Posted by: Nicholas Davis | April 3, 2009

Soros and Special Drawing Rights – an overview

George Soros spoke at the London School of Economics on Monday, and I’ve only just managed to get around to listening to it (download the mp3 here). His key points:

  • The prevailing view that markets are self-correcting (with deviations from the norm produced by exogenous factors) has been demolished by the recent crisis, where massive crisis arose from within the system itself.
  • We need a new paradigm about how markets function, which he calls “reflexivity” (he’s written about this in his latest book and many times before). This consists of two key ideas: 1) Markets ALWAYS distort reality, there is always a bias, and 2) the mispricing that occurs has ways of affecting the so-called fundamentals that markets are supposed to reflect- hence markets affect reality
  • Bubbles are based initially on some fundamental trend but at some point there is a misinterpretation of that trend. If this isn’t corrected, the misconception can validate intself and reinforce both the trend and the misconception, causing behaviour that separates market movements from the fundamentals. Eventually the distortion becomes to big, unsustainable for the system to maintain and we experience a big, fast crash – where the rapid fall is asymmetric to the slower build-up
  • The current financial crisis is not a simple bubble but a composite of two bubbles: the deflation of a ‘simple’ housing bubble, which in turn acted as  a trigger to burst a bigger, more systemic ‘super-bubble’ that has building since WW2, driven by credit and increased leverage in the global economy.
    • The misconception in housing was that asset prices are independent of willingness to lend, and hence as asset prices go up, it is possible to continue to expand lending
    • The super bubble is more complicated, and is based on fundamental misconception of market fundamentalism (markets self correct and therefore don’t need regulation), which provided the basis for the globalization of financial markets, deregulation and increase of financial engineering – the “alphabet soup” of synthetic instruments, rise in risk management techniques, VAR and other complex calculations based on using historical data
    • This misconception failed to account for the uncertainty which cannot be quantified, which is produced by reflexivity and self-reinforcing misconceptions
  • Since the theory behind the super-bubble (i.e. self-correcting markets) was false, we’ve had a number of crises since 1980. Each time, markets didn’t correct, so authorities intervened, fixed institutions, reinforced credit, stimulus etc, thus reinforcing underlying fundamental trends
  • Since last year, the system has actually collapsed in a way that exceeded Soros’s expectations – he didn’t expect Lehman would be allowed to go under. The system suffered cardiac arrest and had to be put on artificial life supportby developed governments.  This led to “too big to fail” argument, which led to stabilization at the centre, but had the unintended consequence of endangering the periphery – since some governments were not in the position to give similar guarantees, there was a flight of capital from periphery to the centre.
  • The issue now is that the situation at centre has been brought under control, but the situation in periphery still in crisis.
  • The basis for a systemic solution exists in Special Drawing Rights issued by the IMF ($250bn of which were agreed on at the G20 meeting – ed), which exist but not in the form Soros sees as helpful. Then new twist is for the rich countries to lend or reallocate their allocations to LDCs as permanent loans at zero interest. This would enable countries that receiving SDR allocations to access additional liquidity and monetary base (convertible to any other currency), provide support to their banking systems and engage in counter-cyclical policies.
  • Basically, the task confronting world is twofold: 1) The collapse of credit that must be arrested and reversed, and  2) We need to reconstitute the very foundations on which the financial system is based – “we can’t put humpty dumpty together”. Hence we need to need to reinflate and regulate – both at the same time, which is not so much a dichotomy as a problem of sequencing. SDRs will help the reinflation process in developing countries.
  • SDR loans are not the only thing that needs to be done, but it would make a difference for the periphery. There is $1.4 trillion in loans coming due in 2009 – but right now banks in the developed world don’t want to renew loans and there is pressure to draw money back from the periphery. So central banks should cooperate to ensure that sound loans are rolled over, as they did for South Korea for 1998 – should be mentioned in Communique to reassure financial markets.

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