Excerpts are taken from the text of the speech given by George Soros at the Festival of Economics, Trento Italy:
I have, for some time, believed that many of the most successful investors believe and understand Austrian economics – specifically Austrian Business Cycle Theory and the Austrian view of central banking. I believe they understand these and utilize the concepts in their investing strategy; however they do not say that they do, do not explain it as such, and often use the knowledge from this school of economics in order to advocate state actions that exacerbate the business cycle – in order to take better advantage of the economic and financial dislocations. Further, I believe that it is likely that some of these investors utilize these concepts without fully knowing that these are Austrian – Austrian free-market concepts are based on common-sense; you know, like wealth doesn’t come from a printing press. It is possible to fall into this camp and not realize that there is a label that goes with the ideas.
That long-winded introduction was for the purpose of introducing this speech by George Soros. I believe he is one who understands Austrian economics and I suspect he even knows that what he understands is Austrian. I believe he uses this knowledge in his investing approach, and certainly he advocates policies that exaggerate the market inefficiencies that enable even larger out-sized returns. The added advantage is that, in supporting such interventionist policies, he is seen as fully supportive of the interventionists – therefore his comments cause him no powerful enemies (I think he learned the negative side of making enemies after helping to take down the pound.) In fact, it enables him to make friends with some in the innermost circles.
Which leads me to this speech. Soros discusses concepts that are rather Austrian:
I believe that the failure [of modern economic theory] is more profound than generally recognized. It goes back to the foundations of economic theory. Economics tried to model itself on Newtonian physics. It sought to establish universally and timelessly valid laws governing reality. But economics is a social science and there is a fundamental difference between the natural and social sciences. Social phenomena have thinking participants who base their decisions on imperfect knowledge. That is what economic theory has tried to ignore.
Social events, by contrast, have thinking participants who have a will of their own. They are not detached observers but engaged decision makers whose decisions greatly influence the course of events…. [A participant’s] lack of perfect knowledge or fallibility introduces an element of indeterminacy into the course of events that is absent when the events relate to the behavior of inanimate objects. The resulting uncertainty hinders the social sciences in producing laws similar to Newton’s physics.
I am not an Austrian scholar; however it strikes me that these words could have been written by Ludwig von Mises himself.
Instead, I should like to put before you a radically different approach to financial markets.
Could it be that Soros is ready to spill the beans? Before he kicks the bucket, perhaps he wants to clear his conscience? “I am Austrian, and Hayek was my friend,” he is ready to shout from the rooftops!
It was inspired by Karl Popper who taught me that people’s interpretation of reality never quite corresponds to reality itself.
I have not heard of Karl Popper as a founding light of Austrian economics. Let’s find out what Karl Popper has in common with Ludwig von Mises: according to Wikipedia, both were born to Jewish parents, both attended the University of Vienna, both left Vienna in the mid-1930s. The similarities seem to end there. It would seem that Soros picked the wrong Austrian. Instead of explaining the Austrian Business Cycle Theory and the boom-bust cycle brought on by central banks and fractional reserves, Soros is explaining a different theory, based on Popper:
I found a two-way connection between the participants’ thinking and the situations in which they participate. On the one hand people seek to understand the situation; that is the cognitive function. On the other, they seek to make an impact on the situation; I call that the causative or manipulative function. The two functions connect the thinking agents and the situations in which they participate in opposite directions. In the cognitive function the situation is supposed to determine the participants’ views; in the causative function the participants’ views are supposed to determine the outcome. When both functions are at work at the same time they interfere with each other. The two functions form a circular relationship or feedback loop. I call that feedback loop reflexivity. In a reflexive situation the participants’ views cannot correspond to reality because reality is not something independently given; it is contingent on the participants’ views and decisions. The decisions, in turn, cannot be based on knowledge alone; they must contain some bias or guess work about the future because the future is contingent on the participants’ decisions.
