Soros: The worst market crisis in 60 years from FT

Another, less-than-happy view of today’s financial world comes in the form George Soros’s comment article in Thursday’s FT. No less relevant for having been written before the Fed’s Wednesday rate cut - and for reiterating as well as adding to recent comments, he likens the current financial crisis to other upheavals that have wracked markets and economies since the end of the second world war at intervals of four to 10 years.

The key difference this time, he says, is that the current crisis marks the end of a “super-boom” that has lasted for more than 60 years. While global recession could be held off by strong growth rates in the developing world, the resulting political tension from a rebalancing of international economic power risks plunging the world into “recession or worse”, he warns.

Examining the roots of the current turmoil, Soros says the periodic crises that punctuated the era of credit expansion based on the dollar as the international reserve currency were part of a “larger boom-bust process”.
Boom-bust processes usually revolve around credit and always involve a bias or misconception - “usually a failure to recognise a reflexive, circular connection between the willingness to lend and the value of the collateral,” he notes:

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 Soros calls “market fundamentalism” - ie, the view that markets tend towards equilibrium and the common interest is best served by allowing participants to pursue their self-interest.

In fact, he reminds readers, it was only intervention by the authorities that prevented financial markets from breaking down, not the markets themselves.

By 2006, the US current account deficit reached 6.2 per cent of gross national product. 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, says Soros, and moves now by central banks to inject unprecedented amounts of money and extend credit on an unprecedented range of securities to a broader range of institutions than ever before have “made the crisis more severe than any since the second world war”.

Credit expansion must now be followed by a period of contraction, he predicts, 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… 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”, according to Soros, 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, concludes Soros, is that the resulting political tensions, including US protectionism, may disrupt the global economy and plunge the world into recession or worse.

Meanwhile, we’re glad to see that the veteran investor is still seeking top advice at his hedge fund, Soros Fund Management. Reuters reported last week that Soros has hired money management firm BlackRock’s co-founder Keith Anderson as his hedge fund’s chief investment officer, selecting the fourth person for the position in eight years.

Anderson, who recently stepped down after nearly two decades with BlackRock will succeed Soros’s son Robert in the job from Feb 20, Robert and his brother Jonathan wrote to shareholders.

Reuters reminds us that Soros Fund Management established its huge reputation when it earned $1bn in a bet against the British pound in the early 1990s and often sparred with central bankers and government officials. Like most hedge funds, the firm is privately held.

Since 2000, the New York-based firm, has kept a lower profile. After suffering heavy losses and parting ways with top traders, Soros’s flagship fund was renamed the Quantum Endowment Fund and adopted more conservative strategies.

The fund, which invests $17bn returned 32 per cent last year, against the average hedge fund gain of 11.6 per cent, says Reuters, citing the Hennessee Group.

But returns have not always been that strong in recent years, the report adds.

Well, now we know why.