Customer Reviews

The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means

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In August 2006 the risk manager of the home equity division of one of the largest banks in the United States collected his staff together and told them that the portfolio they manage had begun to exhibit dramatic losses. All the other banking institutions were beginning to exhibit similar losses he said, but that policies to be put in place will mitigate these losses and therefore "not to worry." He resigned his position only six months later, and at the time the mortgage losses throughout the nation were accelerating dramatically, forcing layoffs, resignations, panic in the financial markets, and aggressive action from the Federal Reserve.

Theories abound on why this turmoil is occurring, one of these being discussed in this book, which is written by one of most well-known financial speculators of all time. The tone of the book is general and philosophical, and the author refrains from indulging in mathematical considerations, but there are many concepts in the book that are interesting and merit further investigation. The author's intellectual honesty is refreshing, in that he admits the job he has taken on is a formidable one. Describing the workings of the financial markets is challenging, and has occupied the time of countless researchers and financial analysts.

The author wants to get rid of the "market equilibrium" paradigm in traditional economics and replace it with one that he has called "reflexivity". This concept is similar to a few that have been discussed in recent months, one holding that investor analysis and modeling activities actually serve to change the markets, rather than just "mirror" them. The author's idea is that humans have both a cognitive function and a "manipulative" one when they approach the financial markets. This has the implication that social phenomena cannot be described or studied in the same way as natural phenomena. They are separate areas of study, he argues, and he attempts to justify their separation on the pages of this very short book.

His analysis is interesting and provocative, and certainly worthy of attention, but to put it on a firm quantitative foundation would require a large amount of work. The theory of reflexivity is not the only proposal to be put forward that differs from the classical one. There have been many in recent years due to the increasing importance of financial engineering, the latter of which has been applied on a massive scale. But the author proposed this theory almost two decades ago, when derivatives trading and financial modeling were beginning to ramp up. He therefore foresaw the need for alternative points of view when dealing with financial instruments and market activities that cannot be captured by the classical paradigm.

The book is part autobiographical and could probably be better appreciated if the reader was familiar with the author's earlier works. But anyone interested in making sense out of the current news reports will find an interesting read here, even though at times the author's political affiliation comes out a bit heavy-handed. In addition, his attitude about free markets and "laissez faire" is somewhat puzzling since a purely "laissez faire" economy has not been realized historically. Any arguments against its efficacy are therefore misplaced. Those who still believe in "laissez faire" may therefore object strongly to many of the author's assertions and his recommendations at the end of the book for fixing the current "credit crisis." Whatever your world view though it is perhaps fair to say that the increasing complexity of the financial markets demands new ideas and approaches.If anything a good understanding of financial dynamics is a matter of survival. The financial markets of the twenty-first century take no prisoners.

I saw Mr. Soros testify before Washington State (home state of my favorite soccer goal keeper) Sen. Maria Cantwell's committee the other day (on TV, of course) concerning possible oil futures speculation. I was impressed with Senator Cantwell (although we'd agree on little, policy-wise) and with Mr. Soros (despite myself). So I picked up this book to see what he had to say on the central economic issue of the day.

I won't bash the book, exactly, but it was pretty rambling, pretty repetitive, and spent a considerably longer time trying to defend/explain his theory of "reflectivity" and bashing Republican politics than discussing the credit crisis. Still it offered some useful points and observations. It's personal account of worlwide historical financial events that Mr. Soros himself not only lived through but participated in as well as a concise account of the events that comprise the subprime mortgage meltdown were themselves worth, in my view, the price of admission.

In the end, though, the central theme of the book, it's overarching structure, is Mr. Soro's longstanding theorem about "reflectivity" in financial markets. He maintains that both the factual "reality" and the participants' resort to emotional facilities as a result of imperfect informational access interact with each other in a kind of feedback loop. As a result of this "reflectivity" serious degrees of uncertainty are injected into the marketplace that are not predicted by "classical" economic theories of "rationality" or "equilibrium". This, he says, invalidates market models based on those classic concepts. What to do about that, of course, he's not quite so clear about, except, perhaps, you should vote Democratic (his advice, not mine).

