Episode 2 Stephanomics

who has an exclusive interview with billionaire financier, Gorge Soros.

1234 three years ago, governments had to step in to save the banks.

Now they're battling to save the euro. In a crucial week for the

single European currency, I'm asking my guests, who deserves most

blame for this financial mess we're all in? The bankers? Or should we

save some time for the economists and who better to answer that

question than the billionaire investor George Soros, who thinks

all of us, bankers, eeconomists and governments need to go back to

square one. We're filming this special series of BBC Radio four

programmes about the global economy, so you can seat discussion as well

as hear it. -- see the discussion as well as

hear it. With me to discuss all this today

are George Soros, the billionaire financier turned activist, Sir

Howard Davies, who's previously been the director of the London

School of Economics and the deputy Governor of the Bank of England and

the economist Dr DeAnne Julius, chairman of the think-tank Chatham

House and a former member of the Bank of England's Monetary Policy

Committee. This mess we're in, let's talk about it and who's to

blame for it. I want to get to lessons and solutions later. First,

I want a better sense of the root causes. I have a funny feeling

there's more to this than just the greed of bankers. George Soros, I

must start with you. Was it the bankers and traders who brought on

this mess, this crisis? Or the eknomists teachers who told them to

put all their faith in markets? bankers and traders are running the

markets and the institutions, but the rules by which they play are

set by the authorities and the thinking of the authorities is very

much influenced by the economic theory. And I think there is

something fundamentally wrong with the economic theory that has been

guiding us all these years. What, briefly, what do you think was the

heart of that problem? Basically, economics tries to be a natural

science, but there's a difference between natural science and social

science. Because in social science, you're dealing with people who act

on the basis of imperfect understanding. The whole economic

theory is somehow trying to create an artificial world where this

imperfections don't come into play. Dr DeAnne Julius you're an

economist, I don't know, should I ask you to stand up for the

economists. Did they trap us in a false universe and this is the

result? I think the criticism is probably more appropriate to some

American economists than European ones. But having said that, I don't

think I would put the bulk of the blame for this global financial

crisis on the economists. For one thing, economists aren't that

powerful. And for another thing, it was such a systemic crisis that

mistakes made by many, many actors affected each other and it was

intermingled. We have to look at governments, at regulators, at the

credit rating agencies, at the boards of some of the major banks

and at economists, indeed, and the bankers. Sir Howard Davies, we

probably should have started with you. You have written a book called

the Financial Crisis - who's to blame. A quick summary? I had 38

different answers in the book. Perhaps it's helpful if I spend a

couple of minutes on each of them. LAUGHTER

. One way of thinking about it is to think about this terrible car

crash which we had and to think about the distinction between,

that's were, the climatic conditions and the way in which

people drove. The climatic conditions,, if you like,, where we

had global imbalances, we had a large excess of liquidity, assets

coming from China in particular, looking for financial home,, if you

like, for safe assets, yielding more than US treshries. We had

loose liquidity conditions. We had monetary policy, that at crucial

times was too weak, particularly in the US, too loose. But so you had a

difficult environment in which it was easy to make mistakes. It was

foggy. There was all kind of wind. And within that, financial

institutions drove extremely badly. You know, they thought this was

fine, that these conditions would carry on. They took on increased

debt and borrowing. They created fancy instruments which exploited

these conditions to an exaggerated degree. Then, when the climatic

conditions suddenly changed and monetary policy started to be

tightened and house prices in the US started to flatten off, suddenly,

we discovered that we had a horrible house of cards, which then

collapsed. I do agree, however w, George, that there was, in the mind

set of the authorities, a what now seems touching belief that market

prices were fair, that you shouldn't, as the regulators

challenge what was going on in the markets, and if people were trading

at crazy prices for subprime assets, who were the regulators to

challenge that. I do believe that the economics profession influenced

the way in which the regulators and the financial authorities worked.

To put it simply. You have this concept of equilibrium in economics.

That has very little to do with financial markets. Financial

markets are rarely in equilibrium. It's assumed that they tend towards

eek wi Librium. That's true half the time. At other times they move

away from echoey Librium. So this idea that actually people per suing

their self-interest, actually result in the best allocation of

resources is, in my opinion, a false conception. But if the

regulators had come to you during this period, when you were doing

very well in your reading of the markets and said, actually, we

think these things are getting out of hand. We don't trust you. We

don't think you should get involved in these unstruments, what would

your response have been? Most of these regulators were scared of

saying that. That's right. And I saw it. I was not the only one who

saw it. It was clear that this is going to lead it a bad end. I

didn't, of course, get it right in the sense that I thought it would

collapse much sooner. If I could predict correctly the course of

eseents, I would be falsifying my own -- events, I would be

falsifying my own theory. So nobody is perfect. This is the whole point

that lack of understanding, misunderstandings, false dogmas

play a very important role in shaping the course of events.

that's a very hard lesson for governments to hear, because they

like to think that they can influence the world. But they also

want to think that there are rules and there are levers that they can

pull. Is this something that we're only just beginning to get to grips

with? I certainly agree with George that no-one can really foresee the

future or know exactly how things will work out. That's why there

needs to be quite an important learning by doing, as it were,

rather than for example, at the Bank of England and other central

banks, putting too much faith in a forecast and inflation forecast,

which I think has not served them very well over this peer yofd time.

