The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means
by George Soros
PublicAffairs, £12.99
IT IS now almost a year since the liquidity crisis of August 2007 set off a chain of events that looks set to impact on the lives of many people. As investment banks became concerned about the viability of US sub-prime mortgages, so they became reluctant to lend to each other, fearful of the potential exposure of market counterparties. Interest rates in the money markets rose, which made mortgages more expensive to finance and so mortgage interest rates rose. As credit markets effectively closed, or at least the terms on which individuals and companies could get credit considerably worsened, so a liquidity crisis became a credit crunch. The financial crisis is working its way through the economy, slowing growth and hurting some sectors, such as housing, very hard. The days of easy credit are over and it seems the world has changed. The famous hedge fund manager George Soros believes this demonstrates that we need to look at markets and society in a very different way.
It could be argued that Soros inadvertently helped Labour win power. For, along with others, he bet against the pound in 1992 until it fell out of the European Exchange Rate Mechanism. The Conservatives’ reputation for sound management of the economy never recovered. Soros retired from active involvement in markets and converted his hedge fund into an endowment fund for the foundations he runs. The crisis last year brought him back into active fund management as he realised the world had changed.
Soros has written extensively on capitalism and markets and his words are closely followed, not least by investors who want to discover the philosophy behind his profitable trading strategies. He argues for his theory of reflexivity, which states that markets do not just reflect changing reality (for example, a share price falls if a company looks set to make a loss) but they change reality, too. Recent financial events would seem to demonstrate this. Soros argues that the economic theory that markets tend towards equilibrium (based on perfect information) does not hold in reality, even though the financial system is set up as if it does. This is why so many unexpected events occur, surprising investors. Regulators had come to believe the market was essentially self-regulating but this belief is wrong. Soros believes reflexivity explains how trends can develop which are self-reinforcing because people make decisions based on an interpretation of the facts and trends they perceive. Reality can be manipulated. Investor opinion shifts prices, which send new signals about assets and the wider economy, which in turn affects investor behaviour. This phenomenon can also be seen in other areas such as politics, he argues.
Readers searching for the secret of Soros’ success will be disappointed. A great deal relies on individual judgement and, he notes, he has personally been prompted to make significant investment decisions by a recurrence of back pain; a subconscious instinct that a new strategy was required.
I wanted Soros to apply his theory of reflexivity to the current condition of the markets and the economy in more detail. Nevertheless, I was fascinated by his approach and hope that, as the world economy responds to the financial market turbulence, he will continue to share his thoughts with us.
Stephen Beer
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