The big bust theory

The book explains how principles propounded by classical economists have led to the crash in the global markets and recommends ways to control the situation. It also proposes a new theory to understand market behaviour, says Namrata Dadwal.

Namrata Dadwal | Print Edition: December 11, 2008


Price: Rs 660

Pages: 162

By: George Soros

Published by: Public Affairs

Target audience: Evolved and experienced investors

Quick read tip: Peruse ‘Setting the Stage’ to know how the crisis began

Language: Needs dictionary

Style: Academic

Visuals: Graph

In economics, one of the basic and most revered tenets has been laissez-faire, the principle of free markets. This professes that the markets always tend to move towards equilibrium. Classical economists have repeatedly espoused that economics is a science, and under certain conditions, markets will behave in a perfect manner and with the same results.

But George Soros, the chairman of Soros Fund Management, has pronounced this paradigm a fallacy. In fact, in his recent book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means, he has blamed the blind belief in the concept of market equilibrium as one of the factors that has led to the present global crisis in the financial markets.

Instead, Soros propounds his own theory, ‘The Theory of Reflexivity’. According to him, the greatest misconception harboured by investors is that social sciences will follow the same rules as natural sciences. He ridicules this idea, stating that since financial markets comprise thinking participants, their decisions will greatly influence the market behaviour. Investors are not only trying to understand their circumstances, but also manipulate them. They always try to exploit the situation to their own benefit and so markets can move away from their equilibrium to a great extent. This gives rise to asset bubbles and super-bubbles.

In order to explain his theory and analyse how the reckless belief that markets will automatically correct themselves led to the financial crisis, Soros has divided the book into two parts.

The first section describes how Soros came up with the idea of “reflexivity” and how his over 50 years of experience in the financial markets has convinced him about the correctness of his theory. If you are running short of time or are not interested in economic ideas and concepts, you can give this section a miss. And don’t worry, you won’t miss much because Soros tends to harp over his theory in other chapters as well.

However, some investors may find it interesting to read the chapter ‘Reflexivity in Financial Markets’ since it describes in detail Soros’ boom-bust model and some of the crises that have occurred in the past.

It is the second part of the book that makes for gripping reading. In a nutshell, it explains how the markets arrived at this juncture and where they are headed from here. Soros, as does everybody else, talks about the housing bubble. But what distinguishes him is his description of a superbubble.

 Soros’ Boom-Bust Model

1. The initial stage, when the boom trend is not yet recognised.

2. The period of acceleration, when the trend is recognised and reinforced by the prevailing bias. This is when the process approaches the far-fromequilibrium territory.

3. A period of testing may intervene when prices suffer a setback.

4. Far-from-equilibrium conditions become firmly established if the bias and trend survive the testing. In this period, the normal rules do not apply.

5. The moment of truth, when reality can no longer sustain the exaggerated expectations.

6. The twilight period, when people continue to play the game though they no longer believe in it.

7. A crossover point is reached, when the trend turns down and the bias is reversed.

8. A catastrophic downward acceleration, which is commonly known as the crash.

* While 5 and 7 refer to specific points in time, the rest indicate time intervals

According to him, the crisis has been more agonising because the sub-prime crisis acted as a trigger that released the super-bubble, which was created in the 1980s. It is the bursting of this superbubble that has left the markets reeling and the world facing a recession.

Soros lays the blame squarely at the door of the regulators who, he thinks, failed to do their job properly. He questions why the regulators, when they found it difficult to calculate the risk of certain financial instruments, allowed such products to be sold or traded in the markets. He is also very caustic about the Bush administration, which he feels was incapable of formulating the right policies to capture the downslide.

Reading about his aversion for Bush, it is safe to assume that he voted for Barack Obama. But since the book was written in April 2008, we don’t know if he thinks Obama will be able to control the crisis.

The book is interesting, but most readers will be left floundering in a sea of financial jargon. It will be better understood by those who are conversant with economic concepts and the latest market lexicon. A lay investor will have to either brush up on the terms or at least have Google handy.

Soros has interspersed the book with autobiographical anecdotes from his childhood, his years as a student and his experience as a hedge fund manager. It’s interesting to know how these incidents later shaped his financial decisions. Indian investors have something to cheer about while reading this book.

Soros is emphatic that the growth in China, India and West Asia will help fight the global recession. Though he is hesitant about India’s infrastructure, he lists the reasons why he is optimistic about the growing economic power of these regions.

For investors who are intimately involved with the unfolding drama, an interesting chapter to go through first would be ‘My Outlook for 2008’. Soros has conducted a real-time experiment, where he has documented his decisions as a hedge fund manager at the same time that he was taking them. The first entry is for 1 January 2008, but unfortunately, the last entry is for 23 March.

This will probably leave you feeling cheated because the worst period of the crisis was in October when most global markets hit rock bottom and the Wall Street quaked. Perhaps, Soros should have waited a while before writing the book.

Read our review of the book Wall Street: A Cultural History

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