The international financial crisis – International Solutions – interview with hedge fund manager George Soros – Interview
Interview with George Soros
George Soros is the best known hedge-fund manager in the world. He has bet aggressively against the world’s leading central banks and made billions of dollars in the process. But he is also a leading critic of the very financial markets in which he operates and he discusses what he thinks are the necessary solutions to the current crisis.
Q The collapse of the Thai currency, the baht, in July 1997 was the immediate cause of the global financial crisis. I know that you had been selling the baht many months before the decline. Why?
A. The trouble could be seen six to nine months before the decline actually occurred. Thailand’s trade deficit was very high, and it had to be offset by an enormous inflow of capital. The amounts of money required were expanding rapidly. We could anticipate that. But what we couldn’t anticipate was the magnitude of the consequences.
Q. Was it that when the link of the baht to the dollar was broken, international investors fled?
A. It was not so much that the speculators were attacking the Thai currency at the outset. There were a many private loans to Thai borrowers in foreign currencies. A lot of people in Thailand had borrowed in foreign currencies, converted into the Thai currency, and invested the money or lent it out for real estate development and other investments. Investors assumed that the relationship to the dollar would be stable. But suddenly, when the baht collapsed, those dollar obligations became enormous and debtors had to run for cover. They sold baht and bought dollars. A company like Siam Cement, the best company in Thailand, took a currency loss that wiped out not only all its earnings but a large part of its equity as well. So, naturally, since this happened to many companies, the stocks also fell. It was a combination currency; stock market, and banking crisis. Each element reinforced the other. The debtors depressed the local currency, the fall caused losses, which then reinforced the decline in the stock market. The banks were now loaded down with bad debts.
Q. How did the fall of the baht affect the other nations of the region?
A. Once the link with the dollar was broken, the Indonesian and Malaysian currencies fell as well. The decline was contagious and spread to Taiwan, the Philippines, and Singapore. It built up to a speculative attack on the Hong Kong dollar. Korea was temporarily insulated because it had some form of capital controls. But the Korean and Japanese banks were heavily involved in Indonesia. They could not renew the loans they had made there, and this eventually caused the problems in Korea.
Q Many critics now say that excessive lending by the major Japanese, American, and European banks was the principal problem. Obviously, local business could not have borrowed so freely unless the money was readily available at attractively low interest rates. Do you agree?
A. That was certainly a common element. I would hesitate to say it was the sole cause. There were some differences among these nations. For example, Malaysia’s borrowing was mostly internal, not international. Indonesia was not really overindebted. Their trouble was that they had borrowed from the Korean and Japanese banks, which now wanted to get their money back because of their own troubles and troubles elsewhere.
I am more familiar with the Korean situation than with some of the others. The chaebol, the big Korean conglomerates, had debt-to-equity ratios of 4 to 1. This was wholly unacceptable by international standards. And they were operating with very low profit margins. Their earnings totaled only 1.3 times their debt service, mostly interest costs. Once problems started, the banks had good reason to worry whether these companies could repay their debt. So it was the interconnections among the various countries – through international markets and through the banks – that turned it into a widespread crisis.
Q One of the long-standing controversies involving you and other hedge fund investors is that you sell an enormous amount of the currencies when you think they are high. But this puts on pressure for the currencies to be devalued, forcing the nations to spend a lot of their reserves to buy their currency in an attempt to bolster it. What do you make of the claim that the baht would have been able to hold its value if you and other investors had not sold short in such great volume?
A. I don’t think it is right. This is something that had to happen, irrespective of whether we took a position. As a matter of fact, though we were in the market early; we were not selling the baht for six months before the collapse. There may have been others who were attacking the currency in July, but we were not. Actually; we were buyers of these currencies during the decline because we didn’t expect them to fall as far as they did. For instance, when the Indonesian rupiah fell from 2,400 to the dollar to about 4,000, we thought it was too low. So we bought it. It immediately proceeded to fall to 16,000 to the dollar. That was not a pleasant experience for us. But at the time we were actually a balancing factor rather than a reinforcing one. It shows that speculators can lose money.
Q. In England, you are still highly criticized in some circles for having been the most active seller of the pound in 1992. They say you drove it down, costing British taxpayers billions. Your defenders, such as the financier Leon Levy, claim the British government had overspent its reserves to maintain the pound at insupportably high levels, making their exports too expensive and weakening their economy. So the fall in the pound only helped the British economy. Do you also believe the pound would have fallen, anyway?