Unfortunately by his own analysis, this theorem is unsatisfactory as anything other than a cautionary alarm bell. By it's own definition and assertion it is untestable and (in the terms of one of Mr. Soros's own favorite philosophers, Karl Popper) incapable of falsification. Since it's prime tenent is that it's unpredictable and not even of consistent relevance in any given situation, it is roughly akin to the statement of Cretan philosopher, Epimenides, (quoted by Soros himself) that "all Cretans always lie". If, claiming unpredictablility, "reflectivity" yields accurate predictions, it is false.

Nassim Nicholas Taleb has called these same kind of events as said to be caused by "reflectivity" black swans. Inductive reasoning in financial markets has led to some frightening financial meltdowns. Having seen only white swans (even in their hundred thousands) and therefore betting the ranch there ARE only white ones is a sound foundation for disaster. Mr. Taleb helpfully also points out that somewhere downunder there are, in fact, black swans.

Benoit Mandelbrot has suggested that his fractile geometry, rather than bell curves, is a better financial model and, in fact, perhaps allows for better predictability. Don't know about that. The intersection between regulators and markets that Mr. Soros rather convincingly argues must be, at least in part, responsible for the subprime mortgage meltdown, doesn't strike me as a geometric intersection, fractile or otherwise. And besides, Herr Doktor Mandelbrot's math is WAY beyond my (or I'd postulate any other non genius math brain's) comprehension.

For me though, the persuasiveness of Mr. Soros's point about unpredictablity and odd shaped (non bell) curves can be found in the seminal work of William James, who demonstrated 100 years ago what every good salesman has always known (at least by instinct, if not overtly): that human beings ACT on feelings and use their intellectual reasoning to rationalize the result. I would accept, a priori, that no single individual actor in today's complex financial markets in our globally interwoven world can possibly know all the relevant facts about any one proposed action therein. Thus he must have imperfect information. And even as among the myriad of facts he does "know", he will use his experience, his intuition based on it and on the recounted experiences of those he has learned to trust, to value those various factual inputs.

I would submit (and I don't think Mr. Soros would raise too strenous an objection) that gernerally speaking, in a broad enough marketplace, all those individual "emotional" decisions ought to cancel each other out to a degree that would render them indistinguishable for practical purposes from randomness. Perhaps not perfect bell curves (some fat tails and modified kurtosis), but within acceptable (and perhaps hedgeable) limits.

But humans are also herd animals (we, however, call them tribes), and that instinct is a survival trait and still strong. One need only contemplate the blowing of a single car horn on a gridlocked highway that is inevitably followed in nanoseconds by hundreds more, to understand it's continued pervasive presence. When that happens in financial affairs, when smart guys get afraid of being left behind the "easy" money, when they can't stand the other tribe harvesting all that golden fleese or bear the thought of some young ambitious upstart taking over their hard won desk by merely following sombody else's playbook (what have you done for me lately says the boss), then homework vanishes. Smart guy follows smart guy in a kind of stampede. Risk of loss no longer matters or is outweighed by the risk of being stranded alone. Each of us (no I'm not a trader, but empathy demands the collective pronoun) falls all over ourselves to steal candy from the blind confectioner, never mind that we know that the poison pill is there in one of those jars on one of those shelves. It won't happen to me, we say. I'm too smart, I'll see it coming, I'll get away. This time it'll be different. We rationalize the emotional decision to chase after the leaders, to blow our horn, too.

This is far too long, let me try to wind up. In this crisis surely whole truckloads of the "smartest guys in the room" demonstrated levels of greed, arrogance, and impaired judgment that, despite being all too human (to borrow a phrase from Nietzsche, who seems particularly apt in this context) are still, in retrospect, shocking. Still, "free markets" provide efficiencies and multiplicities of choice that cannot be duplicated (or even approached) by any central planner or micromanaging regulator. But when these herd markets fail as spectacularly as they have here, the individualist free marketer along with the "reflectivist" (if I may be so bold as to lable Mr. Soros) are both left wanting a better way, a better regulatory system, for keeping these rampaging smart guys from trampling in their passing our own hard won little (in my case) or not so little (in Mr. Soros's) net eggs. This is a thoughtful book. Even just trying to "deconstruct" it may lead you down interesting thoughtways.

