A finance insider reads Soros' intervention at Trento and wonders whether this is just a trading superstar talking up his own portfolio?
George Soros is superstar of the investment world. Much of his reputation in the UK stems from his central role in 'breaking the Bank of England' in 1992. His Quantum investment fund was responsible for 30%+ of investor firepower targeted at expelling the £ from the ERM. If any one person kept the UK out of the EZ, it was Soros: but investment industry insiders also recall the 'St Valentine's Day Massacre' of 1994, when Quantum was the wrong side of another huge currency move. What earlier he made from sterling he later lost in yen.
Soros is far from the only investment industry superstar to take the occasional bath in the markets. It goes with the territory. Myron Scholes (of Black/Scholes fame) is a Nobel Prize Winner; when LTCM, of which he was a leading partner, went bust in 1998 it took the best part of $5bn and a bank or 2 with it. (The LTCM debacle was a dry run for the Lehman bankruptcy and what a pity lessons were not learned from it, but that is another story.)
I do not mean to detract from the achievements of Soros. Any investment manager/trader of his standing can only have reached that position the hard way and there must have been a few uncomfortable P&L days on his climb to riches and fame. When he speaks, it pays to listen. What I am saying is, notwithstanding the success and veneer of infallibility of Soros and others like him, they can be wrong too and that when they are wrong they can be very, very wrong.
I am slightly puzzled that, when Soros provides a prescription for the euro's troubles, few question why. In my experience, when an investor/trader starts proffering advice, it's usually an indication of which way their book is positioned. It may also be an indication that things haven't been going particularly well. It is not my suggestion or assumption that this is the case with Soros; nonetheless, he has made a career and a significant amount of money by taking advantage of imbalances in currency markets. Perhaps we should bear that mind when considering his advice for the euro.
In his speech he starts by expressing a "widespread recognition" that economic theory has failed. My immediate reaction is, well maybe, but with respect to the euro, economic theory was never given a chance. No theory I am familiar with would have put Germany, Italy, Ireland and Greece all in the same currency zone. A recent report suggested that a random collection of countries beginning with the letter M - including Madagascar, Myanmar and Malaysia - would have had a greater chance of success.
He speaks at length of his home-grown reflexivity theory, which he considers a radically new approach to financial markets. Much of what he writes is not particularly controversial, least of all his comments about the failures of politicians (or "authorities") and I do not propose to address each and every point that he makes, nor to critique his reflexivity theory. Others have done so before me at least as well as I could. Every investor/trader has their own way of approaching the markets, their "process", and his process has clearly worked for him. What I would like to do is to pick up on a few points that I think are critical inasmuch as they apply specifically to the eurozone crisis.
Soros says that the Maastricht Treaty was fundamentally flawed and the main failing was that it established monetary union without political union. So far, so uncontroversial. Actually, I don't think one requires to read anyone's "reflexivity theory" to reach that conclusion: but notwithstanding Maastricht's failings - and lack of political union was not the only one - I do think the Maastricht Treaty was not as flawed as was its shoddy implementation; that had its terms concerning sustainable fiscal convergence been adhered to strictly, it would have resulted in a significantly more secure EZ economy and currency than currently exists. Maastricht wasn't perfect but it wasn't expected to be perfect. It was always intended to be a staging post on the way to greater integration. Soros writes of the approach of an earlier generation of euro-politicians, which set "limited objectives" and tried to advance them a "small step forward" at a time. He is right about that and also about why Maastricht could not envisage full political (and fiscal) union. It was simply a small step too far at the time.
The Maastricht Treaty was a perfect example of the "small step forward" approach, providing a framework in which aspirant countries could join the EZ as and when they met its terms; actually, the deficit and debt:GDP criteria of the Maastricht Treaty were not quite so clear cut as is usually portrayed. There was a certain amount of flexibility within the Treaty that could enable aspirant nations to enter the euro even if they did not meet the 3% deficit and 60% debt:GDP limits specified, provided that they were making good progress towards those targets. Meeting the terms was tough for many aspirant countries, including mighty Germany. However, even allowing for Maastricht "flexibility" one can be unequivocal about this; that neither Italy nor Greece met the terms for entry and that the suitability of certain others, including Belgium and Spain, was at best debatable.
Soros is quiet on the subject of convergence of EZ economies: he says the inability of countries to create fiat money was the "main source of trouble". Actually, the whole point of a currency zone is that regions ("countries") don't get to print money. Wisconsin and Lanarkshire are in currency zones, they don't print money either. Regional fiscal policy is supposed to pick up the slack but that requires political and fiscal union and that particular "small step forward" was always just a step too far for post-Maastricht politicians.
The consequence of entering the EZ for some non-convergent "peripheral" countries was that for several years they endured what were in effect entirely random interest rates, suitable somewhere else (maybe) but not suited to them. A number of economies were turbo-charged by low interest rates. Systemic instability became hard-wired when economies proved unmanageable with domestic fiscal policy alone; or maybe because national governments proved incapable of taking necessary hard decisions. In the good times, they didn't cut fiscal expenditures enough, in the bad, they borrowed too much. Central budgetary control was lax: actually, not all EZ countries even bothered to wait until the bad times before borrowing too much, and bad times became worse when some public exchequers were required to inherit private sector property debts.