This seems very complex, and a round-about way to explain what should be simple (and where it seemed Soros might be headed): central banking, as a form of central planning, has enabled infinite ability to create credit, and we are now suffering the consequences of this philosophy. Maybe this is what Soros is saying, but if he is about to break free, why not just come out and say it? It is possible (to the extent these words are understandable) to still get to Austrian economics while taking this path, I suppose.
Among other things, I developed a model of a boom-bust process or bubble which is endogenous to financial markets, not the result of external shocks. According to my theory, financial bubbles are not a purely psychological phenomenon. They have two components: a trend that prevails in reality and a misinterpretation of that trend. A bubble can develop when the feedback is initially positive in the sense that both the trend and its biased interpretation are mutually reinforced. Eventually the gap between the trend and its biased interpretation grows so wide that it becomes unsustainable. After a twilight period both the bias and the trend are reversed and reinforce each other in the opposite direction. Bubbles are usually asymmetric in shape: booms develop slowly but the bust tends to be sudden and devastating. That is due to the use of leverage: price declines precipitate the forced liquidation of leveraged positions.
Wait a minute - George is describing a mental bubble. But why would all market participants share the same trend misinterpretation at the same time? To what market signals are they reacting? In other famous words, who is standing at the punch bowl and serving the punch? Maybe the answers to these questions are forthcoming.
Well, not directly. Soros goes on to a discussion of the Euro crisis. Perhaps it is here that he will apply in detail his conclusions based on this “Road to Mises” that he is on (is that a Bob Hope movie?). Now we will have answers. Saints be praised, Soros is coming out of the closet!
He begins by explaining the history of the European Union – step by step, drip by drip, with the faith that each step would always lead to the next on the road to complete centralization: from the Coal and Steel Community to the Maastricht Treaty and the introduction of the euro.
The Maastricht Treaty was fundamentally flawed, demonstrating the fallibility of the authorities. Its main weakness was well known to its architects: it established a monetary union without a political union. The architects believed however, that when the need arose the political will could be generated to take the necessary steps towards a political union.
But the euro also had some other defects of which the architects were unaware and which are not fully understood even today. In retrospect it is now clear that the main source of trouble is that the member states of the euro have surrendered to the European Central Bank their rights to create fiat money.
The source of the trouble is the inability for each country to create fiat money on its own authority? This doesn’t sound like Mises.
He goes on to explain in some technical detail why the structure of the Maastricht Treaty and the Euro would inevitably lead to the crisis that Europe now finds itself in. On one level, his explanations may very well be accurate – in an environment of fiat money and further centralization, where the duration possible for deficit gain without economic pain is extended due to the subsidized borrowing rates afforded to periphery countries based on the perceived strength of the union, it is difficult to succeed if state freedom in creating fiat money is curtailed.
He further explains that, due to the lack of complete knowledge in the European technocrats charged with solving this dilemma, many policy mistakes are now being made, and in fact the problems are being exacerbated.
This is right on point with Hayek’s Pretense of Knowledge – and completely consistent with the analysis Soros used to begin this speech – no actor has complete knowledge, and the knowledge each actor has is imperfect and flawed based on the expectations and experience of the actor himself. If it is true for the individual actor, acting on his own behalf, it is infinitely more true for an actor pulling the levers of super-centralized bureaucracies. Perhaps there is hope that he will yet return to expose himself as the Austrian he really is (in the economic sense, of course).
Financial institutions are increasingly reordering their European exposure along national lines just in case the region splits apart. Banks give preference to shedding assets outside their national borders and risk managers try to match assets and liabilities within national borders rather than within the eurozone as a whole.
I have long felt that the step described here by Soros would be one step on the path to the inevitable breakup. Banks would reduce exposure to the sovereign debt of countries not their own. They would do this passively at first, by buying less debt from others (Deutsche Bank would replace maturing Spanish debt it held with new German debt, and Santander would do the opposite), but eventually this would become an active policy: Santander and Deutsche Bank will swap government bonds of like duration – Santander will swap out of its German bonds, and Deutsche Bank will swap out of its Spanish bonds. There is certainly a question of pricing, and to make this transition happen more smoothly, Germany may agree to the swap at market price. Spain certainly would!