George Soros thinks that the current credit crunch is the most severe financial crisis since the 1930s and that it marks the end of an era of credit expansion based on the dollar. In this book he argues that a new paradigm is urgently needed to better understand what is going on. The paradigm used until now by most economists was based on false premises.

The existing paradigm, often referred to as free-market fundamentalism, holds that markets are self-correcting, that they naturally tend toward equilibrium. Economists as far back as Adam Smith have argued against regulation or government intervention of any kind since it would interfere with the natural forces of the market.

Soros correctly argues the contrary. In fact government intervention has repeatedly saved the market. A few examples are the bankruptcy of Continental Illinois in 1984, or the failure of Long Term Capital Management in 1998, or the current bolstering of Fannie Mae and Freddie Mac (my example). The notion that the market deviates from an orderly path is the rule rather than the exception.

The new paradigm that is needed, according to Soros, must incorporate the theory of reflexity. Developed in previous works by himself and his mentor Karl Popper, reflexivity examines the relationship between thinking and reality, between the cognitive function and the manipulative function. In the investment world, this means that when investors are bullish on, say, housing or mortgage backed securities their values go up, not because they become intrinsically more valuable, but because everyone else is thinking they are more valuable. This is basically old-fashioned market psychology dressed-up in theory. The mechanism that allows the market to go up is self-reinforcing but ultimately self-defeating. The market goes from euphoria to despair overshooting the top, and ultimately the bottom too. Witness today's housing market.

We are currently experiencing the consequences of unregulated credit markets and Soros argues that if more is not done the crisis could get much worse. He points out that moneterist doctrine in inadequate. Controlling the money supply is only half of the picture. The internet bubble, the housing bubble, and the current commodities bubble were created through excessive use of leverage. The amount of debt currently outstanding is unprecedented. Any new financial regulations will need to temper the use of credit to avoid future bubbles.

Soros argues that the US must come to grips with the new realities if it is to maintain its preeminent position in the world. If we are not careful the dollar will lose its standing as the reserve currency of choice. The task of regulating credit will now became even more precarious since the credit market is already tightening. Soros, as a former hedge fund manager, realizes that credit is the lifeblood of capitalism and any overregulation will also damage the economy. Reflexivity theory aside, this book is an excellent discussion of the challenges we are facing today.

I admire Mr. Soros for his philanthropy but I find this book disappointing. I was hoping to gain some insight into the economic crisis but instead got the wordy, unedited version of what amounts to a paper on his theory of reflexivity. The book contained too many extraneous pages about how he always wanted to be a philosopher, how criticisms of his initial theory were right (sort of) but also wrong and why he is now vindicated and is truly a philosopher. There was a chapter documenting trades he made recently that seemed out of place.

Had the editor done her job I think this book would have deflated into a paper which presented little to nothing new.

About the previous review, I find it interesting that you say the subprime issue is: "a situation that has perplexed all economists" and then you proceed to give your own solution at the end of what you wrote. Are you saying that you alone have the solution to something that has "perplexed all economists?" Anyway, not all economists are "perplexed" by the issue...they merely speak in technical terms so most people don't understand the gravity of what they are saying. They have known of this issue for a long time. In fact, Bernanke wrote a book on what he is about to do with interest rates. It is called "Inflation Targeting." He will seek to maintain a certain "core inflation rate." Note that *food* and *fuel* are NOT included in the "core rate." They are part of what he is calling "headline inflation." The FED will not react to changes in food and fuel (headline) inflation directly...only after they have affected the "core inflation rate." This lag in control will likely create oscillations in the system. Great for stock traders, but tough for the average person with a life. The FED will have tough times politically.

Further, you say that it has "instilled fear in anybody who wasn't vacationing in the space station in the last year." Perhaps you have forgotten that Soros fought hard during the last election (longer than a year ago) for a change in these very policies. Buffett spoke out against derivatives long ago. Jim Rogers (co-founder of Quantum Fund with Soros) wrote about the commodities boom in 2004 in his book "Hot Commodities." Implicit in the view that commodities will boom is the view that there will be hyper-inflation, since everything is made of commodities and the hyper-inflated prices will be passed along or the companies will go out of business. Greenspan also alluded to hyper-inflation in his book.

