By Eugene T. Lowe
February 2, 2009

George Soros, successful investor and hedge fund manager, philanthropist and author, spoke at the closing luncheon of the Conference of Mayors 77th Winter Meeting. Explaining many of the themes of his most recent book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, Soros said that the financial crisis of 2007, which changed dramatically on September 15, 2008 with the bankruptcy of Lehman Brothers was really the collapse of a super bubble that had been growing since the 1980s. The housing crisis, which was also a bubble, acted like a detonator to the supper bubble.

Soros said that a bubble has two components: 1) something, usually a trend, actual happening in reality, and 2) a misconception or misinterpretation of that reality or trend. These components interact with each other, reinforcing each other until the distance between reality and the prevailing view reaches a tipping point that brings about a reversal.

As for the housing bubble, the first component was low interest rates that led to increasing loans and a housing boom, while the second component was the belief that the housing on which the loans were made would keep rising in value; the difference in the two components became unsustainable. The super bubble, triggered by the housing bubble is "more difficult to understand" but it involves the misconception that markets correct for mistakes. Soros said that this is a misconception "because markets don't typically tend toward equilibrium; they go to extremes." In reality, there was a growth in credit and leverage that had been going on since the end of World War II. A number of financial crises such as the Savings and Loans crisis and the emerging market crisis of 1997–98 occurred. In each, authorities intervened with lower interest rates or bailouts that served to increase credit and leveraging. And, of course, these actions reinforced the misconception that markets were self-correcting.

But authorities didn't understand the present financial crisis. A painful mistake was made when Lehman Brothers was allowed to go broke. The financial system broke down. Soros said that the present situation is much larger than the financial failure in the 1930s, particularly when compared to the credit/GDP ratio where 2008 is twice the size. In addition, derivatives were not a factor in the 1930s, as they are now having a far greater and negative impact on the economy.

Soros asked the question: "What is to be done in this deflationary environment?" With so much accumulated debt, the authorities must create money to offset the collapse of credit, write down accumulated debt, and recapitalize the banking system. This will take radical and unorthodox policy measures. He said that an economic stimulus plan will do a lot of good, but it is not enough to alleviate the problem. He closed by saying that it is important to remember that the problem originated in the financial system, which had a deficiency and collapsed under its own weight.