I put forward a pretty general theory that financial markets are intrinsically
unstable. That we really have a false picture when we think about markets
tending towards equilibrium. Equilibrium is appropriate when a market deals
with known quantities. But in financial markets, you deal with unknown
quantities. You're trying to discount the future. But the future depends on how
you discount it today. It's not something fixed, so your discounting can't
correspond to the future. |
Now, there is the prevailing theory which holds that financial markets should
be regarded as if they were in continuous equilibrium. I think that is actually
a false image. Because, in effect, they are in continuous disequilibrium.
Therefore, they are given to going to excesses in one direction or another. You
can have a boom and a bust. Now, in practice, we have learned that that's the
case. Through experience, we have evolved a system of central banking that
prevents these excesses from going too far. Controlling the money supply,
dampening the boom so that you don't get a bust. Then stimulating the economy
[that] is in decline. You have various regulatory authorities and so on.
We now have global markets. We don't have an appropriate international
mechanism for regulating the global financial markets. That's a problem. We
have the Bretton Woods Institutions--the International Monetary Fund and the
World Bank. But they were created for a different world, a world in which there
were no capital movements. In fact, these institutions were designed to make
trade possible in the absence of international lending, and so on. These
institutions adopted themselves to changing circumstances.
You also had, at the time, fixed exchange rates. So the fixed exchange rate
system broke down. Global capital markets developed. The institutions, the IMF,
is not adequate to meet these circumstances. It adapted itself and did
reasonably well in one crisis after another. There was a big international
crisis in the '80s ... mainly focused in America. Then you had the Mexican
crisis in '94. Now, you had this latest crisis. Here, the IMF method proved to
be inadequate. So their intervention became part of the problem, instead of
being part of the solution.
You criticize people who you called, "market fundamentalists." Tell me what
their theory is, and why you're critical of it.
Well, market fundamentalists recognize that the role of the state in the
economy is always disruptive, inefficient, and generally has negative
connotations. This leads them to believe that the market mechanism can take
care of all the problems. Get the state out of there. The markets are perfect.
In fact, they will take care of themselves.
The first part of the proposition is correct. The second part is false. Just
because state intervention is imperfect, is full of negative effects, doesn't
mean that markets are either stable or provide social justice. Or are
appropriate for certain functions that society needs, but cannot be, in my
opinion, provided by the market. So it's carrying the belief in markets to an
extreme, which is, I think, today very, very dangerous.
So do you think that the markets today have too much power?
Well, they are too influential. They have penetrated into areas of society
where they weren't previously, or to a much lesser extent. For instance, they
have come to dominate the professions. Law has become a business. Health care
has become a business. Unfortunately, politics has also become a business. That
really undermines society.
Since the middle of 1987, beginning in Thailand, it tends to be the
countries, themselves, who are blamed by many for the problems, for the crisis.
You've seen some other unifying themes ...
That's right. I mean, of course, there is something wrong in the policies
followed by those countries. But the crisis affected a great number of
countries, some of which followed very different kinds of policies. There is,
however, a unifying theme. That is the role of capital flows.
The capital flows themselves can be destabilizing. I mean, it's sort of an
innate feature of markets. It's very good to have capital flows, but you also
have to recognize that they can be destabilizing. Therefore, you need some
mechanism to prevent them from creating these dislocations ...
As you said, you consider this situation quite dangerous.
Well, I do.
Well, so far, there have been tremendous economic dislocations, tremendous
human suffering as a result of what happened in financial markets, affecting
what is now called innocent bystanders. Millions of people who are not
entrepreneurs, who hadn't made any decisions, didn't borrow foreign currency. A
lot of them, rather poor people, who have actually benefited over the years, in
an improvement in their standard of living. Suddenly a collapse--losing their
jobs, having much less income, much higher prices, and so on. Losing their
savings, in the case of currencies that collapse.
So tremendous dislocations. They have occurred in what I call the periphery of
the global capitalist system. These are the countries that have been attracting
capital or using capital coming from abroad. It has, if anything, actually
benefited us and our economy, because we have had the benefit of cheaper
imports. Its incipient inflationary tendency was nipped in the bud. Actually,
we were on the verge of perhaps having higher interest rates, which would have
pushed us into a slow-down. Because of the financial crisis, we actually got
lower interest rates and a new shot of stimulus.