Anyway, Soros is an expert in this field and has been quite prescient on this topic for years. Following advice such as his (as well as that of Rodgers, Buffett, Graham, and other notables) has permitted me to position my portfolio defensively for these times. I started years ago (hence my knowledge of what was known more than a year ago.) I sold my home at the peak of housing and bought a home in an area that did not have the same unrealistic home inflation. The remaining cashed-out home equity was invested in other defensive things. My home value has not fallen nearly as much as it would have had I kept my other home, thanks to Mr. Soros' foresight. I look forward to what he has to say about the coming financial winds so I can plot my next step in capital preservation/expansion.

Don't judge the book based on theoretical criticisms. Look at the reality of the track record of the man himself. Also, consider the fundamental fact that most "bubbles" occur because of over leveraging and greed. Years ago there was the LBO bust and today, we have a bust from over leveraged banks and improperly leveraged homeowners. I say "improperly" because the way those contracts were written practically assures a bust...prepayment penalties that are really refinance penalties, interest rates dependent on LIBOR (London Inter-Bank Offerring Rate) instead of US rates, etc.

In short, if the FED can't use its tools to avoid the foreclosures, it will cause a depression in the housing market. In fact, the housing market is already in depression by definition. That is, interest rate changes cannot be used to avoid the harm...therefore, severe price deflation (i.e., "depression") and job losses result. Since 78% of the US economy is housing related (e.g., furniture sales, appliance sales, insurance, lawn care, carpeting, mortgage banking, etc.) the situation is clearly serious.

Now...all of this has a deeper level. There is a larger case of over-leveraging that is starting to unwind right as you read this review: The National Debt. Yes, deficits *do* matter. They are obligated taxes...with interest. The payment of the trillion dollar national debt will be painful and require a type of tax that noone voted for: Inflation. Why? Well, how is one going to get people to vote for a tax to pay off the debt when they were already voting against the taxes they already had? The only solution is an involuntary, hidden tax: Inflation. Over time, Inflation makes debts look smaller and more managable. The hidden inflation tax is *already* here because of the current interest rate cuts and will grow to a size people haven't yet imagined. Buy gold, oil, or any other commodity. This will be about a ten year cycle, overall, so inflation has a long time to run.

Since inflation has already started, it will be difficult to stop. Like a fire, it will continue to burn until susceptible assets are destroyed. The remaining assets will be helped by it though.

Buffett warned of this years ago. He recently said that more and more deficit spending and rate cuts would eventually make the dollar "worthless" (a statement he later "corrected" under some pressure to "worth less".) Anyway, the situation is serious. Don't trust any particular review of the book...not even this one. Look at the book yourself and make your OWN judgement regarding Soros' acumen.

Soros' book offers quite a few insights into the financial markets for the layman but not so many for those with backgrounds in economics and financial markets (academic or practical). In short, the book's most important insights are (not necessarily in order of importance):

1) Soros' views on what he calls "reflexivity". He posits that the current prevailing paradigms in economics that stress that supply and demand are independent of the actions of market participants is flawed AND that, contrary to rational expectations theory, markets may not reflect economic fundamentals (i.e., may instead reflect "herd mentality"). Soros' view is not new with respect to what he has written in past. For more detailed discussion on "reflexivity" one should refer to his "Alchemy of Finance". With respect to behavior economics one would learn much more reading one of Schiller's books (i.e., Irrational Exhuberance or Market Volatility). They discuss the gap between actions based on economic fundamentals and psychological factors in much greater depth. However, the fact that he even provides such a critique is mind opening even to those who have had many years of education in undergraduate economics. It forces one to question the all important assumption of "rational expectations" and the assumption that in economic markets the actions of the economic actors and the results in markets are independent of each other. These assumptions undermine modern micro, macroeconomic and financial market theory and seriously need to be examined.

2) Soros provides his views as to the causes of the current financial bubble (i.e., a combination of high leverage, cheap credit, introduction of many financial instruments that have not been that well understood and corporate malfeasance). If you are student of economic history this is nothing new.

