Monday, November 24, 2008

Soros: what to do about the crisis

George Soros has a long article in the New York Review of Books entitled "The Crisis & What to Do About It." It presents many things we know already, but the perspective is illuminating. And it raises interesting questions from a tax justice perspective. Near the beginning, he says this:

"The crisis was generated inside the system itself. This fact -- that the defect was inherent in the system -- contradicts the prevailing theory that financial markets tend towards equilibrium and that deviations from the equilibrium either occur in a random manner or are cased by some sudden external event."

This is important, if not exactly new. But now consider this.

"Guaranteeing that the banks at the center of the global financial system will not fail has precipitated a new crisis that caught the authorities unawares: countries at the periphery, whether in Eastern Europe, Asia, or Latin America, could not offer similarly credible guarantees, and financial capital started fleeing from the periphery to the center. . . . The International Monetary Fund is establishing a new credit facility that allows financially sound periphery countries to borrow without any conditions up to five times their annual quota, but that is too little too late. A much larger pool of money is needed to reassure markets. And if the top tier of periphery countries is saved, what happens to the lower-tier countries? The race to save the international financial system is still ongoing."

In light of this paragraph above, we should point out that another entire area of debate - and a huge one at that - has been neglected by everyone, as far as we can tell, except us: the powerful role that illicit financial flows have played in building up the giant global macroeconomic imbalances that have underpinned this crisis. (We provide a preliminary sketch of this forgotten area here, and we will develop this in due course.)

But back to Soros. He presents (not for the first time) his theory of "reflexivity": a two-way circular feedback loop by which financial markets present a distorted picture of underlying reality; these distortions in the picture feed back to the so-called fundamentals that market prices are supposed to reflect. And this has consequences for regulation too:

"It is important to recognize that regulators base their decisions on a distorted view of reality just as much as market participants—perhaps even more so because regulators are not only human but also bureaucratic and subject to political influences. So the interplay between regulators and market participants is also reflexive in character. In contrast to bubbles, which occur only infrequently, the cat-and-mouse game between regulators and markets goes on continuously. As a consequence reflexivity is at work at all times and it is a mistake to ignore its influence. Yet that is exactly what the prevailing theory of financial markets has done and that mistake is ultimately responsible for the severity of the current crisis."

Soros believes (and he is not alone) that the "subprime" crisis in the US housing market was merely the detonator for what he calls a "super-bubble" that has been brewing since the days of Ronald Reagan and Margaret Thatcher in the 1980s and prevailing financial market theory.

"This theory has been used to justify the belief that the pursuit of self-interest should be given free rein and markets should be deregulated. I call that belief market fundamentalism and claim that it employs false logic. Just because regulations and all other forms of governmental interventions have proven to be faulty, it does not follow that markets are perfect."

And he notes something that TJN knows all too well:

"Although market fundamentalism is based on false premises, it has served well the interests of the owners and managers of financial capital. The globalization of financial markets allowed financial capital to move around freely and made it difficult for individual states to tax it or regulate it. Deregulation of financial transactions also served the interests of the managers of financial capital; and the freedom to innovate enhanced the profitability of financial enterprises. The financial industry grew to a point where it represented 25 percent of the stock market capitalization in the United States and an even higher percentage in some other countries. Since market fundamentalism is built on false assumptions, its adoption in the 1980s as the guiding principle of economic policy was bound to have negative consequences."

It would only be a short intellectual step for this arch-capitalist to conclude that tax havens and tax competition are entirely pernicious, and harmful to most of the world's citizens. Soros, after all, is an interesting fellow, who by no means fits the stereotype of the ultra-wealthy speculator: he has provided major support to human rights and pro-democracy movements around the world, and in some countries his support has been helped bolster the most powerful political opposition to tyrannical régimes. Nevertheless, Soros has not taken this step. Perhaps because he knows that to do so would open him to cries of hypocrisy, for many of his wealth-attainment strategies have used offshore vehicles.

Nevertheless, he makes several other points.

"Whenever a crisis endangered the prosperity of the United States—as for example the savings and loan crisis in the late 1980s, or the collapse of the hedge fund Long Term Capital Management in 1998—the authorities intervened, finding ways for the failing institutions to merge with others and providing monetary and fiscal stimulus when the pace of economic activity was endangered. Thus the periodic crises served, in effect, as successful tests that reinforced both the underlying trend of ever-greater credit expansion and the prevailing misconception that financial markets should be left to their own devices. It was of course the intervention of the financial authorities that made the tests successful, not the ability of financial markets to correct their own excesses. But it was convenient for investors and governments to deceive themselves. . . . Eventually even the Federal Reserve and other regulators succumbed to the market fundamentalist ideology and abdicated their responsibility to regulate. They ought to have known better since it was their actions that kept the United States economy on an even keel."

Soros comments on the need for financial services companies to hold sufficient capital cushions, and of the cat and mouse games between market participants and regulators. He has a fair few things to say on this, but one important point is this:

"Sophisticated financial engineering of the kind I have mentioned can render the calculation of margin and capital requirements extremely difficult if not impossible. In order to activate such requirements, financial engineering must also be regulated and new products must be registered and approved by the appropriate authorities before they can be used."

Jim Stewart's piece in the last edition of Tax Justice Focus, on the Dublin International Financial Services Centre (IFSC,) recently looked at this issue, highlighting the ridiculous laxity in letting funds set up, willy-nilly:

"In Ireland, for example, if the relevant documents are provided to the regulator by 3 p.m. the fund will be authorised the next day. A prospectus for a quoted instrument is a complex legal and financial document (a debt instrument issued by Sachsen Bank ran to 245 pages) so it is unlikely it could be adequately assessed between 3 p.m. and the normal close of business (5 p.m.) Even worse, Luxembourg has a new law stating that as long as the fund manager “notifies” the regulator within a month of launch, the fund can enjoy pre-authorisation approval."

Which regulator ever cried wolf about this? Well, the wolf is now at the door, and at least things like this are getting some attention.

Soros, near the end of his article, says this:

"Since the risk management models used until now ignored the uncertainties inherent in reflexivity, limits on credit and leverage will have to be set substantially lower than those that were tolerated in the recent past. This means that financial institutions in the aggregate will be less profitable than they have been during the super-bubble and some business models that depended on excessive leverage will become uneconomical."

Which is exactly what we were talking about in our last blog, on the excess supply of financial services. Finance has been flying too high, and too freely, for too long. It is incumbent on all of us to fight for a re-assertion of democratic controls over this unruly beast.


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