George Soros Lecture Series: Financial Markets

[Applause] thank you very much and thank you for coming and also I want to greet the students at MIT uh today I'll apply the concepts introduced yes yesterday fallibility reflexivity and the human uncertainty principle in into the financial markets please brace yourselves because I'll pack a lifetime of experience into this one lecture the financial markets provide an excellent laboratory for testing the ideas that I put forward in an abstract form yesterday the course of events is easier to observe than in most other places many of the facts take a quantitative form and the data are

well recorded and well preserved the opportunity for testing occurs because my interpretation of financial markets directly contradicts the efficient market hypothesis which has been the prevailing Theory uh about financial markets that theory claims that markets tend towards equilibrium deviations occur in a random fashion and can be attributed to extraneous shocks if that theory is valid mine is false and vice versa let me State the two Cardinal principles of my conceptual framework as it applies to the financial markets first market prices always distort the underlying fundamental the degree of distortions may vary from the negligible to

the significant this is in direct contradiction to the efficient market hypothesis which maintains that market prices accurately reflect all the available information second instead of playing a purely passive role in reflecting an underlying reality financial markets also have an active role they can affect the so-called fundamentals that they are supposed to reflect there are various Pathways by which the mispricing of financial assets can occur the most widely traveled are those which involve the use of Leverage both debt and Equity leveraging the various feedback loops may give the impression that markets are are often right but

the mechanism at work is very different from the one proposed by the prevailing Paradigm I claim that financial markets have ways of altering the fundamentals and that may bring about a closer correspondence between market prices and the underlying fundamentals contrast that with the efficient market hypothesis which claims that markets are always accurately reflecting reality and automatically tend towards equilibrium my two propositions Focus attention on the reflexive feedback loops that characterize financial markets there are two kinds of feedback negative and positive negative feedback is self-correcting positive feedback is self-reinforcing thus negative feedback sets up a tendency

towards equilibrium while positive feedback produces Dynamic disequilibrium positive feedback loops are more interesting because they they can bring about big moves both in market prices and in the underlying fundamentals a positive feedback process that runs its full course is initially self-reinforcing but eventually it is liable to reach a climax or reversal point after which it becomes self-reinforcing in the opposite direction but positive feedback processes don't necessarily run their full course they may be aborted at any time by negative feedback I have developed a theory of about boom bus processes or bubbles along these lines every

bubble has two components an underlying Trend that prevails in reality and a misconception relating to that Trend a boomas process is set in motion when a trend and a misconception positively reinforce each other the process is liable to be tested by negative feedback along on the way if the trend is strong enough to survive the test both the trend and the misconception will be first further reinforced eventually Market expectations become so far removed from reality that people are forced to recognize that the misconception is involved a Twilight period ensues during which doubts grow and more

people lose Faith but the prevailing trend is sustained by inertia as Chuck Prince former head of citybook group said we must continue dancing until the Music Stops eventually a point is reached when the trend is reversed it then becomes self-reinforcing in the opposite uh Direction let me go back to the example I used when I or originally proposed my theory in 1987 the conglomerate boom of the late 1960s the underlying trend is represented by earnings per share the expectations relating to to that uh Trend by stock prices so here you have the the earnings per

share and the stock prices conglomerates improved their share their earnings per share by acquiring other companies inflated expectations allowed them to improve their earnings performance but eventually reality could not keep up with expectations after a Twilight period the price trend was reversed all the problems that had been swept under the carpet surfaced and earnings collapsed as the president of one of the conglomerates ogan corporation told me at the time I have no audience to play to this this is a model of um of uh the conglomerate bubble the the the charts of actual conglomerates like

ogan Corporation closely resemble uh this chart bubbles uh uh that conform to this pattern go through distinct stages uh there is the Inception then a period of acceleration um reinforced by uh okay by successful tests when the price de lines but the it's still the trend reinforces is strong enough to reinforce itself then a Twilight period ensues uh um and a reversal point or climax is reached followed by an acceleration on the the downside cating in a financial crisis the length and strength strength of each stage is unpredictable but there is an internal logic in

