Global Economic Trends: The Credit Crunch

Speaker:
George Soros Chairman, Soros Fund Management LLC; Author, "The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means"
Presider:
Sebastian Mallaby Director, Maurice R. Greenberg Center for Geoeconomic Studies; Paul A. Volcker Senior Fellow, International Economics, Council on Foreign Relations
Description

As strains on financial markets continue, six months after Federal Reserve Chairman Ben Bernanke officially recognized the credit crisis in testimony before Congress, understanding the origins of the situation and future ramifications are important to any evaluation of solutions. Join George Soros to discuss how the mortgage crisis has spilled over into other sectors and implications for the international economic system.

Audio
Transcript

SEBASTIAN MALLABY:  (In progress) -- Council on Foreign Relations.  Thanks to all of you for coming and for finding us, even though this is not our usual venue.  This is the latest in our series of meetings on global economic trends.  I'm delighted we have George Soros to talk to us.

Before we just get going, I should just remind you that please turn off those cell phones, BlackBerrys and things that go bleep.  This meeting, unlike some council meetings, will be on the record.

And George Soros has been described in many ways.  My favorite, I think, is this is the only individual who has his own personal foreign policy.  But it's actually not your philanthropy that's at issue today, it's rather the recent turmoil in financial markets.  I saw that Secretary Paulson said yesterday that he felt we had turned some kind of corner in the crisis.  When I checked the markets this morning, it wasn't clear that the equity markets agreed.  We'll see what George thinks in a moment.

But just to get started, I thought I'd ask a question in this way.  You've been a student of bubbles for a very long time.  What caused this bubble?  And what cause bubbles generally?

GEORGE SOROS:  Well, bubbles have two components -- a component in reality, a trend that is really happening in the world, and then a misinterpretation, some misconception.  And that misconception can initially reinforce both the trend and the misconception itself.  So you get these initially self-reinforcing but eventually self-defeating processes.  Because eventually, the trend accelerates and the misinterpretation is carried to an extreme, and the gap between reality and the perception becomes so wide that it becomes unsustainable.  And then the process goes on, eventually you reach a reversal point.

Now, the most common misconception, and actually the most common bubble, is in real estate.  And the misconception is that the value of the real estate or the house is not affected by the willingness of the banks to provide credit.  But in fact, it is affected, and banks sometimes ignore it.  And it's amazing, but it keeps on recurring.  So that's the most common, and that's an important element in what is going on because it's really the bursting of the housing boom that is at the heart of the current financial crisis.

MALLABY:  So the banks feel they can lend a lot because the real estate is worth a lot, but the real estate is worth a lot because the banks have lent a lot.

SOROS:  And so you had, in this case, you had interest rates too low, too long.  That encouraged lending.  That led to an acceleration in housing prices.  And that led to relaxation of lending standards, reinforcing each other.  And it's really been, you know, from 201 to 206 and then the reversal.

MALLABY:  And this point you're moving is of more than incidental interest in terms of the sort of intellectual consensus around how financial markets work.  I mean, if I'm right, it seems as though one of the central assumptions in modern financial economics has been that investors are rational, they can objectively try to perceive what assets are worth.  And what you're saying is that there's always a misperception, and this objective evaluation of asset prices is impossible.

SOROS:  Yes.  And in this case, you have this housing boom which is sort of the trigger for the larger boom, call it a super boom, which has been going on for at least 25 years.  Whether the real trend is credit expansion -- that's what happened in reality -- credit has been going significantly faster than the GNP and has been the motor that kept the GNP growing. 

And the misconception is what I call market fundamentalism that markets tend towards equilibrium, that deviations from equilibrium are random and that markets correct their own excesses.  And that market fundamentalism became the dominant creed, I think, with President Reagan in 1980 and when Margaret Thatcher came to power at the same time.  And that actually was the basis of the current phase of globalization.  So you've had globalization, liberalization of markets.

And then because markets don't tend toward equilibrium and they actually go to excesses, you have had a series of crises.  But each time, the authorities intervened and they bailed out the failing institution and did whatever was necessary to keep the system going.  And that reinforced both the credit expansion, because that's how they got the economy going again is by finding a new way of fostering expansion, and the misconception that markets can be left alone because they'll take care of themselves.  But of course, they don't.  It's always the authorities that come in and save the situation.

MALLABY:  And so if we look back over the last sort of three or so decades of financial history, there was, of course, the stability afforded by the gold standard up until 1971.  Then there was a kind of interregnum of inflation, stagflation and booming commodity prices, perhaps a bit familiar to people in the audience now.  And then you're saying that in the Reagan era, there began this period of stability around sort of faith in the dollar, faith in the American system, which made people willing to lend in dollars more and more.  So in fact, what you're talking about is the status of the dollar as a reserve currency and whether that may now be questioned.

SOROS:  Yes.  This phase has been based on the dollar as the reserve currency.  And with globalization of financial markets and the Reagan policy at the time of fiscal stimulus -- the (armament ?) actually was a big thing -- and relatively high interest rates attracted the savings of the world to the center.  And that's when we started developing economic current account deficit which has been growing pretty steadily ever since and reached over 6 percent of the GNP at its peak.

So we have effectively, the American consumer became the motor of the world economy.  And we were absorbing the savings of the world to finance that overconsumption.  And that could have continued indefinitely because there were countries that were very happy to produce more than they consumed and to accumulate reserves to build up their wealth.  First there was China, then Japan, the Asian Tigers and China and so on.  So you had willing borrower, the United States, willing lenders, so a chronic current account deficit was actually a kind of equilibrium. 

It could have continued indefinitely except that with the housing bubble, it's the household sector that became overextended because they saw the appreciation of houses as a form of saving.  So the savings rate actually fell into negative territory because the houses provided the wealth accumulation.  And actually, people started withdrawing equity from their mortgages.  And mortgage equity withdrawal at its peak was even higher -- about $850 billion I think or 900 billion (dollars) in 2006 -- was even higher than the current account deficit and is the housing bubble that is now also unwinding this current account deficit.

MALLABY:  So there are two halves, in other words, two sides to this long super bubble.  On the one hand, the willingness of foreigners to provide loans to the United States; on the other hand, the appetite of the United States to borrow.

SOROS:  Yes.  And there's a third.  There's a third element which is the overleveraging of the financial institutions and the use of various, newly invented financial instruments that were not regulated and were used and abused.  And these were connected also with the mortgage market because mortgages were then packaged, repackaged, sliced up and again repackaged and sold to investors.  Banks, instead of keeping loans on their balance sheets, repackaged them and securitized them.  So securitization and the various synthetic instruments are the third factor.  So these three elements come together to give you this super bubble.

MALLABY:  And so do you view financial innovation as more of a negative for the economy than a positive?

SOROS:  No, no.  I think it's -- but it's not an unmitigated benefit as, let's say, you could say that many technological innovations, although not all technological innovations are unmitigated benefit either.

MALLABY:  Most of them are -- (inaudible) -- right?

SOROS:  But we tend to think of it that way.  It's not unmitigated because many of these instruments are developed to avoid regulation.  So for instance, if you have loans, then you need to keep the, say, 10 percent equity in the loans.  But if you just slice up the loan and you take only the risk, you can take risk and have this credit default swaps.  Then you only need maybe 1.5 percent margin, so you can leverage up a lot more.

MALLABY:  And is there a way, do you think, for a government more effectively to be able to extract the benefits of financial innovation, to preserve those as well as mitigating the risks?

SOROS:  I think it's basically very healthy to have this innovation.  But you mustn't abandon regulation, and that's where market fundamentalism which believes that you best leave it to the market, you see, that was the excess that led us to the current.  It's really the failure of regulation.

MALLABY:  I want to probe a little bit more about the super bubble.  Because if you look in the data about the ratio of American debt to GDP, there's no dispute what's happened in the past.  In other words, debt to GDP inched up very slowly between 1950 and 1980.  There's a nice graph of this in your new book.  And then from 1980 -- whew!  It explodes. 

SOROS:  That is a typical parabolic --

MALLABY:  Exactly.  So we know what's happened.  The question is, what's going to happen in the future?  And you've written in the past that there are times when a trend is challenged, it goes through a hiccup for a while, and then it reasserts itself.  And the reconfirmation of the trend, of course, makes people believe in it all the more passionately.  And then whew!  The parabola even accelerates.  So is it possible that at this juncture what we're seeing is sort of a one-year or so interruption in the trend, and then the super bubble will continue because the willingness to provide capital to the United States will remain there?  The sovereign wealth funds, the central banks in the Gulf states and in the East Asian countries that have all the capital, they're going to carry on wanting to put their assets somewhere, and it may well be in dollars. 

And so to the extent that that is true, borrowers will be found in this economy, whether it's the federal government, whether it's the corporate sector, even if the household sector is tapped out, and then this trend will be reasserted or reconfirmed and will carry on in this super bubble.