So we, if anything, benefited. It's very hard right now to convince people that
there is something really wrong, because they don't feel it themselves. But if
they look abroad, they can certainly see it. In my view, there is a very good
chance that the next crisis, which may happen in the next few months, or the
next new years ... we'll actually have a similarly or maybe not quite as
seriously disruptive effect, but a negative effect on our economy.
I say it's not going to be so serious because we gave a very effective
institutional framework to guard against it. So it's not likely to be as severe
as it was, let's say, in Indonesia or Brazil. But nevertheless, it could have a
negative effect in our economy. If that were to happen before the rest of the
world has recovered, then you would have a worldwide depression similar to what
happened in the 1930s.
Because if we began to have problems ...
Well, because, right now, people suffer some dislocations in our economy.
People lose jobs, as we turn to cheaper imports from Mexico or from other parts
of the world. But there's tremendous new job creation. Actually, our
unemployment is very low. The economy is really very prosperous. We aren't
overheating. It's probably the best of all possible worlds. But if you now
started to go into slowdown, and people who lost their jobs couldn't find new
jobs, then the outcry against cheap imports and the loss of jobs, would become
politically much more powerful.
As it is, we are imposing some restrictions, for instance, on imports of steel,
because they are, in fact, flooding our market. That protectionist sentiment
would then become much stronger. Then you would start disrupting international
trade, as a result of the disruption of financial markets. Then you would get
into a problem that the countries that have to repay their debts would not be
able to earn the hard currency, which they need, in order to service their
debts. So that you would have financial distress, as well as interruption of
... A lot of people marked the beginning of the current crisis is Thailand.
But there are others who say that ... the wrong lessons were learned in '94 and
'95 in Mexico ...
Yes. Well, you see, what happened in '94-'95, Mexico had, again, a pegged
exchange system, had a trade deficit, and a current account deficit, and the
peg couldn't be maintained. There was a crisis. The IMF, under the leadership
of the Treasury came in with a very large rescue package, which allowed Mexico
to service its debt, the Treasury bills that it had issued, in dollars. So the
people who had invested in Mexico came out scot-free. That gave rise to what is
considered the moral hazard--that it's safe to invest, even in an unsound
economy, because if things go wrong, the IMF and the Treasury is going to bail
This is a particularly important factor in Russia, which was totally unsound,
but people kept on lending money, because they were convinced that Russia is so
important geo-politically, that we wouldn't let them default. It turned out to
be false. But it led to this unsound lending and the moral hazard.
Opinion has turned very strongly against moral hazard now, which actually
creates the opposite problem, that the IMF is unable to come to the rescue,
because if it did, it would be accused of bailing out the speculators and the
unsound lenders. So it's unable to come to the rescue. Therefore, it's very
risky to lend, and nobody wants to lend. So you now have a situation when there
is a reverse flow of capital fleeing from the periphery, coming back to the
center. Whereas, most of the remedies that are proposed are remedies against
excessive investments, excessive lending. The problem now is exactly the
So what I am advocating is a more balanced approach, where you, on the one
hand, do impose some penalties on people who lend or invest in countries that
are unsound. You make that clear in advance. This will discourage them from
investing. You prevent sort of unsound booms, but, at the same time, you must
also create conditions that will encourage people to lend or invest in
countries which are in need of capital and are following sound policies. For
that, the IMF has to develop into something like a lender of last resort for
those countries which are sound enough that it is appropriate to lend to them.
Not to countries that are broke. This would correct the imbalances which have
The other thing that is wrong with the IMF policies is that they can only come
in when there is a crisis. They really have absolutely no standing until they
are called in. They are only called in after a breakdown. Now, the best way to
prevent a bust is to moderate the boom. You really need to come in earlier and
to follow the correct policies. So if you have the IMF acting as a lender of
last resort for countries that meet the right conditions, then the IMF can
exert influence to prevent, let's say, excessive borrowing, and so on. This
would give you a more balanced system of rewards and punishments. Similar to
the position of a central bank, that actually sort of stimulates an economy, or
dampens a boom, by changing the interest rates. So that is the new architecture
that you would need.
There is one major objection to this, that the distinction between good guys
and bad guys is too rough. There is too much discontinuity. That you actually
have to create a more sort of nuanced rating of the countries, match the
facilities that you provide to the conditions in that country. That would then
be a balanced system. So that is what I am, generally speaking, proposing. It
is being considered. But politically, the idea of making the IMF more powerful,
especially after it has failed, is a very difficult thing to sell ... the IMF
has failed, because it didn't have adequate resources. I don't think that you
can have a global market without a lender of last resort, and something
resembling a global central bank, which is what this would, in fact, be.
