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George Soros extends his â€śtheory of reflexivityâ€ť from abstraction to application in the realm of investing. His book, The New Paradigm for Financial Markets, offers a timely look at the credit crisis that reached crescendo in 2008. His views fall between prescience and vindication. Nevertheless, he concedes fallibility: â€śWith all my great, deep understanding, I donâ€™t always get the markets right.â€ť
In conversation with Ricardo Caballero, Soros recounts the formative experience of his life -- surviving the German occupation of Hungary -- â€śa far from equilibrium situation.â€ť He credits his father for recognizing that â€śthe normal rules donâ€™t applyâ€ť and falsifying documents permitting the familyâ€™s escape from fascism. Soros attributes his intellectual development during college to the philosophy of Karl Popper. This led him eventually to question the economic postulate of â€śperfect knowledge and perfect competition.â€ť
He concluded that markets do not exist in a vacuum nor spontaneously self-correct. Thinking participants introduce friction, inevitably influencing outcomes for better or worse. Soros characterizes this phenomenon as the cognitive function interfering with the manipulative function and vice versa, thus the reflexivity of his theory. â€śPath dependence is very much due to imperfect understanding,â€ť he states and â€śactions have unintended consequences.â€ť
Time and again Soros has anticipated financial bubbles and capitalized on opportunities he foresaw. Caballero elicits his ideas on bubble formation and collapse. Sorosâ€™s metaphor is â€śpeople go on dancing even though they realize that the music is about to stop.â€ť He says the most common bubble is real estate where the misconception is that value â€śis independent of the willingness to lend.â€ť Soros asserts that a â€śsuperbubble has been growing for at least 25 years,â€ť periodically manifested by the international banking crisis and Latin debt in the early â€™80s; 1997â€™s emerging market crisis; the Internet technology explosion; overleveraging that created the housing bubble; and escalating oil and commodity prices. He also faults financial innovation and securitization of debt. â€śPeople became very loose in their lending habitsâ€ť and increased risk â€śby separating agent from principal.â€ť
Sorosâ€™s prescription for a sounder financial system begins with reducing troubled mortgages to 80% of current value, thereby minimizing foreclosures and preventing further decline of housing prices. He also recommends recapitalizing banks to encourage lending, and lowering the reserve requirement to 6%. His ultimate suggestion sounds simple enough: â€śStabilize the global economy.â€ť
Soros admits markets will always tend toward bubbles. He places responsibility on regulators to rein this in, adding â€śthat would require the use of judgment and theyâ€™re bound to get it wrong â€¦ because theyâ€™re human.â€ť
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