SOROS:  No, you are absolutely right.  In the past crises, we have had a number of them that were actually successful tests of the thesis, of the misconception, and led to an acceleration.  And it was, for instance, the successful way of dealing with the Internet bubble, the IT bubble, lowering interest rates that then directly led to the housing bubble.  So maybe there is something that could be used to keep this process going.  And so it's actually an open question.

And right now, actually the stock market seems to believe that the worst is behind us, and in fact this is a crisis like any other crisis and a great opportunity to buy.  And it may well be true.  I take a different view.  But since we are all fallible, I may be wrong.  You know, history will tell us.  I personally think that we have the acute phase of the financial crisis largely behind us. 

And in fact, the authorities have it as their mission to stop the system from falling apart and provide liquidity at all costs.  And they've done it, and they've done it again.  And in fact, they have gone sort of past several new thresholds in doing it, but they've done it.  So that is a source of reassurance that the system is not going to fall apart.

However, the damage that has been done to the system has to affect, in my opinion, the real economy.  And the effect of that is only beginning to be felt.  And there is a certain time lag because the motor has been consumers, now they have lost their mortgage equity withdrawal and housing appreciation.  And so they have to increase their savings.  But it takes time for them to adjust their behavior.  And so actually, currently, you know, credit card debt is still rising.  People find other ways of maintaining their living standards or habits.  But I think inevitably they will pull back.  And that process is only beginning. 

The housing problem, I think, continues to be the leading factor as far as the real economy is concerned.  Because just as they overshot on the upside, they will also overshoot on the downside.  And currently, house prices are accelerating on the downside.  They were falling at an annual rate of, I think, 21 percent in December, about 24 percent in January, 29 percent in February.  That's an accelerating rate.  And to expect that by the end of the year you will have passed through that, I think, is an unrealistic thing because you've got certain processes going on with the subprime loans.  There are about 5 million of them.  And in the next 18 months if they are (rebagged ?) they will be just six months into that process.  And about 40 percent, I think, will default.  This is my estimate.

Then you've got this option adjustable rate mortgages -- the same thing.  So I think you will have, unless something more is done, you will have about 4 million defaults in the next two years.  And it takes about a year before a default leads to foreclosure, and about half the defaults end in foreclosure.  So right now, you've only got a very few foreclosures.  But that is at the very beginning of an uptrend.

So I think what needs to be done is to try to keep the foreclosures to a minimum.  And I don't think that either the fiscal measures or the monetary measures will stop that process unless something more is being done.

MALLABY:  It sounds as though you think that President Bush would be making a mistake if he delivers on this threat to veto the housing bailout package that the House Democrats are cooking up.

SOROS:  Yes.  I think this administration ideologically is not prepared to intervene.  And there's also strong public opinion against bailing out the lenders or borrowers who have gone to an excess, so political pressure also.  So I think that pressure will have to mount before adequate measures are taken.

MALLABY:  But it also seems that you are fairly pessimistic about the ability of all this official activity to cushion the economy from the contraction and consumption that you're predicting.  I mean, we've had a fiscal stimulus.  We've had liquidity pumped into the banking sector.  We've had the Bear Stearns bailout.  We may or may not get some kind of housing action.  We've had a range of measures, as you say, but you don't think that's going to be enough to save us from a recession next year?

SOROS:  Yes.  And the markets have taken heart, at least the stock market, and we now have a rally.  And I think this is a fairly typical bear market rally.  I may be wrong.  But I think this is it.  This is a bear market rally.

MALLABY:  And I mean, obviously, the nightmare analogy is with Japan in the 1990s where the equity market broke in 1990.  The property market broke in '91.  And then it was most of the decade before anything looked any better.  How many years do you expect that it might take to sort this out here?

SOROS:  That's the other extreme actually.  One is that this is, you know, we are out of the woods, and by the end of this year the economy is re-accelerating and profits are rising.  This is the optimistic extreme.  And the Japanese is the pessimistic extreme because you have the real estate bubble -- it wasn't housing but real estate -- and you had the financial system loaded down with bad debt.

But the big difference between Japan and us is that here the losses are being recognized, written off.  Actually, some of the write-offs may turn out to be excessive because you don't have proper measures, you lose these indexes, and the indexes are the source sellers use, so they may be --

MALLABY:  The ABX index.

SOROS:  The ABX index and so on.  So we have the write-offs, and the authorities are urging the banks to re-capitalize themselves and in fact they are doing that.  Therefore, this accelerates the process of adjustment.  So I don't expect it to last nine or 10 years.

But on the other hand, the amount -- right now, markets are very ready to provide new capital.  But a lot of the new capital comes in, but the activities of the banks or the institutions will be shrunk.  That's why the capital comes in to turn those companies into profitable enterprises.  So the credit squeeze will continue. 

And also, it remains to be seen whether there's enough capital around.  Because even though the figures are very large, the losses that have to be made up for are even larger.  So this is now the (confession ?) that only the future will tell.

MALLABY:  There was a moment in the late 1980s after the Wall Street crash and before the economic troubles emerged in Germany and Japan where people spoke in quite sweeping terms about the decline of the American economic model, maybe bank-led capitalism was superior and so forth.  I mean, how do your view of the markets now affect your view of sort of geopolitics?  I mean, do you think we're in for a period when people question American supremacy and that adds to the -- (inaudible) -- of foreign policy that already exist?  And how would cross that bridge into politics?

SOROS:  Yes, unfortunately, I happen to agree that there is serious questioning of American governance.  The system was built on American supremacy and the financial system even more perhaps than the political system.  The dollar was the unquestioned (deserved ?) currency.  That is not the case anymore.  And the Washington consensus imposed certain principles of balancing budgets on other countries but did not impose that discipline on the center, on the United States.  And we did abuse that privilege by running up this chronic current account deficit.

And unfortunately, as you know, I've been a severe critic of the Bush administration's policies, the war on terror and the invasion of Iraq and so on, which meant to assert American supremacy in the world, and it had the opposite effect.  It has undermined America's power and influence in an unprecedented way. 

And now something is happening on the financial side which also there's now an increased reluctance to hold dollar assets.  The central banks don't want to accumulate dollars.  They've been diversifying into other currencies, pushing up the exchange rate and depressing the dollar.  But actually, there isn't a suitable alternative to the dollar.  I mean, the Euro, to some extent, but it isn't quite there, certainly not -- (inaudible). 

And so because of that, there has now been a general flight from currencies.  And the (carriage ?) of countries set up sovereign wealth funds.  Now, you are right in pointing out that these sovereign wealth funds could be, in a way, the saviors of the system by replenishing the equity of the financial institutions.  I don't think that politically it will be possible for Abu Dhabi in Russia and China to put enough capital into Citibank to actually accomplish it.

But it has been a positive factor as far as the financial replenishing is concerned.  But I don't think it can provide.  And if it did, of course, it would really make the decline of American power and influence pretty well official.

MALLABY:  So we've had a sort of parallel between, on the one hand, a diminution in America's military readiness and its ability to project military power.  And you're saying also that there's a sort of similar thing on the financial side.  In most countries, if there's a financial shock and the central bank tries to respond by cutting rates, the response of savers is to move money out of that currency,  And so the currency shock sort of neutralizes the central bank's freedom to response, right?  And the U.S. has been an exception in the past because people wanted to hold dollars, they thought in dollars.  And so the Fed could cut rates and be the savior after the (LTCM ?) incident, the Russia incident, the dot-com boom and so forth.  The Fed could cut rates and rescue the world economy, but that may no longer be the case if the willingness to hold dollars and think in dollars comes into question.

SOROS:  That is exactly the constraint.  And also, you have inflationary pressures which provide additional concern.  So I don't think we can go back to 1 percent Fed funds.  And in fact, recognizing the dangers that that would involve to the status of the dollar, the Fed has indicated that it doesn't really want to go below 2 percent where it is now, it at all possible. 

That is why actually currently there's a certain recovery in the dollar because people are reassured that maybe they won't be flooded totally with dollars.

MALLABY:  That the Fed recognizes the limits to its own power.

SOROS:  That's right.  That is right.

MALLABY:  So I want to go to the audience in a second, but just let me ask one last thing.  In terms of sort of prescriptions for how to make the system safer, people have talked about moving derivatives transactions onto exchanges more, requiring financial institutions, both banks and hedge funds, to hold more capital as a cushion.  In this realm of prescriptive ideas, what do you say there?

SOROS:  I think the most important lesson that we need to learn is that it's not enough to control the money supply, that we also have to control credit separately from money.  And we have to recognize that markets go to extremes of euphoria and panic; and therefore, we have to adjust the margin requirements and the minimum reserve requirements that we impose on banks and market participants.  So adjustable margin requirements and minimum reserve requirements, these are tools that have fallen into disuse.  They've been deliberately left unused, and I think we need to start using them again.  And central banks have to accept that they have a responsibility to prevent asset bubbles from going too far, for instance, by imposing higher minimum reserve requirements on banks when they lend too much.  So that's, I think, the change in the regulatory environment, that's a central change.

