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Soros sounds off on world credit crunch

The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means by George Soros. PublicAffairs, £12.99

It is now almost a year since the liquidity crisis of August 2007 set off a chain of events that look set to impact the lives of thousands of people.  As investment banks became concerned about the viability of US sub-prime mortgages, so they became reluctant to lend to each other, fearful of the potential exposure of market counterparties.  Interest rates in the money markets rose, which made mortgages more expensive to finance and so mortgage interest rates rose.  As credit markets effectively closed, or at least the terms on which individuals and companies could get credit considerably worsened, so a liquidity crisis became a credit crunch.  The financial crisis is working its way through the economy, slowing growth and hurting some sectors, such as housing, very hard.  The days of easy credit are over and it seems the world has changed.  The famous hedge fund manager George Soros believes this demonstrates that we need to look at markets and society in a very different way.

It could be argued that Soros inadvertently helped Labour win power.  For along with others he bet against the pound in 1992 until it fell out of the European Exchange Rate Mechanism.  The Conservatives’ reputation for sound management of the economy never recovered.  Soros retired from active involvement in markets and converted his hedge fund into an endowment fund for the foundations he runs.  The crisis last year brought him back into active fund management as he realised the world had changed.

Soros has written extensively on capitalism and markets and his words are closely followed, not least by investors who want to discover the philosophy behind his profitable trading strategies.  Soros argues for his theory of ‘reflexivity’.  This states that markets do not just reflect changing reality (eg a share price falls if a company looks set to make a loss) but that they change reality too.  Recent financial events would seem to demonstrate this.  Soros argues that the economic theory that markets tend towards equilibrium (based on perfect information) does not hold in reality even though the financial system is set up as if it does.  This is why so many unexpected events occur, surprising investors.  Regulators had come to believe the market was essentially self-regulating but this belief has been falsified.  Soros believes that reflexivity explains how trends can develop which are self-reinforcing because people make decisions based on an interpretation of the facts and the trends they can perceive.  Reality can be manipulated.  Investor opinion shifts prices, which give out new signals about assets and the wider economy, which in turn affect investor behaviour.  These feedback loops do occur.  Soros argues that we must not ignore them.  The phenomenon can be seen in other areas of life such as politics, he argues. 

While Soros reproduces his diary entries for the first part of this year, containing conclusions about markets and investment decisions, a reader searching for the ‘secret’ of Soros’s success will be disappointed.  A great deal relies on individual judgement and, as he notes himself, he has personally often been prompted to make significant investment decisions by a recurrence of back pain; a subconscious instinct that a new strategy was required.

This latest book from Soros focuses on explaining and applying his theory of reflexivity.  I wanted him to apply it to the current condition of markets and the economy in more detail.  Nevertheless, as a financial market participant I was fascinated by his approach.  Most successful fund managers have developed a way of thinking about the world.  I hope that as the world economy responds to the financial market turbulence, George Soros will continue to share his thoughts with us.

This review previously appeared in Tribune magazine.
Stephen Beer, Friday 18 July 2008

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