I just finished George Soros’ latest book “The New Paradigm for Financial Markets – The Credit Crisis of 2008 and What it Means”
He just wrote an article on his thoughts for the New York Times Review of Books – which is a great summary of the thinking outlined in his book and update on his ideas.
The article is of interest if you want to learn of Soros’ basic ideas on markets, financial theories, etc. and his views of how regulation should be moderated by a new paradigm of financial thinking which he calls “reflexivity.”
"The misconception is derived from the prevailing theory of financial markets, which, as mentioned earlier, holds that financial markets tend toward equilibrium and that deviations are random and can be attributed to external causes. This theory has been used to justify the belief that the pursuit of self-interest should be given free rein and markets should be deregulated. I call that belief market fundamentalism and claim that it employs false logic. Just because regulations and all other forms of governmental interventions have proven to be faulty, it does not follow that markets are perfect."
The ultimate moment of the breakdown of market fundamentalism was when Greenspan admitted that he was wrong in his pursuit of free market fundamentalism which allowed this bubble to get out of hand. MSNBC Reports, "Badgered by lawmakers, former Federal Reserve Chairman Alan Greenspan denied the nation’s economic crisis was his fault on Thursday but conceded the meltdown had revealed a flaw in a lifetime of economic thinking and left him in a 'state of shocked disbelief.'"
Soros is clear that regulation is necessary - yet in the current situation he is cautious of the pendulum swinging too far the other direction.
Here’s a link - and here are last two paragraphs:
“Since the risk management models used until now ignored the uncertainties inherent in reflexivity, limits on credit and leverage will have to be set substantially lower than those that were tolerated in the recent past. This means that financial institutions in the aggregate will be less profitable than they have been during the super-bubble and some business models that depended on excessive leverage will become uneconomical. The financial industry has already dropped from 25 percent of total market capitalization to 16 percent. This ratio is unlikely to recover to anywhere near its previous high; indeed, it is likely to end lower. This may be considered a healthy adjustment, but not by those who are losing their jobs.”
“In view of the tremendous losses suffered by the general public, there is a real danger that excessive deregulation will be succeeded by punitive reregulation. That would be unfortunate because regulations are liable to be even more deficient than the market mechanism. As I have suggested, regulators are not only human but also bureaucratic and susceptible to lobbying and corruption. It is to be hoped that the reforms outlined here will preempt a regulatory overkill.”
My friend Dan Krimm responded to this and I thought he said it so well - I'll post his comments:
Cool. So, "reflexivity" amounts to a sort of feedback loop between
perceptions and reality (along the lines that some political elites
characterize as "perception *is* reality"...). Sometimes that feedback is
corrective, but sometimes it is self-reinforcing.
In other words, the financial system is rife with highly nonlinear
dynamics, and thus not reliably equilibrium-seeking. (This is what
Nicholas Nassim Taleb was getting at in his 2007 book "The Black Swan".)
Taleb points out at one point in *his* book that fully 50% of the gain in
the market over the last several decades can be isolated to *ten individual
days*. He points out that this violates the assumption that the randomness
of the market is "Brownian random-walk" randomness that tends to fit a
Gaussian bell curve (so-called "normal distribution" underlying
conventional statistical tools used for conventional risk analysis --
outliers are supposed to be unimportant in influencing the mean). On the
contrary, the variability in the market is self-scaling in a much more
extreme manner, like earthquakes, along the lines of Benoit Mandlebrot's
"hyperbolic scaling distributions" more commonly called "power-law
distributions" (where outliers can make a huge difference in the mean).
The fact that all the risk analysts were using an abjectly false assumption
about the distribution of variation in the market was one huge contributor
to the cluelessness in recognizing the potential for and strategically
avoiding this magnitude of disaster.
In short, market analysts have assumed that all the oddities of market
jumps are anomalous and external in origin. (Otherwise, as Soros points
out, the market would be assumed to reach equilibrium.) But in fact, this
nonlinear effect is internal in origin.
As the economists would say, not exogenous, but rather, endogenous.
I really hope that people in the market get this message loud and clear,
and the sooner the better. The orthodoxy is what got us into this mess.
And Alan Greenspan was "shocked, simply shocked"...
The solution: rein-in the nonlinear dynamics with smart regulation. Cap
the degree of risk leverage. Regulate things that look and behave like
insurance (credit default swaps) like other forms of insurance. Require
information transparency (trails of origin) in derivative securities, so
you can actually trace the behavior of the elements that comprise them.
Why do we care if some investor gets hit by the risk they take on, however
unwittingly? Because we are all invested in it, in the end, through
multiplier effects. The stability of the economy is a public good, and the
public deserves to protect itself collectively by regulation that
illuminates and contains risk.
It is patently unfair to society to privatize the upside while socializing
the downside.
Dan
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