George Soros interview: A very good crisis

George Soros interview: A very good crisis

EXCLUSIVE: Peter Wilson | March 19, 2009

George Soros is having a very good crisis. Other investors are wilting, political power structures are being upended and market economists are scrambling to fashion new theories, but the world's most famous speculator is having a belated heyday.
George Soros: A very good crisis

George Soros is now recognised as one of the most effective philanthropists, finding a new sense of purpose by spending billions to promote civil society in new democracies.

"It is, in a way, the culminating point of my life’s work," the 78-year-old says in his heavy Hungarian accent during an interview at his London mansion.

If Soros had retired from the money markets at 48 to become a philosopher – which was his life plan when he set up his own Wall Street hedge fund at the age of 43 – the world is unlikely to have heard of him, as either an ideas man or a money man. Even if he had ended his career 20 years later, he would have been remembered as little more than the big-stakes gambler who "broke the Bank of England" with his 1992 bet against the pound that earned him $US1.1 billion.

At 68 Soros had just predicted a global financial collapse which did not happen, just as he had done a decade earlier; his pet theory of market behaviour, which he calls "reflexivity", had been largely ignored; and his political donations had bought him little sway in Washington. Yet today, he says, all those strands seem to have come together – "the American election, the financial crisis, the theory of reflexivity, so it is actually a very stimulating period".

For one thing Soros is now recognised as one of the most effective philanthropists, finding a new sense of purpose by spending billions to promote civil society in new democracies.

Having twice cried wolf, he finally got it right by being one of the very few people to anticipate the 2007 credit crunch and current economic collapse. In the process he has gained enough respect for his ideas on market behaviour to help his ninth book, The New Paradigm for Financial Markets, win the sales and positive reviews that had eluded him.

And foreseeing the biggest economic crisis since the Great Depression has certainly paid off financially. In August 2007, with the first symptoms of the credit crunch on the horizon, Soros came out of semi-retirement to reassume control of his Quantum investment fund, astutely repositioning it for the tsunami about to hit. By year’s end Quantum was up almost 32 per cent for 2007, netting Soros profits of $US2.9 billion at a time when other financiers were struggling to break even.

His fortune was estimated at $US11 billion by Forbes in September 2008 and it has grown even larger amid the spreading financial carnage. That same year, in which Hedge Fund Research estimates the hedge fund industry lost a record 18.3 per cent, Soros was up another 9 per cent. He now believes he can step back from a hands-on role at Quantum.

"I think that I have done what I can to preserve capital," he says with some understatement, "and going forward I need to be less engaged. Also, I now have a chief financial officer who can take over. I am sort of handing over to him again and I am more engaged in policy issues than ever before."

INTERVIEW TRANSCRIPT, PART ONE: how Soros stays informed, why the crisis is stimulating, and how he helped Henry Paulson change his mind.

That new engagement on the policy front coincides with a remarkable improvement in the political environment for Soros, who spent $US25 million in a failed effort to help Democrat John Kerry defeat George W. Bush in 2004.

Some Wall Street donors jumped onto Barack Obama’s bandwagon just before last November’s election, when he was comfortably leading John McCain in the opinion polls. Others can boast that they backed Obama before he stitched up the Democratic nomination in May and there are a few who can even say that they were on board before he won the Iowa Democratic caucuses in January.

Soros held a fundraiser for Obama at his New York home and donated the maximum legal amount in June – June 2004, that is, before Obama had even been elected to the US Senate. Two years later he urged Obama to run for president, and when he did become a candidate Soros organised a meeting with other financiers in Soros’s own Wall Street office.

The result is that after being a political outcast under the Bush administration and having little infl uence under Bill Clinton, Soros is confi dent that “at least I will get a hearing” in Washington. And he will use it to advocate radical regulatory and financial reform to rein in financiers like himself.

After decades exploiting any weakness he could find in the regulatory system, Soros certainly knows where the flaws are, and he warns that past US policies have been based on the “ideological excess (of) market fundamentalism” – the assumption that markets can correct themselves with little need for government intervention in financial affairs.

If regulators and major governments stick to that approach in the current fi nancial crisis, rather than making radical changes, then “all hell will break loose”, Soros says. “For instance, having put the fi nancial system on artificial life support after the Lehman breakdown, that artificial life
support then created problems for the periphery countries that were not able to give the same kind of credible guarantees” as the US and other wealthy nations, he says.

“You now face the situation where a lot of loans are going to come due that cannot be rolled over, so unless the authorities get their act together and do something to prevent it, there will be tremendous problems ... in all the emerging markets. I am talking 2009, I am talking about right now.”

