Soros Explains The Credit Crisis

The New Paradigm for Financial Markets: The Credit Crisis of 2008 And What It Means by George Soros ($23, Public Affairs, 2008).

[George Soros is the Founder and Chairman Open Society Institute. See biography here]

With his near real-time critique of the credit crisis, George Soros has saved financial historians a lot of work. If he's right, the summer of 2007 and all of 2008 will be the topic of many an academic paper, much like how Ben Bernanke made a career out of studying the Great Depression. Soros sees this as a monumental time. It's not just a bursting housing bubble, he says. It's the end of a quarter-century of credit-driven economic expansion. We're in a whole new world.

Up until August 2007, Soros had mostly farmed out management of his hedge fund to outsiders so that he could devote his time to philanthropy, philosophy and politics. The first troubles in subprime spurred Soros back into the markets. This time his goal wasn't so much to find the next billion-dollar trade but to preserve the wealth of his foundations.

This market has been so tough that it's vexed even Soros. His book offers a broad trading diary from January 2008 through the end of March, when The New Paradigm went to the printer. Soros' investment plan was to "short U.S. and European stocks, U.S. 10-year government bonds and the U.S. dollar; long Chinese, Indian and Gulf States stocks and non-U.S. currencies."

On March 10, he noted that commodities were stronger than he thought they'd be, that the Federal Reserve acted more aggressively than he'd anticipated and that the Indian and Chinese stock markets, not quite decoupled from the U.S. economy, took major hits. On March 16, he observed that "The panic is palpable," and bought into ailing Bear Stearns (nyse: BSC - news - people ), expecting some return on a Federal Reserve brokered auction of the company. He got burned admitting that, "We forgot to take into account that Bear is disliked by the establishment, and the Fed would use the occasion to deal with a moral hazard by punishing shareholders."

For those who might be confused by Soros' analysis there, Bill Miller, manager of the Legg Mason Value Trust explains: "Bear had been very aggressive in seizing the capital of Askin Capital in 1994 and precipitating its failure. In 1998 it opted out of rescuing Long Term Capital Management. That's the kind of thing where, if you're Merrill, Citigroup or the Fed, you remember." Miller also bought shares in Bear, for the same reasons Soros did.

The trading diary ends with Soros losing money. While he wishes he could have reached a more triumphant ending, he notes that the result "may be more appropriate for the purposes of the book."

Indeed, it is. While Soros is investing actively again, he's really using the market as a laboratory where he can test his philosophical ideas, especially the notion of reflexivity--that no market participant can ever have perfect knowledge because their beliefs, and the beliefs of others, effect and distort the markets. Because investors tend to herd--they buy things that are going up and sell things that are going down--markets are constantly beset by bubbles. Irrationality reigns supreme.

Soros was once a student of the philosopher Karl Popper, who spent most of his time studying science. Popper came to the conclusion that all scientific statements must be falsifiable and that no scientific theory is ever absolutely true. They are just able to withstand people's attempts to prove them wrong. So long as a theory isn't falsified, it's as good as true. But we're 100% certain about nothing.

The turmoils we see in the markets reflect the turmoils of human thought. The implications of this go far beyond investing. It means that market fundamentalism, the idea that markets are always self-correcting and don't need regulation, is just wrong. Markets are flawed because they reflect human delusions of certainty. Banks make money by issuing loans. If they want to make more money, they need to issue more loans. Absent regulation to stop them, the banks will issue new loans in new ways. They rationalize the risk away by building models based on past experience. The risk models say that the loans are safe. The flaw? All of these new loans fuel an unprecedented housing bubble that the risk models, which are backward looking, can't account for. All of these new loans also create new levels of debt, also unprecedented in history. So the risk models, once again, miss them.

It's time, says Soros, to bring back some of the regulations that were put in place after the Great Depression and then eroded in the decades that followed. Leverage and credit creation, he says, need to be reigned in. Regulators need to start looking to control asset bubbles as they manage the economy for the more usual goals of full employment and price stability.

Soros sees a new economy, indeed a new world order emerging. If the U.S. leaves its fate to the whims of flawed markets, it will lose much of its worldwide influence. Without the dollar as the reserve currency of first choice, the U.S. really has nothing but military supremacy in order to defend its position in the world, and even that, says Soros, has been undermined by the debacle in Iraq.

Soros' message for citizens, investors, politicians and regulators is to approach this new economy and new political order with humility. Be flexible and never dogmatic. Strive to find truth while realizing it's unattainable. It's false certainty that trips us up, in both investing and life.

First published here.