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Karen Gibbs and Geoff Colvin Karen Gibbs Geoff Colvin Geoff Colvin Karen Gibbs
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Dangers of an unfettered market:
George Soros interview, Sept. 20, 2002

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Wall $treet Week with FORTUNE co-host Geoff Colvin interviewed George Soros earlier this week. Portions ran on the Sept. 20 program. Here is the complete discussion:

GEOFF COLVIN: You say that financial markets are not, as many people say, this well-oiled machine that's constantly pushing assets toward their correct prices; but rather a sort of lurching unpredictable thing, in which among other things, the big players can do very well and the small players often don't do very well. Why is it so?

GEORGE SOROS: Well, I think that the markets are pretty well-oiled, they are pretty smooth. But I think there is a lack of understanding of what really, markets are about.

There's this concept that they tend toward equilibrium, and I think that idea may be true for the markets for widgets, but it is not true for financial markets, because financial markets are trying to discount the future. And the future they are trying to discount is not something given, pre-determined. It is actually contingent on how the financial markets discounted today.

COLVIN: Meaning that the future they are trying to discount is based on valuations in the market today?

SOROS: In a way, (but) what I am saying is, that the financial markets play an active role in determining what's going to happen, how the economy is going to function.

And you can see that today, when the economy actually is a lot better than the market, and the market is actually pushing the economy down. For instance, you know, because of the decline in the market consumers may be getting now more cautious. This is the kind of active role that is left out of account.

COLVIN: And so the financial markets, the markets for stocks and bonds, you think behave fundamentally differently from the markets for anything else people buy and sell.

SOROS: That's right.

COLVIN: And what can we learn from that, how can we use this fact?

SOROS: We have to realize that the markets are genuinely unpredictable, that they, if you leave them to themselves, they actually go to extremes and lead to financial collapse. So you need the presence of the authorities to keep the markets on reasonably even keel. And this is without the kind of guidance that you get from the Federal Reserve, Alan Greenspan and so on. Markets wouldn't actually know how to react to certain things.

COLVIN: So we need the presence of the authorities, government authorities in financial markets. Do we need more than we have right now?

SOROS: I think that the authorities need to recognize the role they have to play. And I think they are guided at the moment by a false ideology which I call the market fundamentalism -- that is, that you leave everything to the markets.

Now basically, when the authorities take action they are very often wrong. In fact almost always wrong. But they can correct it because they get feedback on how the market works. Now the false idea is that markets are always right -- they are not. They are also always wrong, except that most of the time they can actually make it come true, whatever they are projecting for the future.

COLVIN: Example?

SOROS: The boom/bust that we have just lived through. Look how Internet for instance, became a big thing, partly because the markets thought it's a big thing. It became a bigger thing then it would have been if the markets hadn't taken them up. Take the revolution in telecommunications. That was also helped by the market enthusiasm, and to some extent could be validated, but in the end, it became unsustainable.

And so you have -- it's built into the financial markets to have these boom/bust developments, and it is up to the authorities to try to take the edge off it. In other words, not to let it go too far in either direction. Usually you have to come in and stop when there is a collapse, but to prevent a collapse is better if you can stop the boom from getting out of hand.

Now you know Alan Greenspan talked about the exuberance of the markets, then he changed his tune. Today he defends his position, saying that it would have been impossible to separate the asset markets from the economy. But he could have, for instance, used the margin requirements.

COLVIN: So in other words, Alan Greenspan could have damped down the final most extreme stages of the great bull market in your view. For example by requiring that investors borrow less, the margin requirements being made more stringent.

SOROS: That's right.

COLVIN: And I presume you think he should have.

SOROS: That's right. But you see, under -- with the market fundamentalist principles, margin as a tool has been left in abeyance. In other words, we do have margin regulations, but they never change. Actually they should be activated, should have been activated.

COLVIN: You have said that the bursting of the Internet bubble was an entirely predictable event -- only the timing was uncertain. What is the next big financial event that is entirely predictable even if the timing is uncertain?

SOROS: I don't think anything is entirely predictable, because if the theory is that financial markets are unpredictable, then you can't predict them. So I don't think that anything is entirely predictable.

I think we have some very serious defects in the global financial system. Actually that system has really broken down, only we haven't realized it. Because it doesn't provide an adequate flow of capital from the center from the financial markets and the multinational corporations to the periphery.

COLVIN: The developing nations.

SOROS: The less developed countries. And if you look at the problems that have developed in Brazil, they are a demonstration of that. You see the global financial markets suck up all the savings of the world basically through the center. But they are not pushing it out to where they are needed.

COLVIN: In other words, countries like Brazil, or other developing countries are not able to borrow the money that they need from the great financial centers?