A. Yes. It would have fallen whether or not I was born, so I believe our position was completely defensible. I believe markets are amoral. The problem is that they are not always stable. They frequently swing to excesses. That is why I say that markets, instead of swinging like a pendulum, can sometimes act like a wrecking ball, knocking over economies.
In the Asian collapse, the interesting thing is that the crisis there varied from country to country. You can identify some similarities, but none of the causes was present in all the countries. Some had too much debt. Others had weak banks. So there has to be a unifying theme and that was the international financial system itself.
Q. There has rarely been a more vivid example of the interconnectedness of the international financial system than the recent crisis. Most commentators apparently thought the Asia crisis would be contained.
A. I did not believe it necessarily would because I was quite familiar with the situation in Russia. I could see the financial connections that were linking, for instance, Indonesia to Korea because Korean banks had invested rather heavily in Indonesia. Then when Korea got into trouble, the Korean banks had to withdraw considerable funds from Russia and Ukraine. That contributed to the crisis in Russia. And the Brazilian banks had invested rather heavily in Russian treasury bills, which got one of the Brazilian investment banks into trouble, so there was a resulting tremor in Brazil.
Q What was the immediate cause of the Russian collapse in late August 1998?
A. The government was unable to collect taxes. This was a long-standing, chronic situation. It financed its expenditures by issuing ruble-denominated treasury bills. As the situation got riskier, the interest it had to pay went higher. In the end, it had to pay 100 percent a year. This was untenable. The International Monetary Fund came in with a program that was inadequate because it assumed that the Russian government could roll over its treasury bills – that those who owned them would just buy again and again when they came due. But the domestic banks that held much of this debt became insolvent because the value of the treasury bills fell as interest rates rose, and the bank’s investments in stocks also fell. They could not keep buying more bills. With the Asian crisis, foreign banks were not about to buy more of these bills. They; too, were selling. It was a full-fledged banking crisis.
Q. Do you believe the shortfall could have been met by a concerted action from the more prosperous members of the international community?
A. Yes. The shortfall was $7 billion. If it had been made up, it would have enabled the government to pay out the maturing bills until the end of the year. It was then late summer. During that time, the government officials could have shown whether or not they were able to collect taxes. And if they had been able to, then the market conditions would have improved and the crisis would have been resolved.
Q. But those were serious unknowns. Didn’t outside sources fear that they would be throwing good money after bad?
A. Yes. But making up the shortfall would have been a reasonable calculated risk. Russia under Prime Minister Sergei Kirienko actually had the best, most determined reform government since the collapse of the Soviet Union. But it had to deal with the fact that enormous economic power in Russia was held by the groups that can accurately be called robber capitalists. And because the government officials were trying to collect taxes from them, they went out of their way to destroy the government.
Q In your new book you say that a major investment of yours in Russia was the worst of your professional career. You participated in a syndicate that bid for and won the Russian telephone company; Svyazinvest. Why did you make the investment? You had long resisted investing in nations in which you had charitable foundations. One of your most active was in Russia.
A. It was a very difficult decision. I got involved because I was, in effect, betting the government was making the transition from robber capitalism to legitimate capitalism. Had the government succeeded, it would have been a very rewarding investment. As it turned out, the sale provoked a fight among the oligarchs, as the powerful business leaders there are called. Before this, they more or less staged rigged auctions of state businesses, with one syndicate or another taking over through hidden arrangements. This time, from all appearances, we had a real auction. When competitors like me showed up, however, this caused a lot of problems; the old arrangements were threatened. So the oligarchs brought the Anatolii Chubais government down.
Q. How did they do this?
A. For one thing, they controlled the press, so there was a tremendous campaign against Chubais. And Chubais, it was disclosed, had taken $90,000 in payment from one of the oligarchs for a nonexistent book. Remember, the same oligarchs had gotten Chubais to run Boris Yeltsin’s political campaign. It’s typical of such mafia-type action that you want your associates to have dirty hands, so you can use it against them if you have to. It turned out that the oligarch with whose syndicate I was working also bought a book from a minister. So the auction I participated in was not as clean as I thought it was.
