By staff reporter Hu Jiao and intern researcher John Cho

Caijing invited George Soros on the U.S. Treasury’s response to the financial crisis, its consequences for other economies, and the role China will play as the world struggles to regain economic stability. Born in Hungary, Soros fled to England during the Second World War and entered the London School of Economics. After graduating, he emigrated to the U.S. and in 1969 started an offshore fund. His success in finance has accorded him a public persona and considerable influence. Soros currently serves as the chairman of Soros Fund Management and his foundation The Open Society Institute.

Interview

Caijing: In your October 12 article in the Financial Times, you made a proposal for a bailout plan. In light of your recommendations, how do you view the latest version of the U.S. government’s rescue strategy? Do you think this version will work out?

Soros: This is a move in the right direction, but not really as good as what I suggested. But if it doesn’t work, additional measures will be taken because the decision has been made to prevent a collapse of the financial system at any cost.

Caijing: You certainly favor the idea of recapitalization of banks over the purchases of distressed assets. In hindsight, if Mr. Paulson had adopted this in his original proposal to the Congress, could we have avoided the global market meltdown we saw in the beginning of October? And this isn't the only thing that people blame about the policy measures, others including letting Lehman to fail, and the short period of short-selling ban. Which government moves do you think have been mistakes?

Soros: The meltdown was caused by allowing Lehman Brothers to go bankrupt. Therefore, Paulson’s proposal came after Lehman, so the meltdown could not have been prevented. [Since] the proposal was in response to the meltdown, it could not have prevented it. Paulson was not properly prepared, so he did not have a well-formed plan. He just rushed to Congress asking for the money, with full discretion to allow him to develop a plan.

Caijing: Do you think the bankruptcy of Lehman Brothers is the cause of the stock market crash?

Soros: The Lehman default caused a temporary meltdown in the financial markets. That could have been avoided if Lehman had not been allowed to go bankrupt.

Caijing: How about other government measures?

Soros: This was not the first mistake, and it was not the last one. (Paulson) also proposed this, which never succeeded. And the way he handled Fannie Mae and Freddie Mac was also the worst way possible. I said so in a previous article.

Caijing: To what extent is the US$ 250 billion able to meet the needs of the U.S. banking system? Do you expect many banks to apply for the government capital or more would rather keep away from the government? If there turns out to be more requests than the US$ 250 billion can cover, how would the government select which banks to invest in?

Soros: I don’t know the answer for this because I’m not in charge.

Caijing: So what do you think of splitting the US$ 250 billion between major banks and other smaller banks?

Soros: I’m not responsible for that decision. I think it was an arbitrary decision, and as I explained in my article, I would have done it differently.

Caijing: It seems to me that it is the housing market that fundamentally matters. If the housing prices continue to fall in the next few years, as many expect, should we see more losses in the banks and thus more capital injections from the government? Could that lead to the ultimate failure of any government?

Soros: Yes. If housing prices decline and overshoot on the down side the way they went up too high, then in fact it could cause new losses in the banking system. Also, it could require additional capital injection. But I don’t expect any government to fail because we have a democracy, and the democratic process ensures a stable government even during a financial crisis.

Caijing: What’s the worst scenario?

Soros: I don’t want to speculate on that because it could be very bad.

Caijing: If things do turn worse, what other options do the Treasury and Fed have?

Soros: In my opinion, there is no limit to the ability of the authorities to provide liquidity. There are limits to dealing with insolvency. So they cannot rescue every bank that is insolvent, and they don’t intend to do that. But they can provide any amount of liquidity to keep the financial system going.

Caijing: Will that cause inflation?

Not in the near term because it is only making up for money that is disappearing through deleveraging and lesser use of credit. It only fills a hole that has been created by the losses and deleveraging. When the economy recovers, then you have to flatten the money supply to prevent inflation.

Caijing: There appears to be discrepancies between the U.S. and UK schemes, concerning the dividend policy, the restriction on executive compensations and terms for deposit guarantees. Will these discrepancies undermine the success of the bailouts, as investors might vote with feet?

Soros: I think that each country can follow its own speed. They won’t interfere with each other.

Caijing: How about arbitrage?

Soros: I don’t see how you can see arbitrage because the banks will have different earnings. If you pay for the money, you have (fewer) earnings so it will show different earnings for the banks. But there is no possibility for arbitrage because the banks have no choice between one or the other.

