‘George Soros has won the first few rounds, so must I now eat my words?’

Rarely in the history of human prognostication can so few words have been so prescient in so short a period of time. In the spring of 2008, the celebrated billionaire, hedge fund manager and pundit, George Soros, said that the world was in the midst of a financial crisis that was “the worst since the Great Depression” of the 1930s. Right on cue stock markets have collapsed. In the six months to late November, the Standard & Poors’ 500 was down by more than 35 per cent, while the FTSE 100 tumbled by 40 per cent.

In my July 2008 Standpoint column I took issue with Soros. I didn’t deny that the world economy would slow down in late 2008 and 2009, but emphasised that almost everywhere the macroeconomic numbers are far better today than they were in the 1970s or 1980s. Further, in my view a recession like that in the early 1980s was unnecessary to control inflation and unlikely in practice. My verdict was that the slowdown would be “only a blip on the path to further prosperity”. Given the slump in share prices, must I now eat my words?

Soros has been vindicated so far because he saw two key points with clarity. First, as is typical after long upswings in asset prices, too many participants in financial markets had too much “leverage” in early 2008. Leverage is a fancy word for debt and the reader may wonder why I have preferred it. The answer is that in 2008, many operators did not have a plain vanilla loan, which is what we usually mean by “debt”, but something more esoteric and complicated like a big risk position in derivatives.

An example is the Royal Bank of Scotland, which by mid-2008 had written “credit default swaps” to the tune of more than £400 billion compared with its own capital of £40 billion. RBS ought in an average year to make a few hundred million pounds from its CDS business. Contrary to rumour, the activity is not that risky, despite the huge face value of the transactions. Like a bookie, RBS might accept a bet that a particular credit risk/horse would win and then offset that by accepting another bet that the same credit risk/horse would lose, taking money from two sets of customers and having quite a small net exposure.

But bookmaking can go wrong. In extreme conditions several outsiders, for each of which it has been difficult to match positive and negative bets and significant uncovered risk remains, might win a sequence of races. The bookie is then bust. When markets start to worry and keep on worrying, the fear becomes – as Roosevelt might have said – a fear of fear itself. Even organisations as diversified and massive as RBS, Citibank or Goldman Sachs might then have difficulty in funding their business. Leverage leads to fear and, when things go wrong, people scurry for safety.

Second, Soros saw that the contagion of fear would hit the banks worst of all. Over the last 40 years banks have built up huge claims on each other, much of it in the so-called “offshore markets”. Since summer 2007, they have been cancelling these claims. Any bank dependent on financing its assets by inter-bank indebtedness has had to shrink its lending to genuine non-bank customers, causing the global “credit crunch”. Banks with large books of CDS business or holding exotic securities (such as supposedly triple-A bonds priced at huge and puzzling discounts to their original cost) were most vulnerable.

Although the causes of the Great Depression are controversial, one feature of the historical record is obvious. In the US, a vast number of bank failures occurred during the key period. With the crisis in the inter-bank market recalling the problems of the early 1930s, Soros warned that the decades-long “super-boom” in dollar credit had to go into reverse.

But how bad will the reversal of the credit boom become? In their groundbreaking A Monetary History of the United States 1867-1960, Milton Friedman and Anna Schwartz showed that a sharp fall in the quantity of money was the dominant reason for the Great Depression. Between October 1929 and April 1933, the US money supply (mostly bank deposits) slumped from $48.2 billion to $29.7 billion, or by over 38 per cent. Indeed in 2008, there was a sharp fall in money growth in some economies, with the implosion of money market mutual funds in the US being perhaps the most alarming. But nowhere is there any suggestion that the money supply will drop by 20 or 30 per cent. In sharp contrast with the 1930s, policy-makers are not constrained by the barbarous ideology that money is “sound” only if it is linked to gold. US policy is now wildly reflationary, both monetarily and fiscally.

The Federal Reserve has countered the implosion of the money market funds by taking up huge quantities of commercial bills. US banks can tap capital (via preference shares to the government) at the absurdly low rate of 5 per cent and the Federal government will have to finance a looming budget deficit of about $1 trillion largely from the banks. The result may well be that in 2009, the US money supply, far from contracting, will grow rapidly. Soros has won the first few rounds of the debate on the financial crisis, but it remains true that the current slowdown is only a blip in the world economy’s onward progress.

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