In general, what are the reactions ... to your diagnosis? To your saying
that there's something quite wrong here and that we need some new rules.
I think that they are very much aware of it. In fact, some of their statements
went a long way in that direction. When they talked about preventive lending,
that's what they were talking about. There is a danger that the calamity is not
severe enough, and hasn't touched us directly enough to gather the political
will to do something about it. So the punitive or negative aspects are moving
For instance, there is discussion to change the nature of international bond
contracts, so that it's easier to restructure them and to delay payment. But
the effect of that will be merely that people will demand a higher risk
premium. So while all these measures are useful, there has to be something on
the positive side. That is where it's difficult to gather the political will
... Especially, to gather the political will in the United States, where
Congress is very much opposed to it.
Is the Treasury also opposed to it?
The Treasury is much more open minded. In other words, they are studying it,
but they are aware of the political realities. So while my ideas are being
considered, I don't think they are considered very realistic.
When you, as an investor, as a trader, look out at the world, six months,
nine months down the road, what kinds of things are you looking for?
The financial markets generally are unpredictable. So that one has to have
different scenarios ... The idea that you can actually predict what's going to
happen contradicts my way of looking at the market.
Actually, I see tremendous imbalance in the world. A very uneven playing field,
which has gotten tilted very badly. I consider it unstable. At the same time, I
don't exactly see what is going to reverse it. Certainly, a slowdown in our
economy would leave the world extremely vulnerable, because the U.S. economy
is, today, the single engine that is driving this very big plane. So if that
engine were to conk out, you'd have a very serious problem. It's a question
[of], can you repair the other engines before this one gives out. Because even
though people say that we live in a new world, and the past is not relevant ...
cyclical fluctuations are not eliminated. That's my main concern.
... I just want to clarify ... that what you have is a very uneven playing
field. You have excess liquidity at the center and a great deficiency of
capital at the periphery. The money is still flowing from the periphery towards
the center. So we ought to find a way to inject liquidity in the periphery.
Instead of that, we can only inject liquidity at the center. The Federal
Reserve can lower interest rates, and has done so.
What you need is a mechanism to provide capital to countries like Brazil, which
is where money is fleeing. Interest rates are very high. The country is going
into recession. So this is what creates a tremendous imbalance, at the moment,
which is not sustainable. It could lead to ... if this engine now gives out,
then you have a problem.
I mean, in fact, there is a certain danger that because of the injection of
liquidity, our financial markets have become overheated. You have signs of
speculation, excessive speculation in areas like Internet stocks, and so on.
You could conceivably have at some point a crash that would then have negative
effects on the real economy ... In this country. And then, indirectly, on the
rest of the world ...
Let's talk about Russia ... Is there any way that what happened there could
have been moderated? That the fall could have been not so severe?
Well, you see, it's really a tragic situation, because again, everything that
could be done wrong, we have done wrong. We have failed to provide the kind of
aid that Russia would have needed, which would have been more in the nature of
a Marshall Plan or something more intrusive than the Marshall Plan was in
Instead of that, we left it to the IMF to provide support. The IMF deals with
countries where the government promises to fulfill certain conditions, and the
IMF then lends them the money. But actually, in Russia, you did not have a
functioning central government. Therefore, they kept on promising, but they
couldn't possibly deliver. So the IMF was actually the wrong institution to be
helping Russia, but we were not willing to put taxpayers' money at work. We
gave it to the IMF, which had its own resources, so we could do it costlessly.
That's the background. Now, gradually, Russia tried to change from this
robber-capitalist system that prevailed, to something more legitimate. Just at
the time that the crisis came, they actually had the best government, the most
honest, the most committed to reform, who actually tried to do battle with the
robber-capitalists, and tried to get them to pay their taxes.
The robber-capitalists then fought them. They controlled the media. They
actually destroyed the reformers and created or, let's say, coincided with the
crisis. The IMF had a program which was unfortunately short on money. The
deficiency was not that great. I, at the time, estimated it to be $7 billion,
which is really peanuts in this context.