Then in addition to that, I think, you do have a specific problem with mortgages, and you have to find ways to reduce the foreclosures to a minimum.  You can't eliminate them.  You can't interfere with the right to foreclose.  But you can adjust mortgages and downsize them, write them off.  It's more efficient than going through the foreclosure procedure.  So that's a technical, specific issue for this particular crisis.  But generally speaking is controlling credit, not only money.

MALLABY:  So Greenspan was wrong in saying you should not target asset bubbles, there should be these adjustable margin requirements for traders so that they put up more capital when you want to rein in the amount of investment and for banks as well adjustable capital requirements, like in Spain.

SOROS:  Yes.

MALLABY:  Okay.  Well, let's go to members of the audience.  I'd invite you to wait for the microphone, speak directly into it.  Stand, state your name and affiliation.

I have a question in the front -- Mr. Clemons. 

QUESTIONER:  Steve Clemons, New America Foundation.

George, I have read the book.  And you were a student of Karl Popper, and that fundamentally your experience with Popper and your thinking about really this question of reflexivity drove you to do the book, not the financial market crisis.  But there's a charming part of the book where your son Robert says, my father is just full of it, he doesn't make investment decisions like this.  It matters more in whether he had a backache or a shoulder ache, and you've devised an interesting thing.  And it raises a question.  At Soros Fund Management, do you put those workers through school on reflexivity?  And how do you think it's best to sort of transmit the template of your thinking?

One other part of this is you've returned to manage your own account, which you had stopped doing.  And you take us through your decisions.  And you have a big rise and then a big fall.  And you finish the book saying, we're below water.  And I'm interested in, since the book came out, are you back above water?

(Laughter.)

SOROS:  Well, several questions here.  It's always backache, never shoulder ache.  (Laughter.)  It comes from tension.  And the tension -- you know, when I can resolve the tension, the stomach ache goes away.

MALLABY:  Has that always been true?  That's not just a story from the 1970s?

SOROS:  When?

MALLABY:  That's not just a story from the 1970s?  That's always been the case, that still now you have backache when --

SOROS:  No, I don't have backache.  No, no.  I used to have backache when I was active in running the fund.  And I've had no backache, even though I'm currently more involved in the market.  So I'm happy to be out of that.  But that was one question.

But I don't impose my philosophy on others.  I think it's my view, and I may be wrong, and other people -- I've delegated my money to other people to run.  And when I saw this crisis coming up, since it's my money and I didn't want to lose it, I set up a savings account, a macro account, where I counterbalanced what they were doing.  (Laughter.)

So I offset it.  I didn't impose my will on them, but I protected my own wealth.  And, in fact, I'm still slightly under water, and maybe I'll get a little bit more under water, because I do not buy into the current market rally.  I think it's pretty close to having run its course.  But while it's running its course, I'll lose some money.

MALLABY:  Okay.  Let's see.  There's a question here in the front.

QUESTIONER:  Allan Wendt.

Mr. Soros, do you think that the Fed has gotten the balance right in terms of the tradeoff between low interest rates and their impact on the domestic economy and the impact on the dollar abroad?  Have they not possibly gone overboard?  And what are the consequences of a perennial weak dollar?  Isn't it a form of mercantilism whereby we sell everything we produce more cheaply and pay more for everything we import?

SOROS:  No, I think that the Fed is right to have not gone below 2 percent, because I think if it has to go below 2 percent, it will have pernicious consequences, because they would do that because the economy is still in recession.  They haven't done enough; they have to do more.  And with the economy in recession and interest rates going down, the dollar would certainly come under renewed pressure.

The fact that they stopped at 2 percent is now giving the dollar breathing space also, so the dollar has stabilized as a result of this action.  So I think, in this respect, they were slow in starting.  They lagged.  They were behind the curve.  But then, at the beginning of the year, acting very radically, I think they are now just in the right place.

And it's now the Europeans, and particularly the British, who are behind the curve, because the fall in the dollar has had the effect of us exporting our recession to them, because our current account has greatly improved.  It has added at least 1 percent to the GNP in the first quarter.

That's what has kept it in the positive territory, as far as we know.  So (final ?) demand is down below zero, and GNP is 0.6 percent.  But that 1 percent has come out of the rest of the world.  So now Europe is slowing down and they are sticking with their one-directional (fight inflation ?) policy.

MALLABY:  There's a question back there.

QUESTIONER:  Thank you.  Camille Caesar from Commerce.  Thank you, Sebastian.

Two quick questions.  The first is, how do you think that the powers of the Fed and also the other agencies charged with financial institution regulation should be changed, if at all?

SOROS:  I have difficulty hearing you.  Can you repeat the question?

MALLABY:  How do you think that the powers of regulation of the Fed should be changed?  Is that right?

SOROS:  How the --

MALLABY:  The regulatory powers of the Fed -- regulatory powers.

QUESTIONER:  Should they be --

SOROS:  Let me answer you, and then -- (inaudible).

I think the Fed has all the powers it needs.  It just hasn't used it, because they had the power, for instance, to regulate the mortgage market, and they didn't.

QUESTIONER:  And my second question is about the long-term real rise in commodities prices, assuming that what we have is a permanent shift there.  How do you think this change is going to lead to any restructuring in our economy?  Are we, for example, going to become more of a resource-saving type of economy, as you find elsewhere?

SOROS:  Again I can't --

MALLABY:  Okay, sir.  Does the run-up in commodity prices augur structural changes in the economy, or do you think it's a bubble or --

SOROS:  That's a very difficult question with the commodities, because there is a commodities bubble.  There's a flight from currencies into commodities, and there is definitely a bubble element.  But then you have different causes as well.

In the case of oil, I think that, to some extent, one can speak of what you might call a backwards-sloping supply curve; you know, the higher the price goes, the less incentive the oil-producing countries to take the oil out from under the ground and convert it into dollar reserves above ground.  So that's part of it too.  And then there's also, of course, the global warming and the difficulty of increasing cost of finding new oil.

So all those things, plus the increased demand from emerging markets, which are very heavily energy-intensive.  So all those things come together to create this quite amazing rise in oil prices.  And I think that rise is now also in this parabolic phase where it's difficult just to explain it by anything reality-based.  There is something else going on.  So that's the bubble aspect.

And then in food, global warming has affected food prices in two ways.  One is because of biofuels, and the other one is because of the failure of the rice crop in Australia.  Now you have the cyclone in Burma.  That again is destroying the rice-growing areas; so disruptions in the production cycle, and again, the improvement in living standards in the emerging markets.

So all these things come together creating these commodity bubbles, which set up inflationary pressures.  Now, this makes the job of the regulators very difficult, because you are faced with recession and inflation, and that requires opposite policies.  And that, again, is why this time I think the authorities will not be able to get us out of this the way they did on previous occasions.  It's one of the things that makes me more pessimistic than the markets.

MALLABY:  (Inaudible.)

QUESTIONER:  Ted Smith from the Heinz Company.

Thank you, George, for coming here.  As one of the leaders of the reality-based community, I welcome you to Washington, the capital of the fiction-based community.  It's probably no coincidence that you're here, because it's clear that, having read your book, that the leaders of the financial community have no incentive to stop the boom-bust cycle, because the plutocracy gets rich on the boom and the  American middle class picks up the tab for the bust.

Given that, my question to you is, what can Main Street do to tame Wall Street, particularly to enforce the Fed and other things to prevent the further weakening of the American middle class?

SOROS:  Well, I think people can vote and express their votes in voting.  And I won't express my views, because I try to be less party political than I have been in past occasions.  So that, I think, is the main way that, in a democracy, people express their views.

MALLABY:  Back there with the glasses.  Right in front of you.

QUESTIONER:  (Inaudible.)

MALLABY:  Can you identify yourself?  Thank you for identifying yourself.

QUESTIONER:  Okay.  You mentioned earlier on the $900 billion home equity -- you know, the withdrawal.  I've seen numbers that may not be quite that large, but very large for the few years preceding that, which I assume has contributed a lot to the growth of our economy.

My question to you is, can we really expect a recovery here before that amount of money has been placed in our economy?  And, if not, what is the source of this equity?  Do we wait for the mortgage market to reprice and the home market to appreciate?  Are we looking at tax cuts?  Are we looking at a technology bubble?  What is going to drive the recovery?

SOROS:  I happen to share your view that the American consumer that has been the main motor, not just of the U.S. economy but of the world economy, is not incapacitated to play that role.  So consumption as a percentage of GNP, and maybe in absolute terms, has to decline and is already declining.  So then the question is, what will take its place?

And I personally believe that we have a tremendous challenge ahead of us with global warming.  We have to develop non-polluting fuel sources.  We have to take carbon out of coal and fossil fuels generally.  That will require tremendous investment, and we need to do for our survival.  And I think that could provide the motor for the world economy.  It requires the United States to change its policies towards global warming, getting together with the Chinese and the Indians, who have become now very large polluters.  And I think that's where we need to go.