the sequence of stages so the sequence is predictable but even that can be terminated by government intervention or some other form of negative feedback in the case of the conglomerate boom it was the defeat of lisco in its attempt to acquire manufacturers Handover trust that constituted the climers climax or reversal Point typically bubbles have an asymmetric shape the Boom is long and and drawn out slow to start it accelerates gradually until it flattens out during the Twilight period the bust is short and steep because it's rainforce by the forced liquidation of unsound positions disillusionment turn

turns into Panic reaching its climax in a financial crisis the simplest case is a real estate Boom the trend that precipitates it is that credit becomes cheaper and more easily available the misconception is that the value of the collateral is independent of the availability of credit as a matter of fact the relationship between the availability of credit and the value of the collateral is reflexive when credit becomes cheaper and more easily available activity picks up and real estate values rise there are fewer defaults credit performance improves and lending standards are relaxed so at the height

of the Boom the amount of credit involved is at its maximum and a reversal precipitates forcely liquidation depressing real estate prices yet this misconception continues to ur in various guises for instance the international banking crisis of 1982 revolved around sovereign debt where no collateral is involved the credit worthiness of the S Sovereign borrowers was measured by various debt ratios like debt to GDP and that service to exports these ratios were considered objective criteria while in fact they were reflexive when the re recycling of Petr dollars in the 1970s increased the flow of credit to countries

like Brazil their debt ratios improved encouraging further inflows and starting a pple not all bubbles involve the extension of credit some are based on Equity leveraging the best examples are the conglomerate boom of the 1960s and the internet bubble of the late 1990s When Alan Greenspan spoke about irrational exuberance in 1996 it misrepresented bubbles when I see a bubble for in are rushing to buy adding fuel to the fire that's not irrational and that's why we need Regulators to counteract the market when a bubble is threatening to grow too big because we can't rely on

Market participants however well informed and rational they are bubbles are not the only form in which reflectivity manifests itself the they are only the most dramatic and the most directly opposed to the efficient market hypothesis therefore they deserve special attention but reflexivity can take many other forms in currency markets for instance the upside and downside are symetrical so that there is no sign of an asymmetry between boom and bust but there is no sign of equilibrium either freely floating exchange rates tend to move in large multi-year waves and the most important and most interesting reflexive

interaction takes place between the financial authorities and financial markets because markets don't tend toward equilibrium they are prone to produce periodic crisis Financial crises lead to regulatory reforms that's how Central Banking and the regulation of financial markets have evolved both the financial authorities and Market participants act on the basis of imperfect understanding and that makes the interaction between them reflexive and unpredictable while bubbles only occur intermittently the interplay between authorities and markets is an ongoing process misunderstandings by either side usually stay within reasonable bounds because Market reactions provide useful feedback for to the authorities allowing

them to correct their mistakes but occasionally the mistakes prove to be self validating send setting in motion we should or virtuous circles such feedback loops resemble bubbles in the sense that they are initially self-reinforcing but eventually uh self-defeating but otherwise they take quite a different shape it's important to realize that not all price distortions are due to reflexivity Market participants can't possibly base their decisions on knowledge they they have to anticipate the future and the future is contingent on the decisions that people have not yet made what makes what those decisions are going to be

and what effect they will have can't be accurately anticipated nevertheless people are forced to make decisions to guess correctly people would have to know the decisions of all of the other participants and their consequence quences but that's impossible rational expectations Theory sought to circumvent this impossibility by postulating that there is a single correct set of expectations and people's views will converge around it that postulate has no resemblance to reality but it is the basis of financial economics as it's currently taught at in universities in practice participants are obliged to make their decisions in conditions of

uncertainty their decisions are bound to be tentative and biased that's the general generic cause of price distortions occasionally the price distortions set in motion a boomas process more often they are corrected by negative feedack back in these cases Market fluctuations have a random character I compare them to the waves sloshing around in a swimming pool as opposed to a tidal wave obviously the L the latter are more significant but the former are more ubiquitous the two kinds of price distortions intermingle so that in reality boomas processes rarely follow follow the exact course of my model