Q. Would you make the investment again?
A. No. I was combining two considerations – a political one, which was to help to transform the economy into legitimate capitalism, and a financial one, which was to make a profit. Obviously, they didn’t combine well. When the Russian economy collapsed, we took a big loss.
Q The crisis was at last brought home to America in the late summer soon after the Russian collapse. The large hedge fund Long-Term Capital Management almost went bankrupt. It was eventually saved by the intervention of the New York Federal Reserve Bank, which organized a rescue by private investors, who invested over $3 billion in the company and took it over. What precisely occurred?(1)
A. When the markets were shaken by the Russian situation, a lot of the normal relationships between different markets were thrown off – say, the relationship between the prices of corporate bonds and treasury bonds. When these relationships get out of line, they can be a profitable opportunity because eventually they can be expected to return to normal. But this time they did not return to normal or, at least, not soon enough. The analytical system that Long-Term Capital Management used to exploit such opportunities works 99.9 percent of the time. But because they had borrowed so heavily, that very unusual deviation of the markets, which might occur 0.1 percent of the time, caused them almost to run out of capital.
Q The problems at Long-Term Capital Management nearly brought down a lot of other financial institutions. The banks that had lent them money lost hundreds of millions of dollars.
A. If Long-Term Capital had been forced to liquidate, the deviations from the normal behavior of bonds and other investments would have been even greater and the effects on the banks would have been even worse. That is why the New York Federal Reserve intervened. One really interesting thing is that it showed how faulty are the methods banks use to assess and manage risks.
Q You believe that the Asian economies could have been stabilized much earlier and the crisis there minimized. Did the International Monetary Fund make matters worse, as many observers, including the World Bank, now argue? They imposed harsh restrictions on these countries when they lent them more money.
A. Well, let’s remember that, under the present system, the IMF is not in a position to intervene before a crisis develops. According to its mandate, it is there as a lending facility to which countries can turn in times of emergency. But the IMF officials can’t turn to a country and say, “You are a bad boy and misbehaving and you have to change your policies.”
Now they could, in the future, issue reports in which they could point out that these countries are following bad policies. This would frighten international investors into more circumspect lending policies. Such a suggestion has been put before the IMF, but it has its drawbacks. The fact is that these countries often try to deceive the IMF. If the reports were going to be made public, they would have an even greater incentive to hide the facts.
Q. I am a little surprised that you are treating the IMF so tolerantly. Even given their mandate to stabilize currencies, they attached very strict requirements to the money they were lending to the Asian nations. As a result, interest rates soared in these countries, business ground to a halt, and these countries were thrust into severe recession.
A. The IMF was worried that if they did not raise interest rates, the currencies would fall even more. To stabilize a currency; they insist on raising interest rates so that capital will not flee abroad. Or if it flees, it will have to pay a very heavy cost in the lost high interest rates. Then when a recession occurs as a result of high interest rates, the people can’t afford to buy foreign goods, and imports fall. The country then generates a trade surplus and currency is now on balance coming in. That is how the IMF figures the country will again be able to pay its debt service and start rebuilding the economy.
Q. At the price of a steep and humanly cruel recession, and perhaps political turmoil. As many as 25 million people have sunk into dire poverty in Indonesia and Thailand. Social unrest is on the rise.
A. Certainly, the IMF has never been a popular institution. In the past, IMF programs caused riots in some countries like Venezuela. But that is the way the current system works. You turn to the IMF, and the IMF imposes an austerity program on you. The system needs to be reformed.
Q You point out in your book that the IMF treated the Asian problems as if they were a government crisis, when in fact the governments’ finances were largely in good shape. It was private finance that was the problem.
A. Undoubtedly the IMF policy was counterproductive. The right thing to do would have been to approve a moratorium on the payment of debt. The IMF would have been worried that this would have caused a panic among the banks. A moratorium, however, would have allowed a more gradual adjustment. It certainly would have avoided what has happened in Indonesia, where 75 percent of the businesses are effectively bankrupt. That’s why we badly need reforms in the international system.
