That was the advice George Soros had for U.S. regulators at the conclusion of a keynote he gave last week as part of the Tenth Annual International Seminar on Policy Challenges for the Financial Sector. The alternately reviled and revered financier is on the cusp of turning 80, but he still demonstrated a very sharp mind and a quick wit during his 30-minute speech. It was quite a contrast with the introductory remarks given by Ben Bernanke, who spoke with a poker face, stuck precisely to his talking points, and took no questions from the assembled brain trust of central bankers the world over, many of whom have dealt with financial crises in their own countries in the past few decades with varying degrees of success.
Soros kicked off his talk with a helpful analogy. The world's financial system is similar to a car that has gone into a skid. To correct the skid, the driver first has to turn into the skid—in other words, financial authorities tried through various means to prop up leverage, the very thing that got us into trouble in the first place. This first manuever has been successfully executed. But now the driver must turn back onto the road without careening off into the abyss on either side. By this, Soros meant that we must put in place regulations that will limit leverage and prevent asset bubbles from getting out of hand. I found the analogy quite persuasive.
But Soros went a step further and gave a sketch of a theory he has of how financial markets function. He savagely attacked the efficient markets hypothesis, blaming it for the deregulatory mindset that got us into the most recent financial crisis. (Alan Greenspan et al. were given short shrift as "free market fundamentalists".) In its place, Soros offered an idea he calls 'reflexivity'. The idea builds on the concept of Knightian uncertainty, and it is this:
Financial markets always provide a distorted view of the fundamentals of the economy, but the degree of distortion varies over time. Sometimes these distortions are not far removed from reality. But sometimes markets get far removed from fundamentals, as they have in the recent past. So far, so good. Soros argues further that financial markets aren't simply a mirror of the economy (whether distorted or not), but that there is a degree of endogeneity in the relationship between markets and the real economy. In other words, the ups and downs of the Dow can have an impact on the way the broader U.S. economy functions.
So how does an asset bubble arise out of this? A disequilibrium develops when market participants identify a trend (e.g. rising house prices), and this trend is tested against reality. If this trend passes the reality test (think, for instance, of the fact that housing prices didn't drop during the collapse of the dot-com bubble in 2000), then the disequilibrium will continue to build until another reality test is reached. In the meantime, distorted market views will have an impact on the broader economy, e.g. via a construction boom, which in turn will push markets ever higher. But eventually reality kicks in and a crash ensues.
Soros called the most recent financial crisis a "superbubble". While bubbles have built up in the past in the U.S., they do not compare with the most recent crisis. Soros was quick to point out that it was not only a market failure that created this superbubble, but also a regulatory failure, in that during each "reality test" of the past few decades the Federal Reserve stepped in to make sure things didn't get too bad for market participants. Thus, more risk and greater disequilibrium built up in the financial system.
So what does all this mean for regulation? Soros argued that authorities now have to accept responsibility for dealing with bubbles. They cannot confine themselves to worrying only about the money supply, but also have to take a hand in ensuring that the supply of credit does not overheat certain sectors or the economy as a whole. This could be done, at a minimum, by varying minimum capital requirements, but Soros believed that new tools would also need to be invented. He also spoke somewhat approvingly of the Chinese system, whereby authorities have a lot of leeway to direct banks to reduce lending to overheated sectors of the economy.
I found most of what Soros had to say quite persuasive. Beyond a short time frame, financial markets are unpredictable in the Knightian sense I mentioned above. And financial markets also present many more types of classic "market failures" than markets for most goods and services, so there is a strong argument in favor of regulation. But there is at least one big whole in his story. If market participants are not smart enough to identify an asset bubble when they see one, how in the world will government bureaucrats be able to do any better? Soros himself brought up this issue, but, as he himself admitted, he didn't have a persuasive answer. Perhaps this is where the Chinese-style self-criticism he recommended for U.S. regulators is supposed to help?