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A Soros Solution for the Global Meltdown03-16 08:31 Caijing comments( 0 )"It's the end of an era, as far as the United States is concerned, because theprosperity was built on a false foundation." – George SorosBy staff reporter Ye Weiqiang(Caijing Magazine) What are the economic realities behind and possible solutionsfor the crisis gripping U.S. banks, emerging markets and the entire financial world?Caijing finance editor Ye Weiqiang traveled to New York to pose this and otherquestions to U.S. billionaire investor George Soros. Their discussion follows:CJ: How do you identify economic cycles?Soros: I have developed a theory about the financial market -- it

s really aphilosophy -- which is at variance with the general theory, and it has given meperhaps a certain ability to identify bubbles when they develop. The prevailingtheory, which is called efﬁcient market hypothesis, holds that the market alwaysreﬂects adequately or accurately all available information. I think this is false. I havea different hypothesis, which consists of two principles. One is that the marketalways distorts the available information. First of all, the market has to deal with thefuture, and the future is not predictable, and it always has a biased view, in someway a distorted view from the reality -- that

s the first principle. The second principleis reflexibility, as I call it. It says that mispricing of financial prices can have a way ofaffecting or changing the fundamentals of prices they are supposed to reflect.So the two-way connection between the markets and the underlying reality is thatthe markets not only passively reflect, but also affect reality, and I call it the principleof reflexibility. This crisis now, I think, has proven that the effective markethypothesis is wrong. I think my interpretation provides a better understanding ofwhat is happening.Based on this general of reflexibility, I have in particular talked about what ishappening now. The theory of bubbles is that to have a bubble, you have to havesome trend that actually prevails over the reality, and there has to be amisconception about the trend, and the reflective interaction between those twocan give rise to these bubbles that both the trend and the misconception mutuallyreinforce, and then eventually it becomes unsustainable, and it bursts. That

s thecharacter of a bubble. It

s not the only form of reﬂexibility, but it

s very dramatic formbecause bubbles can be very powerful.I have a special theory hypothesis with regard to what

s happening now. I say thatthe housing bubble in the U.S. was a regular small bubble but it acted like anatomic bomb -- a super-bubble which has been growing since the 1980s. So that

swhy this crisis is not like other crises.

CJ: Is it good to change the game?Soros: It

s not something you can control. It

s out of control. This is the situationnow. The global financial structure has collapsed, so private sector credit hascollapsed, and the financial system is actually broken. There is now artificial lifesupport from the authorities.CJ: Is faith in the authorities failing?Soros: Yes. It

s more than conﬁdence because, in reality, the international bankingsystem has become largely insolvent. So it

s not just the problem of liquidity butalso solvency; bank assets are falling in value, and so their liability exceeds theirassets, and that means they are effectively insolvent.CJ: Is nationalization necessary at this point?Soros: Nationalization is a false label. Since the banks lost a lot of capital, and theprivate sector is not willing to replace the capital, the government has to do it. Andone case when they decided not to do it, Lehman Brothers, set in motion thiscollapse.The governments have determined not to let any other institutions that couldendanger this system fail, so they are keeping them artiﬁcially alive. But it

s notenough to keep them alive; you also have to recapitalize them, and has to be doneby the government.But there is a big problem in emerging markets on the periphery of the system,where governments are not strong enough to provide guarantees for the bankingsystem. The capital is moving out, creating a worse crisis than in the United States.CJ: What is the current debate?Soros: It looks like the government is not willing or able to recapitalize the banks ina way that will give them adequate capital to lend; all they do is prevent the banksfrom collapsing.CJ: What is the current political barrier?Soros: Unfortunately, the previous administration spent US$ 700 billion in anineffective way, and it

s now politically difﬁcult to secure additional funds neededfor proper recapitalization.CJ: What

s the government

s best course?Soros: I advocate separating the existing assets of the banks and leaving the

existing capital to be responsible… to suffer ﬁrst loss, if the value of the assetsdecline, and put new capital into the future business of the bank. So separate pastbusinesses from future businesses, and create a clean bank within the bank, whichis not weighed down by these toxic assets that are losing value. And then put thenew capital either from the private sector and the government into this new bank.Then this new bank would have adequate capital and would be eager to lend. Thatwould restart the economy.CJ: What

s the government

s approach, in reality?Soros: The government is examining the balance sheets of banks, and that

ll takeuntil the end of April. Then the decision will have to be made what to do in the caseof individual banks. So the government is on the way, but for the time being it takestime to prepare and decide.CJ: What should we consider when banks privatize?Soros: You now have conditional collapsing credit; that

s very far from normal. Youcan

t get back to normal in a simple way; you have to ﬁrst replace the credit withgovernment credit, which means effectively creating money, increasing the balancesheet of the Federal Reserve Bank. But that

s too technical; it really means creatingmoney. But when credit is restarted, and you put this very big base of money,suddenly the danger of deﬂation would be replaced by the danger of inﬂation, andthen you have to shrink the money supply as far as credit is increased. So you havetwo steps: First you have to increase the money supply to replace shrinking credit,and then you have to reduce the money supply to offset the growth of credit.CJ: After recapitalization, should the government control bank system decision-making?Soros: No. The governments should regulate, but government is not suited to makeeconomic decisions. It should regulate the amount of credit available, but how thecredit is used should be determined by economic actors. Of course, thegovernment is an economic actor itself responsible for a very large part ofeconomic activity. But it

s not the only actor; it needs counterparties to balance.CJ: How do you value toxic assets?Soros: You don

t value it; you avoid the valuation problem. If you separate andauction it, then you will have to value it. But if you just keep it in the bank, and youkeep the capital of the bank, the equity, and the subordinated debt to cover thoseassets, then you can wait and allow assets to be gradually liquidated. Then you willdetermine whether there is anything left for shareholders. What are values? Itdepends on the asset. Probably the asset will recover some value, especially overa long period.