3) Soros also provides his advice as to how to mitigate (at least partially) the problems caused by the latest bubble, in particular liquidity in the housing bubble. He stated in the book (written in early 2008) that the Federal Govt. would almost inevitably have to step in to provide liguidity in the housing, banking and other financial sectors (i.e., large investment banks or what may also be called "market makers"). The weekend of September 7, 2008, he was proven correct regarding with respect to the Government's bailout of Fannie and Sallie Mae. Earlier the government had to prop up some of the larger investment bankers. He argued that not doing so would lead to massive contraction in liquidity surrounding the markets, particularly housing markets, with implications much like those leading to the Great Depression.

4) Related to item 3 above, he calls for greater regulation of financial markets due to the risks implied in high leverage, liguidity crunches, nd the inherent risks of high leverage financial instruments being introduced (especially in early stages when they are least understood - much like Collaterized Debt Obligations). With respect to CDOs, his fears were born out in mid and late 2008. It turns out that many of the participants in that market really did not have a grasp on the risks. This even included the rating agencies that were supposed to have graded these instruments (in reality they did a very poor job hence leading poor quality debt being given a higher rating and being passed on from banks and fianncial entities issuing them to other market participants).

If you have a good economics background (especially in economic history and financial instruments), items beyond 1) are not that profound. For layman, however, his views are probably of quite a bit of value.

The one weakness of the book is his lack of a much more detailed disucssion regarding poor audit work by the large accounting firms and the poor credit ratings issued by the major credit agencies. For a great discussion of the former one should read Boogle's The Battle for the Soul of Capitalism. Unfortunately few, if any, decent books for the layman have yet to come out (as of September 2008) on credit agency ratings poor performance and the resulting implications for the credit markets. Something is desperately needed here.

as an investor, free-thinker, and proponent of free society, i found deep value in this book. whether soros is right or wrong--i'm certainly not sold on all of his claims--the book stokes thought on the fundamental nature and function of markets, economics, and society.

what reader's will gain

* a clear, concise explanation of the scope and causes of the subprime crisis.

* an introduction to soros's philosophy and worldview. he addresses reflexivity, fallibility, human uncertainty, the boom-bust model, and the open society.

* a few financial predictions. soros is at times cagey, but there are just enough predictions on currencies, asset classes and countries to satisfy the investor. nevertheless, specific financial forecasts are not the focus of this book.

* insight into markets, economics, human behavior, society, and politics. for example: soros foregrounds the need for inhabitants of an open society to value and reward truth over demagoguery. this is the ethos of science. somewhat conversely, politics values power over truth. the book also contains an excellent example of reflexivity at work: one person stating to another "you are my enemy."

new paradigm repeats some material from the alchemy of finance. nevertheless, the concision of the book, plus the promise that it contains the author's best-yet exposition of his philosophy, make the repetition tolerable. i no longer feel any compulsion to finish alchemy, which i left in medias res to read new paradigm.


the book's flaws

some of the old, low-resolution diagrams from alchemy have found their way into new paradigm. these diagrams are difficult to read, especially in an e-book. i expected high-resolution, zoomable images. (by the way, there's a spelling error on p. 124, "sbome".)

soros is, at times, alternatively self-indulgent and self-nullifying. he occasionally reminds the reader that he is launching a philosophy career with his new book. he then proceeds to obliquely apologize for this self-indulgence. the book might have been better without such self-referential chatter. that said, it is somewhat comforting to see a self-nullifying billionaire who is willing to admit that he is "always wrong" and repeatedly corrects his perceptions to match reality (see his google talk).

readers will have to think carefully about reflexivity, human uncertainty and other elements of soros's philosophy. whether soros is right or wrong is secondary because, in your analysis of his work, you'll learn.


philosophical foibles

* soros builds reflexivity and the human uncertainty principle on the following foundations: strong epistemological skepticism (especially with regard to the possibility of knowledge about the future); a specific interpretation of the correspondence theory of truth; some of karl popper's conclusions. as a result, many of soros's arguments are susceptible to the same objections that can be raised against their foundations. (i won't get into those objections in this review. they are better tackled as problems of epistemology and philosophy.)

