on Tue, 12 Jun 2012 15:03:44 +0200 (CEST)

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Re: <nettime> Nightmare or Opening? the Soros perspective

Frederic Janssens wrote me to say that a recent article by George Soros was
the best thing he had read about the Euro crisis. He's right, it's quite a
good read. I am going to pick out the key paragraphs and offer some
comments. At the end there is a technical bit I do not understand, and if
anyone else has an explanation it would be great! The whole text is here:

Soros starts out with his main idea as a financier: that market
participants are both fallible and self-reflexive. They make mistakes and
they readjust their moves according to their perceptions of the boomerang
effects that they and other participants have had on market dynamics.
Intervene, observe, imagine what will happen next and intervene again.
Soros has been proposing this for years. His obvious and intuitive approach
flies in the face of all of the neoclassical market theory promoted by
Hayek, Friedman and their ilk:

"Social events... have thinking participants who have a will of their own.
They are not detached observers but engaged decision makers whose decisions
greatly influence the course of events. Therefore the events do not
constitute an independent criterion by which participants can decide
whether their views are valid... Economics, which became the most
influential of the social sciences, sought to remove this handicap by
taking an axiomatic approach similar to Euclid's geometry. But Euclid's
axioms closely resembled reality while the theory of rational expectations
and the efficient market hypothesis became far removed from it...

"I am not well qualified to criticize the theory of rational expectations
and the efficient market hypothesis because as a market participant I
considered them so unrealistic that I never bothered to study them. That is
an indictment in itself but I shall leave a detailed critique of these
theories to others."

Austrian neoclassical economics is - or was? - an amazing phenomenon. We
have - or had? - an academic theory of self-regulating markets (naturally
tending toward efficient allocation of goods and price equilibrium) which
serves - or served? - only to convince politicians and regulators that
everything was fine. Economic actors had no reason to even learn these
theories. Soros was far from alone in undrstanding this. Everyone directly
involved with the markets necessarily understood this. Alan Greeenspan, who
only recently claimed there was a "flaw in his theory," was continuously
involved with gigantic reflexive actions to stave off each successive
financial collapse, from the Mexican loan crisis of 1982, to the 1987 Black
Monday which was the prototypical computerized trading crisis, to the
Tequila Crisis of 1994 and the far bigger 1997 Asian-Russian-Latin American
crisis, to the dot-com bust in 2000. Each time he played his role by
pumping huge amounts of federal and private dollars into the maelstrom.
This gave rise to the belief in a Washington-based "Plunge Protection Team"
continuously operating to make the financial system viable. More
pertinently, it gave rise to the doctrine of "too big to fail." So in other
words, the very people whose authority rested on the efficient-markets and
equilibrium theories were constantly intervening self-reflexively to create
the appearance of the validity of those theories. And that's still going on
today even though the theories have been discredited by the facts. I think
the higher level academic economists should be divested of their positions
and some should be thrown in jail for profiting off their obvious lies. For
a good example, see Charles Ferguson's movie "Inside Job" and in
particular, its treatment of an academic and former governor of the Fed
named Frederic Mishkin (for more on this controversy check and

Soros continues:

"Among other things, I developed a model of a boom-bust process or bubble
which is endogenous to financial markets, not the result of external
shocks. According to my theory, financial bubbles are not a purely
psychological phenomenon. They have two components: a trend that prevails
in reality and a misinterpretation of that trend. A bubble can develop when
the feedback is initially positive in the sense that both the trend and its
biased interpretation are mutually reinforced. Eventually the gap between
the trend and its biased interpretation grows so wide that it becomes
unsustainable. After a twilight period both the bias and the trend are
reversed and reinforce each other in the opposite direction. Bubbles are
usually asymmetric in shape: booms develop slowly but the bust tends to be
sudden and devastating. That is due to the use of leverage: price declines
precipitate the forced liquidation of leveraged positions.