Indeed, the MoD els that the banks use or at least the Bank of England

was using when I was there, didn't even have a financial sector. It

was not very helpful in looking at the effects of a financial crisis.

It's true that individuals in the marketplace have their own

incentives, their own vested interests as it were. Governments

of the day, the British Government got a quarter of its tax revenues

from the financial sector. So while the financial sector was doing very

well, it was not really in the interest of the politicians or the

Treasury at the time to rein it back. Economists and others who

work in financial institutions have bonuses related to their own profit

pools. So taking additional risk means that they benefit from that.

Howard, a lot of this comes down to where our economy can go in the

next few years. I mean, if all of these aspects of the environment

are now, would go -- working against growth and against the kind

of recovery that people are used to, have we got our heads round that?

What we're living through at the moment is an unpleasant hangover

period after this crisis. One of the most insightful books by

economists about the crisis has been a book called This Time is

Different, where they look at the different financial crises over the

last century or so and they tend to reach the conclusion that crises

which begin in the financial sector, with the kind of overleverage and

excessive debt that we had, take a lot longer to work off than crises

that begin in the real economy, when there's perhaps an excess of

enthusiasm and optimism and there's a business cycle. This time we have

the mother and father of all hangovers with a huge amount of

debt. That debt has migrated to some extent in that governments

responded to the crisis mark one,, if you like, by doing the rational

think by allowing their fiscal position to deteriorate, to offset

the private sector recession. Now all that's meant is that the debt

has sort of bounced from the private sector into the public

sector. The governments have now got an excess of debt.

Unfortunately that has got to be worked off in some way. Now we can

all argue and perhaps we'll come onto, about precisely the balance

of policies that you need in this environment, but I honestly think

that anyone who thinks that you can get out of this without more pain

and grief is telling fairy stories. The question is just, how do you

balance the monetary and fiscal policies to minimise the pain of

this adjustment process? Some would say mention of fairy stories brings

us neatly to the euro crisis. I want to think about the failures

involved there and politicians and economists have been a role in that

crisis. George? Let's take something very simple, credit.

What's wrong with credit? There is something actually wrong with

credit, because you lend against collateral. Right? You give people

loans an they want security. Now, you assume that the security is

actually safe, that it's always -- it always has the same value, but

it doesn't, because the value, let's say of a house, depends on

the willingness of the banks to lend. If you have easy monetary

conditions, and you can get a loan easily, then the value of the

houses goes up. Then you can borrow against that more, right, because

and in fact, you, in America, you developed all these fancy

instruments where you could take a profit from the improvement in the

value of the houses and it was that seeming profit that fuelled the

boom. So when you have credit involved, you have the makings of a

self-reinforcing process, where the value of the collateral goes up

with your willingness to lend, which then increases the amount of

credit and it feeds on itself until it becomes unsustainable. Then, you

eventually have a process going the other way. What's interesting about

the last few years, is that was a private sector problem initially.

It was home owners in the US who had that problem. Then in a sense,

the solution to that part of the crisis was for all the debt to go

onto the government balance sheets. Now in the eurozone, you see the

same process playing out with questions about whether the

Italians are good for the money that's been lent to them. I mean,

this has been a real problem for the Europeans to deal with because

of the nature of the structure of the eurozone. Do economists bear

some responsibility for not talking louder when the eurozone began and

saying, look, this is not going to work? With hindsight I suspect a

lot of these problems were certainly discussed at that time.

