Open Society Reforming Global Capital
Open Society Reforming Global Capital
Open Society Reforming Global Capital
ALSO
BY G E O R G E
SOROS
GEORGE
SOROS
OPEN SOCIETY
Reforming
Global Capitalism
PublicAffairs
New York
Soros, George.
Open society: Reforming global capitalism / George Soros.
p. em.
Rev. ed. of: The crisis of global capitalism, 1998.
Includes index.
ISBN [-58648-019-7
1. Financial crises. 2. Financial crisesSocial aspects.
3. CapitalismSocial aspects. 4. International financeSocial aspects.
5. GlobalismSocial aspects. 6. Democracy. 7. Human rights.
8. Economic history1900- 9, World politics1980-I. Title.
HB3722.S67 2000
332'.042-dc2i
00-042542
FIRST EBITION
I
3 5 7 9
IO 8 6 4
Contents
Acknowledgments
Introduction
vii
ix
3
38
58
91
116
138
Conclusion
Index
167
208
235
265
301
330
360
361
Acknowledgments
This is the first time that the conceptual framework I started developing in my student days has received serious critical attention. It
has been a stimulating and in some ways liberating experience. I am
grateful to all those who took an interest in either the previous or
the current version of this book.
Anatole Kaletsky acted as the de facto editor of The Crisis of
Global Capitalism: Open Society Endangered, helping me to organize
the material and make it more accessible; Roman Frydman was particularly helpful on the conceptual framework; Leon Botstein raised
many interesting points and we had several animated discussions;
Anthony Giddens commented on more than one version of the
manuscript; William Newton-Smith put rne right on some philosophical points; and John Gray made me reread Karl Polanyi's
Great Transformation. Others who made helpful comments include
Robert Kuttner, John Simon, Jeffrey Friedman, Mark Malloch
Brown, Arminio Fraga, Tom Glaessner, Aryeh Neier, Daniel Kahneman, Byron Wien, and Richard Medley.
In preparing the current version, I had the valuable help of Adam
Posen at the Institute for International Economics, although he is
in no way responsible for my views. Yehuda Elkana organized a
study group at the Central European University in Budapest, and I
received written communications from Lorand Ambrus-Lakatos,
Fabrizio Coricelli, John Gray, Janos Kis, Maria Kovacs, Petr Lorn,
and Istvan Rev. Katie Jamieson summarized the proceedings in her
usual lucid style. Les Gelb organized a discussion at the Council on
vii
Acknowledgments
Foreign Relations in New York from which I learned a lot. It was
attended by Elizabeth Colagiuri, Morris Goldstein, Nancy Goodman, Roger Kubarych, Lawrence Korb, Michael Mandelbaum,
William Luers, Walter Mead, Peter Osnos, David Phillips, Adam
Posen, Gideon Rose, Geoff Shandler, Dimitri Simes, Benn Steil,
and Fareed Zakaria. Mort Abramowitz, Martti Ahtisaari, Anthony
Lester, Charles W. Maynes, Aryeh Neier, Stewart Paperin, Alex
Rondos, Comelio Sommaruga, and Joseph Stiglitz attended a
weekend discussion at my home. Lord Lester raised some important issues with regard to my definition of open society that I did
not resolve to his satisfaction. 1 wish to thank all those who took the
trouble to read the manuscript at various stages of its evolution.
They are too numerous to list, but I should like to acknowledge
Benjamin Barber, Leon Botstein, Bill Clapp, Jacques de Larosiere,
Jeffrey Friedman, Roman Frydman, Ekaterina Genieva, Anatole
Kaletsky, Alex Lupis, Aryeh Neier, Joseph Nye, Andrei Shleifer,
John Simon, and F. van Zyl Slabbert, who sent me written communications. Justin Leites made some valuable suggestions at the last
minute.
I have been very happy with Peter Osnos and his team at PublicAffairs and I am grateful to Kris Dahl for suggesting him.
Yvonne Sheer has retyped the manuscript innumerable times,
checked references, and acted as general manager of the project. I
could not have done without her.
mi
Introduction
This is a book of practical philosophy: It offers a conceptual framework that is meant to serve as a guide to action. I have been guided
by that framework in both my money-making and philanthropic
activities, and I believe that it can also apply to society7 at large: It
provides the guiding principles for a global open society. This is an
ambitious undertaking. In executing it, I shall have to cover a lot of
ground and move on several levels: philosophical and practical,
public and personal.
On the practical level, I have established a network of foundations devoted to fostering open societies. This network covers all
the countries of the former Soviet empire and it has branched out to
other parts of the world: South Africa, the ten countries of Southern Africa, the sixteen countries of Western Africa, Haiti, Guatemala, Burma, and more recently Indonesia. There is also an Open
Society Institute in the United States. Each national foundation has
its own board and staff who decide their own priorities and take
responsibility for die activities of the foundation within their own
countries. They support civil society; tiiey also try to work with the
central and local governments because a democratic and effective
government is an essential part of an open society, but often they
are at loggerheads with the government or some of its activities. In
some countries, notably in Slovakia and Croatia, the foundations
were successful in mobilizing civil society in opposition to repres-
ix
Introduction
sive regimes. In Belarus and Burma, the foundations are banned and
operate from the outside. In Serbia, it is functioning in precarious
circumstances. In addition, we have network programs in those
program areas where the network is most actively engaged: higher
education and general education; youth; the rule of law, the judiciary and law enforcement, including prisons; arts and cultural
institutions; libraries, publishing, and the Internet; the media; vulnerable populations such as the mentally disabled; minorities, with
special emphasis on Roma peoples (Gypsies); public health, alcohol
and drug abuse; and so on.
