Will Capitalism Survive Its Own Success?

Cynics’ eyebrows shoot skyward when a financial titan decides to bestow his Big Thoughts on the world, as George Soros does in his latest book, “The Crisis of Global Capitalism.” Skeptical smiles broaden when he insists on opening with a disquisition on his “theory of reflexivity”--obviously, another wealthy egomaniac like Donald Trump striving for respectability.

If cynics stopped reading there, however, they would miss a very good book. Soros became famous in 1992 when he made $1 billion in a matter of weeks by single-handedly forcing a devaluation of the British pound. Last year, some East Asian governments assigned him primary blame for creating havoc in global currency markets and wrecking the Asian economic miracle. Through his philanthropic activities, he has also rendered important assistance to countries in Eastern Europe and, less successfully, to the countries of the former Soviet Union that are making the transition to free enterprise economies.

The Soros on display in “The Crisis of Global Capitalism” is obviously a very smart man, with a crisp writing style, considerable modesty and many useful things to say about global finance and the state of the world. Here and there, he gets a bit high-flown--with his eight-stage cycle of financial booms and busts and occasional digressions on Kant--but he balances the reach for profundity with a refreshing lack of dogmatism and considerable candor in describing his own missteps and ventures gone sour.

“Crisis” is actually two books in one. The first, called “Conceptual Framework,” sets out Soros’ philosophy of knowledge, finance and contemporary values, and though it is often sharp and interesting, most readers will skip to Part 2, where the master holds forth on the economic crisis in Asia and other developing countries. While his assessment of the current state of global finance is quite gloomy--he believes the world is heading toward a prolonged period of depression--he makes his points without shouting and offers a set of fairly modest, albeit politically complicated, reforms that he feels could avert a crisis.

In the book’s more philosophical opening section, Soros mounts a sharp attack on the assumptions behind conventional economics and the theory of finance. Both fields have been taken over by mathematicians who implicitly assume that economies mirror the regularities of physical systems. Graduate students in economics spend many hours proving the existence of equilibrium points that never occur in the real world, an enterprise that recalls medieval theologians spinning out theories about angels and pinheads.

By his “theory of reflexivity,” Soros means that economic outcomes are determined as much by perception as by reality and that economically irrational but very human behaviors like “herding”--the tendency of even the most sophisticated investors to follow the mob--account for the booms and busts that characterize most of economic history. Although he lays out his case clearly, it is not quite as original as he apparently believes. John Maynard Keynes long ago pointed to the “animal spirits of investors” as a key economic driving force, and among today’s mainstream economists, MIT’s Paul Krugman specializes in exposing the fatuities of academic economics.

Soros’ dismal investment record over the last year or so actually lends a certain credibility to his analysis of current crises in the second half of the book: These are not the theories of an ivory-tower academic but the sober reflections of someone who’s been through the wars. But at the same time, Soros is making the case that his speculations were not to blame for the 1997 East Asian currency crises, as the prime minister of Malaysia, Mahathir Mohamad, among others, has charged. Soros, in fact, was actually buying East Asian currencies when they started to collapse because he thought they would recover. The Indonesian currency, the rupiah, for example, had been pegged at a pre-crash value of about 2,400 to the dollar; Soros started buying when they fell to 8,000 and took huge losses when they continued their free fall all the way to 16,000.

Soros’ publisher, PublicAffairs, has made a specialty of producing books very rapidly--it had “The Starr Report” in bookstores hardly more than a week after it was released--and one of the great virtues of “Crisis” is its magazine-like immediacy. Soros didn’t deliver the final manuscript until September and so was able to include substantial selections from personal notes taken during August’s crisis in Russia. As a native of Hungary, Soros knows as much about Eastern Europe and Russia as any other Western investor, and he charts the disintegration of the Russian government and the dithering of the West in considerable detail. As investors fled Russia, the government was forced to pay rates as high as 450% to induce foreigners to hold rubles.

Soros himself had resisted investing in Russia until just before the crisis, but he says he was sufficiently heartened by, or taken in by, a new reform government that he bought shares when Russia privatized its national telephone company. But that transaction touched off such a vicious spoils fight among the Russian oligarchs that all hopes of reform were crushed; for Soros it was “one of the worst investments of my professional career.”

At the height of the Russian crisis, Soros’ intense lobbying for a $50-billion Western rescue effort drew considerable criticism, for he clearly would have benefited from a rescue. But he presents the case for intervention and details his own conflicts with considerable candor, so readers can choose whether to take him at his word that he was more worried about global economic thrombosis than an ill-timed stock investment.

Russia’s default did indeed trigger a worldwide crisis. The American mortgage-backed and high-yield bond markets were devastated, and the sudden market turmoil caused the very dangerous $100-billion collapse of the hedge fund Long Term Capital Management. Soros concludes with the reflection: “I have no regrets with regard to my attempts to help Russia. . . . I have grave regrets as an investor. It goes to show how difficult it is to reconcile the two roles.”

Soros offers three primary reasons why he thinks the global economy is heading for a cliff. In the first place, he believes that global banks are much weaker than their balance sheets suggest. They routinely swap loans with each other to smooth out their cash flows. (If a bank pays floating rates on its deposits, its earnings will be more stable if it swaps fixed-rate loans for floating-rate loans.) Because banks swap only the interest obligations and not the risk on the underlying loans, the swaps are typically not reported on their balance sheets. Over the last year or so, however, many swaps broke down amid the global currency turmoil, and banks found themselves facing much greater exposure than they had thought. (Despite their loud protests, American banks will be required by the Accounting Standards Board to report the value of swaps on their balance sheets starting next year.)

Second, Soros believes that the weakness of the banks will create a credit crunch and a long-term withdrawal of finance from developing countries. China and Brazil will go down like tenpins, severely affecting world trade. Although the book went to press before the recent $42-billion bailout package for Brazil, it is not likely that Soros would expect it to be sufficient. Finally, he believes that international authorities have neither the will nor the understanding to do much about it.

Given the depth of his concerns, Soros’ reform proposals are surprisingly modest: more consistent rules governing international banks, international credit insurance, measures to force banks to convert developing country debt to equity (which helped in resolving the 1980s Latin American debt crisis) and “sand in the wheel” circuit breaker-like reforms to slow down short-term international capital flows.

Economic reform, however, will not address the deeper causes of Soros’ gloom--that the raw operations of the market are becoming the paradigm for all of society, sweeping away civic virtue and reshaping all social relations in the form of market transactions. That is a gloomy prospect indeed and one can only hope that the canny old investor is once again on the wrong side of a short sale.