December 22,
2008http://www.realclearmarkets.com/articles/2008/12/the_theory_of_market_equilibri.html
The Theory of Market Equilibrium
Is Wrong
ByGeorge Soros
We are in the midst of the worst financial crisis since the
1930s. The salient feature of the crisis is that it was not caused by some
external shock like OPEC raising the price of oil. It was generated by the
financial system itself. This fact - a defect inherent in the system -
contradicts the generally accepted theory that financial markets tend toward
equilibrium and deviations from the equilibrium occur either in a random manner
or are caused by some sudden external event to which markets have difficulty in
adjusting. The current approach to market regulation has been based on this
theory, but the severity and amplitude of the crisis proves convincingly that
there is something fundamentally wrong with it.
We are in the midst of the worst financial
crisis since the 1930s. The salient feature of the crisis is that it was not
caused by some external shock like OPEC raising the price of oil. It was
generated by the financial system itself. This fact - a defect inherent in the
system - contradicts the generally accepted theory that financial markets tend
toward equilibrium and deviations from the equilibrium occur either in a random
manner or are caused by some sudden external event to which markets have
difficulty in adjusting. The current approach to market regulation has been
based on this theory, but the severity and amplitude of the crisis proves
convincingly that there is something fundamentally wrong with it.
I have developed an alternative theory which
holds that financial markets do not reflect the underlying conditions
accurately. They provide a picture that is always biased or distorted in some
way or another. More importantly, the distorted views held by market
participants and expressed in market prices can, under certain circumstances,
affect the so-called fundamentals that market prices are supposed to reflect.
I call this two-way circular connection
between market prices and the underlying reality "reflexivity." I
contend that financial markets are always reflexive and on occasion they can
veer quite far away from the so-called equilibrium. In other words, financial
markets are prone to producing bubbles.
The current crisis originated in the
subprime mortgage market. The bursting of the UShousing bubble acted as a
detonator that
exploded a much larger super-bubble that started developing in the 1980s when
market fundamentalism became the dominant creed. That creed led to
deregulation, globalization, and financial innovations based on the false
assumption that markets tend toward equilibrium.
The house of cards has now collapsed. With
the bankruptcy of Lehman Brothers in September 2008, the inconceivable
happened: The financial system went into cardiac arrest. It was immediately put
on artificial respiration: The authorities in the developed world effectively
guaranteed that no other important institution would be allowed to fail.
But countries at the periphery of the global
financial system could not provide equally credible guarantees. This
precipitated capital flight from countries in Eastern Europe, Asia,
and Latin America. All currencies fell against the dollar and
the yen. Commodity prices dropped like a stone, and interest rates in emerging
markets soared.
The race to save the international financial
system is still in progress. Even if it is successful, consumers, investors,
and businesses are undergoing a traumatic experience whose full impact is yet
to be felt. A deep recession is inevitable and the possibility of a depression
cannot be ruled out.
So what is to be done?
Because financial markets are prone to
creating asset bubbles, regulators must accept responsibility for preventing
them from growing too big. Until now, financial authorities have explicitly
rejected that responsibility.
Of course, it is impossible to prevent
bubbles from forming, but it should be possible to keep them within tolerable
bounds. This cannot be done simply by controlling the money supply. Regulators
must also take into account credit conditions, because money and credit do not
move in lockstep. Markets have moods and biases, which need to be
counterbalanced. To control credit as distinct from money, additional tools
must be employed - or, more accurately, reactivated, since they were used in
the 1950s and 1960s. I refer to varying margin requirements and the minimal
capital requirements of banks.
Today's sophisticated financial engineering
can render the calculation of margin and capital requirements extremely
difficult, if not impossible. Therefore new financial products must be
registered and approved by the appropriate authorities before being sold.
Counterbalancing the mood of the market
requires judgment, and because regulators are human, they are bound to get it
wrong. They have the advantage, however, of getting feedback from the market,
which should enable them to correct their mistakes. If a tightening of margin
and minimum capital requirements does not deflate a bubble, regulators can
tighten some more. But the process is not foolproof, because markets can also
be wrong. The search for the optimum equilibrium is a never-ending process of
trial and error.
This cat-and-mouse game between regulators
and market participants is already ongoing, but its true nature has not yet
been acknowledged. Alan Greenspan, the former US Federal Reserve chairman, was
a master of manipulation with his Delphic utterances, but instead of
acknowledging what he was doing, he pretended that he was merely a passive
observer. That is why asset bubbles could grow so large during his tenure.
Because financial markets are global, regulations
must also be international in scope. In the current situation, the
International Monetary Fund (IMF) has a new mission in life: to protect the
periphery countries against the effects of storms that originate at the center,
namely the United States.
The USconsumer can no longer serve as the motor
of the world economy. To avoid a global depression other countries must also
stimulate their domestic economies. But periphery countries without large
export surpluses are not in a position to employ countercyclical policies. It
is up to the IMF to find ways to finance countercyclical fiscal deficits. This
could be done partly by enlisting sovereign wealth funds and partly by issuing
Special Drawing Rights so that rich countries that can finance their own fiscal
deficits could cede to poorer countries that cannot.
While international regulation must be
strengthened for the global financial system to survive we must also beware of
going too far. Markets are imperfect but regulations are even more so.
Regulators
are not only human; they are also bureaucratic and subject to political
influences. Regulations should be kept to the minimum necessary to maintain
stability.
** George Soros is Chairman
of Soros Fund Management.
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