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Two books about the credit crisis of 2008

George Soros and Charles R. Morris

posted on 30 May 2008

reviewed by Joseph L. McCauley

The New Paradigm for Financial Markets:

The Credit Crisis of 2008 and What it Means

George Soros


The Trillion Dollar Meltdown:

Easy Money, high rollers, and the Great Credit Crash

Charles R. Morris

There are three books that should be read in order to begin to understand where we stand financially in the world today. Second and third are the two reviewed here, the first and most basic is the one that I reviewed last year: Eichengreen's 'Globalization of Capital'.

Eichengreen presents the history of the Dollar from the gold standard until convertibility was cancelled in 1971 and then through 1995. Specific details of recent financial history under deregulation, which we date from 1971, are also usefully provided in Lewis's 'Liars Poker' and Dunbar's 'Inventing Money'. We can date the use of the Dollar as international default reserve currency since 1945, while the inflation of the worldwide credit bubble dates exactly from the deregulation of the Dollar in 1971. The two books reviewed here mention the necessary background history in highly capsulized form, and focus on the onset of deregulation to the present era of worldwide financial instability due to the flood of Dollars as the result of uncontrolled derivatives creation and trading.

Both Soros and Morris present numbers that help the reader to understand what's happening, but neither paints a full picture. See also the 2nd edition of my 'Dynamics of Markets' to appear in 2009, where some qualitative ideas of market instability are quantified empirically. Morris and Soros should be read in parallel, Soros consulted Morris for certain details.

Morris begins with the Reagan era of easy credit, big spending, and the systematic deletion of financial rules that had been set up under FDR as a result of The Great Depression. Eichengreen correctly presents the Great Depression as a liquidity crisis that could have been avoided, we've had no depression since that time because central banks have always been able to provide adequate liquidity in financial crises (with the new shadow banking, the number of Dollars in the world is so great that this is no longer guaranteed to work as before). Morris notes that the exercise of judgment in policy making was dropped when politicians shared the illusion of economists that, under the marriage of (neoclassical) economics with high-powered math,
economics had become a science. Lucas's famous laissez faire policy critique (which Soros labels 'market fundamentalism') represents the epitome of that illusion. The Chicago School of Economic ideology is rightly blamed by Morris for the current morass.

Morris describes various synthetic option products, especially collateralized mortgage obligations (CMOs), created in 1983 in era of the collapse of savings & loans in the U.S. as a result of splitting mortgages into derivatives (see also Lewis). CDOs, credit default swaps, and other derivatives that were useful in
expanding the bubble are also described. One is the SIV (structured investment vehicle), which has been extremely useful in getting credit created by mortgages off the balance sheets of banks (again, the number of Dollars in the world is great due to uncontrolled credit, and wealthy people are always looking for profitable places to 'park' all that money). Unfortunately, the money supply is discussed by neither author, but the Dollar M2 is roughly $7 trillion, M3 is about twice that. M2 describes all money (credit is counted as money) under the control of the U.S. Federal Reserve Bank. M3 includes 'Eurodollars', money outside the U.S. that's used to create credit in, say, China, under the multiplier rules of Chinese banks. M3 includes all 'on balance book' Dollars in the world. To understand where we now stand, the reader must know about 'shadow banking', also mentioned by Morris with SIVs as the prime vehicle for that form of uncontrolled money creation. Shadow banking, so far as I've managed to understand it, includes credit that is at least triple the amount of M3. This means that the U.S. is in a worse position financially than we were in the 19th century before the Federal Government outlawed currency printing by commercial banks. In a word, and as Morris argues convincingly, financial regulations are absolutely necessary, the free market/free trade binge is over, the Dollar cannot be salvaged under current financial, trade, and political policy. I read on the web that total Dollar mortgages are on the order of magnitude of M3, meaning that mortgages are largely an unregulated form of money creation today (again, due to shadow banking where the banks that create the mortgages get them off the books quickly via derivatives). The world was quite different before the Reagan-Thatcher ideology took hold.

