Soros: Instability of Global Markets is Self Interest

The financial markets can be regarded as a circulatory system of liquidity. The economic theory that is used to support free markets was derived from Adam Smiths free market theory depicting self interest as the invisible hand as follows (wikipedia):

“…the term “an invisible hand”: in The Theory of Moral Sentiments[68] (1759) and in The Wealth of Nations[69] (1776). This last statement about “an invisible hand” has been interpreted as “the invisible hand” in numerous ways. It is therefore important to read the original:

As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestick industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestiek to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other eases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the publick good.”

The other school of thought advocated by Maynard Keynes asserts that markets require government intervention, that they do not return to equilibrium (where demand and supply intersect). Here is an excerpt from Wikipedia:

“Keynesian economics (play /ˈkeɪnziən/ KAYN-zee-ən; also called Keynesianism and Keynesian theory) is a macroeconomic theory based on the ideas of 20th century English economist John Maynard Keynes. Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and therefore advocates active policy responses by the public sector, including monetary policy actions by the central bank and fiscal policy actions by the government to stabilize output over the business cycle.[1] The theories forming the basis of Keynesian economics were first presented in The General Theory of Employment, Interest and Money, published in 1936; the interpretations of Keynes are contentious, and several schools of thought claim his legacy.

Keynesian economics advocates a mixed economy—predominantly private sector, but with a large role of government and public sector—and served as the economic model during the later part of the Great Depression, World War II, and the post-war economic expansion (1945–1973), though it lost some influence following the stagflation of the 1970s. The advent of the global financial crisis in 2007 has caused a resurgence in Keynesian thought. ”

Interestingly when in the UK I visited Oxford which is known to advocate left wing or Keynesian thought and the other is Milton Friedman who advocated (monetary policy) and free markets. This thought is associated withthe Chicago School of Economics.

We also see politicians defining themselves or trying to differentiate from opposition by taking a position on the basis of economics. Hence Labour/Labor/Democrats advocate Keynesian based economic philosophy whereas the Liberals/Conservatives/Capitalists advocate free markets doctrine or unregulated capital markets. Typically the left wing were assoicated with social programs and spending and the right wing with less or no government regulation favouring capitalists or termed the business sector these days.

George Soros on of the 35th richest men in the world and most successful speculator, touted has having made a 1 billion profit in a trade who turned to question the very system he benefited from. He stated the Open Society Institute with the aim of encouraging open thinking and new ideas. Below I have extracted an excerpt from his testimonial to the US House of Representatives and below I have pasted the full testimonial which provides a good insight into market captialism and how the markets work and fail.

An excerpt from George Soros testimony to the US House of Representatives, this is the centrepiece to his argument:

“…The rethinking must start with the recognition that financial markets are inherently unstable. The global capitalist system is based on the belef that financial markets, left to their own devices, tend towards equilibrium. They are supposed to move like a pendulum: they may be dislocated by external forces, so-called exogenous shocks, but they will seek to return to the equilibrium position. This belief is false.
Financial markets are given to excesses and if a boom/bust sequence
progresses beyond a certain point it will never revert to where it came
from. Instead of acting like a pendulum financial markets have recently
acted more like a wrecking ball, knocking over one economy after another. There is much talk about imposing market discipline but, imposing market discipline means imposing instability, and how much instability can society take? Market discipline needs to be supplemented by another discipline: maintaining stability in financial markets ought to be the objective of public policy. This is the general principle that I should like to propose.”

The full testimony is below and will give you a feel for the reality of financial markets and their inherent instability. This is an excellent overview of the global financial crisis in 1997-1998 and how interconnected markets are around the world. You can visualise a domino effect to gain an idea of how meltdown works and how wealth can be wiped in an instant.

http://www.nettime.org/Lists-Archives/nettime-l-9809/msg00082.html

TESTIMONY OF GEORGE SOROS TO THE U.S. HOUSE OF REPRESENTATIVES

Committee on Banking and Financial Services

September 15, 1998

“This hearing is very timely because the global capitalist system which has been responsible for the remarkable prosperity of this country in the last decade is coming apart at the seams. The current decline in the US stock market is only a symptom, and a belated symptom at that, of the more profound problems that are afflicting the world economy. Some Asian stock markets have suffered worse declines than the Wall Street crash of 1929 and in addition their currencies have also fallen to a fraction of what their value was when they were tied to the US dollar. The financial collapse in Asia was followed by an economic collapse. In Indonesia, for instance, most of the gains in living standards that accumulated during 30 years of Suharto’s regime have disappeared. Modern buildings, factories and infrastructure remain, but so does a population that has been uprooted
from its rural origins. The Japanese banking system is in deep trouble.
The world’s second largest economy just reported an annualized 3.3 %
decline in economic activity for the second quarter. Russia has undergone a total financial meltdown. It is a scary spectacle and it will have incalculable human and political consequences. The contagion has now also spread to Latin America.