"Well-formed financial bubbles always follow this pattern but the magnitude
and duration of each phase is unpredictable. Moreover the process can be
aborted at any stage so that well-formed financial bubbles occur rather

The neoclassical theories postulate a closed system, where production
increases along a predictable growth-curve and all monetary inputs to the
world market cancel each other out around a point of equilibrium that
defines the proper price of everything. That's a negative or
self-correcting feedback model which can absorb lots of data but does not
allow for any modeling of systemic change. The Soros approach is a
second-order cybernetic model based on both positive and negative feedback.
This is great for the short-term understanding of bubbles: everyone
involved in the financial markets uses such models. They constantly "make"
the market (establishing an advantageous price through major placements of
capital) and then they "pull out" of the market just when they calculate
that its trend is about to reverse. However, when political regulation gets
involved, then something else comes in. This is the possibility of systemic
change. By using their bubble models financiers profit from every
successive crisis; and then the Treasury departments come in and clean up
the mess. Soros is highly aware that the structure of market interactions
is set by more-or-less arbitrary and fallible political decisions, which
provide both the underlying parameters for market activities, and the
more-or-less predictable forms of intervention to stave off market failure.
So he goes on:

"According to my theory financial markets may just as soon produce bubbles
as tend toward equilibrium. Since bubbles disrupt financial markets,
history has been punctuated by financial crises. Each crisis provoked a
regulatory response. That is how central banking and financial regulations
have evolved, in step with the markets themselves. Bubbles occur only
intermittently but the interplay between markets and regulators is ongoing.
Since both market participants and regulators act on the basis of imperfect
knowledge the interplay between them is reflexive. Moreover reflexivity and
fallibility are not confined to the financial markets; they also
characterize other spheres of social life, particularly politics. Indeed,
in light of the ongoing interaction between markets and regulators it is
quite misleading to study financial markets in isolation. Behind the
invisible hand of the market lies the visible hand of politics. Instead of
pursuing timeless laws and models we ought to study events in their time
bound context."

Great, I agree. Except when he says "politics," it's a bit too vague. Maybe
he should say "statecraft" and "electioneering," so as to get at the
interplay between the kinds of closed-room decisions made by career
politicians and top functionaries, on the one hand, and the need to justify
those decisions in the public popularity contest of the news and the
elections, on the other. Obviously the process of justification and
vote-courting has some reflexive influence on the regulatory actions.
That's an important part of the "time bound context" in my view. Anyway,
he's totally right that mathematical laws do not have much to do with it.
Models of timeless natural laws are useless in human affairs. On the other
hands, the attempt to build dynamic models, to adjust them en route and
then abandon them when they don't work any more, has everything to do with
reflexive intervention. Not only for financiers but also for politicians
and even for citizens. Let's have a look at the Soros view of the political
model known as the EU single currency:

"The Maastricht Treaty was fundamentally flawed, demonstrating the
fallibility of the authorities. Its main weakness was well known to its
architects: it established a monetary union without a political union. The
architects believed however, that when the need arose the political will
could be generated to take the necessary steps towards a political union.

"But the euro also had some other defects of which the architects were
unaware and which are not fully understood even today. In retrospect it is
now clear that the main source of trouble is that the member states of the
euro have surrendered to the European Central Bank their rights to create
fiat money. They did not realize what that entails -- and neither did the
European authorities. When the euro was introduced the regulators allowed
banks to buy unlimited amounts of government bonds without setting aside
any equity capital; and the central bank accepted all government bonds at
its discount window on equal terms. Commercial banks found it advantageous
to accumulate the bonds of the weaker euro members in order to earn a few
extra basis points. That is what caused interest rates to converge which in
turn caused competitiveness to diverge. Germany, struggling with the
burdens of reunification, undertook structural reforms and became more
competitive. Other countries enjoyed housing and consumption booms on the
back of cheap credit, making them less competitive. Then came the crash of
2008 which created conditions that were far removed from those prescribed
by the Maastricht Treaty. Many governments had to shift bank liabilities on
to their own balance sheets and engage in massive deficit spending. These
countries found themselves in the position of a third world country that
had become heavily indebted in a currency that it did not control. Due to
the divergence in economic performance Europe became divided between
creditor and debtor countries...

