> The London Times November 30, 1998 > GLOBAL MELTDOWN - UNLESS WE HEED THE WAKE-UP > CALL > 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." > > ************************************************************** David Spratt Telephone 613-9482-5436 / fax 613-9482 4268 email:dspratt@peg,apc.org. ***************************************************************