I think that providing that extra money could have given that government, let's
say, six months breathing space, during which they could have proven whether
they are, in fact, able to collect the taxes that they had to do. So, it would
have been a very small price to pay. But for various reasons, the international
community didn't come through.
You then had a collapse, effectively a default, which shook markets. The
government immediately fell. You now live in a kind of a twilight period, when
things are drifting. You have a government that has proven itself quite good in
sort of holding things together, so that cushioning the rate of decline, but
not showing any ability to turn things around.
So you just have a deteriorating situation. Also, a kind of a political vacuum.
You have a drift. There's very little you can do right now, except to hold the
door open. Try to avoid an official default that would isolate Russia, in a way
that would be quite dangerous. Wait for some kind of political resolution, and
the emergence of a government with whom one could work towards more active
How do they get out of it, when essentially, they have no money?
Well, they can't. They don't get out. They get out of it by not using money,
actually. You see, practically everything is done by barter. So, as far as
money is concerned, they are broke. But since the economy doesn't use money, it
kind of grinds along. I mean, it's very inefficient. Barter is much more
inefficient than a monetary economy, but it doesn't totally break down.When the government began to issue its short term notes, the infamous GKOs,
was that a mistake on the government's part? How much did the U.S. Treasury and
the IMF know about this hole that they were digging themselves into?
It was not a mistake, because it's the only thing they could do. As long as
people were willing to lend to them, it's not a mistake to borrow, when you are
broke. I would say that any observer could see that the whole situation is
unsound and unsustainable.
The only question was whether they could actually start implementing the
reforms which they were promising ... The tragedy was that ... in the spring of
'98, they started raising the cost of electricity and collecting taxes ... Then
they got involved in this fight with the so-called oligarchs, the
robber-capitalists, which preoccupied them, and the reform effort kind of fell
by the wayside. Then came the global crisis. Through hook and crook, they
managed to get a new government in place which was, actually, as I say, a very
good government. But it had no chance to see whether they can actually deliver
on their promises.
... That new, reformist prime minister said the first numbers that he was
shown showed that what they owed to repay their debts was billions of dollars
more than they were bringing in.
I mean, from day one of his ...
There was a hole, actually ... You see, the IMF plan assumed that the maturing
treasury bills will be rolled over or can be rolled over, even if the interest
rate is atrociously high. That [at] some interest rate, there will be some
buyers. But what they've left out of account is that the holders of the GKOs
were banks that borrowed dollars to buy the GKOs, couldn't repay the dollars.
The foreign banks were not willing to lend them any more money. So they could
not roll over the GKO at any price. So there was a hole there. As the Russian
public started withdrawing its savings from the national savings bank, the hole
got bigger. What started out as a hole of $7 billion, within a week or two
became a hole of $15 billion. Would have even become bigger.
So you began to understand that they were in deep trouble ... What did you
think was going to happen? ...
Well, you see, I made probably the worst miscalculation of my investment
career, because I invested in the Russian telephone company, in the expectation
that they were going to make this transition from robber-capitalism to
legitimate capitalism. Then it would have been a very good investment. They
turned to me and wanted to borrow some money against the next tranche of the
telephone company to be privatized. That prompted me to look at the situation.
I realized that it was beyond redemption. Except through another additional
[loan] package. I thought at first that it could perhaps be put together as a
Then, when the situation got worse, I concluded the only way would have been to
introduce a currency board and stabilize the situation. So right up to the last
minute, the situation could have been at least temporarily stabilized, but it
would have been a very, very high risk. Lending money to people who have
consistently failed to deliver on their promises, in the hope that this time
they'll do better. So the political risk of throwing good money after bad was
just too much, with a very hostile Congress. With Germany preoccupied with the
elections, and Chancellor Kohl didn't want to deal with this issue at all.
There was no support from Germany. So it was impossible to put a package
You wrote a famous letter that was published in The Financial Times,
when you proposed this currency board, but you also said that people did not
understand the urgency of the situation ...
Well, you see, I wrote a letter to The Financial Times, proposing a
currency board. As part of the currency board, a 15%-25% devaluation, which
would have been necessary, because the currency had become overvalued. Also,
would have taken into account this moral hazard problem, because people who had
invested in the local Treasury bills would have lost at least 15%-25% of their
money. So I thought that that was necessary. Unfortunately, people didn't
understand what a currency board was, but they understood what devaluation was.
