Martin Wolf of the London Financial Times said all the leading explanations of the current financial crisis have something to them:  "Global macroeconomic imbalances played a huge part in driving monetary policy decisions.  These, in turn, led to house-price bubbles and huge financial excesses, particularly in securitized assets."[1]  --  For George Soros, the present crisis has something unprecedented about it:  "[T]he current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency.  The periodic crises were part of a larger boom-bust process.  The current crisis is the culmination of a super-boom that has lasted for more than 60 years."[2]  --  Unlike earlier boom-bust cycles that have to do principally with credit, wrote Soros on Tuesday, also in the Financial Times, the present situation will lead to a painful appreciation of new realities:  "Credit expansion must now be followed by a period of contraction, because some of the new credit instruments and practices are unsound and unsustainable.  The ability of the financial authorities to stimulate the economy is constrained by the unwillingness of the rest of the world to accumulate additional dollar reserves.  Until recently, investors were hoping that the U.S. Federal Reserve would do whatever it takes to avoid a recession, because that is what it did on previous occasions.  Now they will have to realize that the Fed may no longer be in a position to do so.  With oil, food, and other commodities firm, and the renminbi appreciating somewhat faster, the Fed also has to worry about inflation.  If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield.  Where that point is, is impossible to determine.  When it is reached, the ability of the Fed to stimulate the economy comes to an end."  --  The significance of these developments goes far beyond economic cycles to fundamental geopolitics:  "[T]he current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the U.S. and the rise of China and other countries in the developing world." ...

1.

Columnists

THE FINANCIAL TURMOIL IS LIKE AN ELEPHANT IN A DARK ROOM
By Martin Wolf

Financial Times (London)
January 22, 2008

http://www.ft.com/cms/s/0/18083bfa-c8f8-11dc-b14b-0000779fd2ac.html

“I was gradually coming to believe that the U.S. economy’s greatest strength was its resiliency -- its ability to absorb disruptions and recover, often in ways and at a pace you’d never be able to predict, much less dictate.” —Alan Greenspan, The Age of Turbulence.

We all hope that Mr. Greenspan proves right about the U.S. economy. The Federal Reserve’s rate cut on Tuesday will succeed if Mr. Greenspan’s view is correct. Yet many fear he is wrong. Many, too, blame him for the current mess. So how did the world economy fall into its predicament?

One view is that this crisis is a product of a fundamentally defective financial system. An email I received this week laid out the charge: the crisis, it asserted, is the product of “greedy, immoral, solely self-interested, and self-delusional decisions made throughout the 2000s, and earlier, by very real human beings at the very top of the financial food chain.”

The argument would be that a liberalized financial system, which offers opportunities for extraordinary profits, has a parallel capacity for generating self-feeding mistakes. The story is familiar: financial innovation and an enthusiasm for risk-taking generate rapid increases in credit, which drive up asset prices, thereby justifying still more credit expansion and yet higher asset prices. Then comes a top to asset prices, panic selling, a credit freeze, mass insolvency and recession. An unregulated credit system, then, is inherently unstable and destabilizing.

This is the line of argument associated with the late Hyman Minsky, who taught at Washington University, St Louis. George Magnus of UBS distinguished himself by arguing early that the present crisis is a “Minsky moment”: “A collapse of debt structures and entities in the wake of asset price decay, the breakdown of ‘normal’ banking functions and the active intervention of central banks.” This follows an extraordinary dependence on credit growth in the recent cycle (see chart).

[INSET GRAPHS: 1) U.S. credit intensity of GDP growth; 2) Fed interest rates and the 'Taylor rule']

Economists would offer contrasting explanations for this fragility. One is in terms of rational responses to incentives. Another is in terms of the short-sightedness of human beings. The contrast is between misdirected intelligence and folly.

Those who emphasize rationality can readily point to the incentives for the financial sector to take undue risk. This is the result of the interaction of “asymmetric information” -- the fact that insiders know more than anybody else what is going on -- with “moral hazard” -- the perception that the government will rescue financial institutions if enough of them fall into difficulty at the same time. There is evident truth in both propositions: if, for example, the U.K. government feels obliged to rescue a modest-sized mortgage bank, such as Northern Rock, moral hazard is rife.

Yet it is also evident that everybody involved -- borrowers, lenders, and regulators -- can be swept away in tides of all-too-human euphoria and panic. To err is human. That is one of the reasons regulation is rarely countercyclical: regulators can be swept away, as well. The financial deregulation and securitization of the most recent cycle merely encouraged an unusually wide circle of people to believe they would be winners, while somebody else would bear the risks and, ultimately, the costs.

Yet there is a different perspective. The argument here is that U.S. monetary policy was too loose for too long after the collapse of the Wall Street bubble in 2000 and the terrorist outrage of September 11, 2001. This critique is widely shared among economists, including John Taylor of Stanford University.* The view is also popular in financial markets: “It isn’t our fault; it’s the fault of Alan Greenspan, the ‘serial bubble blower.’”

The argument that the crisis is the product of a gross monetary disorder has three variants: the orthodox view is simply that a mistake was made; a slightly less orthodox view is that the mistake was intellectual -- the Fed’s determination to ignore asset prices in the formation of monetary policy; a still less orthodox view is that man-made (fiat) money is inherently unstable. All will then be solved when, as Mr. Greenspan himself believed, the world goes back on to gold. Human beings must, like Odysseus, be chained to the mast of gold if they are to avoid repeated monetary shipwrecks.