Q. How would a moratorium have worked?
A. First, the lenders would not have been able to collect the interest due them for a definite period of time. And then there would have been a reorganization of the debt – probably an exchange of debt for equity. Equity gives the lenders ownership in the business but frees the business from having to repay the debt and meet regular interest payments. When you have such a situation of overindebtedness, lending more money does not cure the problem. You somehow have to increase the equity held by the lenders. Nobody will provide fresh equity, so you have to convert the debt to equity. It would be a kind of managed bankruptcy, if you like.
Q. This possibility seemed to be far from the minds of IMF officials. To summarize, isn’t the central issue that under the current structure the IMF first protects those who make the loans? They could have gone in and said to big banks and other large lenders, You’ve got to take a small loss here and accept some equity in lieu of debt.
A. There was fear of worldwide panic, as I said. Another problem is that the IMF does not have the resources to replace the money that the banks might withdraw. So it needs their cooperation to roll over their loans and stabilize the situation.
In the case of Korea, the original IMF program did not stop the banks that had made loans to Korea from taking whatever they could get and running. So around Christmas 1997 the foreign central banks had to “persuade” the banks to roll over their debt for three months. It was an organized temporary extension. This allowed Korea to get by. But there is a systemic problem. There is an asymmetry in the treatment of the lenders and the borrowers, the haves and the have-nots. The lenders expect favorable treatment. This has made it rather attractive to engage in international lending, even at considerable risk. Economists call such a situation a moral hazard. The hazard is that investors make unsound investments because there is always somebody to bail them out. The asymmetry between lenders and borrowers imposes severe austerity on the borrowing country in order to help the lenders to come out whole. That’s what happened in the previous crisis, the Mexican crisis in 1994. This pattern made the buyers of Russian treasury bills overconfident.
Q. The IMF did change this policy a bit.
A. Yes, in Ukraine, for instance, it insisted that the holders of treasury notes accept an extension. But the irony is that now the banks have been put on notice. In Indonesia and in Russia, they really lost a lot of money and they had to take write-offs. The Russian meltdown created a moment of panic. People talk about curing the moral hazard, but for now, anyway, events have cured it.
Q. Banks took enough losses to be more careful, you mean.
A. Ironically, they may be too careful. When Brazil got into trouble recently, the U.S., European, and other banks were cutting back on their lines of credit to borrowers as fast as they could, in order not to be asked to contribute when a rescue package was finally announced. There was eventually an informal understanding among some banks. But the effect of this pressure was to chase the banks out of Brazil. So the reserves of Brazil fell by $30 billion because the banks were running for cover.
In a way, fighting against the moral hazard is like fighting the last war. Now the problem is to get capital from the center – the United States, Japan, and Europe – to the periphery – the developing countries – and the banks are running scared. So the countries on the periphery have to pay a big premium in higher interest rates to attract capital. The playing field is uneven. Again, the penalty will be paid by the developing countries. The need is to find a mechanism to provide capital to the periphery when the market will not do so.
Q You would like to see a global bank that performs the functions internationally that a central bank such as the Federal Reserve performs domestically.
A. Exactly how to achieve this objective is not so easy to specify. I propose a way of providing international credit guarantees. It could be done by the IMF’s using so-called special drawing rights – a quasi-money issued by the IMF to guarantee loans issued by countries that follow the right policies but have no access to the market.
Q. Every country would be allocated a certain amount of drawing rights?
A. Yes, according to their size and contribution. But they could delegate their drawing rights to the IMF – say, the United States could delegate a portion of its drawing rights. The IMF in turn could allocate these drawing rights to a particular country that is having trouble attracting capital. In this way, they could get more capital without the debilitating rise in interest rates of the kind just discussed. The countries would have to respond by reforming certain parts of their economic systems that have been causing problems. In the current circumstances, for example, Thailand or Korea would have to reorganize its internal banking system.
Q. So this would be a preventive mechanism?
Q. But there would be significant political problems with such a system. How do you determine who gets what?
A. The problem is that it involves discretionary action. If you guarantee loans to Thailand amounting to 3 percent of its gross domestic product (GDP), how can you not do the same for Korea? But I think these problems can be overcome.
Q You have also said that you favor controls over the flow of capital from time to time.
A. It may be appropriate in some conditions. But I would prefer to keep capital markets open. I would ideally like to discourage speculative currency transactions. Chile was able to do this, and the crisis so far has not harmed the Chilean economy significantly.
Q. Looking back on the Long-Term Capital Management debacle, you observed that the ways that banks deal with risks are now suspect.
