

Soros: I disagree with you.

Clemons: Thanks, Fred.

Soros: I disagree with you fundamentally. Because you have to think of the world as you want it to be when you get out of the crisis. And there, education, healthcare, and climate change will play a very important role. So in getting there you have to have those. When you are pumping money in, you have to pump it into education, you have to pump it into fighting global warming. This is the time to address those issues, and I'm very, very glad that President Obama is doing it.

Clemons: George, before I invite Steve Coll to come up and offer some closing comments -- and I want to thank everyone for being here. I've been just told we've had 5, 500 people spend at least some time watching online, this show. Are you disturbed by how opaque the decision has been on the bailout. You're such an open society institute. As you look at oil industry-dependent nations or others, you've been such a promulgator and crusader for transparency. This hasn't felt to me like a crisis that we've deal with transparently.

I'm interested to see where you are. Have you felt like America is succeeding in an open society format in dealing with this in the public?

Soros: I see it differently. It's not a question of transparency. It's a question that you have a dynamic collapse, self-reinforcing. And our understanding of what's happening is always lagging behind events. It's a collapse of the system; it's more than what one can comprehend, because we have certain things that we are used to, and those rules don't apply. And for us to learn what the new rules need to be takes time. And time is short and things are happening very fast. Financial institutions have been collapsing at a very, very rapid rate. So it's the lack of time and the lack of understanding.

And Obama, why I find he has been lagging in this field, is because he is the great uniter. He wants to forge a consensus. And this is a situation that it automatically leaves you behind the curve. Events will always outpace the understanding of those events.

To deal with them, you have to actually be ahead of the curve, and instead of following consensus, you actually have to create it.

And this is where he had this opportunity when he came in, but unfortunately the plans weren't ready. And so it's really the shortage of time, this condensation of time that creates the crisis situation.

Clemons: Please join me in thanking George Soros. [applause]

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