Caijing: Governments have done many things that would have been unimaginable in the past, such as the Fed buying commercial papers, accepting less creditworthy collateral for loans, partially nationalizing banks, among other examples. Should we be worrying about any negative long-term effects?

Soros: Yes. These are emergency measures, and when the situation settles down, there will have to be a substantial overhaul of the financial system so that it can work better. For instance, in America now, there will only be four big banks, so they will have to be more closely regulated than they have been in the past. In any case, I think that there are important lessons to be learned from this area, and the system will have to be reformed.

Caijing: A lot of blame has been placed on lax regulations. Do you expect a major overhaul of the international regulatory framework? Investment banks and hedge funds alike have profited from loose regulation. If regulations are tightened, do you expect them to become less active?

Soros: Yes again. There is no question that the regulators have failed to apply proper regulation. The lesson to be learned is the prevailing view of the market is false. I think that the view that I am proposing will have to be the basis for regulation, which means that markets by nature are very far from equilibrium, and it is not enough to control the money supply; you also have to regulate credit because money and credit are not identical. Markets have moods, times when they are more willing to lend, and other times when they are much more moved by greed and fear. Regulators have to accept responsibility for preventing asset bubbles from growing too big. Therefore they have to counterbalance the prevailing mood of the market. They have to use marginal requirements and minimal capital requirements more actively than they have in the recent past. (They should) tighten the requirements when the markets are too optimistic and loosen them when markets are too fearful. Incidentally, China uses minimum capital requirements much more actively, so we will have to learn from China.

China always used credit control, but we all think that it is an inefficient measure. The government places a restriction on a certain amount of money that the bank can lend to firms.

It’s funny because you need to find the right balance. In China, maybe they control it actively, but (in America) they don’t control it at all. It’s strange but I’m actually arguing that you might have to revert to the old, and abandon habits of giving direction to guidance as well as absolute guidance in the past. The Bank of England or the Federal Reserve would write letters to the banks and say, “Don’t increase the amount of money you lend to real estate.” This has been abandoned, and I argue that if you want to control asset bubbles then you have to use such directional guidance, which is used too much in China. I often find myself arguing against too much regulation in former Communist countries, and arguing for more regulation in countries that have become addicted to market fundamentalism.

Caijing: How can you find that balance?

Soros: It’s a matter of judgment, and the judgment is liable to being wrong. But the markets provide you with feedback. You can see the result of your action and then you take your cue from the market and adjust, and correct your mistakes. The important thing is to be prepared to be wrong and prepared to correct your mistakes. It requires a critical belief in a critical mode of thinking, rather than a belief in one particular set of rules or laws that govern the world.

Caijing: People have started satirizing a nascent "socialism" in the Anglo-Saxon economies. Do you think that's a real risk? Do you expect the government interventions will impair entrepreneurship and the "free market"?

Soros: Yes, and I expect that the financial industry will become less profitable than it has been in the past because giving it too much freedom has made it too profitable, and it has grown too large. That was an unhealthy development, which is now going to be corrected.

Regulation does interfere with innovation and entrepreneurship. But what is worse is that much of the inventiveness is then directed at avoiding regulation and finding ways around regulation, and that’s how inefficiencies creep into the economy. Entrepreneurs find ways to avoid the intention of the regulators because the regulations are always imperfect, they’re always flawed, and it’s always possible to find some way around it. That’s how markets become very inefficient. That’s how regulation distorts the economy. This has to be recognized, and this is why regulation should be kept to a minimum because it does interfere with efficiency. Nevertheless, you mustn’t forget that markets tend to be unstable. You do need some regulation to maintain stability. It really requires a balance. But you can’t abandon regulation because you then you have the result that you see now. This is the consequence to the current crisis. It is a direct consequence of abandoning all regulation.

Caijing: Actually this is a critical question to China now. Maybe people now doubt the market economy, and that US has failed. Many of our efforts in China are to clarify to the public…

Soros: I can see that, and China has been the main beneficiary of globalization. It now has a lot more leeway to decide how to deal with this crisis. China has a chance to develop a better regulatory system. But in order to do that, it has to recognize that regulators are also human, and they make mistakes. Not only are they human, but they’re also bureaucratic. So there has to be a proper mechanism for correcting the mistakes of the regulators, and that is the challenge for China.

Caijing: You've proved your foresight by suggesting "Short U.S. and European stocks, U.S. ten-year government bonds, and the U.S. dollar. Long Chinese, Indian, and Gulf States stocks and non-US currencies." This was in your book The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means. Do you think we'll see continuously growing capital inflow to the mentioned emerging markets? Would that cause more capital bubbles in these markets such as the ones we've been worried about in China?