* soros waffles on market equilibrium. although he berates the efficient markets hypothesis, he nevertheless contends that markets are mean-reverting and easy to predict so long as they are not under the influence of reflexivity, which is relatively rare. soros then argues that, in reflexive situations, equilibrium becomes the exception rather than the rule. if reflexive situations are exceptional, doesn't that leave markets near equilibrium most of the time? in the long run, perhaps even boom-bust cycles are a form of self-regulation. the devastating effects of each bust engender a new generation of market cognoscenti. (soros himself may be living testimony to this idea. how much of his financial acumen derives from the nazi "bust" that marked his youth?) note that reflexive situations are the unruly ones that, in soros's eyes, necessitate market regulation. this brings us to the next point.

* why regulate? as soros himself admits--in alchemy, i believe--it is in reflexive situations that the greatest opportunity for profit lies. and yet these are precisely the unruly situations that he wishes to mitigate? that's an easy position for an already-made man. moreover, the human uncertainty principle seems to imply that more humans amounts to more uncertainty. so why should soros expect that adding human regulators to the market would tame its uncertainties? the solution is simple, but soros never produces it. i propose that regulators, if they are to act at all, should only work to limit the quantity of leverage available to market participants. regulators must never interfere in the direction of the market. or perhaps markets are best left completely unregulated. who or what can regulate with the efficiency of pain and euphoria?

* soros never explicitly addresses the relationship between size, reflexivity and human uncertainty. in physics, for instance, the uncertainty principle is significant at the quantum level, an infinitesimal scale. uncertainty has little bearing on macro events, such as dropping a 1kg rock from your hand. in somewhat inverted fashion, the broader market is scarcely influenced by the individual trader. since the typical trader cannot move the market, he can safely assume that his cognition of the market is independent from his participation. he can, in this particular instance, safely ignore reflexivity. on the flip side, and somewhat ironically, reflexivity emerges as a market-wide force once a critical number of market participants adopt the same bias. therefore reflexivity is applicable in some instances and not in others. those instances can be sorted along dimensions such as scale. to be fair, soros implicitly addresses some of the criticisms in this paragraph, but he would do better to treat them explicitly.

A book review from my blog:

George Soros has written a new book called 'The New Paradigm for Financial Markets:

The Credit Crash of 2008 and What It Means'. It is currently available as an E-Book, but
will be published on paper in May, 2008. It is his best and most informative book in
terms of information and content. It avoids the difficulties inherit in the Alchemy of
Finance with regards to his obscure syntax- there is none of that. It avoids the political
criticism that you find in his books on Globalization and the Open Society initiatives.

The book is useful for finding blindspots inherent in the economic system. For traders,
he is criticizing the nature of Credit Default Swaps in that there really is no absolute
guarantee that someone will pay you in the event of a default. He argues this because
the margins are so low that systematic risk and exogenous risks can culminate into a
disaster situation. This is similar to the one we have been having, but worse. This is why
Soros rushed out his book early before printing it, because he is sick with worry about
the whole credit mess and suggests that it will be the worst economic event in his life
(which is scary given that he is almost 80, and has survived World War II).

A recent newspaper article in the Toronto Star on Sunday, April 13th noted that Soros'
funds had managed to return 32% in 2007. A very significant return. We understand he
was short US stocks and US Financials and long emerging Markets. It doesn't sound like
he used CDS to short subprime as he apparently was unfamiliar with their use before
the Credit Crisis.

'
Remember that Soros did, in 1998, write the 'Crisis of Global Capitalism', a critique of
the Financial Markets, which if you acted on the suggestion and went ahead shorting
the Markets would have caused almost 3 years of serious pain. What it led to was a
break off between Stanley Druckenmiller and Soros in 2000.

Beyond all this issue with the current financial situation, the deepest and most
provocative argument by Soros is from his criticism of classical economics.
A simple explanation is his criticism of supply and demand curves.