With this step, escape from the Euro will be much easier, and bank nationalization will follow. Each sovereign will then be free to deal with their own national banks. I see this as a great step – anything that leads to further political decentralization can only be good for freedom – first the Soviet Union, then Yugoslavia and Czechoslovakia, today the European Union and perhaps one day the end of American Empire. Maybe this is also the way Soros sees it.
The indirect effect of this asset-liability matching is to reinforce the deleveraging process and to reduce the availability of credit, particularly to the small and medium enterprises which are the main source of employment.
Or maybe not. I don’t think Soros would bring up “deleveraging” and the reduction of available credit in this way if he thought this path was a good solution. Further, just as politicians use “the children” as the excuse to pass any myriad of new controls, Soros here invokes the small and medium enterprises as the victims of this deleveraging process (just as Americans were “sold” on the financial bailouts as necessary for small businesses to meet payroll), as if small businesses have ever benefited from any government program.
Correcting the mistakes and reversing the trend would require some extraordinary policy measures to bring conditions back closer to normal, and bring relief to the financial markets and the banking system.
Extraordinary policy measures? Back to normal? Whoa there, I am pretty well convinced this train is on a different track.
Banks need a European deposit insurance scheme in order to stem the capital flight. They also need direct financing by the European Stability Mechanism (ESM) which has to go hand-in-hand with eurozone-wide supervision and regulation. The heavily indebted countries need relief on their financing costs. There are various ways to provide it but they all need the active support of the Bundesbank and the German government.
Soros is clearly advocating for further centralization, further government interference in the markets – this is certainly not Misesian.
As mentioned before, the gradual reordering of the financial system along national lines could make an orderly breakup of the euro possible in a few years’ time and, if it were not for the social and political dynamics, one could imagine a common market without a common currency. But the trends are clearly non-linear and an earlier breakup is bound to be disorderly. It would almost certainly lead to a collapse of the Schengen Treaty, the common market, and the European Union itself.
Ah, I see now – he is only trying to buy time. It is necessary to further centralize in order to come to an orderly decentralization. In fact, he believes a chaotic decentralization would result in the destruction of the best aspects of the European experiment – open borders for people and goods. Soros wants to destroy national sovereignty in order to save it, and reduce individual freedom in order to protect it!
He then lays it on the Germans: the Germans must carry this load, because a breakup of the Euro and the EU – especially a disorderly breakup – would harm Germany more than it would harm the periphery countries.
We need to do whatever we can to convince Germany to show leadership and preserve the European Union as the fantastic object that it used to be. The future of Europe depends on it.
I am not sure when the European Union ever “used to be” a “fantastic object,” but that is a side issue. Germany must die so that others may live – and then Germany will raise itself from the dead, apparently. Sadly, only one person ever told that story and made it believable by living it – and that person wasn’t George Soros.
Unfortunately I must conclude that Soros is not on the road to repentance. He has not found Mises and the Austrians – well, he has found AN Austrian, but…well, never mind. I am starting to confuse myself.
After rightly explaining that the timing of the bust cannot be predicted, Soros goes on to claim that European leaders have three months to resolve this before the markets take control. How would he know? This three month pronouncement was the headline from this speech in the mainstream accounts, and it was certainly placed for effect – to light a match under the policy makers.
In this speech, Soros explains well that no man has perfect knowledge, but acting as if he does is what gets man in trouble. He then goes on to suggest that what is impossible for one man acting on his own account is possible for a few men acting on everyone else’s account.
Soros is not this blind. Without writing again my introduction in full, it will suffice to say that Soros knows Austrian economics, advocates for policies acceptable to the oligarchs that also (surprise, surprise, surprise), build even greater market inefficiencies for him to exploit. And he won’t yet admit to any of it.