SOROS: They are not able to borrow at the rate which would make them sustainable. Brazil today -- the bonds, the government debt -- yields than 20 percent in dollars. Now that implies that the country is not solvent. And in fact with 20 percent interest rates the country is not solvent. It would be perfectly solvent if interest rates were less than 10 percent.

COLVIN: So what's to be done?

SOROS: You really need to develop some mechanism to bring down the interest rates in Brazil, make credit available that the financial markets currently are not making available. You really need a lender of last resort.

And I have advocated that the central banks -- the Federal Reserve, the European Central Bank, Bank of England -- should actually open a discount window to Brazilian debt as long as Brazil is following sound policies, as it is doing today. Then interest rates would drop to less than 10 percent and the problem would go away. But there is no lender of last resort in the international financial market.

COLVIN: Right. This week is the tenth anniversary of your famous bet on the direction of the pound, the British pound. By most accounts, I think the largest bet ever placed by a hedge fund, and of course, you were correct. You bet properly, by some accounts made a billion dollars on that. Today, ten years later, what's the lesson to be taken from the extraordinary week?

SOROS: Actually it wasn't extraordinary. For us, it was just business as usual. Of course we are not always right, you know. So there isn't anything very special with that event.

COLVIN: Just another bet that you happened to win.

SOROS: That's right.

COLVIN: A big one. A big one.

SOROS: But I've lost something once.

COLVIN: Let me go back to your characterization of the markets as amoral. Because the market fundamentalism you talk about holds that the markets lead to a moral result -- the operations of the financial markets lead to what's best for the country. You don't see it quite that way.

SOROS: There is a theory that everybody pursuing his self-interest actually serves a common interest, because markets tend towards equilibrium, and equilibrium assures the best allocation of resources. That theory happens to be false.

Now, markets are very, very useful, and people do pursue their self-interest. And insofar as markets are efficient, they're right in doing so. So for instance, when I was speculating against the Bank of England or when I'm speculating normally, I don't give any weight to the social consequences of my actions, because in an efficient market there's always somebody else who is ready to take your place at only a marginally different price. Therefore you don't really affect the outcome.

Incidentally, one of -- in the case of the (British) sterling and the falling out of the ERM (exchange rate mechanism) -- if I had not been present, if I had not played, even though I was a big player, same thing would have happened. And if I had done it only by myself, and the rest of the market wasn't moving in the same direction, I would have lost money instead of making money. So this happens to fit this case.

Now, so as a market participant I don't need to give way to moral considerations. That is one of the things that makes markets so efficient. However, as a society we can't live without moral considerations. In other words, we do have to protect the public good. And markets are not designed to do that, so we need a political process. A political process is much less efficient than market, but we absolutely need it and this false theory has led to the idea that we don't we need to have any government intervention.

And so there is a presumption that the markets actually are moral, and that is a false assumption. And if you leave it to the market a lot of things can go wrong and we now find out, for instance, with the excesses that the corporate executives took advantage of their companies and so on.

COLVIN: And we are seeing, as you know, as everyone knows, a huge outpouring of news along these lines. This week, amazing allegations about Tyco, but many others before this. Is it your view that the solution to this must come from governments rather than supposing that the markets will correct themselves?

SOROS: Yes, you do need some tightening of regulations, but that won't be enough. Because basically two things have gone wrong: one, a decline in professional standards and second, conflicts of interest. Now to restore professional standards has to be done by the professionals themselves.

COLVIN: Lawyers, accountants.

SOROS: Lawyers, accountants, security analysts and so on. So if you don't have a change in attitude, in public morality, then putting in more regulations is merely an invitation to find ways around it.

COLVIN: To game the system one again.

SOROS: That's right. And actually what went wrong with Generally Accepted Accounting Principles is that the principles were translated into rules, a very minute rules, and the principles got disregarded. And one of the good things that the Securities and Exchange Commission did, was to require the financial officers, chief executives to testify that the accounts represent the true state of affairs, irrespective of whether they meet the rules. And that reintroduce the principles. So we really do have to go back to principles, and we have to recognize there is such a thing as public good, which is not served by everybody pursuing his self-interest.

COLVIN:So when you look at what has happened over the past few years in business and in the markets, do you think part of the problem is that there has been a decline in morals and ethics?

SOROS: Yes, this amorality of the market has been carried too far into areas where it doesn't properly belong. If you look at what happened, it's really a normal boom/bust, something that happens time and time again. My book Alchemy of Finance, which was published in 1987, draws on the conglomerate boom which got into the late 1960s. And similarities are really quite striking.