A. Yes, we need regulations on the amount that both banks and hedge funds can invest in derivative instruments like options and futures, which give you a claim on an underlying security for a fraction of its value. We have 50 percent margin requirements on stocks, which means that investors can borrow only half the purchase prices of stocks. These were first put into place in the 1930s. But there are no such requirements for derivatives, which are a recent invention. We need them.
Q. Has the worst of the crisis passed, in your view?
A. It seems that the panic phase is over. It is hard to imagine that you could have bigger dislocations than you already had. But we now have 35 percent of the world in recession. That percentage will probably increase in 1999 because countries like Brazil will be pushed into recession by the crisis. We have a basically deflationary environment. There is overcapacity – too many goods and not enough demand. But producers keep producing because they need to generate cash to service their debt. So they feel they must sell at any price. In these circumstances investment has to decline.
Whether that slowdown is going to be severe enough to push the world economy into recession is an open question. After the collapse in Asia and then Russia, I certainly thought that would happen. But the U.S. authorities have responded very aggressively. The Federal Reserve has cut interest rates three times. Just as the extent of the economic decline surprised me, the extent of the market recovery has also surprised me. Nevertheless, I believe that we are actually in a bear market.
Q. What are the odds of a full-fledged recession in the United States?
A. The rate of growth is likely to decline, but the United States will probably have positive growth next year. The real danger may lie in the
possible political consequences.
Q That leads me to your larger concerns. You state that the markets may be more of a threat to open societies than to totalitarian states. What do you mean by this?
A. I am worried about the political reaction to financial instability. For instance, if the U.S. stock market falls sharply, this could lead to recession. Americans are already spending as much as or more than they earn. If consumers cut back, it could send the United States and the entire world into recession. In the United States, this could lead to a political demand for protectionism. If it succeeded and we limited our imports, that would make it even more difficult for the Asian nations to rebound. In turn, they would not be able to buy the goods the United States produces, which could cause more difficulties here.
Then consider what is happening in Malaysia. Prime Minister Mahathir Mohamad has actually closed his country’s financial markets. He has put his political opponent in jail. If we become protectionist and make matters even worse in Asia as a consequence, there is no telling what might happen. Social unrest is high in Indonesia and may be rising in other nations. And if the Malaysian model turns out to work better than the Thai model, Mahathir’s policies might be very appealing in that part of the world. The prospects for open societies will be more and more in jeopardy.
In Russia, there’s such disillusionment with the West and with international openness in trade and investment, you could have a turning inward and xenophobia. You could see the rise of a dictator who tries to reestablish the currently nonfunctioning state by cruel and oppressive measures.
Q You call the current faith in free-market ideology “market fundamentalism.” That has overtones of religiosity, absolutism, coercion.
A. Because we are disappointed with the policies of governments – and with plenty of justification – we tend to idealize the market as something that can take care of everything. And just as Marx claimed that communism was based on a scientific theory of history, market fundamentalism relies on an allegedly scientific economic theory. Basically, Ronald Reagan and Margaret Thatcher were the main movers in adopting a vulgarized version of laissez-faire economics, turning it into a kind of fundamentalist position.
Q. What do you mean by vulgarized?
A. Simplified, in the sense that Reagan spoke of the magic of the marketplace, and distorted, because it claims that markets are perfect. Equilibrium applies best only to markets that deal with known quantities. But financial markets deal with quantities that are not only largely unknown but unknowable. They discount a future that is contingent on how the financial markets assess it at present. The appropriate concept, in my view, is reflexivity, not equilibrium. Reflexive processes are not just unpredictable; they are genuinely indeterminate because the outcomes depend on the predictions that investors have made. The process may be self-correcting, in which case you tend toward equilibrium, or it can be initially self-reinforcing but eventually self-defeating, in which case you have a boom and a bust.
Q. But, despite market instability, the United States grew inexorably in the nineteenth and twentieth centuries. There has been plenty of pain, but for the most part standards of living have risen to extraordinary levels. The same is true in Western Europe. What precisely is different now?
