By George Soros
from The Crisis of Global Capitalism
November 30, 1998
In the first extract from his book, The Crisis of Global Capitalism, the controversial financier George Soros issues
a warning that the world's financial system is set for a complete breakdown - and only co-operation and reforms
on an international scale can prevent it.
The financial crisis that originated in Thailand in 1997 is particularly unnerving because of its scope and severity. We at Soros Fund Management could see a crisis coming and so could others, but the extent of the dislocation took everyone by surprise. A number of latent and seemingly unrelated imbalances were activated and their interaction touched off a pro-cess whose results are entirely out of proportion with the ingredients that went into creating it.
The financial markets played a role that is very different from the one assigned to them by economic theory. Financial markets are supposed to swing like a pendulum. They may fluctuate wildly in response to shocks, but eventually they are supposed to come to rest at an equilibrium point. Instead, financial markets have behaved like a wrecking ball, swinging from country to country and knocking over the weaker ones.
It is difficult to escape the conclusion that the international financial system itself constituted the main ingredient in the meltdown process. It certainly played an active role in every country, although the other ingredients varied from country to country. Financial markets do not just passively reflect economic reality. The role that financial markets play in the world ought to be radically reconsidered.
To see why, let us look at what has happened. The most immediate cause of trouble in 1997 was the manner in which currencies were managed. The South-East Asian countries maintained an informal arrangement that tied their currencies to the US dollar. It was a situation similar in some respects to the ERM.
The apparent stability of the link to the dollar encouraged local banks and businesses to borrow in dollars and then convert dollars into local currencies, without insuring against the risk of the local currencies going down in value. The banks then lent to or invested in local projects, particularly real estate. This seemed to be a riskless way of making money as long as the local currencies maintained their link to the dollar.
But the arrangement came under pressure because the two biggest economies in the area, China and Japan, had currencies which were out of sync with the dollar. The Chinese currency was undervalued, and the yen fell. The balance of trade suffered in South-East Asia. By the beginning of 1997 it was clear to us at Soros Fund Management that the position was becoming untenable. If it was clear to us in January 1997 that the situation was untenable, it must have been clear to others. Yet the crisis did not break out until July 1997 when the Thai authorities abandoned the peg to the dollar and floated their currency. In crude terms, it was their Black Wednesday.
The crisis came later than we had expected because the local monetary authorities kept on supporting their currencies far too long and international banks continued to extend credit even though they must have seen the writing on the wall. The delay has undoubtedly contributed to the severity of the crisis. From Thailand it quickly spread to Malaysia, Indonesia, the Philippines, South Korea and other countries. Some of the countries engulfed in the crisis did not appear to have wrongly valued currencies. Critics argue the problem was their common dependence on a distorted or immature form of capitalism, now described perjoratively as "crony capitalism", but previously extolled as "The Asian Model". There is some truth in the claim, but attributing the crisis to specifically Asian characteristics does not give the full picture. The crisis has now spread to Latin America and Eastern Europe and is now beginning to affect the financial markets and economies of Western Europe and the United States. This global crisis is caused by pathologies inherent in the global financial system itself.
HOW THE MARKETS MADE IT WORSE
It is not just currency speculation that creates problems, but the nature of investment. Institutional investors do not generally measure their performance in absolute terms but relative to each other. They operate as a herd, following the latest trend. Hedge fund managers and others who speculate with borrowed money play a similar role. When they are on a winning streak, they can increase their bets; when they lose they are forced to sell to reduce their debt. Options, hedges and other derivative instruments have a similar self-reinforcing quality about them.But it was not only foreign investors who influenced the situation. In the countries where the local currency was pegged to the dollar, indigenous banks assumed the peg would hold and unwisely failed to insure against it going. When the peg broke they found themselves exposed. They scrambled for cover, and put tremendous pressure on the local currencies. As the currencies nose-dived this caused a sudden deterioration in the balance sheets of local borrowers. This, together with foreign investors fleeing from declining markets, set up a self-reinforcing process that resulted, for example, in a 42 per cent decline in the Thai currency and a 59 per cent decline in the Thai stock market between June 1997 and August 1998.