Self-interest would lead many financiers to oppose tighter government regulations but Soros says that speculators and investors like himself need to be pulled tightly into line, along with banks and other financial players.

He concedes that many of his proposals – such as loosening Washington’s grip on the International Monetary Fund; co-ordinating macroeconomic policies between national governments; and bringing in new international regulatory regimes for banking and markets to oversee some of the wilder financial instruments and derivative products – will be extremely difficult to sell politically. But he claims there is reason for at least some hope because of the growing awareness of the depth of the crisis.

“I am actually fairly optimistic because the problems are recognised and certainly the new team in America understands things pretty well the same way as I do. And I think Gordon Brown does and he is providing leadership. He is working on the G20 meeting in April as the sort of culminating point of some actions, so I think action will be taken. But there will always be slippage, so they may continue to lag behind events.

“It is in the nature of this situation that (things continue) to deteriorate, and if you only respond to problems and don’t foresee them and take preventive action, then the problem always gets larger, and measures that would have worked are inadequate by that time. So actually the problem I see is that some of the policymakers understand what needs to be done but ... what they are afraid of
actually has to happen before action can be taken. And that is why we are liable to have still a number of crises.”

Several governments are considering the creation of so-called “bad banks” to hold the toxic assets of crippled commercial banks. But Soros says more dramatic steps are needed, because even banks relieved of their worst assets will spend years restoring their balance sheets before they offer the sort of lending needed to stimulate economic recovery. For that reason Soros advocates a partial nationalisation scheme, through the creation of a “good bank” as well as a “bad bank”, even though diverting solid assets from existing commercial banks into such a “good bank” would erode shareholder wealth.

Too much has already been done for the banks and their shareholders rather than for the ordinary households and businesses that would benefit from new lending, he says. Governments should keep existing capital with bad assets and move good assets into a new bank, which would then be recapitalised so it could provide new lending.

“I think the Obama administration is moving towards a good bank/bad bank solution, but it is not the right kind of good bank/bad bank solution. What they propose currently is creating this aggregator bank which will take the toxic assets out of the banking system, out of the banks, so it really injects government money into the bad banks, and I am saying that they ought to be injecting money into the good banks. I think it is difficult to generate the political will (for that) ... and this is my main worry right now, that they may get it wrong.

“They (are) in a difficult situation because they have two obstacles. One is that the hole has become too big – you need something like a trillion and a half of new money in addition to the (initial) $US700 billion because the hole has grown.”

The second obstacle to be overcome is that the clumsy way in which the Bush Administration handled the Troubled Asset Relief Program has “poisoned the well”, making it more difficult to get future funding packages through Congress.

Soros advocates much greater restrictions on the sort of short-selling of stocks that has been a mainstay of the hedge fund industry and says the creation of new credit instruments will have to be regulated in the future.

While many are now calling for regulation of credit default swaps, Soros takes a harder line, saying they are toxic and should be used only by prescription. They could be used to insure actual bonds, he says, but not to speculate against nations or businesses. Derivatives and synthetic
instruments, such as the slicing and dicing of collateralised debt obligations, should also be tightly
regulated and monitored.

The limits on credit and leverage will have to be set substantially lower than those tolerated in the past, he says, a move which would make the financial industry less profi table than in recent years and make some highly leveraged business models untenable.

Alongside recapitalisation of the banks, there should be an overhaul of the US mortgage system to cut the cost of mortgages and foreclosures. Governments should also create money, both domestically and globally, through a massive expansion of the IMF’s Special Drawing Rights scheme, running into trillions of dollars. The only way to avoid global deflation and depression, according to Soros, is to first induce its opposite, inflation, and then carefully reduce it.

One potential engine for new growth is the development of alternative energies and a greener economy, Soros says, but he worries that the fall in the price of oil has eliminated a grand
opportunity by reducing the incentive to invest in better options.

“It would have been a perfect fit. You could have introduced effectively a carbon tax and put a floor under (the price of) oil, and stopped it from falling, but now that it has fallen you would have to impose an import duty to raise it.”

That is politically untenable, but at current prices “you have to use less simple instruments to foster alternative energy development, like subsidies and so on – it will be messier”.

The entire world, but especially the West, should now brace for slower economic growth, he warns, and it will be at least a decade before the US sees robust growth.

One important effect will be a new wariness in China about the US economic model, Soros says. “The Chinese used to look up to the West and try to imitate the West and they have now discovered that it may not be the right thing to imitate. They now feel suddenly impelled to develop their own system and in some ways they are actually ahead of us.

