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George Soros on the financial sword of Damocles

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George Soros, speaking in a conference call hosted by the New America Foundation today, had some interesting remarks about the state of the world economy. Given that the first sentence of his new book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, reads: "We are in the midst of a financial crisis the likes of which has not been seen since the Great Depression of the 1930s," I was prepared to hear some dire predictions about the road ahead.

Instead, on a number of occasions throughout the call, Soros stated that he believes the "most acute phase of the crisis is now over," and that the markets are breathing a sigh of relief following the Bear Stearns bailout. Of course, that's not to say that the fallout is over just yet, or that the boom-bust cycle that has recurred consistently since markets began to become unregulated will cease.

Soros was keen to note that the "scariest unregulated market" now is the credit default swap market, with outstanding contracts amounting to $45 trillion today. (Credit default swaps are a form of contract insurance that has been widely sold by hedge funds.) Writing in the Financial Times yesterday and repeating the warning today, Soros says, "The [CDS] market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfil their obligations. This prospect hangs over the financial markets like a sword of Damocles that is bound to fall." It will cause what will essentially amount to banks running on banks. The solution, Soros argues, is to urgently set up a clearinghouse or exchange where the the deals can be registered and settled. Without this type of step, the "entire banking system [will remain] weighed down with bad assets" and stay paralyzed. Even then, there is still little hope that this fallout can play out without significant effects on the real economy.

Soros's concerns extend well beyond the current financial crisis -- although he did mention that it was this crisis that forced him out of retirement. His argument is philosophical and is explained thoroughly in his fascinating new book. But the crux of it is that the idea that markets fall into equilibrium like events in the natural world is a complete myth; humans can't know "truth" and thus expectations and human actions inevitably change how the system functions, which can -- and does (hence boom-bust cycles) -- lead to non-equilibrium outcomes. The solution is finding a balance between regulation and unfettered markets. Soros is highly critical of market fundamentalism, and condemned regulators for failing to do their jobs. They have the tools, he said, but didn't use them. He believes the two Democratic presidential hopefuls are on the right track with dealing with the financial mess and re-regulation, but was careful to highlight the dangers of going to extremes either way.

One of the most interesting points Soros made was his take on the the coming fuel for the global economy:

We've had the American consumer acting as the motor of the world economy and that is what is coming to an end... [We] need a new motor. And I believe we have a tremenous challenge with global warming, where you need to make tremendous investment to reduce carbon emissions... The investments necessary to avoid global warming could replace the excess consumption by the U.S. consumer as the motor of the world economy.

Although Soros certainly didn't try to downplay the seriousness of the current crisis, I'm still left feeling slightly hopeful that the economy will improve and things could get better soon(ish). And I'm now certainly keen to buy those stocks in renewable energy companies.

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