It would be regrettable if we remained complacent just because most of the trouble is occurring beyond our borders. We are all part of the global capitalist system which is characterized not only by free trade but more specifically by the free movement of capital. The system is very favorable to financial capital which is free to pick and choose where to go and it has led to the rapid growth of global financial markets. It can be envisaged as a gigantic circulatory system, sucking up capital into the financial markets and institutions at the center and then pumping it out to the periphery either directly in the form of credits and portfolio investments, or indirectly through multinational corporations.

Until the Thai crisis in July 1997 the center was both sucking in and
pumping out money vigorously, financial markets were growing in size and importance and countries at the periphery could obtain an ample supply of capital from the center by opening up their capital markets. There was a global boom in which the emerging markets fared especially well. At one point in 1994 more than half the total inflow into US mutual funds went into emerging market funds.

The Asian crisis reversed the direction of the flow. Capital started
fleeing the periphery. At first, the reversal benefitted the financial
markets at the center. The U.S. economy was just on the verge of
overheating and the Federal Reserve was contemplating raising the discount rate. The Asian crisis rendered such a move inadvisable and the stock market took heart. The economy enjoyed the best of all possible worlds with cheap imports keeping domestic inflationary pressures in check and the stock market made new highs. The buoyancy at the center raised hopes that the periphery may also recover and between February and April of this year most Asian markets recovered roughly half their previous losses
measured in local currencies. That was a classic bear market rally.

There comes a point when distress at the periphery cannot be good for the center. I believe that we have reached that point with the meltdown in Russia. I am not making any predictions about the stock market, but I am ready to assert that we have reached that point. I have three main reasons for saying so.

One is that the Russian meltdown has revealed certain flaws in the
international banking system which had been previously disregarded. In
addition to their exposure on their own balance sheets, banks engage in swaps, forward transactions and derivative trades among each other and with their clients. These transactions do not show up in the balance sheets of the banks. They are constantly marked to market, that is to say, they are constantly revalued and any difference between cost and market made up by cash transfers. This is supposed to eliminate the risk of any default. Swap, forward and derivative markets are very large and the margins razor thin; that is to say, the value of the underlying amounts is a manifold multiple of the capital employed in the business. The transactions form a daisy chain with many intermediaries and each intermediary has an obligation to his counterparties without knowing who else is involved. The exposure to individual counterparties is limited by setting credit lines.

This sophisticated system received a bad jolt when the Russian banking
system collapsed. Russian banks defaulted on their obligations, but the
Western banks remained on the hook to their own clients. No way was found to offset the obligations of one bank against those of another. Many hedge funds and other speculative accounts sustained large enough losses that they had to be liquidated. Normal spreads were disrupted and professionals who arbitrage between various derivatives, i.e.: trade one derivative against another, also sustained large losses. A similar situation arose shortly thereafter when Malaysia deliberately shut down its financial markets to foreigners but the Singapore Monetary Authority in cooperation with other central banks took prompt action. Outstanding contracts were netted out and the losses were shared. A potential systemic failure was avoided.

These events led most market participants to reduce their exposure all
round. Banks are frantically trying to limit their exposure, deleverage,
and reduce risk. Bank stocks have plummeted. A global credit crunch is in the making. It is already restricting the flow of funds to the
periphery, but it has also begun to affect the availability of credit in
the domestic economy. The junk bond market, for instance has already shut down.

This brings me to my second point. The pain at the periphery has become so intense that individual countries have begun to opt out of the global capitalist system, or simply fall by the wayside. First Indonesia, then Russia have suffered a pretty complete breakdown but what has happened in Malaysia and to a lesser extent in Hong Kong is in some ways even more ominous. The collapse in Indonesia and Russia was unintended, but Malaysia opted out deliberately. It managed to inflict considerable damage on foreign investors and speculators and it managed to obtain some temporary relief, if not for the economy, then at least for the rulers of the country. The relief comes from being able to lower interest rates and to pump up the stock market by isolating the country from the outside
world and squeezing short sellers. The relief is bound to be temporary
because the borders are porous and money will leave the country illegally; the effect on the economy will be disastrous but the local capitalists who are associated with the regime will be able to salvage their businesses unless the regime itself is toppled. The measures taken by Malaysia will hurt the other countries which are trying to keep their financial markets open because it will encourage the flight of capital. In this respect Malaysia has embarked on a beggar-thy-neighbor policy. If this makes Malaysia look good in comparison with its neighbors, the policy may easily find imitators, making it harder for others to keep their markets open.

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 programs do not seem to be working; in addition, 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 in this respect: 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.

These three factors are working together to reinforce the reverse flow of capital from the periphery to the center. The initial shock caused by the meltdown in Russia is liable to wear off, but the strain on the periphery is liable to continue. The flight of capital has now spread to Brazil and if Brazil goes, Argentina will be endangered. There is general panic in Latin America. Forecasts for global economic growth are being steadily scaled down and I expect they will end up in negative territory. If and when the decline spreads to our economy, we may become much less willing to accept the imports which are necessary to feed the reverse flow of capital and the breakdown in the global financial system may be accompanied by a breakdown in international free trade.

