In this extract from The Soros LecturesGeorge Soros outlines his views on how the global financial system has to be adapted for the future
WE HAVE just passed through the worst financial crisis since the second World War. The only relevant comparisons are with the Japanese real estate bubble which burst in 1991 and from which Japan has still not recovered, and with the Great Depression of the 1930s. What differentiates this crisis from the Japanese experience is that the latter was confined to a single country, while this crisis has involved the entire world. What differentiates it from the Great Depression is that this time the financial system was not allowed to collapse but was put on artificial life support.
In fact, the magnitude of the problem we face today is even greater. In 1929, total credit outstanding in the United States was 160 per cent of GDP and it rose to 250 per cent by 1932; in 2008 we started at 365 per cent – and this calculation does not take into account the pervasive use of derivatives which was absent in the 1930s. And yet, in spite of that, the artificial life support has been successful. Barely a year after the bankruptcy of Lehman Brothers, financial markets have stabilised, stock markets have rebounded and the economy is showing signs of recovery. People want to return to business as usual and think of the Crash of 2008 as a bad dream.
I regret to tell you that the recovery is liable to run out of steam and may even be followed by a “double dip” although I am not sure whether it will occur in 2010 or 2011.
My views are far from unique but they are at variance with the prevailing mood. The longer the turnaround lasts the more people will come to believe in it but, in my judgement, the prevailing mood is far removed from reality. This is characteristic of far-from-equilibrium situations when perceptions tend to lag behind reality. To complicate matters, the lag works in both directions. Most people have not yet realised that this crisis is different from previous ones – that we are at the end of an era. Others – including me – failed to anticipate the extent of the rebound. The turmoil is not confined to the financial sphere; it extends to the entire international arena. After the collapse of the Soviet empire, the US emerged as the sole superpower. No other power, or combination of powers, could challenge its supremacy.
But the uni-polar world order did not take root. When president [George W] Bush sought to assert America’s supremacy by invading Iraq on false pretences he achieved the exact opposite of what he intended. The US suffered a precipitous decline in its power and influence. So the disarray in the international financial system is matched by instability in international relations.
The efficient market hypothesis looks at financial markets in isolation and totally disregards politics. But that gives a distorted picture. Behind the invisible hand of markets there is the visible hand of politics which establishes the rules and conditions in which the market mechanism operates. My conceptual framework relates to the political economy, not the market economy as an abstract construct that is governed by timelessly valid laws. I look at financial markets as a branch of history.
The international financial system, as it was reconstructed after the second World War was lopsided by design. The international financial institutions – the International Monetary Fund and the World Bank – were organised as shareholding companies in which rich countries held a disproportionate share of the votes and also controlled the boards. This put the countries at the periphery at a disadvantage.
Ever since, the system has been dominated by the US. Since then, we have gone from an almost completely regulated system to an almost completely deregulated one, but the changes were led by the US and the system has continued to be guided by what has become known as the Washington Consensus.
Although the rules laid down by the Washington Consensus were supposed to apply to all countries equally, the US – as the issuer of the main international currency – was more equal than others. Effectively the international financial system had a two-tier structure: countries that could borrow in their own currency constituted the centre, and those, whose borrowings were denominated in one of the hard currencies, constituted the periphery. If individual countries got into difficulties they received assistance but only on strict conditions. That held true whether they were from the centre or from the periphery. But if the centre itself became endangered, then, preserving the system took precedence over all other considerations.
That happened for the first time in the international banking crisis of 1982. If the debtor countries had been allowed to default, the banking system would have collapsed. Therefore the international financial authorities banded together and introduced what I called at the time “the collective system of lending.”
The lenders were induced to roll over their loans and the debtor countries were lent enough additional money to service their debts. The net effect was that debtor countries fell into severe recession but the banking system was allowed to earn its way out of a hole.
When the banks built up sufficient reserves the loans were restructured into so-called “Brady bonds” and the banks were obliged to take their losses.