Euro-politicians had been keen to make history and so they discarded Maastricht and the "small step forward" approach, instead taking a "leap of faith". If Italy and Greece and perhaps others had been denied entry until they met the criteria, even the "flexed" criteria, and if admitted countries had been required to stick to the full ongoing conditions of Maastricht - Germany and France were the first to fall by the wayside - the euro would not be in its present dismal circumstances. Doubtless the situation would not be without problems, but they would be more containable. There were other factors, not least the interplay between ineffective bank regulation and poor risk management practices in several European (principally German and French) banks, but it is difficult to avoid the conclusion that ditching Maastricht is a central underlying cause of the euro-crisis.
For Soros, what happens now is all about Germany; that only Germany can save the euro because only Germany has the financial muscle. He says that policy makers have just three months to correct mistakes, a time frame set by the likely increasing reluctance of Germans to take on potentially open-ended financial responsibilities with the backdrop of a weakening German economy: and let us be clear, Germans are already reluctant.
Soros is only half right in saying that everything is in the hands of Germany. The German position seems to be, we're ready to make a bigger contribution, show us political and fiscal change and we'll show you the readies. Other nations, fearful of a Germany-dominated agenda in a more federal system, seem to be saying, no, show us the readies now, but we're actually not that bothered about the other things; and by the way, you're not talking about enough readies yet.
A meeting of the minds on fiscal transfers is key to any resolution although Soros points to other measures that must also form part of a rescue package. He specifies the need for a European-wide deposit insurance scheme and for new treaties to ensure that current imbalances will not recur and introducing measures to address banking and government debt problems; remarkably, having expended paragraph upon paragraph explaining his reflexivity theory in minute detail, he deals with these latter issues, the nexus of the whole crisis, in a single sentence.
Non-German EZ countries seem to be pinning their hopes on a Damascene conversion for Merkel, that she will commit Germany to providing the funds required to balance national budgets and to putting economies back on firmer ground: but Germany is itself not without fiscal problems and may not have the broad shoulders that seemingly everyone - everyone but Germans - assumes. There are also significant legal hurdles to overcome within Germany in respect of a rescue package. It is not my view that Germany will commit to the level of support other nations consider necessary: but even if policy makers do manage a meeting of the minds to "save" the euro - leaving aside the question of who blinks first - will they will really be "saving" the euro or merely deferring what may be inevitable?
Soros suggests that, once his policy prescriptions are in place and economies have stabilised, the possibility exists for an orderly EZ break-up in the years to come. This, I think, is a sop to euro-sceptics; because if economies stabilise post-rescue - perhaps even find some growth from somewhere - motivation for break-up will dissipate. The euro will be doing what it was supposed to do all along, bringing peace, harmony and prosperity to Europe, so why break-up? That is the "best case" scenario but more likely in my view is a less optimistic future, one in which the ongoing weakness of some EZ economies continues to fuel instability, a future characterised by low aggregate growth, discrepancies in economic performance and punctuated by spells of social unrest. Rather like now, in fact.
Soros considers it likely that Germany will do just enough to "save" the euro but nothing more, leaving some peripheral nations in a permanently depressed state and in need of permanent transfers. His view and mine differ little in that respect. Poverty would be kept at bay, probably, by transfer payments, but that is not a recipe for job creation. Young people would drift away in search of better lives.
The wild card is if investor panic were to spread to France and perhaps even Germany, in which event - well, who knows? Politicians and public alike may revise their opinions if the flow of cash from Germany were to dry up: unimaginable as that may be, the possibility is not zero, perhaps not even negligible. I would feel a lot happier if I thought euro-politicians were incorporating such a possibility into their contingency planning.
Soros debunks a number of old economics laws and theories. Actually, some of them were already debunked. One old law (not specific to economics) we should bear in mind is the law of unintended consequences. Soros's prescriptions for the euro crisis are widely shared and EZ politicians are likely to put together of package of measures based around his thinking. My concern is that such a package may not fix underlying faults within the EZ so much as exacerbate them.
It is normal practice for politicians to reverse policy errors and in the ten or so years of the euro's existence, things could hardly have gone worse. Maastricht did not include an escape route for economies that, for whatever reason, may subsequently find membership of the EZ was not for them. There was no template for exit and none seems to be contemplated now. New measures under consideration will strengthen ties to the euro, making exit even more difficult: yet imbalances that remain are likely to become increasingly institutionalised, resulting in very bleak economic prospects for certain countries and there is the wild card of France and Germany being sucked into the vortex. My concern is that, rather than providing a "fix" for the euro-problems, policy makers will merely defer them to a later date, and that new measures may merely add to existing policy errors, risking the creation of bigger problems and perhaps leading to even more explosive pressures in the future.