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Monday, April 7, 2008

The Internet Crash and Soros' Pessimism

From March of 2000 till the end of the year nearly three trillion dollars in paper losses occurred in the stock market as a result of the internet bubble. It was a crash of monumental and global proportions, and much of the punditry at the time predicted gloom of unmatched proportion at the time.

Their gloom was well warranted. The internet had transformed the economy and more than that the landscape of the workforce. Silicon Valley had become the place to be. Investors had rushed into catch anything and everything related to the internet. Folks had quit their jobs to jump into the internet craze and many people had put much of their wealth into the internet. The phenomenon was global. When the market crashed, it had exposed an economy that was nothing more than a mirage built on the backs of companies that had nothing but a good idea. Thus, it stood to reason that we were heading for a crash of monumental proportions. Furthermore, the landscape was made even more dicey by 9/11 and several significant accounting scandals that followed.

Yet, despite this gloomy outlook the recession that followed was fairly mild and it was followed by over four years of uninterrupted growth.

Now here comes this analysis of the current economic outlook by George Soros.

Everything that could go wrong did. What started with subprime mortgages spread to all collateralised debt obligations, endangered municipal and mortgage insurance and reinsurance companies and threatened to unravel the multi-trillion-dollar credit default swap market. Investment banks’ commitments to leveraged buyouts became liabilities. Market-neutral hedge funds turned out not to be market-neutral and had to be unwound. The asset-backed commercial paper market came to a standstill and the special investment vehicles set up by banks to get mortgages off their balance sheets could no longer get outside financing. The final blow came when interbank lending, which is at the heart of the financial system, was disrupted because banks had to husband their resources and could not trust their counterparties. The central banks had to inject an unprecedented amount of money and extend credit on an unprecedented range of securities to a broader range of institutions than ever before. That made the crisis more severe than any since the second world war.

Soros makes to simultaneous and interlocking points. The first point is that the economy has become so sophisticated that the real estate crash will damage just about everything else in the economy. That's because the financial products that are created from mortgages have become so sophisticated that they are used by anyone and everyone. Soros is absolutely correct when he says that everyone from hedge funds to municipalities in one way or another invested in these sub prime mortgages. He is correct that the subprime crisis is not merely isolated to the real estate industry. He is also correct when he says that it is now a world wide problem.

Soros makes another philosophical point.

Every time the credit expansion ran into trouble the financial authorities intervened, injecting liquidity and finding other ways to stimulate the economy. That created a system of asymmetric incentives also known as moral hazard, which encouraged ever greater credit expansion. The system was so successful that people came to believe in what former US president Ronald Reagan called the magic of the marketplace and I call market fundamentalism. Fundamentalists believe that markets tend towards equilibrium and the common interest is best served by allowing participants to pursue their self-interest. It is an obvious misconception, because it was the intervention of the authorities that prevented financial markets from breaking down, not the markets themselves. Nevertheless, market fundamentalism emerged as the dominant ideology in the 1980s, when financial markets started to become globalised and the US started to run a current account deficit.

Essentially what Soros is saying here is that in his belief the market tends toward disequilibrium while most of the players believed that it tends toward equilibrium. Keep in mind that Soros made one billion dollars in a day playing on the market's disequilibrium toward the Pound. Furthermore, this philosophy has guided his view of the world

Despite working as an investor and currency speculator (his fortune in 2004 was estimated at US$7 billion), he argues that the current system of financial speculation undermines healthy economic development in many underdeveloped countries. Soros blames many of the world's problems on the failures inherent in what he characterizes as market fundamentalism. His opposition to many aspects of globalization has made him a controversial figure.

Victor Niederhoffer said of Soros: "Most of all, George believed even then in a mixed
, one with a strong central international government to correct for the excesses of self-interest."Soros claims to draw a distinction between being a participant in the market and working to change the rules that market participants must follow.

I have already pointed out that speculative markets are a result of the flawed nature of human beings, and that they are unfortunate part of free markets. Still, anyone that has followed the aftermath of speculative markets knows full well that the natural pull is always toward equilibrium not disequilibrium. In the aftermath of the mortgage crisis all of the products that created the speculation have been nearly eliminated by the market: stated loans, no money down loans, option arms, and pre payment penalties.

Speculative markets are an unfortunate and all too real part of free markets, however it is in my opinion a distortion of free markets to say that speculative markets are what free markets tend to. This is important because Soros argues that the flawed nature of free markets created an atmosphere of taking on undue risk.

That created a system of asymmetric incentives also known as moral hazard, which encouraged ever greater credit expansion. The system was so successful that people came to believe in what former US president Ronald Reagan called the magic of the marketplace and I call market fundamentalism. Fundamentalists believe that markets tend towards equilibrium and the common interest is best served by allowing participants to pursue their self-interest. It is an obvious misconception,

In other words, Soros believes that unrestrained free markets create an atmosphere where irresponsible behavior is rewarded and thus creates more of it. In the case of the credit crisis, more extended borrowing was rewarded and market players thus borrowed more. While I agree that in the real estate crisis that is exactly what did happen, I would argue that this happens only in speculative markets.

Where Soros and I diverge is in the belief that speculative markets are the norm or the exception. Soros believes that eventually all markets become speculative whereas I believe those are anomoles caused by human failings. I believe that I am right because history has shown that markets have always learned from the excesses of speculation. After the market crashed, margins were tightened. After the internet stocks crashed, most of the speculators were forced out of the market, and in the current crisis the market has removed most of the excessive loans.

Soros entire diatrobe is a commercial against globalization and for so called mixed economies which he feels are the only way to curb the failings of humans. I firmly believe he is wrong and that brings me back to the internet crisis. The current doom and gloom was only surpassed by the same sort of doom and gloom following the internet bubble's burst. So, if Soros is right this time, why exactly did the internet bubble lead to a recession that was rather mild? Just like now, internet stocks became a part of portfolios of all sorts of financial institutions all over the world. Just like now, the internet craze was part of a globalized effort. Just like now, it was a result of the failings of greed. The moral hazard of excessive leveraging was only surpassed by the moral hazard of investment in stocks with no earnings and little revenues during the days of the internet bubble.

In fact, if you change a few words around, you are now in fact staring at the internet bubble. Yet the doom and gloom that Soros professes never materialized and that is in my opinion because he is fundamentally wrong about the worth of free markets.


Anonymous said...
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mike volpe said...
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Anonymous said...

The consequences of the stock crash were mitigated by the creation of the housing bubble - the speculators were not flushed out of the market, but simply moved to a different market.

Soros and Buffett speak of instruments so arcane that no one understands them or can price them. These are uncontrollable excesses of unimaginable size, and flushing them from the marketplace may indeed bring the whole market building down.

The "magie of the marketplace" is just vanity, intended to plump up the sleazebags therein.

mike volpe said...

That is generally accurate though not quite and with some important inaccuracies in my opinion.

The internet crash was lessened not because of a speculative real estate market but rather low interest rates that made real estate attractive as well as the well timed tax cuts. The speculative market happened long after the economy had started to boom. The speculative market didn't happen because of archane and complicated financial instruments but rather because everyone believed that real estate was going to go up forever.

The speculators were mostly flushed out of the internet market. While hedge funds and other such players were certainly involved in the internet craze they didn't bet their entire portfolios on them. The folks that did were flushed out.