Soros Examines the Causes of the World Financial Meltdown

In the latest issue of the New York Review of Books, philanthropist, currency trader and international financial expert George Soros offers his own view of the world financial meltdown.

The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. This fact—that the defect was inherent in the system —contradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting. The severity and amplitude of the crisis provides convincing evidence that there is something fundamentally wrong with this prevailing theory and with the approach to market regulation that has gone with it.

Later in his rumination, Mr. Soros gets to an important point that is routinely, even fetishistically, ignored by those who recite incantations of Faith In Blind Markets.

This remarkable sequence of events can be understood only if we abandon the prevailing theory of market behavior. As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, 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. This two-way circular connection between market prices and the underlying reality I call reflexivity.


Soros is quite right to focus on human nature -- and our propensity for delusion, in particular -- as a root of the problem. In fact, while markets are wonderful wealth generating machines, that harness competition between individuals and groups in positive-sum ways that benefit us all, they are not mystically simple or perfect. Nor do they arise (as the sun does) out of immutable physical law.

Indeed, if you scan human history, you will find very few examples of market-based systems that escaped meddling and ruination at the hands of the very same elites who stood at the top of the social order -- the owners of nearly all capital, who insisted that they knew what's best, and nearly always squelched competition, rather than let it flow and thrive. In the vast majority of cultures, it was top owners who shut down what we would call open market behavior. A threat far more prevalent than peasant revolts or socialism.

Market Fundamentalists tell themselves a dogma that Adam Smith himself never believed, that markets are rooted in - and organically emerge from - human nature. This is fundamentally wrong. Our natures developed in a Darwinian-tribal context that predated civilization and markets. In order to understand this, simply study the power and economic arrangements in most tribal or pastoral societies. And even later. Try calculating what fraction of the population in most ancient nations must have been descended from the harems of kings. (Recent data show that 8% of the Chinese population, today, is directly descended from Ghengis Khan.)

While it is true that some deeply human imperatives do work well with markets - e.g. our ability to both cooperate and compete, our embedded notion of fairness and quid-pro-quo. other human drives do not. For example, the propensity to cheat and deceive. And our remarkable tendency to tell ourselves satisfyingly delusional stories that aren't well-based in fact. This latter trait makes us wonderful artists, but also great believers in simplistic dogmas.

Like the simplistic dogma of perfect, equilibrium-seeking markets.

What Mr. Soros appears to see clearly, and describes well, is the role of delusion in our both our recent "credit bubble" and a much longer, post-Reagan "super-bubble" that was based upon the assumption that markets automatically correct for all distortions, even though traders can be like any other tribe, influenced by group-think, by shared myths and by zealous optimism. Even by their own standards. hedge-betters did not include enough wagers that pondered the possibility of a serious downturn to what was obviously a bubble,

What Mr. Soros appears to leave out is another aspect of the present crisis, how it was driven not only be delusion, but also by cheating, predation and parasitism. These are three different - if related - things. Cheating is where players seek to limit Hayekian knowledge flows by limiting the transparency that markets require to function.

Predation is outright lawbreaking -- or else stealing by using some loophole, the way that a crony network of golf buddies took over the boards of scores of US corporations, appointing each other to CEO slots and voting each other huge bonuses -- in effect creating a cartel of top managers -- all somehow without triggering the rules against interlocking directorates and restraint of trade. Above all, their belief in market forces was proved hypocritical, since such pay raises for CEOs should (under capitalism) draw in talent from other fields until managerial talent supply pushed prices down again. (See: The Syndrome of the Essential Man.)

Parasitism is the least examined of these forces, in part because it is almost perfectly legal. It happens when an entire species of creature arrives on the scene, that contributes little to economic activity, but draws sustenance from healthy companies, just like a vampire bat siphoning blood from cattle. In my last economics related posting, I suggested that this has happened to our civilization with the arrival, in layer after layer of management, of swarms of "business school graduates."

For all his faults, when Walter Wriston ran Citi Bank, the institution was all about... banking. Because Wriston and his colleagues were, above all, bankers. Likewise, companies led by widget-makers tended to remember that their core business is widget-making. Even if some of the engineers went on to get MBAs and law degrees, at least they would remember the product. The service that customers paid for.

But as corporations were taken over by a caste who never made a product or provided a service, it is only natural that goods and services dropped in priority, while parasitical aspects of business gained importance, like developing innovative ways to hedge and leverage instruments to squeeze a little more profit out of transactions in commoditized debt.

Think of it this way. When vampires are in charge, they will emphasize blood. Even if they are smart vampires who claim to have the health of the cows at heart (so to speak), their goal will be to maximize the flow of blood. Now, blood is important. Like money, it enables the body to live and take nourishment to all its cells. Money and blood matter... but their purpose, in the long run, is to help the body stay alive -- or to help the company to make competitive goods and services. When the vampire tunes the cow's body to deliver JUST the right amount of blood to keep it alive, under ideal circumstance, and no more, guess what happens when the slightest thing goes wrong?

Above all, both vampires and business majors like to live on the edge. They assume the body that they are tapping will remain in equilibrium forever. Reserves? Those are for wusses. Hence, another "management" psychosis that will hit us hard, very soon... our industrial over-reliance on just-in-time production practices -- abetted by tax laws that punish warehousing and robust practices -- will surely be the second shoe to drop.

The drastic step of closing undergraduate business schools and only allowing MBA candidates who heve spent some time in goods and services, may be drastic. But it could be effective.

These warnings are not new. Last time, I urged that folks try watching “Executive Suite,” a 1954 Robert Wise film starring William Holden and Barbara Stanwyck. Though a bit silly, it really does address some of these issues, at a level that movies seldom aspire-to.

The essay by Mr. Soros should be read. We all need to ponder new ways of looking at old problems.