Financial markets caused this panic to spread; some have referred to this financial contagion as a modern version of the bubonic plague. Other countries in Asia had apparently strong economies, the Malaysian trade deficit was modest and the fundamentals in Indonesia seemed quite sound but it was not long before they were hit, and the crisis forced Thailand, then Korea, then Indonesia to seek the assistance of the IMF.
But the IMF programmes did not work. Perhaps, because the IMF had developed its techniques for dealing with problems caused by improvident governments, its understanding of how financial markets operate left much to be desired. The correct solution to the crisis would have been to convert debts in the stricken countries into equity, giving creditors a share stake in the vulnerable concerns. But international creditors would have balked, and without their co-operation no rescue programme can succeed. Obviously the problem is with the system, and the IMF is part of the problem, not part of the solution. The IMF is now in a crisis of its own. Market confidence has been an essential ingredient to its past success and it has now lost credibility.
>From Asia, the wrecking ball, or bubonic plague, has hit Russia and Brazil, damaging Eastern Europe and devastating Ukraine on the way. The international crisis appeared to reach a climax in 1997. Foreign banks refused to roll-over their loans to Asian banks, Central banks had to intervene and force commercial banks to renew their loans. Soon afterwards the crisis started to ease. Alan Greenspan, the Chairman of the US Federal Reserve, made it clear that the Asian troubles ruled out any possibility of an interest rate rise and the markets took heart.
It was a false dawn. The financial collapse has been followed by economic decline in Asia and elsewhere. Domestic demand came to a standstill and imports shrank, but exports did not expand because a high proportion of the exports were directed towards countries that were also affected. Semiconductors were particularly hard hit.
THERE IS WORSE TO COME
I realised that the music had stopped, and I said so at the time, but I seriously underestimated the severity of the problem. The disintegration of the global capitalist system will prevent a recovery, turning the recession into a depression. I have three main reasons. One is that the Russian meltdown has revealed previously ignored laws in the international banking system. Banks engage in transactions and trade among each other and with their clients which do not show up on their balance sheets. When Russian banks defaulted, Western banks remained on the hook both on their own account and on behalf of clients. Hedge funds and other speculative accounts also sustained large losses. Banks are now frantically trying to limit their exposure, deleverage and reduce risk. Their own stocks have plummeted and a global credit crunch is in the making.Second, the pain at the periphery, in Asia, Russia and elsewhere, has now become so intense that individual countries have begun to opt out of the global capitalist system. First Indonesia, then Russia, suffered a pretty complete breakdown. What happened in Malaysia and in Hong Kong is in some ways even more ominous. The collapse in Indonesia and Russia was unintended, but Malaysia shut itself off from international capital markets deliberately. Its action has brought temporary relief to the Malaysian economy and allowed its rulers to maintain themselves in power but, by reinforcing a general flight of capital from the periphery, it has put additional pressure on those countries that are trying to keep their markets open.
If the capital flight makes Malaysia look good in comparison with its neighbours, the policy may easily find imitators.
The third major factor working for the disintegration of the global capitalist system is the evident inability of the international monetary authorities to hold it together. IMF programmes do not seem to be working and the IMF has run out of money. The response of the G7 governments to the Russian crisis was woefully inadequate, and the loss of control was quite scary.
Financial markets are rather peculiar. They resent any kind of government interference but they hold a belief deep down that if conditions get really rough the authorities will step in. This belief has now been shaken. How events will unfold depends largely on the response of the banking system, the investing public, and the authorities at the centre. The range of probabilities lies between a cascading decline of the stock markets and a more drawn-out process of deterioration. I think the latter more likely.
The public has learned that it pays to buy during dips to what has been an everlasting bull market. But it will take time before it discovers that the bull market does not last forever. Thus it will take time for the three main negative forces to make their effect felt.