I then got blamed for the collapse of the market, which actually is somewhat
unjustified, because it would have collapsed without my letter, but it just
happened to coincide with the collapse.
What would have happened if Russia had devalued back in the spring? Back in
I think it would have helped.
... Tell me something about that last weekend, before Monday, the 17th of
August ... of the feelings that were going on in your conversations with
Well, it was clear to all parties concerned that this was a crisis of the
greatest magnitude. There were a number of conversations about what could be
done. I know of an international conference call among the G-7 countries, who
discussed this issue. But, as I said before, no package could be put together.
Whereupon, the Russians took it up on themselves to act unilaterally.
That really shocked the market, because it was effectively a unilateral
default. The shock then reverberated through the financial markets. Banks
became very anxious about their outstanding loans. Certain relationships
between different markets, which had been sort of moved way out of normal. At
the same time, you had a number of hedge funds, investment banks that had
speculated on those relationships going back to normal. They had large
positions, which normally turned out to be profitable. At this time,
disparities, the divergences, just grew out of all proportion, since these
operations are carried on with very high leverage meaning that it's all done
with borrowed money.
There was a hedge fund, Long Term Capital Management ... this entity lost a lot
of its capital ... The banks started asking for additional collateral, which
they didn't have. There was tremendous danger that if these positions had to be
liquidated, then the disparities would get even bigger. Not only would the Long
Term Capital Management be unable to meet its obligations, but a lot of the
banks, and investment banks, that had lent to Long Term Capital, and also had
similar positions in their own proprietary trading debts, would also be called
up on to liquidate their positions.
So you would have sort of an avalanche of selling, where you wouldn't know who
is a good counterpart and who isn't. You wouldn't know which institution is
solvent and which is broke. That would have been a meltdown of the financial
markets. That would have then had a devastating effect on credit all around.
Seeing it develop, the New York Fed intervened, and got the major
counterparties of Long Term Capital Management to put in addition capital. So
that they didn't have to liquidate their positions. That move prevented this
You've written that not only were you disappointed in the response of the
G-7 countries to the Russian crisis, but that there was a loss of control, as
you've called it, that was quite scary. Can you tell me what you meant by that?
... Well, the consequences of this unilateral default showed up in the market,
where there was a flight to safety. The normal relationship between lower grade
bonds and high grade government bonds, widened. The stock market was shaken and
started to fall. We actually came very close to what I call a meltdown of the
system, as a result of the problems connected with Long Term Capital
So, not only was it, let's say, a reasonable gamble, to give some additional
support to Russia, in order to help Russia from a breakdown, but it also would
have saved us from that particular incident.
Now, the Fed was more effective in intervening in the domestic market, than the
G-7 was intervening internationally. So the worst outcome was avoided. The
effect on Russia, we have seen. But actually, the effect on the financial
markets proved to be very transient.
The Russians were basically told by Monday morning, August 17th, that they
were on their own, that nothing was going to be put together.
Yeah. I think that on Sunday, they were told. They went to Yeltsin, and got his
consent for this default action. So Sunday night, it was announced Monday
morning, it was a fait accompli.
You lost a bunch of money in Russia.
You said it was the worst investment decision in your life.
Right. Right ...
Do you think people understand the seriousness of what happened in Russia,
that there are still potential repercussions?
I think that people generally realize the situation is pretty hopeless right
now. It's probably not quite as hopeless as it seems to us, who have sort of
orderly minds, and we want to see ... Russia seems to be able to get by.At the time, a lot of people were aware how serious the internal situation was.
That's why the markets fell. But it was a temporary panic. Through the
intervention of the Fed, bailing out Long Term Capital Management, and very
shortly thereafter, lowering interest rates, which was a very important
move--markets took heart. It's now sort of like an episode that's almost
But shouldn't be?
Well, it should not be forgotten, because these kinds of episodes are liable to
reoccur. No reform will ever eliminate the risk of some kind of a breakdown.
But when you identify what has gone wrong and what could be done to fix it, you
actually do need to fix it. Because without it, we couldn't have developed the
financial markets we have.
Financial markets have always failed from time to time. Then, they got fixed by
some advance in central banking or in a regulatory environment. As a result,
financial markets got increasingly sophisticated, refined and effective. If you
now allow this belief that markets are best left alone to predominate and
refuse to fix the deficiencies, then you run the really serious risk that you
will have a very serious breakdown.