[INSET GRAPHS: 1) Global foreign exchange reserves; 2) Commodities and gold]

A final perspective is that the crisis is the consequence neither of financial fragility nor of mistakes by important central banks. It is the result of global macroeconomic disorder, particularly the massive flows of surplus capital from Asian emerging economies (notably China), oil exporters, and a few high-income countries, and, in addition, the financial surpluses of the corporate sectors of many countries.

In this perspective, central banks and so financial markets were merely reacting to the global economic environment. Surplus savings meant not only low real interest rates, but a need to generate high levels of offsetting demand in capital-importing countries, of which the U.S. was much the most important.

In this view (which I share) the Fed could have avoided pursuing what seem like excessively expansionary monetary policies only if it had been willing to accept a prolonged recession, possibly a slump. But it had neither the desire nor, indeed, the mandate to allow any such thing. The Fed’s dilemma then was that the only way to sustain domestic demand at levels high enough to offset the capital inflow (both private and official) was via a credit boom. This generated excessively high asset prices, particularly in housing. It has left, as a painful legacy, stretched balance sheets in both the non-financial and financial sectors: debt deflation, here, alas, we come.

When I read these analyses, I am reminded of the story in which four people are told to go into a dark room, hold on to whatever they find and then say what it is. One says it is a snake. Another says it is a leathery sail. A third says it is a tree trunk. The last says it is a pull rope.

It is, of course, an elephant. The truth is that an accurate story would be a combination of the various elements. Global macroeconomic imbalances played a huge part in driving monetary policy decisions. These, in turn, led to house-price bubbles and huge financial excesses, particularly in securitized assets. Now policymakers are forced to deal with today’s symptoms as best they can. But they must also tackle the underlying causes if further huge disturbances are not to come along. What those responses should ideally be at both national and global levels will be the subject of my post-World Economic Forum column next week.

*Housing and Monetary Policy, September 1 2007, www.kc.frb.org

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2.

Comment & analysis

Comment

THE WORST MARKET CRISIS IN 60 YEARS
By George Soros

Financial Times (London)
January 22, 2008

http://www.ft.com/cms/s/0/24f73610-c91e-11dc-9807-000077b07658.html

The current financial crisis was precipitated by a bubble in the U.S. housing market. In some ways it resembles other crises that have occurred since the end of the Second World War at intervals ranging from four to 10 years.

However, there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.

Boom-bust processes usually revolve around credit and always involve a bias or misconception. This is usually a failure to recognize a reflexive, circular connection between the willingness to lend and the value of the collateral. Ease of credit generates demand that pushes up the value of property, which in turn increases the amount of credit available. A bubble starts when people buy houses in the expectation that they can refinance their mortgages at a profit. The recent U.S. housing boom is a case in point. The 60-year super-boom is a more complicated case.

Every time the credit expansion ran into trouble the financial authorities intervened, injecting liquidity and finding other ways to stimulate the economy. That created a system of asymmetric incentives also known as moral hazard, which encouraged ever greater credit expansion. The system was so successful that people came to believe in what former U.S. president Ronald Reagan called the magic of the marketplace and I call market fundamentalism. Fundamentalists believe that markets tend towards equilibrium and the common interest is best served by allowing participants to pursue their self-interest. It is an obvious misconception, because it was the intervention of the authorities that prevented financial markets from breaking down, not the markets themselves. Nevertheless, market fundamentalism emerged as the dominant ideology in the 1980s, when financial markets started to become globalized and the U.S. started to run a current account deficit.

Globalization allowed the U.S. to suck up the savings of the rest of the world and consume more than it produced. The U.S. current account deficit reached 6.2 per cent of gross national product in 2006. The financial markets encouraged consumers to borrow by introducing ever more sophisticated instruments and more generous terms. The authorities aided and abetted the process by intervening whenever the global financial system was at risk. Since 1980, regulations have been progressively relaxed until they have practically disappeared.

The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility.

Everything that could go wrong did. What started with subprime mortgages spread to all collateralized debt obligations, endangered municipal and mortgage insurance and reinsurance companies, and threatened to unravel the multi-trillion-dollar credit default swap market. Investment banks’ commitments to leveraged buyouts became liabilities. Market-neutral hedge funds turned out not to be market-neutral and had to be unwound. The asset-backed commercial paper market came to a standstill and the special investment vehicles set up by banks to get mortgages off their balance sheets could no longer get outside financing. The final blow came when interbank lending, which is at the heart of the financial system, was disrupted because banks had to husband their resources and could not trust their counterparties. The central banks had to inject an unprecedented amount of money and extend credit on an unprecedented range of securities to a broader range of institutions than ever before. That made the crisis more severe than any since the Second World War.

Credit expansion must now be followed by a period of contraction, because some of the new credit instruments and practices are unsound and unsustainable. The ability of the financial authorities to stimulate the economy is constrained by the unwillingness of the rest of the world to accumulate additional dollar reserves. Until recently, investors were hoping that the U.S. Federal Reserve would do whatever it takes to avoid a recession, because that is what it did on previous occasions. Now they will have to realize that the Fed may no longer be in a position to do so. With oil, food, and other commodities firm, and the renminbi appreciating somewhat faster, the Fed also has to worry about inflation. If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an end.

Although a recession in the developed world is now more or less inevitable, China, India, and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the U.S. and the rise of China and other countries in the developing world.

The danger is that the resulting political tensions, including U.S. protectionism, may disrupt the global economy and plunge the world into recession or worse.

--The writer is chairman of Soros Fund Management.