There is one big difference, and that is here, the excesses were much more widespread. Then (in the 1960s), that was only a small number of companies and when they over-reached, they ran into the establishment, and the establishment closed ranks and basically brought the boom to an end. Here (in the current time), the establishment was part of the boom and it really extended to -- it just was much more widespread.

COLVIN: So the booms and busts come and go over the years as they always have. But it sounds like you are saying that in this most recent boom and bust, the morals and ethics in the markets really have declined in a way that doesn't come and go, they really have declined. Is that fair?

SOROS: That's right.

COLVIN: That's a much bigger problem then government regulation. What can be done there?

SOROS: I think there has to be a change in public spirit. And those things actually can happen. I mean, public opinion or public standards do vary.

Now it used to be, morality and religion played a very big role in the country's life. It led to a lot of hypocrisy because people were still pursuing their self-interest, but they sort of covering it up. So reintroducing public morality really involved a lot of posturing and so on, but I think it's better, somewhat better, than when you let the sort of self-interest run rampant and when people gain social recognition just because they made a lot of money.

COLVIN: You are calling for a change in public morality and ethics, and also more in the way of regulation or at least more activity on the part of existing regulators. It's not that often you hear a self-made billionaire calling for, you know, more activity on part of regulators. Would your career have been possible in a more tightly-regulated financial world?

SOROS: I started out in a much more tightly-regulated financial world. So I've seen it, the regulations being changed. And I was reasonably successful under those conditions but of course, my way of operating has changed together with the change of the markets.

COLVIN: You have seen the markets respond to every kind of event in your career. What will happen if there is a U.S. invasion of Iraq?

SOROS: Well I think it's weighing on the markets now. It's one of the elements which is depressing the market because uncertainty is always bad for the market. There is another thing that is weighing, that's a fear of terrorism. And that fear is actually, I think, deliberately fostered by the government for their own purposes. So actually these things are weighing on the market right now.

COLVIN: What are the purposes of the U.S. government for fostering the fear of terrorism?

SOROS: Well, first of all to have the people line up behind the government, the president, giving the president more power, more support.

And I'm actually -- I would go a little further then that. There is, within the government, a certain ideology which says that international relations are relations of power, and we are powerful, particularly the military power, and therefore, we really ought to be able to call the shots. And that I think is very dangerous because we don't have enough international law, but this attitude actually undermines the laws and institutions we have. So I'm very concerned about that.

Now I happen to be in favor of dealing with (Iraqi dictator) Saddam, so I don't want to be misunderstood. But I think that there are now, I would say, probably three alternative scenarios. One, that Saddam really doesn't have that much in the way of weapons ready to be used, and therefore he may actually cave and allow the inspectors to come in. So we may actually get by without, we may be able to contain the threat of Saddam and not have to actually take military action. Second, that he actually does have, and therefore he will not succumb, and we have to go in, then it will be very dangerous because that means that he will be able to hit, let's say, Israel. Israel would hit back and you would have a much broader conflict. So there's a real danger. I don't think we should shy away from it, but I think we have to recognize it that there's a real danger. And the third is that we don't abide by the United Nations, but go it alone. In which case the dangers are multiplied.

So it is a dangerous situation. Now once the issue is resolved, I think if will be a great relief to the market. I think oil prices are likely to go down substantially, which will be a boost to the economy. So I think it's bearish now, but maybe very bullish after this.

COLVIN: You have a lot of investors today who really wonder if the time has come for them to get back into the market. What's your advice?

SOROS: I don't give that advice.

COLVIN: (laughter) You have pointed out that investors, some investors like Warren Buffett who insisted on focusing on the fundamentals even through the craziness of the bubble, ended up doing okay. Surely there is a lesson there?

SOROS: Well, there's a lesson that that's one way to make money. I personally, for instance, am not dependent on the kind of, or guided by the kind of fundamentals that he's guided on, because I believe that markets are reflexive, and market sentiment is one of the fundamentals that you have to take into account.

COLVIN: So you are gauging the psychology?

SOROS: Well, I have been trying to actually play the booms and busts of the market.

COLVIN: How do you gauge the psychology, the sentiment as you say, of the market?

SOROS: Well, I think the sentiment is now bearish and will probably continue in that direction. A lot of people have come into the market that hadn't been there before. A lot of them have to leave before the market actually turns around. But certainly it will turn around, and it is an arena where some people can make money and others will lose.

COLVIN: But that's interesting because people talk a lot about this, the moment of capitulation -- of course there is never a real moment, but the idea of capitulation -- when people have gotten out. Your view is, there is still a lot of people who have to get out.

SOROS: I think that there is still some redemptions in mutual funds. Although we did hit a peak, that may not be repeated.

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