Making sense of George Soros

After having established pretty sound credentials by making his Quantum fund one of the early paragons in hedgefund land and taking on the Bank of England and coming out on top (netting a cool $1B in the process), he’s on to bigger things. 

He’s done terrific work with his Soros foundation, especially strengthening civil societies in Eastern Europe, but he himself seems to crave to be recognized as an intellectual.

He’s now very critical about the financial system that has made him very rich (which is often called the Washington consensus, the conservative views that largely unregulated markets create the best societies), and writes lengthy diatribes against it.

On the one hand, it’s good to hear from an insider, on the other hand, we wonder whether he’s still proud on how he got his billions. Anyway, we read a couple of recent things  he said about house prices, the credit crisis, and the markets and here are our comments.

George Soros actally argues that house prices will “overshoot on the downside” and “the rise of foreclosures is in an early stage.” .

Home foreclosures exploded 112 percent in the first quarter from a year earlier, to 649,917, according to RealtyTrac, so the situation is already dire. Curiously enough, he also thinks that the worst is over for Wall Street, this is what he said:

“Wall Street, meanwhile, is emerging from the credit wreckage, but Main Street — the economy that ordinary people have to live with — is headed downhill fast”

An economy that is “headed downhill fast”, how can that not affect stock prices? Well, here’s the answer, sort off:

“I think we have the acute phase of the financial crisis largely behind us,”

That’s reassuring, so we have to assume that his view is that the markets went down a lot on the credit crisis, but since the worst has now passed on that front, this compensates for further worsening of the housing market?

Well, just after saying that the worst is behind us on the credit front, he does argue:

“But the damage that has been done to the system has to affect the real economy. The effect of that is only beginning to be felt.”

Hmm, how’s that? The worst is over for the credit crisis, but it’s effects on the economy are only beginning to be felt, and we ain’t seen nothing yet on the housing front, but somehow all this won’t affect stock prices?

You might also want to realize that ‘overshooting on house prices‘ means. The Standard & Poor’s/Case-Shiller home price index for the country’s 20 largest cities plunged 12.7 percent in February from a year earlier. That’s the biggest drop in the index since it started in 2001.

However, Shiller argued that house prices were 30% over their historic trend, merely correcting this means another even bigger drop than the one we have had so far. But Soros argues house prices will even fall further than that.

‘Overshooting’ is a pretty well-known phenomenon in asset markets, it’s a well known empirical fact that these markets are highly volatile and the late Rudy Dornbush established the first theoretical underpinning of this concept in the mid 1970s for currency markets.

It specifically refers to a situation in which asset prices gyrate along their long-term equilibrium values (like purchasing power parity in the case of currencies), periods of large overvaluation are followed by strong undervaluation.

In this case, that will mean a much bigger fall (from the top of the valuation, which implied a 30% above the mean). It’s going to have nasty consequences, in another interview, Soros claims that we have reached a period of ‘wealth destruction’, in which:

“Americans ultimately won’t escape this episode without suffering a noticeable decline in their standard of living,”

Even China will not escape unharmed, as it’s exports to the US will suffer and it already has an inflation problem.

The origin he sees in the free-market beliefs that started in the Reagan era and a lack of ‘reflexivity’ in the financial system (more especially, in the people that work in finance).

By ‘reflexivity’ he does not mean that people should reflect more on the consequences of their actions, it’s actually a concept that he coined. It means that prices can influence fundamentals.

Now, that is not nearly as crazy as it seems (there is sound evidence from a sub-discipline of economics called behavioural economics), but how his gloom and doom predictions do not stretch to the stock market (why will that not overshoot?) is really a mystery to us. Perhaps he needs a little dosis of ‘reflexivity’ himself?