MALLABY:  A question in the back, right in front of the TV cameras.

QUESTIONER:  (Inaudible) -- from CNN -- (inaudible).  Thank you very much, sir.

I have two quick questions.  Do you believe that the emerging markets have felt the recent crisis?  Will they ever feel it?  And the second one is, if it was up to you to make a decision about fighting inflation versus growth, which one would you choose at this current situation -- (inaudible)?

SOROS:  The first one is about emerging markets, and I think that they are not immune.  And one of the reasons why I'm under water this year is because I overstayed my welcome in those markets.  (Laughter.)

And the second question I didn't hear.

MALLABY:  Would you target inflation or would you target -- if you were running monetary policy, would you target inflation or would you target growth?

SOROS:  Well, I think you need to balance it.

MALLABY:  (Laughs.)

SOROS:  And I think that the management of the -- macroeconomic management is not a science.  And reducing it to simple rules like, you know, inflation targeting is a mistake.  And I think we are dealing with reflexive processes.  There are many different reflexive processes going on at the same time, and it's a matter of balancing them.  And it's an art, not a science.

MALLABY:  Let's go in the front here.

QUESTIONER:  Thank you very much, both of you.  My name is David Apgar.  I'm with microfinance fund manager Blue Orchard.

A speculator faces possible refutations of her best guesses every day in the market.  One of the problems, it seems, that we have in setting our fiscal policy, our federal budget and its deficits, is that there doesn't seem to be an effective learning process.  We don't get a quick refutation from the market when we get fiscal policy badly wrong.

Are there any ways of building a better learning process into our markets so that there's a faster readout when policymakers get fiscal policy wrong?

SOROS:  No, I think that it's the fate of central bankers that they've got to be wrong eventually.  Now, how long it takes for them to be wrong and how far wrong they go is probably the measure of their success -- how far they go being wrong.

MALLABY:  What about the fiscal side, though?

SOROS:  What?

MALLABY:  What about the fiscal side, when parliaments have a budget that doesn't make sense?

SOROS:  Yes, well, the fiscal side.  Well, that's actually more difficult.  And while fiscal policy can be very useful, it usually takes very long time to kick in.  And honestly, I don't have the answer.

MALLABY:  Steve.

QUESTIONER:  Thank you.  Steve Charnovitz at George Washington University.

I can understand perfectly well the benefits for the environment of taking positive action on climate change.  But you suggested a moment ago that there were economic benefits for the economy in so doing.  And I wonder if you could expand upon why there'll be economic benefits when the cost of energy goes much higher as a result of emission trading and setting limits on -- (inaudible).

SOROS:  Well, if I'm right, if I'm right in thinking that we're heading into a recession, that the recession is effectively unavoidable -- it's only a question of the magnitude of that recession -- then you have idle resources.  And you need to find some way to put them to use in order to create the multiplier effect that will get the economy going.

And I think that making the necessary investments in taking, for instance, carbon out of coal, generally speaking, to reduce our energy consumption, because a lot of energy-saving investments could be made, you need to put a price on carbon, carbon emissions, because that will encourage investment that will reduce carbon consumption.  And that will put these -- will be a stimulus to the economy at a time when the economy needs a stimulus.

MALLABY:  So sort of deficit finance spending.

You've been very patient.  Wait for the microphone, please.

QUESTIONER:  (Inaudible) -- even as our power as a nation declines -- (inaudible) -- wide range of issues.  Now, fortunately, we will have a new administration -- (inaudible).  Do you think that new administration could take some initiatives in the economic field, trade, financial imbalances, immigration, which would reverse this trend?

SOROS:  Well, you are right to point out that protectionism is a great danger; that because of the tremendous strains that we are currently exposed to, that it will lead to protectionism.  There are differences of policies that lead to a breakdown in the global trading system, and that could have really a devastating effect.  So that's a danger that we need to avoid by engaging the right kind of policies, finding the proper understanding between the national interest and reconciling national interests so that we keep the system open.

MALLABY:  Right over here.

QUESTIONER:  I'm Welby Leaman from the Treasury.

I heard you say that we've had, in the last number of years, excessive leverage and perhaps excessive credit and insufficient regulation.  And my question is whether, given Hernando de Soto and others suggesting that in some parts of the world one of the major causes of poverty is excessive regulation, insufficient credit and leverage, are you saying that we should permanently have a policy bias towards more regulation than what we have had and less credit expansion?  Or is it simply that we've gone too far and now is the moment for American democracy to switch back, as at some point in the future we may need again to switch back towards this direction?

SOROS:  There's no question that the regulators failed to exercise their powers and to regulate.  So there's been a regulatory failure.  You now have a financial crisis, maybe serious recession.  There's a great danger now that you go to the other extreme of re-regulating too far.

When you had the Great Depression, the entire banking system was put in a straitjacket, and it stayed in that straitjacket until 1972.  That was the day when -- (inaudible) -- invited security analysts and told them that actually banking -- (inaudible) -- growth industry.

So that was the watershed, let's say.  So until then, banking was frozen.  So we don't want to go back there, because even though markets are imperfect, regulators are also human.  And worse than that, they are bureaucratic.  So they are much slower in adjusting to changing circumstances.

So we need to improve our regulations.  There's no question regulators have failed to exercise their powers.  We must now learn to regulate credit as well as money, but rely on the market mechanism to the greatest possible extent.

So I'm often taken to task for sort of criticizing capitalism when I am myself known as a capitalist.  And I'm doing that because I want capitalism to survive.  It's much better than central banking.  It was the failure of communism, socialism, that led to the (excess ?) of market fundamentalism.  Now we must abandon that.  We have to realize that markets are not perfect, but we mustn't fall back into the other mistake.

MALLABY:  But George, I think, you know, behind Welby's question is the following.  You know, we can agree that the U.S. economy in 1972 had not enough leverage or that Hernando de Soto's Peru has not enough leverage.  But do we really know how much the right level is?

And if we don't really know -- and I think you would say that human perceptions are always fallible and we can't be sure -- shouldn't we decentralize that choice to individual borrowers rather than having regulators step in and set some necessarily arbitrary amount of borrowing that is deemed to be the right balance between, on the one hand, cheap capital, and on the other hand, too much risk?

SOROS:  No, you see, it's a very reasonable argument, but if you leave it to the individual market participants, the bankers and so on, they will go to excess.  And then you have got to save the system and you have to bail them out.  And that creates what is now recognized as the moral hazard.

Now, so if you are subject to being bailed out, you are receiving protection from the authorities, whether you recognize it or not.  And therefore, you have to be also subject to some regulation, because it's really the job of the regulators not to have to bail out the system.

So credit creation inherently involves this potential boom-bust bubble aspect.  And you have to control the bubble on the growing side so you don't have to take all the pain that comes with the bursting of the bubble.  So that's the reason I would give why you have to control leverage.  And, of course, the control will never be perfect, but definitely if you leave it to the markets, they will overleverage.  And they did.

MALLABY:  Should they control the leverage of your fund?

SOROS:  Indirectly, yes, by adjusting the reserve requirements that banks have to keep, depending on the leverage employed by the borrower.  So a less leveraged fund would require less minimum reserve requirement, and the more leveraged fund would require more.  And then you couldn't have the overleveraging that you have had.

MALLABY:  I want to take another question from the floor.  And I want to remind you, before we close, that this going to be -- this has been on the record, this session.  So let's take a last question right there.

QUESTIONER:  Thank you very much.

You have emphasized in your conversation with Sebastian that the U.S. consumer has been the engine of global growth.  You also pointed out that, thanks to exports, we have so far avoided falling into the recession.  My question is whether you envision more opportunity for the United States to be a greater exporter and greater producer, as opposed to consumer, both with regards to manufactured goods as well as agricultural goods, and, if so, in spite of the rising oil prices, whether you see there is an opportunity for a shift of U.S. fortunes towards production.

SOROS:  Yes, definitely.  That supposes we are now in a process of adjustment.  It's like a junkie coming off drug abuse.  It's a painful process, but it is actually happening.  You know, our current account deficit is shrinking, and quite substantially.  And I think it will inevitably have to shrink more if the rest of the world is not willing to support our habit.

MALLABY:  Maybe we've got time for one more.  And let me go right here.  I'm sorry, Allan, you've already asked a question.  Is there anyone else who wants to?  (Inaudible.)

QUESTIONER:  Thank you.  I'm Robert Herstein (sp).

Regarding the reflow of investment from abroad, do you feel that the U.S. policy should be any different toward investment by market players, on the one hand, and investment by state-controlled enterprises or investment vehicles, on the other?  And, if so, how do we find that line and how do we implement it?

