I’ve read a lot of investment books that make some attempt at justifying a particular theory as to why markets perform the way they do and why some investors perform above and beyond what probability would lead us to believe in the long run. Legendary hedge fund manager George Soros is best known for making billions of dollars betting against the British Pound when it foolishly tried to stay in the EMS in the early 1990’s. But unlike some commentators who vilify the likes of Soros for “making money off the back’s of taxpayers”, I recognise the reality of what his type of speculation does. It provides a clear signal to policymakers that they are doing something stupid.
Without the speculators of this world, economic policy could be conducted in a vacuum without any critical feedback in the form of prices and interest rates. Measuring risk would be far more difficult and the world would stumble towards Soviet-style committees deciding on exchange rates and interest rates. We all know how that ended and we all know that New Zealand’s attempt to fix our exchange rate lead to a currency crisis so severe it ran down foreign exchange reserves to near zero, necessitating a float in 1984.
In The Alchemy of Finance, George Soros describes his theory of reflexivity. It was what he attempted to write his PhD on, but the theory was tested in the way he applied it to the financial markets. The central thrust of the theory is that market participants are biased. As opposed to making consistently rational investment decisions, market participants jump on trends in a self-reinforcing and self-fulfilling manner. As opposed to trending towards equilibrium, the financial markets perform in line with the biased expectations of the participants.
He argues that the more people who believe in the efficient markets hypothesis, the less stable financial markets will actually be. Some of his comments with respect to groupthink are very prescient when we think about what happened in the sub-prime mortgage boom.
He disagrees with the idea that markets trend towards equilibrium. He rails against the theory of perfect competition, arguing that imperfect knowledge is almost always the case. In fact, he argues that based on his observations in the financial markets that they tend towards excess as opposed to any form of reality-based valuation.
He uses the rise of conglomerates in the 1970’s to illustrate that executives started creating conglomerates simply because other companies were and because the price/earnings multiples for conglomerates were rising faster than other categories of stock. By jumping on the trend they could raise their share price and earn higher performance bonuses. (1970’s executive earnings were several standard deviations below the obscenities of today). Eventually the conglomerates over-extended and suffered major losses. Up until that point no one took a step back and thought about things. They merely jumped on the trend.
There is also a highly relevant discussion of the international lending boom in the late 1970’s and early 1980’s which culminated in bank failures and the need for a centrally planned response. Arguments of “too big to fail” were being made back then, so leopards don’t change their spots. Banks segued from international lending to bridge loans or junk bonds that fuelled the merger mania of the 1980’s. Until the 1986 Tax Reform Act they also piled into real estate.
Soros argues that regulators are always one step behind the private sector. He believes that loose accounting requirements around recognition of bad debts have simply enabled banks to keep on keeping on when many should have been liquidated a long time ago because they are actually insolvent.
Soros also includes an interesting prediction that Japan will take over the world. The things he talks about – high ownership of US debt, high savings rate, growth, powerful export sector and cultural differences – are very similar to arguments currently made about China. It is clear that while Japan is still an economic superpower, it is not the major force it once was.
From this we can infer that making long term predictions about who will “take over the world” economically is extremely difficult. The thing that stood out to me throughout this book was that many of the situations Soros writes about were happening in the 1970’s and 1980’s. Yet they are analogous to what’s happening right now.
He outlines two interesting things at the end of the book – an argument for a World Bank financed through an oil buffer supply system and for an international currency with an international central bank. He thinks the actions of the G5 meeting at the Plaza Hotel as being key to saving global trade, and seemed frustrated that the German government eventually moved away from close co-operation between central banks.
The book is definitely not a light read. But if you are interested in the opinion of one of the most accomplished speculators on how financial markets actually function as opposed to academic claptrap, The Alchemy of Finance is a good a place as any to begin.