bubbles that follow the pattern I described in my model occur only in those rare occasions when they are so powerful that they overshadow all the other processes going on at the same time it will be useful to distinguish between near equilibrium uh and far from equilibrium conditions the near equilibrium conditions are characterized by random fluctuations and the far from equilibrium situations uh uh are those in which a bubble uh predominates near equilibrium is characterized by hrum everyday events which are repetitive and lend themselves to statistic generalizations far from equilibrium conditions give rise to Unique historical

events where outcomes are generally uncertain but have the capacity to disrupt the statistical gener generalizations based on everyday events the rules that can guide decisions in near equilibrium conditions don't apply in far from equ ium situations the recent financial crisis is a case in point all the risk management tools and synthetic Financial products that were based on the assumption that price deviations from a put putative equilibrium occur in a random fashion broke down and people who relied on mathematical models which had served them well in near equilibrium conditions got badly hurt I have gained some

new insights into far from equilibrium conditions during the recent financial crisis as a participant I had to act under immense time pressure and I couldn't gather all the information that would have been available and the same applied to the regulatory authorities in charge that's how far from equilibrium situations can spin out of control and this is not confined to financial markets I experienced it for instance during the collapse of the Soviet Union the fact that the participants thinking is time bound instead of Timeless is left out of account by rational expectations Theory I was aware

of the uncertainty associated with reflexivity but even I was taken in by I was taken by surprise by the extent of the uncertainty in 2008 it cost me dearly I got the general direction of the markets right but I didn't allow for the volatility as a consequence I took on positions that were too big to withstand the swings caused by volatility and several times I was forced to reduce my positions at the wrong time in order to limit my risk I would have done much better if I had taken smaller positions and stuck with them

I learned a hard way that the range of uncertainty is also uncertain and at times it can become practically infinite uncertainty finds expression in volatility increased volatility requires a reduction in RIS risk exposure this leads to what canes called increased liquidity preference this is an additional factor in the forc liquidation of positions that characterize financial crisis when the crisis abates and the rain of uncertainty is reduced it leads to an almost automatic Rebound in the stock market as the liquidity preference stops rising and eventually Falls that's another lesson uh that I have learned recently I

also need to point out that the distinction between near and equilibrium and near and far from equilibrium conditions uh uh that uh uh that I've mentioned was introduced by me while trying to make some sense out of a confusing reality and it doesn't accurately reflect reality reality is always more complicated than the dichotomies we introduce into it the recent crisis is comparable to a 100e storm we have had a number of Crisis leading up to it these are comparable to five or 10e storms Regulators who had successfully dealt with the smaller sto storms were less

successful when they applied the same methods to the 100-year storms these General remarks prepare the ground for a specific hypothesis uh I put forward or have put forward to explain the recent financial crisis it's not derived from my theory of bubbles by deductive logic nevertheless the two of them stand or fall together so here it goes I contend that the puncturing of the subprime bubble in 2007 set off the explosion of a Super Bubble much as an ordinary bomb sets off a nuclear explosion the housing bubble in the United States was the most common kind

it distinguished only by the widespread use of collateralized debt obligations and other synthetic instruments behind this ordinary bubble there was a much larger Super Bubble growing over a longer period of time which was much more peculiar the prevailing Trend in this Super Bubble was the ever increasing use of credit and leverage the prevailing misconception was the belief that financial markets are self-correcting and should be left to their own devices President Reagan called it the magic of the marketplace and I call it Market fundament mentalism it became the dominant Creed in the 1980s when Ronald Reagan

was President of the United States and Margaret thater was prime minister of the United Kingdom what made the Super Bubble so peculiar was the role that financial crisis played in making it grow since the belief that markets could be safe to left to their own devices was false the Super Bubble gave rise to a series of financial crisis the first and most serious was the international banking crisis of 1982 this was followed by many other crises the most notable being the portfolio Insurance debacle in October 1987 the Savings and Loan crisis that unfolded in various

episodes between 1989 and 1994 the Emerging Market crisis of 1997 98 and the bursting of the internet bubble in 2000 each time a financial crisis occurred the author the authorities intervened merged away or otherwise took care of the Fall failing financial institutions and applied mon and fiscal stimulus to protect the economy these measures reinforced the prevailing trend of ever increasing credit and leverage but as long as they worked they also reinforced the prevailing misconception that markets can be safely left to their own devices that was a misconception because it was the intervention of the authorities