SOROS:  Well, I think that we obviously need to remain open to investment from abroad.  Sovereign wealth funds create -- pose a problem, because there could be political motivations other than commercial motivations.  So that is an issue that needs to be handled, and there needs to be certain standards of transparency.  And it is actually being worked out.  And I think that sovereign wealth funds that abide by those principles should be free to invest like any other institutional investor.

MALLABY:  Well, thank you very much to our guest, George Soros.  Thank you to all of you for coming.  (Applause.)

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SEBASTIAN MALLABY:  (In progress) -- Council on Foreign Relations.  Thanks to all of you for coming and for finding us, even though this is not our usual venue.  This is the latest in our series of meetings on global economic trends.  I'm delighted we have George Soros to talk to us.

Before we just get going, I should just remind you that please turn off those cell phones, BlackBerrys and things that go bleep.  This meeting, unlike some council meetings, will be on the record.

And George Soros has been described in many ways.  My favorite, I think, is this is the only individual who has his own personal foreign policy.  But it's actually not your philanthropy that's at issue today, it's rather the recent turmoil in financial markets.  I saw that Secretary Paulson said yesterday that he felt we had turned some kind of corner in the crisis.  When I checked the markets this morning, it wasn't clear that the equity markets agreed.  We'll see what George thinks in a moment.

But just to get started, I thought I'd ask a question in this way.  You've been a student of bubbles for a very long time.  What caused this bubble?  And what cause bubbles generally?

GEORGE SOROS:  Well, bubbles have two components -- a component in reality, a trend that is really happening in the world, and then a misinterpretation, some misconception.  And that misconception can initially reinforce both the trend and the misconception itself.  So you get these initially self-reinforcing but eventually self-defeating processes.  Because eventually, the trend accelerates and the misinterpretation is carried to an extreme, and the gap between reality and the perception becomes so wide that it becomes unsustainable.  And then the process goes on, eventually you reach a reversal point.

Now, the most common misconception, and actually the most common bubble, is in real estate.  And the misconception is that the value of the real estate or the house is not affected by the willingness of the banks to provide credit.  But in fact, it is affected, and banks sometimes ignore it.  And it's amazing, but it keeps on recurring.  So that's the most common, and that's an important element in what is going on because it's really the bursting of the housing boom that is at the heart of the current financial crisis.

MALLABY:  So the banks feel they can lend a lot because the real estate is worth a lot, but the real estate is worth a lot because the banks have lent a lot.

SOROS:  And so you had, in this case, you had interest rates too low, too long.  That encouraged lending.  That led to an acceleration in housing prices.  And that led to relaxation of lending standards, reinforcing each other.  And it's really been, you know, from 201 to 206 and then the reversal.

MALLABY:  And this point you're moving is of more than incidental interest in terms of the sort of intellectual consensus around how financial markets work.  I mean, if I'm right, it seems as though one of the central assumptions in modern financial economics has been that investors are rational, they can objectively try to perceive what assets are worth.  And what you're saying is that there's always a misperception, and this objective evaluation of asset prices is impossible.

SOROS:  Yes.  And in this case, you have this housing boom which is sort of the trigger for the larger boom, call it a super boom, which has been going on for at least 25 years.  Whether the real trend is credit expansion -- that's what happened in reality -- credit has been going significantly faster than the GNP and has been the motor that kept the GNP growing. 

And the misconception is what I call market fundamentalism that markets tend towards equilibrium, that deviations from equilibrium are random and that markets correct their own excesses.  And that market fundamentalism became the dominant creed, I think, with President Reagan in 1980 and when Margaret Thatcher came to power at the same time.  And that actually was the basis of the current phase of globalization.  So you've had globalization, liberalization of markets.

And then because markets don't tend toward equilibrium and they actually go to excesses, you have had a series of crises.  But each time, the authorities intervened and they bailed out the failing institution and did whatever was necessary to keep the system going.  And that reinforced both the credit expansion, because that's how they got the economy going again is by finding a new way of fostering expansion, and the misconception that markets can be left alone because they'll take care of themselves.  But of course, they don't.  It's always the authorities that come in and save the situation.

MALLABY:  And so if we look back over the last sort of three or so decades of financial history, there was, of course, the stability afforded by the gold standard up until 1971.  Then there was a kind of interregnum of inflation, stagflation and booming commodity prices, perhaps a bit familiar to people in the audience now.  And then you're saying that in the Reagan era, there began this period of stability around sort of faith in the dollar, faith in the American system, which made people willing to lend in dollars more and more.  So in fact, what you're talking about is the status of the dollar as a reserve currency and whether that may now be questioned.

SOROS:  Yes.  This phase has been based on the dollar as the reserve currency.  And with globalization of financial markets and the Reagan policy at the time of fiscal stimulus -- the (armament ?) actually was a big thing -- and relatively high interest rates attracted the savings of the world to the center.  And that's when we started developing economic current account deficit which has been growing pretty steadily ever since and reached over 6 percent of the GNP at its peak.

So we have effectively, the American consumer became the motor of the world economy.  And we were absorbing the savings of the world to finance that overconsumption.  And that could have continued indefinitely because there were countries that were very happy to produce more than they consumed and to accumulate reserves to build up their wealth.  First there was China, then Japan, the Asian Tigers and China and so on.  So you had willing borrower, the United States, willing lenders, so a chronic current account deficit was actually a kind of equilibrium. 

It could have continued indefinitely except that with the housing bubble, it's the household sector that became overextended because they saw the appreciation of houses as a form of saving.  So the savings rate actually fell into negative territory because the houses provided the wealth accumulation.  And actually, people started withdrawing equity from their mortgages.  And mortgage equity withdrawal at its peak was even higher -- about $850 billion I think or 900 billion (dollars) in 2006 -- was even higher than the current account deficit and is the housing bubble that is now also unwinding this current account deficit.

MALLABY:  So there are two halves, in other words, two sides to this long super bubble.  On the one hand, the willingness of foreigners to provide loans to the United States; on the other hand, the appetite of the United States to borrow.

SOROS:  Yes.  And there's a third.  There's a third element which is the overleveraging of the financial institutions and the use of various, newly invented financial instruments that were not regulated and were used and abused.  And these were connected also with the mortgage market because mortgages were then packaged, repackaged, sliced up and again repackaged and sold to investors.  Banks, instead of keeping loans on their balance sheets, repackaged them and securitized them.  So securitization and the various synthetic instruments are the third factor.  So these three elements come together to give you this super bubble.

MALLABY:  And so do you view financial innovation as more of a negative for the economy than a positive?

SOROS:  No, no.  I think it's -- but it's not an unmitigated benefit as, let's say, you could say that many technological innovations, although not all technological innovations are unmitigated benefit either.

MALLABY:  Most of them are -- (inaudible) -- right?

SOROS:  But we tend to think of it that way.  It's not unmitigated because many of these instruments are developed to avoid regulation.  So for instance, if you have loans, then you need to keep the, say, 10 percent equity in the loans.  But if you just slice up the loan and you take only the risk, you can take risk and have this credit default swaps.  Then you only need maybe 1.5 percent margin, so you can leverage up a lot more.

MALLABY:  And is there a way, do you think, for a government more effectively to be able to extract the benefits of financial innovation, to preserve those as well as mitigating the risks?

SOROS:  I think it's basically very healthy to have this innovation.  But you mustn't abandon regulation, and that's where market fundamentalism which believes that you best leave it to the market, you see, that was the excess that led us to the current.  It's really the failure of regulation.

MALLABY:  I want to probe a little bit more about the super bubble.  Because if you look in the data about the ratio of American debt to GDP, there's no dispute what's happened in the past.  In other words, debt to GDP inched up very slowly between 1950 and 1980.  There's a nice graph of this in your new book.  And then from 1980 -- whew!  It explodes. 

SOROS:  That is a typical parabolic --

MALLABY:  Exactly.  So we know what's happened.  The question is, what's going to happen in the future?  And you've written in the past that there are times when a trend is challenged, it goes through a hiccup for a while, and then it reasserts itself.  And the reconfirmation of the trend, of course, makes people believe in it all the more passionately.  And then whew!  The parabola even accelerates.  So is it possible that at this juncture what we're seeing is sort of a one-year or so interruption in the trend, and then the super bubble will continue because the willingness to provide capital to the United States will remain there?  The sovereign wealth funds, the central banks in the Gulf states and in the East Asian countries that have all the capital, they're going to carry on wanting to put their assets somewhere, and it may well be in dollars. 

And so to the extent that that is true, borrowers will be found in this economy, whether it's the federal government, whether it's the corporate sector, even if the household sector is tapped out, and then this trend will be reasserted or reconfirmed and will carry on in this super bubble.

SOROS:  No, you are absolutely right.  In the past crises, we have had a number of them that were actually successful tests of the thesis, of the misconception, and led to an acceleration.  And it was, for instance, the successful way of dealing with the Internet bubble, the IT bubble, lowering interest rates that then directly led to the housing bubble.  So maybe there is something that could be used to keep this process going.  And so it's actually an open question.

