Following is the testimony of George Soros at a hearing of the U.S. House of Representatives Committee on Oversight and Government Reform, chaired by Henry Waxman.Thank you Mr. Chairman.
We are in the midst of the worst financial crisis since the 1930s. The salient feature of the crisis is that it was not caused by some external shock like OPEC raising the price of oil. It was generated by the financial system itself. This fact -- that the defect was inherent in the system -- contradicts the generally accepted theory about financial markets. The prevailing paradigm is that markets tend towards equilibrium; deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty in adjusting. The current approach to market regulation has been based on this theory but the severity and amplitude of the crisis proves convincingly that there is something fundamentally wrong with it.
I have developed an alternative paradigm that differs from the current one in two important respects. First, financial markets do not reflect the underlying conditions accurately. They provide a picture that is always biased or distorted in some way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. I call this two-way circular connection between market prices and the underlying reality â??reflexivityâ??. I contend that financial markets are always reflexive and on occasion they can veer quite far away from the so-called equilibrium. In other words, it is an inherent characteristic of financial markets that they are prone to produce bubbles.
I have originally proposed this theory in 1987 and I brought it up to date in my latest book The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means. I have summarized my argument in the written testimony I have submitted. Let me recall briefly the main implications of the new paradigm for the regulation of financial markets. The first and foremost point is that the regulators must accept responsibility for controlling asset bubbles. Until now the financial authorities have explicitly rejected that responsibility. Second, to control asset bubbles it is not enough to control the money supply. It is also necessary to control credit because the two do not go in lock step. Third, controlling credit requires reactivating policy instruments which have fallen into disuse, notably, margin requirements, and minimum capital requirements for banks. When I say reactivate them, I mean that the ratios need to be changed from time to time to counteract the prevailing mood of the markets because, contrary to the prevailing view, markets do have moods. Fourth, new regulations are needed to ensure that margin requirements and the capital ratios of banks can be accurately measured. The alphabet soup of synthetic financial instruments (CDOs, CDSs, ETSs, and the like) have made risks less transparent and harder to measure. These new products will have to be registered and approved before they can be used and their clearing mechanism has to be regulated in order to minimize counterparty risk. Fifth, since financial markets are global, regulation must also be international in scope. Sixth, since the quantitative risk management models currently in use ignore the uncertainties inherent in reflexivity, limits on credit and leverage will have to be set substantially lower than those that have been incorporated in the Basel Accords on bank regulation. Basel II, which delegated authority for calculating risk to the financial institutions themselves, was an aberration and has to be abandoned. It needs to be replaced by a Basel III which will be based on the new paradigm.
How do these principles apply to hedge funds? Clearly hedge funds use leverage and they contribute to market instability in times like the present when we are experiencing wholesale and disorderly deleveraging. Therefore the systemic risks need to be recognized and more closely monitored than they have been until now. Appropriate regulations need to be devised. But we must beware of going overboard with regulation. Excessive deregulation has inflicted enormous losses on the general public and there is a real danger that the pendulum will swing too far the other way. That would be unfortunate because regulations are liable to be even more deficient than the market mechanism itself. That is because regulators are not only human, but also bureaucratic and susceptible to political influences.
It has to be recognized that hedge funds were an integral part of the bubble which has now burst. But the bubble has now burst and hedge funds will be decimated. I would guess that the amount of money they manage will shrink by between 50 and 75 percent. It would be a grave mistake to add to the forced liquidation currently dislocating markets by ill-considered or punitive regulations. I would be happy to expound on these ideas in greater detail in responding to your questions.