The current false dawn will be followed by a prolonged bear market, just as in the 1930s and in Asia currently. The public will stop buying dips and start moving out of stocks. The wealth effect will take its toll and consumer demand will decline. Investment demand will also decline, for a number of reasons; profits are under pressure, imports are rising and exports falling, and the supply of capital for the less well established enterprises and for real estate has dried up.
Reductions in interest rates will cushion the market decline. The economy would eventually recover if the global capitalist system held together. But the chances of it falling apart have greatly increased. If and when the United States' domestic economy slows down, the willingness to tolerate a large trade deficit will decrease and free trade may be endangered. The US is also looking increasingly inward. The refusal of Congress to provide additional funds for the IMF may play the same role today as the Smoot- Hawley tariff did in precipitating the Great Depression.
Once, I thought that the Asian crisis would lead to the ultimate triumph of capitalism. Multinational corporations would replace family concerns and the Asian model would then be assimilated into the global capitalist model. It is now more likely that countries at the periphery of the system, in Asia, will increasingly opt out of the system altogether as their prospects for attracting capital from the West fade away. It is often said that revolutions devour their own children, and the political changes in Asia which have seen tyrants fall may not leave the current reformers in charge. Already, anti-American, anti-IMF, anti-foreign resentment is building up throughout Asia, including in Japan.
Elections in Indonesia could well produce a nationalistic, Islamic government inspired by the ideas of Dr Mahathir Mohamad, the Malaysian premier.
Banks and investors have suffered severe losses and there are more to come. Russia is likely to default on its dollar obligations. Losses in Indonesia will also have to be recognised. Banks are being punished by shareholders for their exposure to the periphery. They will not want to increase their commitments.
Only international governmental action could pump money into the periphery, but there is no sign of international co-operation.
I can already discern the makings of the final crisis. It will be political in character. Indigenous political movements are likely to arise that will seek to expropriate multinational companies and recapture the "national" wealth. Some of them may succeed in the manner of the Boxer Rebellion or the Zapata Revolution. Their success may shake the confidence of financial markets, engendering a self-reinforcing process.
The breakdown of the global capitalist system could be prevented by the intervention of the international financial authorities at any time. The prospects are dim because the G7 has just failed to intervene in Russia, but the consequences of that failure may serve as a wake-up call.
There is an urgent need to rethink and reform capitalism. The problems will become progressively more intractable the longer they are allowed to fester.
THE SYSTEM IS INHERENTLY FLAWED
Strange as it may seem for someone who has made his reputation and his fortune in the very practical world of business, my financial success and my political outlook have rested largely on a number of abstract philosophical ideas. One of them is my distrust of social sciences.There is a prevailing belief that economic affairs are subject to irresistible laws, like supply and demand, that are comparable to the natural laws of physics. This belief is false. What is more important, decisions and structures that are based on this belief are destabilising economically and dangerous from a political point of view, I am convinced that the market system, like every other human arrangement, is inherently flawed. This conviction lies at the foundation of this book's entire analysis, as well as of my personal philosophy and of my funds' financial success.
Economic analysis cannot have the same validity as the physical sciences. But the most important reason for the failure of economic analysis - and for the inevitable instability of all social and political institutions that assume the absolute validity of market economics - is not properly understood. The failures of economics are not simply due to our imperfect understanding of economic theory or to a lack of adequate statistics. These problems could, in principle, be remedied by better research. But economic analysis, and the free-market ideology that it supports, are subverted by a far more fundamental and irredeemable flaw.
Economic and social events, unlike the events that preoccupy physicists and chemists, involve thinking participants and not molecules. And thinking participants can change the rules of economic and social systems by virtue of their own ideas about these rules. The claims of economic theory to universal validity become untenable once this principle is properly understood. People can operate in a way that bucks the rules. This is not just an intellectual curiosity. For if economic theories are not scientifically valid - and never can be - the entire ideology of market fundamentalism is undermined.