And right now, actually the stock market seems to believe that the worst is behind us, and in fact this is a crisis like any other crisis and a great opportunity to buy.  And it may well be true.  I take a different view.  But since we are all fallible, I may be wrong.  You know, history will tell us.  I personally think that we have the acute phase of the financial crisis largely behind us. 

And in fact, the authorities have it as their mission to stop the system from falling apart and provide liquidity at all costs.  And they've done it, and they've done it again.  And in fact, they have gone sort of past several new thresholds in doing it, but they've done it.  So that is a source of reassurance that the system is not going to fall apart.

However, the damage that has been done to the system has to affect, in my opinion, the real economy.  And the effect of that is only beginning to be felt.  And there is a certain time lag because the motor has been consumers, now they have lost their mortgage equity withdrawal and housing appreciation.  And so they have to increase their savings.  But it takes time for them to adjust their behavior.  And so actually, currently, you know, credit card debt is still rising.  People find other ways of maintaining their living standards or habits.  But I think inevitably they will pull back.  And that process is only beginning. 

The housing problem, I think, continues to be the leading factor as far as the real economy is concerned.  Because just as they overshot on the upside, they will also overshoot on the downside.  And currently, house prices are accelerating on the downside.  They were falling at an annual rate of, I think, 21 percent in December, about 24 percent in January, 29 percent in February.  That's an accelerating rate.  And to expect that by the end of the year you will have passed through that, I think, is an unrealistic thing because you've got certain processes going on with the subprime loans.  There are about 5 million of them.  And in the next 18 months if they are (rebagged ?) they will be just six months into that process.  And about 40 percent, I think, will default.  This is my estimate.

Then you've got this option adjustable rate mortgages -- the same thing.  So I think you will have, unless something more is done, you will have about 4 million defaults in the next two years.  And it takes about a year before a default leads to foreclosure, and about half the defaults end in foreclosure.  So right now, you've only got a very few foreclosures.  But that is at the very beginning of an uptrend.

So I think what needs to be done is to try to keep the foreclosures to a minimum.  And I don't think that either the fiscal measures or the monetary measures will stop that process unless something more is being done.

MALLABY:  It sounds as though you think that President Bush would be making a mistake if he delivers on this threat to veto the housing bailout package that the House Democrats are cooking up.

SOROS:  Yes.  I think this administration ideologically is not prepared to intervene.  And there's also strong public opinion against bailing out the lenders or borrowers who have gone to an excess, so political pressure also.  So I think that pressure will have to mount before adequate measures are taken.

MALLABY:  But it also seems that you are fairly pessimistic about the ability of all this official activity to cushion the economy from the contraction and consumption that you're predicting.  I mean, we've had a fiscal stimulus.  We've had liquidity pumped into the banking sector.  We've had the Bear Stearns bailout.  We may or may not get some kind of housing action.  We've had a range of measures, as you say, but you don't think that's going to be enough to save us from a recession next year?

SOROS:  Yes.  And the markets have taken heart, at least the stock market, and we now have a rally.  And I think this is a fairly typical bear market rally.  I may be wrong.  But I think this is it.  This is a bear market rally.

MALLABY:  And I mean, obviously, the nightmare analogy is with Japan in the 1990s where the equity market broke in 1990.  The property market broke in '91.  And then it was most of the decade before anything looked any better.  How many years do you expect that it might take to sort this out here?

SOROS:  That's the other extreme actually.  One is that this is, you know, we are out of the woods, and by the end of this year the economy is re-accelerating and profits are rising.  This is the optimistic extreme.  And the Japanese is the pessimistic extreme because you have the real estate bubble -- it wasn't housing but real estate -- and you had the financial system loaded down with bad debt.

But the big difference between Japan and us is that here the losses are being recognized, written off.  Actually, some of the write-offs may turn out to be excessive because you don't have proper measures, you lose these indexes, and the indexes are the source sellers use, so they may be --

MALLABY:  The ABX index.

SOROS:  The ABX index and so on.  So we have the write-offs, and the authorities are urging the banks to re-capitalize themselves and in fact they are doing that.  Therefore, this accelerates the process of adjustment.  So I don't expect it to last nine or 10 years.

But on the other hand, the amount -- right now, markets are very ready to provide new capital.  But a lot of the new capital comes in, but the activities of the banks or the institutions will be shrunk.  That's why the capital comes in to turn those companies into profitable enterprises.  So the credit squeeze will continue. 

And also, it remains to be seen whether there's enough capital around.  Because even though the figures are very large, the losses that have to be made up for are even larger.  So this is now the (confession ?) that only the future will tell.

MALLABY:  There was a moment in the late 1980s after the Wall Street crash and before the economic troubles emerged in Germany and Japan where people spoke in quite sweeping terms about the decline of the American economic model, maybe bank-led capitalism was superior and so forth.  I mean, how do your view of the markets now affect your view of sort of geopolitics?  I mean, do you think we're in for a period when people question American supremacy and that adds to the -- (inaudible) -- of foreign policy that already exist?  And how would cross that bridge into politics?

SOROS:  Yes, unfortunately, I happen to agree that there is serious questioning of American governance.  The system was built on American supremacy and the financial system even more perhaps than the political system.  The dollar was the unquestioned (deserved ?) currency.  That is not the case anymore.  And the Washington consensus imposed certain principles of balancing budgets on other countries but did not impose that discipline on the center, on the United States.  And we did abuse that privilege by running up this chronic current account deficit.

And unfortunately, as you know, I've been a severe critic of the Bush administration's policies, the war on terror and the invasion of Iraq and so on, which meant to assert American supremacy in the world, and it had the opposite effect.  It has undermined America's power and influence in an unprecedented way. 

And now something is happening on the financial side which also there's now an increased reluctance to hold dollar assets.  The central banks don't want to accumulate dollars.  They've been diversifying into other currencies, pushing up the exchange rate and depressing the dollar.  But actually, there isn't a suitable alternative to the dollar.  I mean, the Euro, to some extent, but it isn't quite there, certainly not -- (inaudible). 

And so because of that, there has now been a general flight from currencies.  And the (carriage ?) of countries set up sovereign wealth funds.  Now, you are right in pointing out that these sovereign wealth funds could be, in a way, the saviors of the system by replenishing the equity of the financial institutions.  I don't think that politically it will be possible for Abu Dhabi in Russia and China to put enough capital into Citibank to actually accomplish it.

But it has been a positive factor as far as the financial replenishing is concerned.  But I don't think it can provide.  And if it did, of course, it would really make the decline of American power and influence pretty well official.

MALLABY:  So we've had a sort of parallel between, on the one hand, a diminution in America's military readiness and its ability to project military power.  And you're saying also that there's a sort of similar thing on the financial side.  In most countries, if there's a financial shock and the central bank tries to respond by cutting rates, the response of savers is to move money out of that currency,  And so the currency shock sort of neutralizes the central bank's freedom to response, right?  And the U.S. has been an exception in the past because people wanted to hold dollars, they thought in dollars.  And so the Fed could cut rates and be the savior after the (LTCM ?) incident, the Russia incident, the dot-com boom and so forth.  The Fed could cut rates and rescue the world economy, but that may no longer be the case if the willingness to hold dollars and think in dollars comes into question.

SOROS:  That is exactly the constraint.  And also, you have inflationary pressures which provide additional concern.  So I don't think we can go back to 1 percent Fed funds.  And in fact, recognizing the dangers that that would involve to the status of the dollar, the Fed has indicated that it doesn't really want to go below 2 percent where it is now, it at all possible. 

That is why actually currently there's a certain recovery in the dollar because people are reassured that maybe they won't be flooded totally with dollars.

MALLABY:  That the Fed recognizes the limits to its own power.

SOROS:  That's right.  That is right.

MALLABY:  So I want to go to the audience in a second, but just let me ask one last thing.  In terms of sort of prescriptions for how to make the system safer, people have talked about moving derivatives transactions onto exchanges more, requiring financial institutions, both banks and hedge funds, to hold more capital as a cushion.  In this realm of prescriptive ideas, what do you say there?

SOROS:  I think the most important lesson that we need to learn is that it's not enough to control the money supply, that we also have to control credit separately from money.  And we have to recognize that markets go to extremes of euphoria and panic; and therefore, we have to adjust the margin requirements and the minimum reserve requirements that we impose on banks and market participants.  So adjustable margin requirements and minimum reserve requirements, these are tools that have fallen into disuse.  They've been deliberately left unused, and I think we need to start using them again.  And central banks have to accept that they have a responsibility to prevent asset bubbles from going too far, for instance, by imposing higher minimum reserve requirements on banks when they lend too much.  So that's, I think, the change in the regulatory environment, that's a central change.

Then in addition to that, I think, you do have a specific problem with mortgages, and you have to find ways to reduce the foreclosures to a minimum.  You can't eliminate them.  You can't interfere with the right to foreclose.  But you can adjust mortgages and downsize them, write them off.  It's more efficient than going through the foreclosure procedure.  So that's a technical, specific issue for this particular crisis.  But generally speaking is controlling credit, not only money.