This course of events can be prevented only by the intervention of the
international financial authorities. The prospects are dim, because the
G7 governments have 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 the global capitalist system. As the
Russian example has shown, the problems will become progressively more intractable the longer they are allowed to fester.

The rethinking must start with the recognition that financial markets are inherently unstable. The global capitalist system is based on the belief that financial markets, left to their own devices, tend towards
equilibrium. They are supposed to move like a pendulum: they may be
dislocated by external forces, so-called exogenous shocks, but they will
seek to return to the equilibrium position. This belief is false.
Financial markets are given to excesses and if a boom/bust sequence
progresses beyond a certain point it will never revert to where it came
from. Instead of acting like a pendulum financial markets have recently
acted more like a wrecking ball, knocking over one economy after another.

There is much talk about imposing market discipline but, imposing market discipline means imposing instability, and how much instability can society take? Market discipline needs to be supplemented by another discipline: maintaining stability in financial markets ought to be the objective of public policy. This is the general principle that I should
like to propose.

Despite the prevailing belief in free markets this principle has already
been accepted and implemented on a national scale. We have the Federal Reserve and other financial authorities whose mandate is to prevent a breakdown in our domestic financial markets and if necessary act as lenders of last resort. I am confident that they are capable of carrying out their mandate. But we are sadly lacking in the appropriate financial authorities in the international arena. We have the Bretton Woods institutions, — the IMF and the World Bank — which have tried valiantly to adapt themselves to rapidly changing circumstances. Admittedly the IMF programs have not been successful in the current global financial crisis; its mission and its methods of operation need to be reconsidered. I believe additional institutions may be necessary. At the beginning of this year I proposed establishing an International Credit Insurance
Corporation, but at that time it was not yet clear that the reverse flow
of capital would become such a serious problem and my proposal fell flat.

I believe its time has now come. We shall have to establish some kind of international supervision over the national supervisory authorities. We shall also have to reconsider the workings of the international banking system and the functioning of the swap and derivative markets.

These issues are beyond the competence of Congress. There is, however, one issue which is very much within its purvue. That is the request to authorize an increase in the capital of the IMF. I am aware that Congress was greatly influenced by the testimony given by George Schultz opposing such an increase. I hope my remarks will serve to contradict that testimony.

George Schultz argued that it is better if markets are allowed to look
after themselves than if they are looked after by regulators. There is an element of truth in his argument: regulators do make mistakes. The IMF approach clearly did not work, otherwise we would not find ourselves in the current situation. But that does not mean that financial markets can look after themselves. Everybody looking out for his or her self-interest does not lead to equilibrium but to what Alan Greenspan called irrational exuberance and afterwards panic.

George Schultz inveighed against the moral hazard of bailing out
irresponsible investors and speculators. Here he has a valid point.
Bailouts did encourage irresponsible behavior not so much by speculators — because we know that we have to take our lumps when markets decline — but by banks and other lenders who could count on the IMF coming in when a country got into difficulties. The IMF imposed tough conditions on the country concerned but it did not impose any penalties on the lenders. This asymmetry in the treatment of lenders and borrowers is a major source of instability in the global capitalist system and it needs to be corrected. It has to be a focal point in the soul searching that the IMF must undergo, but I am glad to say that the IMF is learning fast. In its $2.2 billion program in Ukraine, it is imposing a new condition: 80% of Ukraine’s treasury bills have to be “voluntarily” rescheduled into longer-term, lower yielding instruments before the program can go forward. This is a long way from the Mexican bailout of 1995 where the holders of Mexican treasury bills came out whole.

The moral hazard now operates in the opposite direction; in not enabling the IMF to do its work when it is most needed. Congress bears an awesome responsibility for keeping the IMF alive. I am convinced that the attitude of the Congress was already an important element in the failure to deal with Russia. As you probably know I have foundations in many of the formerly communist countries. Some of these countries are badly hit by the fallout from the Russian collapse. Countries like Moldova and Romania have no one else to turn to but the IMF. The IMF is perfectly capable of assisting them. It would be tragic if it ran out of resources.

Replenishing the capital of the IMF will not be sufficient to resolve the
global financial crisis. A way has to be found to provide liquidity not
only at the center but also at the periphery. I believe there is an
urgent need for the creation of Special Drawing Rights which can be used to guarantee the rollover of the already existing debt of countries which receive the IMF’s seal of approval. If there is no reward for good
behavior, meltdowns and defections will multiply. But such radical ideas
cannot even be considered until Congress changes its attitude towards
international institutions and the IMF in particular.

So far our stock market has escaped relatively unscathed and our economy has actually benefitted from the global crisis but make no mistake: unless Congress is willing to support the IMF, the disintegration of the global capitalist system will hurt our financial markets and our economy as well because we are at the center of that system.”

In the future we will move to best interest, this will happen when the financial markets collapse. Then I believe people will be open to new ideas.