GEORGE SOROS: There is now a widespread belief that the crisis is over. I think, on the contrary, that the effect on the real economy is yet to be felt. The measures taken by the authorities will not bring recovery. There are four reasons for this. First, the fall in house prices in the US is only halfway over and in Britain it has hardly begun. Second, consumers have been slow to adjust their spending habits, but this is about to happen. Third, the financial system is severely wounded, and even though banks have been remarkably successful at raising more equity, they will cut back on lending and this will feed through to capital spending and business activity. Finally, and most important, there is a threat of inflation at the same time as a slowdown. The rise in energy and food prices will turn the slowdown into a recession.
MARTIN WOLF: The whole risk adjustment process has still not worked its way through. Credit spreads in the inter-bank markets, commercial paper markets and so forth remain wide, and so banks remain reluctant to lend to one another. I am closer to George than I am to Anatole on the US housing market. And looking at the world as a whole, the US shock is combined with two others: inflation and energy prices, particularly for Europe and emerging Asia. It is hard to imagine that this won't have a significant negative effect. The appreciation of the euro is shifting the US current account deficit to Europe. That is creating large stresses within the eurozone in terms of divergences of competitiveness between Germany and southern Europe. Meanwhile, because of inflation fears, the European Central Bank (ECB) will do nothing to help Europe in a difficult world situation. That will lead to a bigger slowdown than we now expect. China and India are suffering from weaker US demand, and will not be able to respond easily because inflation has become a big problem there too. Energy prices also act as a big tax on these economies. If you add these things together, we are heading for a significant global slowdown--if not a global recession--which will last some time.
SOROS: We are coming closer to the crux. As I explain in my new book The New Paradigm for Financial Markets, the regulators and the market participants were acting on a false interpretation of how financial markets operate. They worked on the assumption that markets tend towards equilibrium and deviations are random. That false perception about financial markets led to the construction of the structured products, and it made this crisis much bigger than it would have been if it was merely a US housing bubble. Some people didn't understand this. Ben Bernanke [the Fed chairman], for instance, said that it was a specific problem of the sub-prime loans, which is wrong. Others, like Paul Volcker [a former Fed chairman], did understand it. Asset bubbles are endemic. There are self-reinforcing processes that operate where investors' initial misconceptions then reinforce a trend, and that leads to a bubble.
Regulators have to accept responsibility for preventing asset bubbles from getting out of hand. To do that, it isn't enough to regulate the money supply; you also have to regulate the availability of credit. Markets are given to extremes of euphoria and panic, and therefore you need to use margin requirements and minimal reserve requirements more actively and vary them according to market conditions. That is the main lesson.
SOROS: [the financial sector] should shrink. It has really got overblown. The size of the financial industry is out of proportion to the rest of the economy. It has been growing excessively over a long period, ending in this super-bubble of the last 25 years. I think this is the end of that era.
KALETSKY: (...) There is, though, still a possibility that the financial system will survive the test. If it does, the appropriate analogy would be not 1929 or even 1973 but what happened in the late 1990s with Long Term Capital Management, whose collapse was followed by an even bigger bubble. I think eventually there will be a bubble that totally blows up the financial system, but we may not be there yet. I don't see many hedge fund managers driving taxis. And George, you made a lot of money in 2007.
SOROS: Yes, I did. And if we do pass through this without a hitch you will find that the private equity funds will replace the investment banks as the dominant force in the economy, because they are the ones who are now buying the assets.
WOLF: We have really had only one big backlash against finance in the last 100 years, and that followed the great depression. Things have to become very serious before people connect it to finance. I hope there is enough of a backlash to impose more sensible regulation. Too little response will be a disaster, because then we may have to deal with Anatole's even bigger bubble--which could bring down the system.