George Soros: ‘A Period Of Wealth Destruction’

Billionaire financier and philanthropist George Soros has been claiming for decades that Adam Smith was wrong—markets aren't rational and self-regulating, but flawed, bubble-prone and in need of tweaking by the authorities. Now he believes he's been proved right. In his forthcoming book, "The New Paradigm for Financial Markets," Soros connects the financial crisis to his own "theory of reflexivity," which explains bubbles. Coming off a record year (by one estimate, $2.9 billion in 2007), he spoke to NEWSWEEK's Rana Foroohar. Excerpts:

FOROOHAR: You ' ve been saying for years that the laissez-faire Greenspan view of global markets was wrong. Do you feel vindicated?
SOROS: I've held a different view of markets for 20 years, and everything that's happened since has supported it. From the end of World War II until now, we've been in a kind of superbubble, marked by credit expansion based on the dollar as the international reserve currency. The current crisis marks the end of that era. The United States is facing both a recession and a flight from the dollar. The signs were very much visible to those who chose to see them. Unfortunately, many did not.

What were the characteristics of this bubble?
Every bubble has two components—a trend which prevails in reality, and then a misinterpretation of that trend. The two eventually intersect to create a bubble. The trend over the last few decades is that credit has been growing faster than GNP, in both the U.S. and the world. If you look at the two together, you can see a parabolic curve. The misconception that has fueled this trend is that markets can correct this sort of excess, which led to a cycle of deregulation and liberalization. Deregulation reinforced both the rise in credit and the belief that markets correct themselves. But in reality, we've had a huge number of financial crises in the last two decades, and each time, the authorities have had to step in to correct things.

So, how should capitalism evolve from here?
We have to recognize that markets are prone to excess. Authorities bail out the system, which creates a "moral hazard" problem—they need instead to prevent asset bubbles from occurring. In terms of regulation, for example, it's not enough to control the money supply; you must also control the amount of credit available.

So where did you make your money last year?
In emerging markets—I bet on China and India, and against the developed world. I stayed away from subprime—I'd been out of the market so long that I wasn't familiar with those vehicles.

How far along are we in the current crisis? Will there be much more pain?
The worst of the liquidity crisis has receded, but much of the fallout in the real economy has yet to be felt. I think there will still be a significant decline in U.S. housing prices. We probably aren't yet even half of the way down. Also, consumer spending in the U.S. is going to decline a lot more. Thirdly, there will be a constraint on credit for business activity. A U.S. recession is inevitable, and the idea that it will have worked its way out by the end of the year is inconceivable. It's impossible to make financial predictions, but I do expect a much more protracted recession.

To what extent could the emerging markets buffer against the global fallout from this, and also continue to pump liquidity into the system via sovereign wealth funds?
There is a commodities boom underway, and that's helping some emerging markets, though not all. This to some extent compensates, but emerging markets represent only 30 percent of the world economy; developed markets are 70 percent. So they can't fully compensate. And they create an additional problem, which is inflationary pressure, helping to raise food and fuel costs. That's one of the reasons that authorities around the world are going to find it hard to deal with the current crisis—you've got a slowdown combined with inflationary pressure. And you've got various authorities responding in different ways—the U.S. approach is different from the European approach and so on.

For someone who believes that it ' s impossible to predict markets, you ' ve done a pretty good job of it. What ' s your best advice to investors in the current market?
This is a time to be concerned with wealth preservation. We're in a period of great wealth destruction. So you need to be very conservative—or very nimble.