Have you ever physically seen a supply or demand curve of copper, potash, rice, or RIM
stock? It doesn't exist. Unfortunately, economists see this as a given, which it is not.
The price of something in a stock or commodity is a picture of relationships, but it does
not rely on a predetermined supply and demand curve.
Soros takes this particular argument very far. It is worth paying attention to, because he
uses it to explain further exactly what reflexivity is (Reflexivity is Soros' theory about
how humans can affect the outcome of things). Soros has always been somewhat vague
about reflexivity, but it is clear as day in this new book. For that reason, you should read
the book. Soros' new book is probably going to be one of the top investment books of
2008.

First, Soros is a very savvy financial genius. I'm always amazed when people try to take shots at him. It's like saying Bill Gates doesn't understand technology. When Soros talks, listen. If you don't understand, listen some more.

Reflexivity is Soros's pet theory. He outlined it in the Alchemy of Finance. Basically the idea is that events can become self reinforcing. How does that relate to the mortgage collapse?

The mortgage bubble and collapse was just like any other. Banks and other institutions noticed that lending money was profitable when the economy was expanding. All the loans seemed to be turning out well. The banks were printing money and decided to loan more and more. As more credit became available, the economy continued to perform strongly (the easy availability of money spurs on the economy) causing existing loans to perform even better. Banks were enticed to lend even more. All the while, institutions of all stripes continued to pile on leverage as their investments blossomed. Eventually someone decided to take their chips off the table. All of a sudden, credit came into question. Institutions started to de-lever, worried that they wouldn't be able to get their money off the table fast enough. No one would extend more credit. Money became scarce. Loans defaulted. The housing market crashed.

So, a long slow benevolent cycle followed by a sharp a nasty malevolent unwinding. Pretty common in the financial markets. Predicting where one starts and another ends, however, is very, very, very difficult (an inevitbly a lot of very smart, very experienced people will be very wrong).

An additional problem with mortgages was just how perverse the incentives were. Mortgage originators were paid by volume, not quality. They were encouraged not to check credit and to come up with creative ways to write loans to anyone. Homeowners were getting a tremendous deal - basically a call on the housing market and / or free credit to buy stuff. Investment funds (they should have been smarter) were lured into participating by the continued good returns - remember, until the dam breaks, anyone taking in the higher interest payment (and bearing the greater risk) looks pretty smart. Even the government gets to play along by pushing originators to make high risk loans in the name of "fairness".

A simple solution is just to mandate fixed rate loans, either 15 or 30 years, and a minimum down payment of 25%. Eliminate leverage and the problem is solved. Of course then the same politicians that call the banks who lost billions evil for taking advantage of the home owners (uh, how's that again??) will call the banks evil for cheating main street by not letting it use the same tools as wall street. Populist business bashing is always fun until businesses start to die off.

Some other points were on target, i.e. the effect of a large debt / inflation. Bush gets blamed for a lot of things, but he was actually good for the economy short term. Lower taxes and higher spending => stronger economy. Unfortunately, he's been dangerously reckless long term. Lower taxes is good, but it needs to be accompianied by lower spending. Instead we get irresponsible budgeting, a foreign adventure in Iraq, squandered international good will, no attempt made to curb the entitlement programs (medicare, medicaid and social security) that will destroy our country. So waht happens? People start to lose confidence in the $ and exchange it for other things. Losing 50% against the Euro may seem bad but it's nothing compared to how the $ has fallen against oil, metals and grains. Want a stronger $? Cut taxes and spending. The economy and the $ will go through the roof.

Soros leans a little to the left politically, but anything he writes is worth reading. If you feel the need, just add a little red and take a little blue away from the picture and you'll find some very valuable insights.

George Soros has tried and, on his own account, failed to persuade the world of his philosophy before. This book is another crack of the whip, which he justified by reference to the credit crunch (as it was in March 2008, note - still a vigorous and persistent financial storm and not yet the apocalyptic hurricane it was to explode into in September of that year). Even as of March 2008 it was a situation of such unparalleled intensity that, Soros believed, fin-du-siècle laissez-faire orthodoxy of the last 25 years had finally and unequivocally been falsified.

The world order is broken, and we need a new model. Wherein lies Soros' optimism that, this time, the world will listen.