that saved the system nevertheless these crisis served as successful tests of a false belief and as such they inflated the Super Bubble even further eventually the credit expansion became unsustainable and the Super Bubble exploded the collapse of the subprime mortgage market led to the collapse of one market after another in quick succession because they were all interconnected the firewalls having been removed by deregulation that's what distinguished this financial crisis from all those that preceded it those were successful tests that reinforced the process the subam crises of 2007 constituted the Turning Point the collapse then reached

this climax with the bank csy of Leman Brothers which precipitated the large scale intervention of the financial authorities it's characteristic of my boom buas model that it can't predict in advance whether a test will be successful or not this holds for ordinary Bubbles as well as the Super Bubble I personally thought that the Emerging Market crisis of 1996 7 98 would constitute the turning point for the Super Bubble but I was wrong the authorities managed to save the system and the Super Bubble continued growing that made the bust that eventually came in 2008 all the

more devastating after the bankruptcy of lean Brothers on September 15 2008 the the financial markets had to be put on artificial life support this was a shock not only for the financial sector but also for the real economy international trade was particularly badly hit but the artificial life support worked and financial markets stabilized the economy gradually revived a year later the whole episode feels like a bad dream and people would like to forget it there is a widespread desire to treat the crisis as just another crisis and return to business as usual but reality is

unlikely to oblige the system is actually broken and needs to be fixed my analysis offers some worthwhile Clues to the kind of regulatory reform that's needed first and foremost since markets are Bubble prone the financial authorities have to accept responsibility for preventing bubbles from growing too big Alan Greenspan and others have expressly refused to accept that responsibility if markets can't recognize bubbles Greenspan asserted neither can and regulators and he was right nevertheless the financial authorities have to accept the assignment knowing full well that they will not be able to meet it without making mistakes they

will however have the benefit of receiving feedback from the markets which will tell them whether they have done too much or too little they can then correct their mistakes second in order to control asset bubbles it's not enough to control the money supply you must also control the availability of credit this can be done by using only monetary tools you must also use credit controls the best known tools are margin requirements and minimum Capital requirements currently they are fixed irrespective of the market mood because markets are not supposed to have moods yet they do and

the financial authorities need to vary margin and minimum Capital requirements in order to control asset bubbles Regulators may also have to invent new tools or revive ones that have fallen into disuse for instance in my early days in finance many years ago central banks used to instruct commercial Banks to limit their lending to a particular sector of the economy such as real estate or Consumer loans because they felt that the sector was overheating Market fundamentalists consider that crash interference with the market mechanism but they are wrong now central banks used to do it we had

no financial crisis to speak of the Chinese authorities do it today and they have much better control over the banking system than we do the deposits that commercial banks have to maintain at the Central Bank were increased 17 times in China during the boom and when the authorities revers course the banks obeyed them with electricity or consider the internet boom Alan Greenspan recognized it quite early when he spoke about irrational exuberance in 1996 but apart from his famous speech he did nothing to avert it he felt that reducing the money supply would have been too

blunt an instrument to use and he was right but he could have asked the SEC to put a freeze on new share issues because the internet boom was fueled by Equity leveraging he didn't because that would have violated his Market fundamentalist principles third since markets are potentially unstable there are systemic risks in addition to the risks affecting individual Market participants participants May ignore these systemic risks in the belief that they can always dispose of their positions to someone else but Regulators can't ignore them because if too many participants are on the same side the positions

can't be liquidated without creating a discontinuity or a collap or a a collapse um they have to monitor the positions of the particip partipants in order to detect potential imbalances that means that the positions of all major Mar participants including hedge funds uh and Sovereign wealth funds need to be monitored uh certain derivatives like credit default swaps and knockout options are particularly prone to create hidden imbalances therefore they must be regulated and if appropriate restrict Ed or forbidden the issuing of synthetic Securities needs to be subject to regulatory approval just as ordinary Securities are fourth