I have to confess that I am not familiar with the prevailing theories about efficient markets and rational expectations. I consider them irrelevant and I never bothered to study them because I seemed to get along quite well without them - which was perhaps just as well, judging by the recent collapse of the hedge fund Long Term Capital Management (LTCM).
The fund's managers aimed to profit from the application of modern equilibrium theory, and its strategies were inspired by the joint winners of the 1997 economics Nobel Prize, who won their prize for their theoretical work on options pricing.
The fact that some successful participants in financial markets have found modern theories, supposedly explaining how financial markets function, completely useless may be considered a scathing criticism in itself. But the failure of LTCM is much more conclusive. I have no quarrel with economics itself, as far as it goes, except that it does not go far enough.
'HOPE MADE ME FEEL INSECURE, WORRYING MADE ME FEEL SAFE'
As a fund manager, I depended a great deal on my emotions. That was because I was aware of the inadequacy of my knowledge. The predominant feelings I operated with were doubt, uncertainty and fear. I had moments of hope, even euphoria, but they made me feel insecure. By contrast, worrying made me feel safe. So the only genuine joy I experienced was when I discovered what I had to worry about.
By and large, I found managing a hedge fund extremely painful. I could never acknowledge my success because that might stop me from worrying, but I had no trouble in recognising my mistakes. It is wise to be constantly looking for the fly in the ointment.
Only when others pointed it out to me did I realise that there might be something unusual in my attitude to mistakes. It made so much sense to me that discovering an error in my thinking should be a source of joy rather than regret, I thought it ought to make sense to others as well. But when I looked around, I found that most people went to great lengths to cover up their mistakes. It gave me pleasure to acknowledge a mistake, because I knew that it could save me from future grief.
I will never forget visiting Argentina in 1982 to look at the mountain of debt that country had accumulated. I sought out a number of politicians who had served in previous governments and asked them how they would handle the situation. To a man, they said they would apply the same policies they followed when they were in government. They refused to learn from experience.
I carried my critical attitude into my philanthropic activities. I found philanthropy riddled with paradoxes and unintended consequences. For instance, charity may turn the recipients into objects of charity. Giving is supposed to help others, but in reality it often serves to gratify the ego of the giver. What is worse, people frequently engage in philanthropy because they want to feel good, not because they want to do good.
When I set up my foundation to advance the aims of the open society in Eastern Europe, I took a new approach. I subordinated the interests of the foundation personnel and of the individual applicants to the mission of the foundation. I used to joke that ours was the only misanthropic foundation in the world.
I remember telling my staff in Czechoslovakia in 1991 that foundations were hothouses of corruption and inefficiency, and that I would consider it a greater accomplishment to have the courage to wind up a failed foundation than to have the vanity to set up a new one. I also remember telling a gathering of staff in Prague that networking means not working.
I have mellowed with time. There is a difference between running a hedge fund and running a charitable foundation. Heading a large foundation requires people skills, and people do not like critical remarks. They want praise and encouragement. Not many people share my predilection for identifying error and even fewer share my joy in it.
I used to find public expressions of praise and gratitude positively painful. But I have come to realise that this is a reflex left over from the days when I was actively managing money, when I had to be guided by the results of my actions, not by what other people thought of them.
I am still embarrassed by gratitude and I still believe that philanthropy, if it is deserving of praise, should put the interests of society ahead of ego gratification. But I am willing to accept praise because my foundation has now met this condition.
Whether it can continue to function properly, given my changed attitude towards praise, is a question that troubles me. But as long as I am troubled, the answer will probably still be yes. Worrying is the key to success.
From The Crisis of Global Capitalism by George Soros:
"This global crisis is caused by pathologies inherent in the global financial system itself."
"I realised that the music had stopped..."
"... a global credit crunch is in the making."
"Indigenous political movements are likely to arise that will seek to expropriate multinational companies and recapture the "national" wealth."
"There is an urgent need to rethink and reform capitalism."
"...Economic analysis, and the free-market ideology that it supports, are subverted by a far more fundamental and irredeemable flaw."
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