Soros's new book tells the same story of the mistakes made in the name of 'market fundamentalism' (laissez faire) since 1971, but with some different emphasis and also with even more useful numbers provided for the readers' orientation. He states, e.g., that CDSs (collateralized debt swaps), a synthetic option invented in Europe in the early 1990s, amounts to about $43 trillion, again over three times M3. In stark contrast, U.S. household wealth is about the same, the capitalization of the U.S. stock market is $18 trillion, and the U.S. treasuries market is about $5 trillion. Again, compare the numbers with M3 and you'll understand why the oil price in Dollars has exploded, is still exploding, and will continue to explode. Until a worldwide recession sets in, and the U.S. takes drastic steps to regain control over the Dollar.

In my opinion, shadow banking, combined with the U.S. trade deficit, is the reason that the Dollar is weak. The high price of oil in Dollars reflects not only the new demand for oil in Asia, but equally so far too many Dollars in the form of uncontrolled credit floating around in the world. Under free trade rules the U.S. trade deficit has exploded due to loss of manufacturing capacity to Asia, and is recycled back to Washington to finance the budget deficit (U.S. taxes are far too low) to the tune of half a trillion Dollars in interest paid largely to Beijing and Tokyo each year. It's quite clear that the U.S. taxpayer has not yet contributed to the cost of the Iraq war, that war is largely financed by loans from Beijing and Tokyo in recycled Dollars. Morris and Soros did not mention this directly, but they could have. Extremely low taxes combined with deregulation (permitting the systematic loss of manufacturing capacity to cheap labor) are the reason for the fall of America to its present severely weakened state.

Soros is not less critical of deregulation and the prevailing belief in the illusion of "market equilibrium" than is Morris. George began criticizing those ideas in his first book published in 1994. Included in his new book is the autobiography of both his early years and his life as a trader, this makes for very interesting reading! A quote from his son is hilarious. In an earlier interview, the son was asked by a reporter what he thought of his father's theory (of reflexivity). The son replied
that he knew as a kid that it's at least half B.S., his father trades when his back hurts!

George Soros has a twenty year history warning against the prevailing belief in 'market fundamentalism' and the consequences of extreme deregulation. Because of excessive Dollar creation under those illusions, the chickens have come home to roost, it's George's day now. I would only hope that the Democratic presidential candidate in the U.S. would have enough understanding and insight to appoint him, or someone with
understanding of the instability of unregulated financial markets and unregulated free trade, as his top economic advisor. McCain is of course hopeless, and Obama has as top economic advisor a nonfinancial expert from the University of Chicago. The outlook is indeed gloomy for those of us who would like to see a sharp shift in economic, taxation, and trade policy.

The history of market instability under deregulation is described in chapter 9 of my coming 2nd edition of 'Dynamics of Markets', where I show explicitly that stationary markets (equilibrium markets) violate the efficient market hypothesis,
and consequently the observed martingale dynamics of detrended financial returns. According to Eichengreen, there is circumstantial evidence that pre-WWI FX markets were stationary, speculators systematically made money betting in those markets. The market for derivatives emerged with the deregulation of FX markets in 1971, after which the instability exploded. This history is included in the new chapter 9, while chapter 10 revisits the 'rational expectations' model and the modeling basis for Lucas's laissez faire policy advice.

We're in a worldwide financial crisis because the required liquidity cannot be provided without degrading the Dollar even further: as I've stated above, known shadow banking is at least three times M3. We face either depression (unlikely) or a Dollar plunging even deeper (more likely) because more Dollars must be 'printed' as credit to avoid a worldwide financial collapse. Such a collapse would likely be worse (as Soros points out) than The Great Depression.

Soros's idea of reflexitivity is qualitatively correct, the financial system is not inherently stable, it's inherently unstable. Free markets are not a stable self-regulating dynamical system, markets can only be stabilized by adding regulations. Because of the inventiveness with which 'rocket sciences' can invent derivatives to avoid regulations, derivatives creation must be strongly limited. Either that, or continue as we do now with the instability and degradation of the Dollar. Both Morris and Soros point out that Alan Greenspan, an ideological follower of the free market extremism of Ayn Rand ('Atlas Shrugged', 'The Fountainhead') absolutely refused to consider regulating derivatives and preventing the mortgage bubble. Well, the party is over. The Dollar will have to be replaced as international reserve currency by a basket of regulated currencies, and free trade will have to be regulated if the West is to avoid massive unemployment in the long run. I
end with a joke. A CSU (Bavarian CDU) politician recently responded to concern expressed by a voter over the loss of manufacturing capacity in Germany. He responded (my translation): "Oh, it will be covered by international finance market investments."