Something similar happened again in 1997 but by then the banks had learned to securitise their loans so they could not be forced into a collective system of lending and most of the losses had to be taken by the debtor countries. Banks, whose collective failure would have endangered the system, were bailed out.
The financial crisis of 2008 was different because it originated at the centre and the periphery countries were drawn into it only after the bankruptcy of Lehman Brothers. The IMF was faced with a novel task: to protect the periphery from a storm that originated at the centre. It did not have enough capital but member countries banded together and raised a trillion dollars.
Overall, the international financial authorities have handled this crisis the same way as previous ones: they bailed out the failing institutions and applied monetary and fiscal stimulus. But this crisis was much bigger and the same techniques did not work. The rescue of Lehman Brothers failed. That was a game-changing event: financial markets actually ceased to function and had to be put on artificial life support. This meant that governments had to effectively guarantee that no other institution whose failure could endanger the system would be allowed to fail. That is when the crisis spread to the periphery because periphery countries could not provide equally credible guarantees. The countries at the centre used the balance sheets of their central banks to pump money into the system and to guarantee the liabilities of commercial banks, and governments engaged in deficit financing to stimulate the economy on an unprecedented scale.These measures have been successful and the global economy appears to be stabilising. There is a growing belief that the global financial system has once again escaped collapse and we are slowly returning to business as usual. This is a grave misinterpretation of the current situation. Humpty Dumpty cannot be put together again. Let me explain why.
The globalisation of financial markets that took place since the 1980s was a market fundamentalist project spearheaded by the US and the UK. Allowing financial capital to move around freely in the world made it difficult to tax it or to regulate it. This put financial capital into a privileged position. Governments had to pay more attention to the requirements of international capital than to the aspirations of their own people because financial capital could move around more freely. So as a market fundamentalist project, globalisation was highly successful; individual countries found it difficult to resist it. But the system that emerged was fundamentally unstable because it was built on the false premise that financial markets can be safely left to their own devices. That is why it broke down and that is why it cannot be put together again.
The point I am trying to make is that regulations must be international in scope. Without it, financial markets cannot remain global; they would be destroyed by regulatory arbitrage. Businesses would move to the countries where the regulatory climate is the most benign and this would expose other countries to risks they cannot afford to run. Globalisation was so successful because it forced all countries to remove regulations, but the process does not work in reverse. It will be difficult to get countries to agree on uniform regulations.
This can be seen in Europe. During the crisis, Europe could not reach a Europe-wide agreement on guaranteeing its financial system; each country had to guarantee its own. As things stand now, the euro is an incomplete currency. It has a common central bank but it does not have a common treasury – and guaranteeing or injecting equity into banks is a treasury function. The crisis offered an opportunity to remedy this shortfall but Germany stood in the way.
Germany used to be the driving force behind European integration but that was at a time when Germany was willing to pay practically any price for reunification. Today Germany is at odds with the rest of the world in fearing inflation rather than recession and, above all, it does not want to serve as the deep pocket for the rest of Europe. Without a driving force, European integration has ground to a halt.
Fortunately, Europe had the benefit of the social safety net. It was held responsible for holding down European growth rates in good times, but it served its purpose in the downturn and the recession in Euroland was less severe than expected. Now that the fears of an economic collapse have subsided, the EU is showing some signs of political revival. The ECB has effectively bailed out the Irish banking system and Ireland has resoundingly endorsed the Lisbon Treaty. So I may be too pessimistic about Europe.
The prospects for international co-operation may be more endangered by the different long-term impact the financial crisis is having on different countries. In the short term, all countries were negatively affected, but in the long term there will be winners and losers. Although the range of uncertainties for the actual course of events is very wide, shifts in relative positions can be predicted with greater certainty. To put it bluntly, the US stands to lose the most and China is poised to emerge as the greatest winner. The extent of the shift is likely to exceed most expectations.
