Asset Price Deflation
George Soros on the financial crisi:
The Financial Crisis: George Soros: I think it was, but it would have required recognition that the system, as it currently operates, is built on false premises. Unfortunately, we have an idea of market fundamentalism, which is now the dominant ideology, holding that markets are self-correcting; and this is false because it's generally the intervention of the authorities that saves the markets when they get into trouble. Since 1980, we have had about five or six crises: the international banking crisis in 1982, the bankruptcy of Continental Illinois in 1984, and the failure of Long-Term Capital Management in 1998, to name only three.
Each time, it's the authorities that bail out the market, or organize companies to do so. So the regulators have precedents they should be aware of. But somehow this idea that markets tend to equilibrium and that deviations are random has gained acceptance and all of these fancy instruments for investment have been built on them.... The large potential risks of such investments are not being acknowledged....
The authorities, the regulators--the Federal Reserve and the Treasury--really failed to see what was happening. One Fed governor, Edward Gramlich, warned of a coming crisis in subprime mortgages in a speech published in 2004 and a book published in 2007, among other statements. So a number of people could see it coming. And somehow, the authorities didn't want to see it coming. So it came as a surprise.... [Y]ou have a whole establishment involved. The economics profession has developed theories of "random walks" and "rational expectations" that are supposed to account for market movements. That's what you learn in college. Now, when you come into the market, you tend to forget it because you realize that that's not how the markets work. But nevertheless, it's in some way the basis of your thinking....
[T]he situation is definitely much worse than is currently recognized. You have had a general disruption of the financial markets, much more pervasive than any we have had so far. And on top of it, you have the housing crisis, which is likely to get a lot worse than currently anticipated because markets do overshoot.... I'm sure that it will be necessary to arrest the decline [in housing] because the decline, I think, will be much faster and much deeper than currently anticipated.... [F]oreclosures are going to add to the supply of housing a very large number of properties.... There are about six million subprime mortgages outstanding, 40 percent of which will likely go into default in the next two years.... Problems with... adjustable-rate mortgages are going to be of about the same magnitude as with subprime mortgages. So you'll have maybe five million more defaults facing you over the next several years....
[Y]ou need to reduce the number of foreclosures. You need to keep as many people as possible in their houses so that they don't come onto the market. You need to arrest the decline in house prices, but you also need to prevent human suffering and social disruption because it's going to be very, very severe....
[Rescue] is their [the Federal Reserve's] job, whether unhealthy or not... to save the system when it is in danger. However, because that is their job, it ought to be their job also to prevent asset bubbles from developing. And that task has not been recognized. Greenspan once spoke about the "irrational exuberance" of the market.... [I]t's generally accepted that the Fed tries to control core inflation, but not asset prices. I think that control of asset prices has to be an objective in order to prevent asset bubbles because they are so frequent.... You have to recognize that just controlling money doesn't control credit.... [Y]ou have to take into account the willingness to lend. And if it's too great—if borrowers can obtain large loans on the basis of inadequate security--you really have to introduce margin requirements for such borrowing and try to discourage it....
[W]e are close to a tipping point [for the dollar] where, in my view, the willingness of banks and countries to hold dollars is definitely impaired. But there is no suitable alternative so central banks are diversifying into other currencies; but there is a general flight from these currencies. So the countries with big surpluses—Abu Dhabi, China, Norway, and Saudi Arabia, for example—have all set up sovereign wealth funds, state-owned investment funds held by central banks that aim to diversify their assets from monetary assets to real assets. That's one of the major developments currently and those sovereign wealth funds are growing. They're already equal in size to all of the hedge funds in the world combined. Of course, they don't use their capital as intensively as hedge funds, but they are going to grow to about five times the size of hedge funds in the next twenty years.
I must say, these days when I read my backlist I feel like a genius--for example, back in 1998 I tried to convince the Brookings Panel that:
Why We Should Fear Deflation: Economies may well have more to fear than declines in broad goods-and-services price indices alone. If securities and real estate holdings have been pledged as collateral for debt contracts, then large-scale asset price declines also trigger the confusion of macroeconomic events with entrepreneurial failure that makes deflation feared.
Is the United States today potentially vulnerable to large-scale asset price declines in this way? In real estate no [this was written in 1999]. In the stock market yes [ditto]. Perhaps fundamental patterns of equity valuation have truly changed, as investors have recognized that the equity premium over the past century was much too large--in which case stock prices have reached a permanent and high plateau. But it seems more likely that there are substantial risks of stock market declines on the order of fifty percent back to Campbell-Shiller fundamentals...
