George Soros is on a roll – generating more publicity than Britney Spears on a very bad day with his gloomy predictions for markets (“facing their worst crisis in 60 years”) and attacks on the Fed. In Thursday’s edition of The Times, economic commentator Anatole Kaletsky takes on Soros and argues that there’s more to the recent bull market than just an unprecedented expansion in credit.
Early this year, Kaletsky wrote that if the financial markets did not resolve the credit crisis by February, the governments of the world would have to come up with a Plan B. Central banks would slash interest rates or governments would cut taxes and offer guarantees or regulators would fudge accounting rules to ensure that banks could keep lending.
“Events have moved faster than I expected,” he now says. “On Tuesday, the US Federal Reserve Board implemented its biggest rate cut since the early 1980s. Previously implacable enemies in the US political leadership have reached a bipartisan agreement on $150 billion of emergency tax cuts. In Britain, Gordon Brown has offered Northern Rock shareholders the biggest subsidy ever paid by any government to any private company.”
Does this hyperactivity mean that the world economy is on the brink of catastrophe? Or does it suggest that the credit crunch is now almost over, and that the world economy faces only a moderate slowdown or, at worst, a mild recession?
The risks are certainly greater today than they have been since the 2001 US and European recession – and for Britain the prospects seem dimmer than at any time since 1992. But is this really, as George Soros proclaimed, “the worst market crisis in 60 years”?, he asks.
The claim is “unequivocally wrong,” in Kaletsky’s view, “since the 20 per cent fall in share prices and the US mortgage problem cannot remotely compare with the crises that racked the world economy in the 1970s and early 1980s, when inflation and interest rates soared to 20 per cent, stock markets plunged by 80 per cent in real terms, big banks fell like ninepins and unemployment was double or triple the present level.”
Allowing for poetic licence, however, Mr Soros offers the most persuasive case for the prosecution. His argument rests on three assumptions, each of which offers important insights into how the global economy got into its present troubles, but which may nonetheless prove misleading in anticipating what happens next.
His first insight is that this crisis is more than just a typical boom-bust cycle. This cycle, he contends, marks the climax of a 60-year boom in consumer borrowing and credit growth. This has produced excesses in banking, asset values and financial innovation that will take years or decades to unwind. Economies addicted to easy credit will be devastated if their banking systems suffer a long-term decline, which is what Mr Soros’s “super-cycle” implies.
His second insight is that reversal of “the 60-year super-boom” will damage America most, ending the global dominance of the dollar and shifting the balance of power in the world economy to the creditor nations of Asia and the Middle East.
Both these points are absolutely valid, in Kaletsky’s view. The reversal of credit growth, the slowdown in US consumption and the shift in economic power towards Asia will all undoubtedly happen, but there is no evidence that these shifts will be so abrupt as to cause a serious recession, still less the greatest economic crisis for 60 years.
Mr Soros’s third, and most important, insight is that the two super-cycles he describes – in global credit and in US consumption – were part of an even bigger super-cycle in politics. The excesses of financial innovation and consumer spending were encouraged by deregulation, based on a belief that the market was always right and could solve its own problems. This “market fundamentalism” ignored, in Mr Soros’s view, the driving force of all boom-bust cycles, which is what he calls “reflexivity”. As markets are driven not by reality but by investors’ often misguided views about reality, prices tend to overshoot on the way up (when everyone is too bullish) and also on the way down. As investors chase prices up or down, they change reality and justify their own expectations.
The collapse of confidence in the US banking system is changing reality and causing a recession that will justify investors’ fears of further catastrophic deterioration in the banks. But Soros’s assumption ignores a powerful force in human nature: rationality. Businesses driven by the profit motive have a natural bias to try to create wealth, rather than destroy it – and they elect governments to support, rather than sabotage, this process.
Soros is right that markets have a natural tendency to create reflexive boom-bust cycles, Kaletsky concedes. “A world of pure market fundamentalism would degenerate into the madhouse of manic-depressive speculation that Mr Soros describes. “That, however, is not the real world. Laissez-faire politicians constantly overrule market forces when they face serious crises”.
Politicians are naturally less eager to limit excessive booms than devastating busts. There are, of course, times when governments fail to stimulate an economy enough to prevent a serious recession. There are also situations where governments and central banks have been constrained in providing stimulus, either by high inflation or ERM membership. In general, though, it is much more likely that politicians will err on the side of too much stimulus, rather than doing too little too late. This is the main reason why the world economy has a bias towards long booms and short, shallow slowdowns.
My hunch is that a combination of monetary and fiscal easing, along with some regulatory changes – the political Plan B – will lessen the credit crisis and prevent a world recession. So, will stabilising rationality or destabilising reflexivity emphasised by Mr Soros be the main force driving the economy this year? It is impossible to say for certain yet. But we will soon find out.
Not to let up for a moment, however, now that he’s on his roll, Soros on Wednesday came out swinging in Davos – this time accusing central banks of losing control of the economy following the Fed emergency rate cut, reports the FT. The investor, who almost single-handedly drove the pound out of the European exchange-rate mechanism on Black Wednesday, also said that a recession was almost inevitable, telling BBC’s Today programme, “I think it will be very difficult to avoid it.”
Speaking from the World Economic Forum in Davos, he said: “Central banks have lost control,” adding his voice to a number of other business leaders with the same view.
While Stephen Roach, head of Asia at Morgan Stanley, the US investment bank, said: “I’m sort of worried that all they did yesterday was to hit the snooze button…(This is) excessive monetary accommodation that just takes us from bubble to bubble to bubble.”