MALLABY:  So Greenspan was wrong in saying you should not target asset bubbles, there should be these adjustable margin requirements for traders so that they put up more capital when you want to rein in the amount of investment and for banks as well adjustable capital requirements, like in Spain.

SOROS:  Yes.

MALLABY:  Okay.  Well, let's go to members of the audience.  I'd invite you to wait for the microphone, speak directly into it.  Stand, state your name and affiliation.

I have a question in the front -- Mr. Clemons. 

QUESTIONER:  Steve Clemons, New America Foundation.

George, I have read the book.  And you were a student of Karl Popper, and that fundamentally your experience with Popper and your thinking about really this question of reflexivity drove you to do the book, not the financial market crisis.  But there's a charming part of the book where your son Robert says, my father is just full of it, he doesn't make investment decisions like this.  It matters more in whether he had a backache or a shoulder ache, and you've devised an interesting thing.  And it raises a question.  At Soros Fund Management, do you put those workers through school on reflexivity?  And how do you think it's best to sort of transmit the template of your thinking?

One other part of this is you've returned to manage your own account, which you had stopped doing.  And you take us through your decisions.  And you have a big rise and then a big fall.  And you finish the book saying, we're below water.  And I'm interested in, since the book came out, are you back above water?

(Laughter.)

SOROS:  Well, several questions here.  It's always backache, never shoulder ache.  (Laughter.)  It comes from tension.  And the tension -- you know, when I can resolve the tension, the stomach ache goes away.

MALLABY:  Has that always been true?  That's not just a story from the 1970s?

SOROS:  When?

MALLABY:  That's not just a story from the 1970s?  That's always been the case, that still now you have backache when --

SOROS:  No, I don't have backache.  No, no.  I used to have backache when I was active in running the fund.  And I've had no backache, even though I'm currently more involved in the market.  So I'm happy to be out of that.  But that was one question.

But I don't impose my philosophy on others.  I think it's my view, and I may be wrong, and other people -- I've delegated my money to other people to run.  And when I saw this crisis coming up, since it's my money and I didn't want to lose it, I set up a savings account, a macro account, where I counterbalanced what they were doing.  (Laughter.)

So I offset it.  I didn't impose my will on them, but I protected my own wealth.  And, in fact, I'm still slightly under water, and maybe I'll get a little bit more under water, because I do not buy into the current market rally.  I think it's pretty close to having run its course.  But while it's running its course, I'll lose some money.

MALLABY:  Okay.  Let's see.  There's a question here in the front.

QUESTIONER:  Allan Wendt.

Mr. Soros, do you think that the Fed has gotten the balance right in terms of the tradeoff between low interest rates and their impact on the domestic economy and the impact on the dollar abroad?  Have they not possibly gone overboard?  And what are the consequences of a perennial weak dollar?  Isn't it a form of mercantilism whereby we sell everything we produce more cheaply and pay more for everything we import?

SOROS:  No, I think that the Fed is right to have not gone below 2 percent, because I think if it has to go below 2 percent, it will have pernicious consequences, because they would do that because the economy is still in recession.  They haven't done enough; they have to do more.  And with the economy in recession and interest rates going down, the dollar would certainly come under renewed pressure.

The fact that they stopped at 2 percent is now giving the dollar breathing space also, so the dollar has stabilized as a result of this action.  So I think, in this respect, they were slow in starting.  They lagged.  They were behind the curve.  But then, at the beginning of the year, acting very radically, I think they are now just in the right place.

And it's now the Europeans, and particularly the British, who are behind the curve, because the fall in the dollar has had the effect of us exporting our recession to them, because our current account has greatly improved.  It has added at least 1 percent to the GNP in the first quarter.

That's what has kept it in the positive territory, as far as we know.  So (final ?) demand is down below zero, and GNP is 0.6 percent.  But that 1 percent has come out of the rest of the world.  So now Europe is slowing down and they are sticking with their one-directional (fight inflation ?) policy.

MALLABY:  There's a question back there.

QUESTIONER:  Thank you.  Camille Caesar from Commerce.  Thank you, Sebastian.

Two quick questions.  The first is, how do you think that the powers of the Fed and also the other agencies charged with financial institution regulation should be changed, if at all?

SOROS:  I have difficulty hearing you.  Can you repeat the question?

MALLABY:  How do you think that the powers of regulation of the Fed should be changed?  Is that right?

SOROS:  How the --

MALLABY:  The regulatory powers of the Fed -- regulatory powers.

QUESTIONER:  Should they be --

SOROS:  Let me answer you, and then -- (inaudible).

I think the Fed has all the powers it needs.  It just hasn't used it, because they had the power, for instance, to regulate the mortgage market, and they didn't.

QUESTIONER:  And my second question is about the long-term real rise in commodities prices, assuming that what we have is a permanent shift there.  How do you think this change is going to lead to any restructuring in our economy?  Are we, for example, going to become more of a resource-saving type of economy, as you find elsewhere?

SOROS:  Again I can't --

MALLABY:  Okay, sir.  Does the run-up in commodity prices augur structural changes in the economy, or do you think it's a bubble or --

SOROS:  That's a very difficult question with the commodities, because there is a commodities bubble.  There's a flight from currencies into commodities, and there is definitely a bubble element.  But then you have different causes as well.

In the case of oil, I think that, to some extent, one can speak of what you might call a backwards-sloping supply curve; you know, the higher the price goes, the less incentive the oil-producing countries to take the oil out from under the ground and convert it into dollar reserves above ground.  So that's part of it too.  And then there's also, of course, the global warming and the difficulty of increasing cost of finding new oil.

So all those things, plus the increased demand from emerging markets, which are very heavily energy-intensive.  So all those things come together to create this quite amazing rise in oil prices.  And I think that rise is now also in this parabolic phase where it's difficult just to explain it by anything reality-based.  There is something else going on.  So that's the bubble aspect.

And then in food, global warming has affected food prices in two ways.  One is because of biofuels, and the other one is because of the failure of the rice crop in Australia.  Now you have the cyclone in Burma.  That again is destroying the rice-growing areas; so disruptions in the production cycle, and again, the improvement in living standards in the emerging markets.

So all these things come together creating these commodity bubbles, which set up inflationary pressures.  Now, this makes the job of the regulators very difficult, because you are faced with recession and inflation, and that requires opposite policies.  And that, again, is why this time I think the authorities will not be able to get us out of this the way they did on previous occasions.  It's one of the things that makes me more pessimistic than the markets.

MALLABY:  (Inaudible.)

QUESTIONER:  Ted Smith from the Heinz Company.

Thank you, George, for coming here.  As one of the leaders of the reality-based community, I welcome you to Washington, the capital of the fiction-based community.  It's probably no coincidence that you're here, because it's clear that, having read your book, that the leaders of the financial community have no incentive to stop the boom-bust cycle, because the plutocracy gets rich on the boom and the  American middle class picks up the tab for the bust.

Given that, my question to you is, what can Main Street do to tame Wall Street, particularly to enforce the Fed and other things to prevent the further weakening of the American middle class?

SOROS:  Well, I think people can vote and express their votes in voting.  And I won't express my views, because I try to be less party political than I have been in past occasions.  So that, I think, is the main way that, in a democracy, people express their views.

MALLABY:  Back there with the glasses.  Right in front of you.

QUESTIONER:  (Inaudible.)

MALLABY:  Can you identify yourself?  Thank you for identifying yourself.

QUESTIONER:  Okay.  You mentioned earlier on the $900 billion home equity -- you know, the withdrawal.  I've seen numbers that may not be quite that large, but very large for the few years preceding that, which I assume has contributed a lot to the growth of our economy.

My question to you is, can we really expect a recovery here before that amount of money has been placed in our economy?  And, if not, what is the source of this equity?  Do we wait for the mortgage market to reprice and the home market to appreciate?  Are we looking at tax cuts?  Are we looking at a technology bubble?  What is going to drive the recovery?

SOROS:  I happen to share your view that the American consumer that has been the main motor, not just of the U.S. economy but of the world economy, is not incapacitated to play that role.  So consumption as a percentage of GNP, and maybe in absolute terms, has to decline and is already declining.  So then the question is, what will take its place?

And I personally believe that we have a tremendous challenge ahead of us with global warming.  We have to develop non-polluting fuel sources.  We have to take carbon out of coal and fossil fuels generally.  That will require tremendous investment, and we need to do for our survival.  And I think that could provide the motor for the world economy.  It requires the United States to change its policies towards global warming, getting together with the Chinese and the Indians, who have become now very large polluters.  And I think that's where we need to go.

MALLABY:  A question in the back, right in front of the TV cameras.

QUESTIONER:  (Inaudible) -- from CNN -- (inaudible).  Thank you very much, sir.