The view was, well, let's get on with it. Let's create the single

currency. Let's have the growth and Stability Pact. Let's put

constraints on the members' fiscal deficits, as they did. 3% deficit

was supposed to be the limit. They did put in place certain targets or

constraints, but when you're dealing with sovereign countries,

you can't actually do much minister than that. Indeed in the early

years, most the countries did behave pretty well. Perhaps because

the external conditions were more favourable then. It was only when

countries began to take advantage of that situation or to be more

charitable to fail to take the step that's they needed to to keep their

competitiveness up now they were in a single currency, that things

began to get out of hand. Then hit with the global financial crisis,

things got rapidly very much out of hand. I think it was a, it was

circumstances as much as flaws in It is tough to blame economists for

the eurozone. I think actually the centre of gravity of economic

thinking about the eurozone when it was constructed was this was not an

optimal currency union. But also, that a currency union of this kind

needed some kind of fiscal backing. The European Commission's

economists proposed in the early days a central budget of 2-3% of

European GDP which could be used when one country faced particular

difficult economic circumstances so I think economists mainly pointed

to the flaws in this design... were too powerful in the face of

the financial crisis and not powerful enough in... They were

overridden by the political imperative and the access was --

axis was powerful at the time. There was then a degree of

overoptimism about the countries you could admit. It was quite clear

that some countries and Italy was one, and Greece was another, were

admitted when they did not fulfil the letter of the conditions, and

that is now come back to haant them. I want to get on to learning the

lessons of financial crisis, and the crisis in the eurozone, and I

guess I don't just mean do they have a five point plan or a seven

point plan for fixing it, but are the habits of mind, is the mind set

that led to this, any sign that is changing? The problem with

economics is the lack of recognition of imperfect

understanding and the rule of miscop ception, misunderstandings,

and the same applies, to politics. -- misconceptions. It is only only

in economics that people work with imperfect understanding, the same

is true in politics. So the euro was actually misconceived. It was

based on the false understanding of how currencies work. You think it

was a mistake? No, it was flawed but there is nothing special about

the euro, because all our concepts are flawed. You see, so it just, it

happened to be more flawed than most of the others, because it was

built on the, on the idea that imbalances only occur in the public

sector. So if you have too much, too big deficit in budgets, or that

is where things can go wrong. only the Government that can get

into trouble, it is like our previous discussion. And the

trouble in the eurozone came also from the private sector, and there

were no provision within the whole construct for that possibility, so

by introducing a common currency the central bank accepted a

Government bond of all the member states, and the same terms and

conditions, and it was willing to lend against it. Against credit,

the problem, the trouble with the, the collateral, and the credit, so

you used all the Government bonds as collateral equally, and because

of that, the interest rates in the various countries, began to

coalesce, and the differentials went down from several percentage

points to, to a few basis points, so let's say French and, and German

banks would load up on Spanish bonds, or Italian bonds, because

they yielded ten basis points more than the others. So they bought the

actually, the... They were being treated be the same by the market

bus they weren't the same. And that then created real estate booms in

Spain and Ireland and so on, and now we have discovered that in fact

they are not the same, and now the interest rate differential, the

risk premiums have widened and there again now 3 or 4%. That is

what is causing the crisis. So it is really the constructive --

construction of the whole thing and the behaviour of the central bank

that caused a lot of the problem, except I would say for Greece,

which is a special case, because they took advantage of the

structural funds, and there was, there were abuses there, but not in

Spain. They handled things very responsibly, and yet they are now

in a terrible crisis. Howard Davis, do you agree with that, and do you

think they are getting closer to a solution to the problem f I mean,

as George has described it you wouldn't start from here, but given

we are here, do you think they have their heads round what needs to

happen. The December cipsoufpb what went wrong, and it was assumed

somehow that they were all the same credit risk, it was assumed that

somehow the eurozone would come to the aid of individual countries

even though there was nothing written down say they would, and

now we are discovering the problem of that. It is a very tricky thing

to get out of however, because ultimately, the big question is

whether the central economies and roughly we meaner Germany plus are

prepared to stand behind the credit of the southern European periphery,

and the clearly in Germany, this debate is still going on, and the

Germans are not keen to do so, because they point to morale hazard.

They say what is to stop them going crazy again? So it is a very

complicated solution. Do you think they, do you think that is likely,

do you think you will get that kind of commitment to what we are might

say is a fiscal union? I don't really agree a is by far the

central problem. I think there are two other issues that are

complicating the discussions and the fundment lals in Europe. One is

that the European Central Bank is not willing to act as a lender of

last resort. I understand why it is not willing, because that is a

risky thing do and its credibility is not that well established yet,

but I think until and unless it accepted that responsibility, to

provide unlimited support to those solvent countries in Europe,

through the secondary bond market and I am talking about Italy

predominantly, Spain also, I don't think this crisis will be solved.

The second issue and closely interrelated is one of the reasons

the ECB is not willing to play that role and part of the German

difficulty is that there is not a confidence that the countries that

need to undertake structural reforms can actually do it.

Politically speaking. Basically you have a situation where you have got

one central bank, because you have one currency and you have different

Governments, and effectively, the Governments o borrowing not in

their own currency, but in a foreign currency, the euro, because

they don't control the euro. As a result, actually Government bonds

of the European countries carry more risk than, let's say the

Government bonds of Britain. The economic conditions of Britain

actually are much worse than the economic conditions of Spain, but

the risk premium on Spanish bonds is higher, because Spain can't

print its own money. Britain can print its own money. So, Britain

has a central bank, and that is a big, big difference, and that is a

flaw that needs to be somehow now repaired, so Europe faces a big,

big change, it either the eurozone, it either moves closer to a common

fiscal policy, or it will fall apart. If it falls apart, the

consequences will be devastating, not only for the eurozone, but for