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George Soros

“The new paradigm for financial markets”

published by PublicAffairs USA 2008

a member by the Perseus Books Group
ISBN 978-1-58648-683-9


The book is divided in two parts. The first part is more philosophical, formulates
George Soros “Theory of reflexivity” and shows its applicability at the financial markets. The
second part of the book is devoted to the financial crisis (the book is finished in April 2008).

Part 1

Central idea of George Soros is that social events have a different structure from
natural phenomena. In natural phenomena there is a causal chain that links one set of facts
directly with the next. In human affairs the course of events is more complicated. Not only the
facts are involved but also the participant’s views and the interplay between them enter into
the causal chain. There is a two-way connection between the facts and opinions prevailing at
any moment: the participants try to understand the situation and also seek to influence it.
Participant’s views introduce an element of uncertainty into the course of events. This two-
way interference is the core idea of George Soros Theory of Reflexivity.

People’s understanding is inherently imperfect because they are part of the reality and
as such they can not comprehend the whole. The understanding is incomplete and distorted.
The misconceptions or the misinterpretations by the participants introduce an element of
genuine indeterminacy into the course of events. The ultimate truth is beyond the reach of the
human intellect, the more the people acquire some insight into reality, the more is to be

The classical economic theory and the “Concept of equilibrium” imitate Newtonian
physics, but in the financial markets, where expectations play an important role, the
contention that markets tend towards equilibrium does not correspond to reality. The
participants on the financial market are often influenced by its developments, the events on
the financial market affect the shape of the demand and supply in contradiction to the
Equilibrium theory. The theory of “Rational expectations” is also wrong because the market
participants do not act on the basis of their best interests but on their perception of their best
interest, thus on a basis of imperfect understanding.

Because financial markets do not tend toward equilibrium they can not be left to their
own devices. Previous periodic crises brought forth regulatory reforms. This is how central
banking and regulation of financial markets are evolving. While boom-bust sequences occur
only intermittently, the reflexivity between financial markets and the financial authorities is
an ongoing process. Both of them are acting on imperfect understanding and that makes this
interaction reflexive. Market fundamentalists blame market failures on the fallibility of the

regulators but they are half wrong: both markets and regulators are fallible. While the
prevailing paradigm acknowledges only the known risks and fails to allow for the
consequences of its own deficiencies and misconceptions, the Theory of reflexivity
recognizes the uncertainties associated with the fallibility of both regulators and market
participants. The Equilibrium theory leaves out of the account the possibility that deviations
may be self reinforcing in the sense that they may alter the theoretical equilibrium and when
this happens, risk calculations and trading techniques based on these models are liable to
break down. The Theory of reflexivity provides a better explanation of how financial markets
function, but it is also less conducive to the manipulation of reality than the currently
prevailing scientific theories because it avoids making excessive claims about its ability to
predict and explain social phenomena. We can not expect reflexive events to be determined
according to timelessly valid generalizations when reflexivity brings an element of
uncertainty and indeterminacy.

Part 2

George Soros acknowledges that the financial crisis is the worst since the Great
Depression, it is not compatible to the other previous crises because it is not confined to a
particular undertaking or segment of the financial system. The crisis has brought the entire
system to the brink of a breakdown. The author’s concept is that this is not just one boom-bust
process or bubble but two: the housing bubble and the long term super-bubble, both bubbles
did not develop in isolation and are part of the history of the last period.

The housing bubble developed following the course of a regular boom-bust model -
ever more aggressive relaxation of lending standards, expansion of loan to value ratios, rising
of house prices, declining of savings, decline in credit quality, growing share of subprime
mortgages, and growth of synthetic financial products. The cross-over point was reached in
August 2007. The market recovery from August until October 2007 was followed by a
collapse in January 2008.

The super-bubble is founded on the misconception of excessive reliance on the market

mechanism - “Market fundamentalism”. It became a dominant doctrine in the 1980s and
combines 3 trends: ever increasing credit expansion, globalization of financial markets and
progressive removal of financial regulations and accelerating the pace of financial
innovations. The international financial system is under the control of a consortium of
financial authorities representing the developed countries, which seek to impose strict market
discipline on individual countries, but are willing to bend the rules when the financial system
is endangered. The way the system works, the US is “more equal” than others – it enjoys veto
power both in IMF and World Bank. This allowed the US to be able to pursue countercyclical
politics. The liberalization sucked up the savings of the world from the periphery to the center
and allowed the US to develop a chronic current account deficit. Since 1980s the US also
developed a large budget deficit.