“For instance, they have been using variable capital requirements as a policy tool. They changed the minimum capital requirements for banks 17 times in the past year, first raising it rapidly and then lowering it. I think we will have to learn to do the same thing.”

In any case, the Chinese government can no longer be relied on to plough money into US government debt, he warns. “They will have less money to spend because their surplus
is shrinking and their exports are falling, so they will have less to dispose of, so I think that there will be a definite shift.”

Soros sees Australia’s medium-term economic prospects as largely a function of China’s growth and the state of commodity markets. In 2008 he sold a large stake in the Brazilian iron ore producer CVRD before the crash in commodity prices and then profi tably shorted BHP’s stock.

However, he says he did not act decisively enough to take advantage of the fall in other commodities such as oil.

Soros’s enthusiasm for sharing his views on the crisis and its possible solutions is driven by a fierce desire to be seen as more than the archetypal money market man. When the economic historian Niall Ferguson described the early hedge fund managers in The Ascent of Money, he
called Soros “the acknowledged capo dei capi of the new economic hitmen”. But Soros yearns to be respected for his ideas rather than his market clout.

He arrived in Britain as a teenager in 1947 after his Jewish family survived the Nazi occupation of Hungary. He studied philosophy at the London School of Economics under Karl Popper before going into finance and moving to New York in 1956. He was deeply influenced by Popper’s
views on fallibilism – the need to question the information underpinning one’s own assumptions and to be open to the possibility that those assumptions may be wrong.

One of his great strengths as an investor, Soros says, has been his willingness to change positions as soon as he realises that he has made a mistake, rather than clinging on in the
hope that his initial judgements will be vindicated. There is pleasure, he says, “in recognising that you are wrong – because actually the pleasure (comes) from not losing money”.

His view of the markets was also shaped by the sociological concept of reflexivity, the awareness that the simple act of observing a subject can affect that subject and distort the observations.

Soros applied the idea to the markets, rejecting the notion that prices are the efficient outcome of “perfect” knowledge, instead insisting that they are shaped by the biases and ignorance of market players, and that those biases can be self-fulfilling.

During the American housing bubble, for instance, the relentless series of double-digit rises in house prices changed the behaviour and perceptions of market players, who loosened lending practices and allowed the market to move further and further from equilibrium.

Soros says his 1992 attack on the British pound, which forced then Chancellor of the Exchequer Norman Lamont to accelerate Britain’s withdrawal from the European Exchange Rate Mechanism, is an example of his constant search for the opportunities created by imperfect markets overshooting and under-shooting in that way.

“The authorities lagged, you see. There is this reflexive cat-and-mouse game going on between markets and the authorities all the time and I am more aware of it than perhaps most others, therefore I acted more decisively.

“So just like traditional economists predicted seven of the last three recessions, in the same way I anticipated seven of the last three bubbles,” he says with a throaty chuckle.

“What has happened now is that the efficient market hypothesis has been discredited, the evidence is just too overwhelming ... but instead of accepting reflexivity, the
(economics) profession is veering towards behavioural economics and what is called the adaptive systems hypothesis (or) adaptive markets hypothesis.

“And I am worried about that because I think that this will perpetuate the mistake. Because basically the adaptive markets hypothesis says that anything goes that helps the survival of the fittest in terms of systems. And therefore this validates any system that prevails. My contention is that actually systems can be maladaptive, as witnessed by the fact that they can collapse the way they have collapsed.”

Jon Danielsson, a reader in international finance at the LSE, argues that Soros overstates the originality of his theories. “A lot of market participants have focused on finding inefficiencies in the market,” he says. “Soros is just very good at putting that into practice.”

Larry Summers, the director of Obama’s National Economic Council, has a kinder view, telling the Financial Times recently that Soros’s theories deserve attention and have been incorporated not only into the financier’s money-making strategies but also into his philanthropic efforts to promote what Soros describes as “open societies”.

“No philanthropist in the second half of the 20th century has done better in deploying resources strategically to change the world,” Summers said.

Soros is “very proud” of his large donations against Bush in 2004, even though Bush was re-elected. “When you invest, you do it in order to make a profit. When you take a political stance, you do it for the principle and not for the outcome. One of the people I admire is a Russian human rights activist named Sergei. He said to me: ‘All my life I fought losing battles.’ And I think if you keep on fighting losing battles, you actually win the war.”

http://www.theaustralian.news.com.au/business/story/0,28124,25211027-5018057,00.html