"It took some time for the financial markets to discover that government
bonds which had been considered riskless are subject to speculative attack
and may actually default; but when they did, risk premiums rose
dramatically. This rendered commercial banks whose balance sheets were
loaded with those bonds potentially insolvent. And that constituted the two
main components of the problem confronting us today: a sovereign debt
crisis and a banking crisis which are closely interlinked."

The euro acts (as Keith Hart observed) somewhat like a gold standard,
imposing economic discipline on those who use it. You can't just print
money when you need it (as with fiat currencies) and eventually, accounts
have to balance. This discipline is relaxed by the simple fact of emitting
bonds, or in other words, asking for loans: which was done by practically
everyone, both private and public, especially on the edges of Europe. And
of course, the people used their credit cards to keep up with the Joneses.
People everywhere refinanced their houses and the result of all that
borrowing was the overleveraged banking system that we have before our

Soros is obviously right to point out that Germany's structural reforms
(such as the Hartz IV welfare cuts, undertaken by the SPD under the
increasingly strict and more-or-less neoclassical guidance of the
ordo-liberal economists who are directly behind Merkel) was a sharp
exception to this pattern of easy credit. (To understand what German
neoliberalism looks like, check this:
But the only reason the reforms worked was because Germany could sell its
disciplined industrial production to debtor countries, whose governments
and major businesses bought infrastructure products by megacorporations
like Siemens while their citizens bought cars from Volkswagen and BMW and
luxury household fixtures from hundreds of smaller companies, all with
borrowed money. The inability of small borrowers to pay their loans
provoked the crisis of confidence in sovereign bonds: because when citizens
go broke there are no tax revenues for their governments, and then
countries cannot pay the interest on the bonds they took out in order to
pay welfare entitlements and float showy new projects in order to gain
popularity for reelection. It is at this point that the financial markets
exert discipline by refusing to pay for more bond issues. And then
ordo-liberal Germany exerts further discipline by refusing any massive
bailout using central-bank fiat money. So this is the political part of the

Why does the German government under Merkel do this? Because it wants to
maintain a situation which is currently working very well for the German
economy, whose China business is also booming. Germany has cornered
high-end productive technology in Europe and it is producing prosperity for
lots of people. Exerting financial discipline in hopes of prolonging this
prosperity is now a ticket for reelection. The knot is knotted.

It is still quite possible that what will emerge from all this, under the
pressure of a crisis situation, is a fiscal union of Europe with a central
bank much more like the American Fed and very tight economic rules that
force the so-called "peripheral" countries to bring spending in line with
production. The crisis would then be a Hegelian "ruse of history" prompting
further progress toward the rationalization of government and the
integration of a European super-state, able to cooperate with the other
continental-sized states in a world federation. Obviously the US and, to a
lesser degree, China, are pushing very hard for this solution, along with
the IMF and the OECD and other proto-institutions of world government. Then
you would have institutionalized American capitalism everywhere, no
pretence of democracy or equality, basically a rule of the bourgeoisie with
a strong police force protecting a shrunken but still important  middle
class against lots of unemployed and marginalized people, according to the
demands a very impressive corporate-financial oligarchy on a sure path to
ecological suicide. Does that sound nice? It would be awful. And it's
entirely possible. But let's check another scenario.

The second most likely possibility, in my view and perhaps that of Soros
too, is that financial "discipline" will be exerted in the typical,
irrational, deflating-bubble mode that is currently the rule, where large
market-making actors actually precipitate crises where they can profit from
the downside, then pull out with various forms of short-selling and
derivative-based profits, which they think they can reinvest in China,
America, Russia, Brazil, Canada, India, South Africa, etc. In this case we
would get a full-fledged Great Depression due to a major collapse in world
demand, and the productive South would have to make attempts to break away
from its dependence on the North as a market for its products. This would
be great for the South by the way, and most of the southern countries have
done fairly well in the last four years. In Europe, numerous countries
would split from the Euro and probably a Core Europe would remain. Here the
question would be whether self-protective authoritarian fascism or some
more redistributive, commons-oriented social-democratic alternative gets
the upper hand. In the US you would have the same question, indeed we
already see its outlines. So let's look further.