we must recognize that financial markets evolve in a on directional nonreversible manner the financial authorities in carrying out their duty of preventing the system from collapsing have extended an implicit guarantee to all institutions that are too big to fail now they can't withdraw that guarantee as long as there are institutions that are too big to fail therefore they must impose regulations that will ensure that the guarantee will not be invoked too big to fail Banks must use less leverage and accept various restrictions on how they invest the depositor's money deposits should not be used to

finance proprietary trading but Regulators have to go even further they must regulate the compensation packages of proprietary traders to ensure that risks and rewards are properly aligned this may push proprietary Traders out of banks into hedge funds where they properly belong just as oil tankers are compartmentalized in order to keep them stable there ought to be firewalls between different markets it's probably impractical to uh separate Investment Banking from Commercial Banking as the glass SLE Act of 1933 did but there have to be internal compartments keeping proprietary trade in various markets separate from each others each

other in order to prevent contagion some banks that have come to occupy Quine monopolistic positions may have to be broken up finally the Basel Accords made a mistake when they gave Securities held by Banks substantially lower risk ratings than regular loans they ignored the systemic risks attached to concentrated positions in Securities this was an important factor aggravating the crisis it has to be corrected by raising the risk ratings of Securities held by Banks and that will probably discourage the securitization of of loans all these measures will reduce the profitability and average of banks this raises

an interesting question as to timing this is not the right time to enact permanent reforms the financial system and the economy are very far from equilibrium and they can't be brought back to near equilibrium conditions by a straightforward corrective move just as when a car is kidding you must first turn the wheel in the direction of the skid before you uh correct the car what makes what needs to be done in the short term was exactly the opposite of what is needed in the long term first the credit that evaporated had to be replaced by

using the only source of credit that remained credible namely the state and that meant increasing the national debt and extending the monetary base as the economy stabilizes you must then shrink the monetary base as fast as credit revises otherwise deflation will will be replaced by the Spectre of inflation we are still in the first phase of this delicate maneuver the banks are in the process of ear earning their way out of a hole to reduce their profitability now would be directly counterproductive regulat reform has to await the second phase when the money supply needs to

be brought under control and it needs to be carefully faced in so as not to disrupt the recovery but we can't afford to forget about it uh you you have seen that my interpretation of financial markets uh call it the theory of reflexivity is very different from the efficient market hypothesis strictly speaking neither theory is falsifiable by Poppa's standards I predicted the bursting of the Super Bubble in 1998 I was wrong then so am I right now and some proponents of the efficient market hypothesis are still defending it in the face of all the evidence

still there is a widespread feeling that we need a new paradigm and I contend that my theory provides a better explanation than the available Alternatives behavioral economics which is gaining increased recognition deals with only one half of reflexivity the misinterpretations of reality but doesn't study the pathways by which mispricing can change uh the fundamentals I realize that my theory of financial markets is still very rudimentary and needs a lot more development the the pathways by which uh the the U Mis mispricing can affect the fundamentals uh need a lot more study obviously I can't do

it on my own so I may have been premature in putting forward my theory as the new paradigm but the efficient market hypothesis has certainly proved inadequate that has been the entire edifice of global financial markets that has been erected on the false premise that markets can be left to their own devices has to be rebuilt from the ground up and that concludes my today's lecture but I would like to also want to use this occasion to make an announcement I have decided to sponsor an Institute for New Economic thinking IET for short it will

be a major institution fostering research workshops and curricula that will develop an alternative to the prevailing Paradigm I have committed $50 million over 10 years and I hope other others will join I also hope that reflexivity will one of will be one of the concepts that will be explored but clearly it should not be the only one I recognize the potential conflict between being a protagonist and a financial sponsor at the same time to protect against it I want to erect a Chinese wall between me and The Institute to this end I will extend my

financial support through the central European University and I will not personally participate in inet the jury will be expressly instructed to encourage other Alternatives behind besides the theory of ref flexibity the plan is to launch inet at a workshop on the lessons of the financial crisis at Kings College Cambridge on April 10th and 11th and I hope that the new economic thinking will find a home here at the ceu thank you very much