Soros article…

Opinion piece by Soros in today’s FT arguing why the contraction of credit
is likely to continue.  Interesting point on the limits of monetary policy.  Like Krugman, when he sticks to economics, he’s not half-bad.

The worst market crisis in 60 years

By George Soros

Published: January 22 2008 19:57 | Last updated: January 22 2008 19:57

The current financial crisis was precipitated by a bubble in the US housing
market. In some ways it resembles other crises that have occurred since the
end of the second world war at intervals ranging from four to 10 years.

However, there is a profound difference: the current crisis marks the end
of an era of credit expansion based on the dollar as the international
reserve currency. The periodic crises were part of a larger boom-bust
process. The current crisis is the culmination of a super-boom that has
lasted for more than 60 years.

Boom-bust processes usually revolve around credit and always involve a bias
or misconception. This is usually a failure to recognise a reflexive,
circular connection between the willingness to lend and the value of the
collateral. Ease of credit generates demand that pushes up the value of
property, which in turn increases the amount of credit available. A bubble
starts when people buy houses in the expectation that they can refinance
their mortgages at a profit. The recent US housing boom is a case in point.
The 60-year super-boom is a more complicated case.

Every time the credit expansion ran into trouble the financial authorities
intervened, injecting liquidity and finding other ways to stimulate the
economy. That created a system of asymmetric incentives also known as moral
hazard, which encouraged ever greater credit expansion. The system was so
successful that people came to believe in what former US president Ronald
Reagan called the magic of the marketplace and I call market
fundamentalism. Fundamentalists believe that markets tend towards
equilibrium and the common interest is best served by allowing participants
to pursue their self-interest. It is an obvious misconception, because it
was the intervention of the authorities that prevented financial markets
from breaking down, not the markets themselves. Nevertheless, market
fundamentalism emerged as the dominant ideology in the 1980s, when
financial markets started to become globalised and the US started to run a
current account deficit.

Globalisation allowed the US to suck up the savings of the rest of the
world and consume more than it produced. The US current account deficit
reached 6.2 per cent of gross national product in 2006. The financial
markets encouraged consumers to borrow by introducing ever more
sophisticated instruments and more generous terms. The authorities aided
and abetted the process by intervening whenever the global financial system
was at risk. Since 1980, regulations have been progressively relaxed until
they have practically disappeared.

The super-boom got out of hand when the new products became so complicated
that the authorities could no longer calculate the risks and started
relying on the risk management methods of the banks themselves. Similarly,
the rating agencies relied on the information provided by the originators
of synthetic products. It was a shocking abdication of responsibility.

Everything that could go wrong did. What started with subprime mortgages
spread to all collateralised debt obligations, endangered municipal and
mortgage insurance and reinsurance companies and threatened to unravel the
multi-trillion-dollar credit default swap market. Investment banks’
commitments to leveraged buyouts became liabilities. Market-neutral hedge
funds turned out not to be market-neutral and had to be unwound. The
asset-backed commercial paper market came to a standstill and the special
investment vehicles set up by banks to get mortgages off their balance
sheets could no longer get outside financing. The final blow came when
interbank lending, which is at the heart of the financial system, was
disrupted because banks had to husband their resources and could not trust
their counterparties. The central banks had to inject an unprecedented
amount of money and extend credit on an unprecedented range of securities
to a broader range of institutions than ever before. That made the crisis
more severe than any since the second world war.

Credit expansion must now be followed by a period of contraction, because
some of the new credit instruments and practices are unsound and
unsustainable. The ability of the financial authorities to stimulate the
economy is constrained by the unwillingness of the rest of the world to
accumulate additional dollar reserves. Until recently, investors were
hoping that the US Federal Reserve would do whatever it takes to avoid a
recession, because that is what it did on previous occasions. Now they will
have to realise that the Fed may no longer be in a position to do so. With
oil, food and other commodities firm, and the renminbi appreciating
somewhat faster, the Fed also has to worry about inflation. If federal
funds were lowered beyond a certain point, the dollar would come under
renewed pressure and long-term bonds would actually go up in yield. Where
that point is, is impossible to determine. When it is reached, the ability
of the Fed to stimulate the economy comes to an end.
Although a recession in the developed world is now more or less inevitable,
China, India and some of the oil-producing countries are in a very strong
countertrend. So, the current financial crisis is less likely to cause a
global recession than a radical realignment of the global economy, with a
relative decline of the US and the rise of China and other countries in the
developing world.

The danger is that the resulting political tensions, including US
protectionism, may disrupt the global economy and plunge the world into
recession or worse.

The writer is chairman of Soros Fund Management

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