In the Great Depression scenario, the police-state/postmodern fascist
alternative is not sure to win. Borders would clearly be sealed to the flow
of people (check out the trends in the US once again) but inside the
borders it is not clear what would happen. It takes a lot of nationalism to
support a police state and that nationalism is in limited supply. In the US
much of it has already been spent on the failed Global Wars on Terror. The
Great Depression that I heard about when I was a kid lead to an (admittedly
stunted) version of social democracy. Obama has been our Herbert Hoover so
far, but we could come up with something more like FDR, or better yet,
change the system entirely through a new kind of widespread political
engagement prefigured by the Occupy movement. European countries have an
equal or better chance at this. All it will take, in both regions, is a
total breakdown of the current system in order to find out what happens
next. And that is essentially what Soros is predicting. Well, actually, he
is predicting a "lost decade" for Europe comparable to the "lost decade" of
Latin America in the 1980s. However, I think he is underestimating the real
effects of a serious and prolonged decline in the demand of the world's
biggest consumer market.

This is the part I don't understand though: the precise mechanism of the
breakdown which Soros thinks will happen (if it happens) in the next three
months or so:

"At the onset of the crisis a breakup of the euro was inconceivable: the
assets and liabilities denominated in a common currency were so
intermingled that a breakup would have led to an uncontrollable meltdown.
But as the crisis progressed the financial system has been progressively
reordered along national lines. This trend has gathered momentum in recent
months. The Long Term Refinancing Operation (LTRO) undertaken by the
European Central Bank enabled Spanish and Italian banks to engage in a very
profitable and low risk arbitrage by buying the bonds of their own
countries. And other investors have been actively divesting themselves of
the sovereign debt of the periphery countries.

"If this continued for a few more years a break-up of the euro would become
possible without a meltdown -- the omelet could be unscrambled -- but it
would leave the central banks of the creditor countries with large claims
against the central banks of the debtor countries which would be difficult
to collect. This is due to an arcane problem in the euro clearing system
called Target2. In contrast to the clearing system of the Federal Reserve,
which is settled annually, Target2 accumulates the imbalances. This did not
create a problem as long as the interbank system was functioning because
the banks settled the imbalances themselves through the interbank market.
But the interbank market has not functioned properly since 2007 and the
banks relied increasingly on the Target system. And since the summer of
2011 there has been increasing capital flight from the weaker countries. So
the imbalances grew exponentially. By the end of March this year the
Bundesbank had claims of some 660 billion euros against the central banks
of the periphery countries."

I don't get how the interbank market worked before 2007. What I do get is
that the German Bundesbank is now hugely exposed to the sovereign default
risk of the weaker Eurozone countries, who have gradually had to buy up the
debt of their private banks and have financed this debt-buying activity
through bond issues and EU emergency loans that lead back to Germany. The
Bundesbank (and the private banking interests it represents and incarnates)
wants to collect on this debt, but at the same time, they don't want to
throw good money after bad. They want the proper rules, but because of
their Hayeckian ordoliberal approach they can only suggest belt-tightening
and austerity which provokes a severe and spreading political crisis in the
endebted states. The break-up scenario would then arise from this
insistence on restoring equilibrium. So we are back to where we started:
the insufficiency of neoclassical economics in the face of complex social
dynamics in open, second-order systems.

In fact, this has ever been the problem of capitalism, not since Adam Smith
but since the days of Malthus and Ricardo. To understand that genealogy,
and a lot of other things, I can only recommend rereading my favorite
anthropology book, Polanyi's Great Transformation.

Where did all this come from? Where are we now? What's gonna happen? How to
model the probabilities? How to prepare for the different scenarios? Once
again, these are the questions I would like to raise in an intensive
one-week seminar, "Three Crises: 30s-70s-Today," which is gonna happen next
week in Berlin. The new homepage is here (just scroll down a little):

Hope to see you and anyway, good luck to all, Brian

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