Soros: No. This is one of the mistakes I made, both in my book and in my investment strategy. I thought that China and India and the Gulf States would be immune to the crisis, but they were not, and their stock markets went down even more than the American markets. That has been a source of actual loss for me. I lost a lot of money in making that mistake. I still think that China has a good chance of coming out of this crisis in better shape than the rest of the world, but that would require, in my opinion, political reform and economic reform. You need a political system that allows for the proper conditions for authorities to change policies when policies are wrong. It’s a big challenge, but I don’t think that China will succeed if it abandons reform. In this case, in my opinion, it has to be political reform as well as economic reform.

Caijing: What kind of role do you think China can play in this financial crisis? Do you think China should provide capital to bail out the global system?

Soros: Yes. I think that China has the makings of being a global player and an important factor in the global system. But it cannot reach this position unless it is distracted by the rest of the world. Just as America made a mistake in thinking that in can dominate the world, the same thing applies to China. It cannot dominate the world, unless the rest of the world accepts its dominant role. There are great fears about the rise of China, and if China behaves in a way that justifies those fears, then the world is headed to conflict. And I don’t think that China can possibly win.

However, China today could play a very important role in helping the rest of the world to cope with the crisis. I will be more specific. I have great fear that the steps that have been taken now to protect the financial system at the center of the global system, that is to say in the U.S. and in Europe, will reinforce the flow of capital from the periphery to the center. Because the countries in the periphery – in Eastern Europe, in Latin America, and in Asia – their governments don’t have the capability to guarantee when they provide guarantees to their banks. There needs to be an international guarantee because without it capital will flee those countries. It’s already happening. You can see the weakening of currencies like the Brazilian real, the Turkish lira, Hungarian forint. You can see that they are now falling in relation to the (U.S.) dollar. This is actually really dangerous, and there needs to be an international pull – led by the IMF but also supported by countries with very large dollar reserves like Japan, China, and the Gulf States – to provide a guarantee to the banking systems of the periphery countries. They should enable those countries to run a budget deficit in order to have a counter cyclical policy to support domestic demand in the face of a world-wide slowdown. They cannot do it without such support. Japan has actually offered to participate in such a scheme, and China ought to do the same.

Caijing: But do you think the (Chinese) government will do that?

Soros: I doubt it too, but that’s what they ought to be doing if they want to be accepted as a facilitator for the world economy.

Caijing: Do you see the possibility of that?

Soros: I have some hopes of that happening, and I think it would create a great opportunity for China, even more than the Olympic Games, to show something to the world. I believe this is a very important step to preserve the world economy, in which China has prospered. If China doesn’t do it, in my opinion, the world economy can easily collapse. Then China would be hurt also. So it is in China’s interest to preserve the globalization that has made China so prosperous.

But China’s economy is also on the downturn, and the government has a lot of fear…

China needs to stimulate it’s own domestic economy in the face of declining exports. And it must also help the rest of the world to do the same so as to protect China’s exports. Now this requires great foresight and vision by the Chinese government. I hope they are capable of it.

Caijing: Does the U.S. need a second fiscal stimulus?

Soros: Yes. I think it is needed, and I hope it will be directed at stimulating investment aimed at preventing global warming. Because that is a problem that is facing the world. I hope both the U.S. and China will introduce energy saving and alternative energy generation as a way of stimulating the economy because that is what you need to come out of this global recession that we are currently facing. The global economy was supported by U.S. consumers spending more than they were earning. That is finished. That has come to an end. Something else has to take its place, and in my view, the world is facing the problem of energy shortage and global warming. To build this requires very large investments and those investments should provide the motor for the world going forward. Otherwise we will be in a worldwide recession, and at the same time, we are going to be cooked together.

Caijing: Do you think the financial market crisis is spreading to the real economy, and is it a problem?

Soros: It is inevitable, and it could cause as big… I already said that I don’t want to speculate because it can be very bad, but in fact it can be fatal for the world economy unless the governments take the right measures to counteract it. It could be as bad or worse than it was in the 1930s.

Caijing: Is the fiscal stimulus the best way?

Soros: Yes. We are back to Keynes now. John Keynes – he had the right idea for the 1930s, and those ideas have come back in a cyclical fashion, and they are right for the 21st century.