I have two quick questions.  Do you believe that the emerging markets have felt the recent crisis?  Will they ever feel it?  And the second one is, if it was up to you to make a decision about fighting inflation versus growth, which one would you choose at this current situation -- (inaudible)?

SOROS:  The first one is about emerging markets, and I think that they are not immune.  And one of the reasons why I'm under water this year is because I overstayed my welcome in those markets.  (Laughter.)

And the second question I didn't hear.

MALLABY:  Would you target inflation or would you target -- if you were running monetary policy, would you target inflation or would you target growth?

SOROS:  Well, I think you need to balance it.

MALLABY:  (Laughs.)

SOROS:  And I think that the management of the -- macroeconomic management is not a science.  And reducing it to simple rules like, you know, inflation targeting is a mistake.  And I think we are dealing with reflexive processes.  There are many different reflexive processes going on at the same time, and it's a matter of balancing them.  And it's an art, not a science.

MALLABY:  Let's go in the front here.

QUESTIONER:  Thank you very much, both of you.  My name is David Apgar.  I'm with microfinance fund manager Blue Orchard.

A speculator faces possible refutations of her best guesses every day in the market.  One of the problems, it seems, that we have in setting our fiscal policy, our federal budget and its deficits, is that there doesn't seem to be an effective learning process.  We don't get a quick refutation from the market when we get fiscal policy badly wrong.

Are there any ways of building a better learning process into our markets so that there's a faster readout when policymakers get fiscal policy wrong?

SOROS:  No, I think that it's the fate of central bankers that they've got to be wrong eventually.  Now, how long it takes for them to be wrong and how far wrong they go is probably the measure of their success -- how far they go being wrong.

MALLABY:  What about the fiscal side, though?

SOROS:  What?

MALLABY:  What about the fiscal side, when parliaments have a budget that doesn't make sense?

SOROS:  Yes, well, the fiscal side.  Well, that's actually more difficult.  And while fiscal policy can be very useful, it usually takes very long time to kick in.  And honestly, I don't have the answer.

MALLABY:  Steve.

QUESTIONER:  Thank you.  Steve Charnovitz at George Washington University.

I can understand perfectly well the benefits for the environment of taking positive action on climate change.  But you suggested a moment ago that there were economic benefits for the economy in so doing.  And I wonder if you could expand upon why there'll be economic benefits when the cost of energy goes much higher as a result of emission trading and setting limits on -- (inaudible).

SOROS:  Well, if I'm right, if I'm right in thinking that we're heading into a recession, that the recession is effectively unavoidable -- it's only a question of the magnitude of that recession -- then you have idle resources.  And you need to find some way to put them to use in order to create the multiplier effect that will get the economy going.

And I think that making the necessary investments in taking, for instance, carbon out of coal, generally speaking, to reduce our energy consumption, because a lot of energy-saving investments could be made, you need to put a price on carbon, carbon emissions, because that will encourage investment that will reduce carbon consumption.  And that will put these -- will be a stimulus to the economy at a time when the economy needs a stimulus.

MALLABY:  So sort of deficit finance spending.

You've been very patient.  Wait for the microphone, please.

QUESTIONER:  (Inaudible) -- even as our power as a nation declines -- (inaudible) -- wide range of issues.  Now, fortunately, we will have a new administration -- (inaudible).  Do you think that new administration could take some initiatives in the economic field, trade, financial imbalances, immigration, which would reverse this trend?

SOROS:  Well, you are right to point out that protectionism is a great danger; that because of the tremendous strains that we are currently exposed to, that it will lead to protectionism.  There are differences of policies that lead to a breakdown in the global trading system, and that could have really a devastating effect.  So that's a danger that we need to avoid by engaging the right kind of policies, finding the proper understanding between the national interest and reconciling national interests so that we keep the system open.

MALLABY:  Right over here.

QUESTIONER:  I'm Welby Leaman from the Treasury.

I heard you say that we've had, in the last number of years, excessive leverage and perhaps excessive credit and insufficient regulation.  And my question is whether, given Hernando de Soto and others suggesting that in some parts of the world one of the major causes of poverty is excessive regulation, insufficient credit and leverage, are you saying that we should permanently have a policy bias towards more regulation than what we have had and less credit expansion?  Or is it simply that we've gone too far and now is the moment for American democracy to switch back, as at some point in the future we may need again to switch back towards this direction?

SOROS:  There's no question that the regulators failed to exercise their powers and to regulate.  So there's been a regulatory failure.  You now have a financial crisis, maybe serious recession.  There's a great danger now that you go to the other extreme of re-regulating too far.

When you had the Great Depression, the entire banking system was put in a straitjacket, and it stayed in that straitjacket until 1972.  That was the day when -- (inaudible) -- invited security analysts and told them that actually banking -- (inaudible) -- growth industry.

So that was the watershed, let's say.  So until then, banking was frozen.  So we don't want to go back there, because even though markets are imperfect, regulators are also human.  And worse than that, they are bureaucratic.  So they are much slower in adjusting to changing circumstances.

So we need to improve our regulations.  There's no question regulators have failed to exercise their powers.  We must now learn to regulate credit as well as money, but rely on the market mechanism to the greatest possible extent.

So I'm often taken to task for sort of criticizing capitalism when I am myself known as a capitalist.  And I'm doing that because I want capitalism to survive.  It's much better than central banking.  It was the failure of communism, socialism, that led to the (excess ?) of market fundamentalism.  Now we must abandon that.  We have to realize that markets are not perfect, but we mustn't fall back into the other mistake.

MALLABY:  But George, I think, you know, behind Welby's question is the following.  You know, we can agree that the U.S. economy in 1972 had not enough leverage or that Hernando de Soto's Peru has not enough leverage.  But do we really know how much the right level is?

And if we don't really know -- and I think you would say that human perceptions are always fallible and we can't be sure -- shouldn't we decentralize that choice to individual borrowers rather than having regulators step in and set some necessarily arbitrary amount of borrowing that is deemed to be the right balance between, on the one hand, cheap capital, and on the other hand, too much risk?

SOROS:  No, you see, it's a very reasonable argument, but if you leave it to the individual market participants, the bankers and so on, they will go to excess.  And then you have got to save the system and you have to bail them out.  And that creates what is now recognized as the moral hazard.

Now, so if you are subject to being bailed out, you are receiving protection from the authorities, whether you recognize it or not.  And therefore, you have to be also subject to some regulation, because it's really the job of the regulators not to have to bail out the system.

So credit creation inherently involves this potential boom-bust bubble aspect.  And you have to control the bubble on the growing side so you don't have to take all the pain that comes with the bursting of the bubble.  So that's the reason I would give why you have to control leverage.  And, of course, the control will never be perfect, but definitely if you leave it to the markets, they will overleverage.  And they did.

MALLABY:  Should they control the leverage of your fund?

SOROS:  Indirectly, yes, by adjusting the reserve requirements that banks have to keep, depending on the leverage employed by the borrower.  So a less leveraged fund would require less minimum reserve requirement, and the more leveraged fund would require more.  And then you couldn't have the overleveraging that you have had.

MALLABY:  I want to take another question from the floor.  And I want to remind you, before we close, that this going to be -- this has been on the record, this session.  So let's take a last question right there.

QUESTIONER:  Thank you very much.

You have emphasized in your conversation with Sebastian that the U.S. consumer has been the engine of global growth.  You also pointed out that, thanks to exports, we have so far avoided falling into the recession.  My question is whether you envision more opportunity for the United States to be a greater exporter and greater producer, as opposed to consumer, both with regards to manufactured goods as well as agricultural goods, and, if so, in spite of the rising oil prices, whether you see there is an opportunity for a shift of U.S. fortunes towards production.

SOROS:  Yes, definitely.  That supposes we are now in a process of adjustment.  It's like a junkie coming off drug abuse.  It's a painful process, but it is actually happening.  You know, our current account deficit is shrinking, and quite substantially.  And I think it will inevitably have to shrink more if the rest of the world is not willing to support our habit.

MALLABY:  Maybe we've got time for one more.  And let me go right here.  I'm sorry, Allan, you've already asked a question.  Is there anyone else who wants to?  (Inaudible.)

QUESTIONER:  Thank you.  I'm Robert Herstein (sp).

Regarding the reflow of investment from abroad, do you feel that the U.S. policy should be any different toward investment by market players, on the one hand, and investment by state-controlled enterprises or investment vehicles, on the other?  And, if so, how do we find that line and how do we implement it?

SOROS:  Well, I think that we obviously need to remain open to investment from abroad.  Sovereign wealth funds create -- pose a problem, because there could be political motivations other than commercial motivations.  So that is an issue that needs to be handled, and there needs to be certain standards of transparency.  And it is actually being worked out.  And I think that sovereign wealth funds that abide by those principles should be free to invest like any other institutional investor.

MALLABY:  Well, thank you very much to our guest, George Soros.  Thank you to all of you for coming.  (Applause.)

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