A. Remember, the nineteenth century also gave rise to Marxism amid a lot of social discontent. We have learned to control financial markets since then. After each crisis, we made institutional changes. We now have a Federal Reserve system. We have developed securities and banking regulations. We have national institutions that keep excesses from going too far. During this period when market fundamentalism has become the dominant dogma, however, markets have become truly global. And we do not have comparable international institutions to prevent the excesses.
Q You put a lot of emphasis on financial instability. But many of the problems you associate with market fundamentalism have developed in times of financial stability.
A. I worry about instability. But I also worry about inequity. The markets are good for expressing individual self-interest. But society is not simply an aggregation of individual interests. There are collective interests that do not find expression in market values. Markets cannot be the be-all and end-all. These collective decisions, and even individual decisions, must involve the question of right and wrong. Markets are amoral, as I said. But moral values are necessary to prevent their excesses and inequities.
Q. Can you give an example? Many would argue that the markets not only are amoral but can be immoral.
A. In the case of labor markets, work itself is turned into a commodity. As such, the labor markets often work very efficiently. But you can also sack someone even if he has an ailing mother and may have nowhere to turn. People need to be treated as people.
Q. They may work more productively if they are.
A. Well, I am worried about that sort of problem. For instance, the replacement of professional values by market values – turning law or medicine into businesses. It changes the character of those activities. In the case of politics, the huge role of money in elections undermines the political process.
Q How do you reconcile your own money-making activities with your concern that the markets can cause problems that endanger an open society?
A. By writing a book about it, for one thing. Because I consider the market amoral, I am concerned as a businessman with being a successful competitor in these markets. At the same time, I recognize that I am also a human being and a member of society who must be concerned with moral issues. But if I allowed moral considerations to influence my investment decisions, it would render me an unsuccessful competitor. And it would not in any way influence the outcome because there would be someone else to take my place at only a marginally different price. That, at least, was true as long as I was an anonymous participant. It is not true for me anymore.
I actually decided to go into money-making because I realized how important money is in our society. Since I have been successful, I can now address my other concerns. I believe one should distinguish between competing by a given set of rules and the process of making and improving those rules. When it comes to making the rules, I am guided by the common interest. And when it comes to competing, I am guided by my self-interest.
In fact, if this distinction were drawn by everybody, the political process would probably work much better than it now does. At the moment, people are voting their pocketbooks all the time. They are trying to bend legislation to their own financial interests. The common interest gets lost. There used to be a concept of civic virtue, but because of the sharpening of competition in recent years, people have become so involved in fighting for their survival that they cannot indulge their concern for the common good. This may sound odd, but Bill Gates, perhaps the richest man in the world, is not exaggerating when he says he is actually fighting for his survival all the time. Competition is so intense and technology so liable to change that I do not believe he is exaggerating when he says that he could be wiped out in a few years. The concern with the common good has been practically eliminated by allowing markets to be the main forum for decision-making.
Q. Isn’t there a point, however, when even the best proposals will not solve a problem? Some people will argue that nothing could have been done to correct the Russian economic situation, for example. Even if we had the international system you propose, it still might not have worked.
A. Yes. I agree. One of the things we all have to learn is that there are problems that have no solutions. On the other hand, how we deal with these problems has a great effect on how we live. In Russia, there may actually be no solution. You can make the situation better or worse, however. This is one of the themes on which my philanthropic work is based. My concept of an open society is one that is imperfect but is open to improvement. So, for instance, in the United States I have a project on death. Death is clearly a problem that has no solution. But the way we treat death can make it either better or worse. If we deny the fact and refuse to deal with the circumstances of death, which many Americans do, that makes it worse. My project is about helping Americans come to terms with death, and I believe it has made a contribution.
The drug issue in America again illustrates the principle I am talking about. I believe that drug addiction is a problem with no solution. A drug-free America is unobtainable. But the war on drugs actually does more harm to our society than the drug problem itself. There are many situations, and Russia is certainly one of them, that have no solution, but that is no excuse for giving up on them.
1. On this question, see the interview with Leon Levy in Challenge 41, no. 6 (November-December 1998): 27-38.
GEORGE SOROS has gained a reputation as one of the world’s most successful hedge fund managers. Since 1989 he also has devoted himself to philanthropic activities and writing about the world economy. He is the author of The Crisis of Global Capitalism: Open Society Endangered (New York: Public Affairs, 1998). This interview is reprinted with permission from the New York Review of Books (January 14, 1999).
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