As a preliminary observation, therefore, those wishing to hear war stories and glean trading tips from the saddle of the warrior who conquered Sterling in 1992 will be disappointed: Lamont's vanquisher is in reflective mood. Some - including his son, it would seem - would say it doesn't suit him. Currency speculation, not metaphysics is George Soros' strong suit. George Soros, apparently, sees it rather differently.

In a nutshell, his view is this: market orthodoxy - that markets tend towards equilibrium; that event probabilities follow a normal distribution; that it is meaningful to act on assumptions that market participants ever have perfect information, rational expectations and unlimited choice, are flat out wrong. Any philosophy that proceeds on these assumptions is headed for disaster.

There is good evidence for this in the frequency of extreme market shocks. Assuming a normal "gaussian" distribution of events (on which conventional risk metrics such as VaR are based), a crash on the magnitude of October 13 1989 might be expected once in approximately 15,000 years of market trading; an event on the scale of the LTCM collapse is not statistically likely even in the entire history of the universe. Now either we're freakishly - reeeeeally freakishly - unlucky, or the Gaussian distribution is a bad measure.

Soros adopts the latter approach, and explains it by way of his "doctrine" of reflexivity. Markets are social things; they're comprised of human beings, who both observe and react to the markets, and participate (and therefore inform) them. There's a feedback loop, therefore - what Soros terms "reflexivity" - whereby the actions and aspirations of market participants in themselves have a compounding effect on the market level itself. The occurrence of one event by its very occurrence alters the probability of another such even occurring. Normal distributions don't have that "interrelated" quality.

About this much, George Soros is very compelling, though it must be said this isn't really news - Benoit Mandelbrot in particular has been banging on about this for years, and with a fair bit more rigour and detail.

Like fellow literary trader Nassim Nicholas Taleb, George Soros yearns to be taken seriously as a philosopher - a discipline in which he has little formal training - and perhaps by way of compensation therefor, he couches his theory in terms of "postulates", "constructs", "doctrines" and "hypotheses". This would be fine - if a little pompous - were the theory in other respects considered, organised, and contextualised within a prevailing stream of contemporary philosophical tradition. But is isn't. The New Paradigm for Financial Markets is distinctly short, lean on ideas, repetitive, haphazardly organised and overtly hurried into print - if this really was George Soros' great push to turn the world on to reflexivity, he's muffed it through haste and laziness in execution.

For all his personal commitment to reflexivity it remains poorly described - aside from the grandly labelled (but gingerly articulated) postulates, Soros doesn't really flesh out what reflexivity means let alone what it does or what practical use it has, other than undermining our faith in Gaussian distributions - which in itself is fair enough though hardly news (it did not escape the financial world's attention that LTCM wasn't meant to happen in this universe).

Reflexivity also suffers from philosophical illiteracy - surely a serious shortcoming for an aspiring philosopher. Just as, like Taleb, Soros hankers to be a philosopher, like Taleb, he hasn't spent nearly enough time actually reading it, and instead sees the laboratory of his own eventful life (featuring Nazi and Communist oppression on one hand; pistol-whipping Norman Lamont on the other) as all the empirical data and research he needs. This leads to a predictably idiosyncratic theory, and one shot through with incongruity: he pledges allegiance - repeatedly - to intellectual hero Karl Popper, yet titles his book after the central concept in Thomas Kuhn's subsequent theory, which did much to throw Popper's own paradigm of falsifiability into crisis, so to speak, in the philosophy of science.

The thing is, Soros *is* onto something, though better familiarity with the philosophical (and scientific) literature may have helped him to see that considerable work has already been done here. Not only have Mandelbrot, Taleb and others written extensively about power law relationships, but the reflexive loop - and its relationship through language with Goedel's undecidability theory - has received some in depth treatment from Douglas Hofstadter, Dan Dennett and Roger Penrose.

The introduction to the book was valuable and interesting, but the paucity of Soros' epistemology (some decidedly dodgy appeals to the correspondence theory of truth and what Soros perceives as a hard line between "truthy" physical sciences and "value laden" dismal ones like economics) and his tendency to repeat the same points over and over again - surely a bad sign in such a short book - leave this as being a disappointing experience.

Olly Buxton