The current crisis is a cross-over point not just in the housing bubble but also in the
long term bubble, where the subprime crisis was the trigger. It’s an end of an era. This time
the crisis is not confined to a particular segment of financial markets but has endangered the
whole system. The markets have defied the efforts of the financial authorities to bring them
under control. The central banks were slow, may be because they have believed that the
subprime crisis was an isolated phenomenon. Later, their ability to stimulate the economy was
constrained by the unwillingness of the rest of the world to hold dollars, the financial

innovation, which has run amok during the last years and the impaired capital base of the

The Theory of Reflexivity can explain the events better then the prevailing paradigm,
but it can not offer any generalizations. According to the new paradigm events on the
financial market are best interpreted as a history. The past is uniquely determined and the
future is uncertain.

One of the book’s chapters is a history of the financial markets from the period since
World War II until 2007 – the period is characterized by less and less restrictive regulations,
the emerge of Bretton Woods system with fixed but adjustable rates, growth of the banks, new
and sophisticated kinds of financial instruments and start I US (in the 1980s) of a self
reinforcing process in which a strong economy, a strong dollar and large budget and trade
deficits reinforced each other to produce noninflationary growth. The international banking
crisis in the 1980s was contained by the active intervention of the authorities. The IMF and
creditor countries (including central and commercial banks) were used for rescue packages for
debtor countries. In the 1980s under the influence of market fundamentalism, banks in the
USA were granted great freedom to make money and the separation of investment and
commercial banking disappeared (The Glass-Steagall Act, provided for the separation of bank
types according to their business (commercial and investment banking), was introduced in
1933 and revoked by the Gramm-Leach-Bliley Act of 1999). The few crises after the 1980s
did not lead to regulatory reforms; the ability of the system to withstand reaffirmed the market
fundamentalists and led to a further relaxation of the regulatory environment.

After 11.09.2001 the lowering of the federal funds rated to 1% (the US central bank's
most important official interest rate) for a period of almost 3 years engendered the housing
bubble. With the newly invented methods and instruments the regulatory authorities lost their
ability to calculate the risks involved. The Basel 2 agreements allowed the largest banks to
rely on their own risk management systems, which the author considers as a most shocking
abdication of responsibility on the parts of the regulators, because the risk models of the
banks were based on the assumption that the system is stable. The credit expansion became
unchecked, higher standard deviations occurred more frequently. The various synthetic
mortgage securities were based on the assumption that the value of houses in the US would
never decline and the market is stable. The interventions of the regulatory authorities created
moral hazard. The Federal Reserve failed to exercise it’s authority to regulate the mortgage
market and became active when the crisis was already advanced and complicated.

The book ends with an experiment, where George Soros documented his decision
making and made some predictions for 2008. The predictions include harder obtaining credit,
insolvency of financial institutions, changes in banking and investment banking, reversing the
trend of ever looser regulations, no prediction of a prolonged period of credit contraction and
economic decline, because of the economic expansion in India, China and some of the oil-
producing countries, the decline of the dollar as a generally accepted reserve currency with far
reaching political consequences. George Soros is certain that in 2008 the US will slip into
recession, despite the fact that in January most of the economists forecast the chances of that
as less than 50%. One of the predictions is about the financial institutions where unpleasant
surprises are expected. The predictions for Europe and especially for the UK and Spain are
also negative, because of the housing bubble in Spain and because of the importance of
London as a financial center.

The prediction for China is that there also forms a bubble, but it is an early-stage one
still. The recession in the developed world will affect Chinese export and the rate of growth
will slow down, but the bubble will continue to grow. China is expected to challenge the
supremacy of the US much sooner then expected. Source of strength for the world economy
are also India and the oil-producing countries of the Middle East.

The policy recommendations by George Soros are that major new initiatives are to be
expected by the new Democratic US President. Credit creation needs to be regulated in order
to prevent excesses, but should not be put into a straitjacket. Some of the newly introduced
financial instruments should be abandoned, because they have shown themselves as
unsustainable. Risk management should not be left to the participants and the regulators
should not allow practices that they do not fully understand. The financial authorities must
exercise more vigilance and control, they must be concerned not just with the inflation but
also with avoiding assets bubbles, they must take into account not just the money supply but
also the credit conditions. One of the specific measures that must be taken is the establishment
of a clearing house or exchange for credit default swaps (CDS) with a sound capital structure.
Additional measures should be taken to contain the collapse in house prices and the systemic
approach should be accompanied by an individual one, including guarantees that will help
refinance subprime borrowers, amendment of bankruptcy law and loans modifications.


Plamen S. Slavov
Paralegal to
Prof. Dr. René Smits