I enjoy widespread, indeed exaggerated, recognition as some
kind of financial guru, but my credentials for holding views on
political and security issues are less well recognized. In fact, I am
only one of many practitioners in finance; but I am almost unique in
practicing crisis prevention in a purposeful and organized way.
In this book I am advocating that the democracies of the world
ought to form an alliance with the dual purpose of, first, promoting
the development of open societies within individual countries and,
second, strengthening international law and the institutions needed
for a global open society.
We live in a global economy that is characterized by free trade in
goods and services and even more by the free movement of capital.
As a result, interest rates, exchange rates, and stock prices in various
countries are intimately interrelated, and global financial markets
exert tremendous influence on economic conditions everywhere.
Financial capital enjoys a privileged position. Capital is more
mobile than the otJher factors of production, and financial capital is
even more mobile than other forms of capital. The globalization of
financial markets has reduced the ability of individual states to tax
and regulate capital because it can move elsewhere. Given the decisive role that international financial capital plays in the fortunes of
individual countries, it is not inappropriate to speak of a global capitalist system.
Introduction
We can speak about the triumph of capitalism in the world, but
we cannot yet speak about the triumph of democracy. There is a
serious mismatch between the political and the economic conditions that prevail in the world today. We have a global economy, but
the political arrangements are still firmly grounded in the sovereignty of the state. Flow can the needs of a global society be reconciled with the sovereignty of states? That is the crucial problem
facing us today.
Capitalism and democracy do not necessarily go hand in hand.
There is some correlation: Rising standards of living and the formation of a middle class tend to generate pressure for freedom and
democracy; they also tend to support greater political stability. But
the connection is far from automatic. Repressive regimes do not
relax their grip on power willingly, and they are often aided and
abetted by business interests, both foreign and domestic. We can
see this in many countries, particularly where natural resources
such as oil or diamonds are at stake. Perhaps die greatest threat to
freedom and democracy in the world today comes from the formation of unholy alliances between government and business.
This is not a new phenomenon. It used to be called fascism, and
it characterized Mussolini's Italy and to various degrees Hitler's
Germany, Franco's Spain, and Salazar's Portugal. Today it takes
more diverse forms, but it can be detected in Fujimori's Peru,
Mugabe's Zimbabwe, the SPDC's Burma, and Mahathir's Malaysia,
to mention only a few cases. More disconcerting, the collapse of
communism has also led to an unholy alliance between big business
and government in many countries, including Russia. The outward
appearances of the democratic process are observed, but die powers
of the state are diverted to the benefit of private interests. The
democratic countries do not pay much heed to the internal political
conditions prevailing in other countries: Other priorities usually
take precedence. Yet the people living in repressive regimes need
outside assistance; often it is their only lifeline.
XI
Introduction
Capitalism is very successful in creating wealth, but we cannot
rely on it to assure freedom, democracy, and the rule of law. Business is motivated by profit; it is not designed to safeguard universal
principles. Most businesspeople are upright citizens; but that does
not change the fact that business is conducted for private gain and
not for the public benefit. The primary responsibility of management is to the owners of die business, not to some nebulous entity
called the public interestalthough enterprises often try, or at least
pretend, to be acting in a public-spirited way because that is good
for business. If we care about universal principles such as freedom,
democracy, and the rule of law, we cannot leave them to the care of
market forces; we must establish some other institutions to safeguard them.
All this is almost too obvious to be stated, yet it needs to be said
because there is a widely held creed that the markets will take care
of all our needs. It used to be called "laissez-faire" in the nineteenth
century, but I have found a better name for it: market fundamentalism. Market fundamentalists hold that the public interest is best
served when people are allowed to pursue their own interests. This
is an appealing idea, but it is only half true. Markets are eminently
suitable for the pursuit of private interests, but they are not
designed to take care of the common interest. The preservation of
the market mechanism itself is one such common interest. Market
participants compete not to preserve competition but to win; if they
could, they would eliminate competition.
The protection of the common interest used to be the task of the
nation-state. But the powers of the state have shrunk as global capital markets have expanded. When capital is free to move around, it
can be taxed and regulated only at the risk of driving it away. Since
capital is essential to the creation of wealth, governments must cater
to its demands, often to the detriment of other considerations.
Chasing away capital can do more harm than taxation and regulation could bring. This point was brought home recently by the
in
Introduction
spectacular failure of Oscar Lafontaine, the German finance minister, when he tried to increase the burden of taxation on business.
In some ways that is a welcome development. Private enterprise
is better at wealth creation than the state, and free competition on a
global scale has led to an acceleration in productivity. Moreover,
states often abuse their power; globalization offers a degree of individual freedom that no state could provide.
But there is a downside. The capacity of the state to perform the
functions that the citizens have come to expect of it has been
impaired. This would not be a cause for concern if free markets
could be counted on to take care of all needs, but that is manifestly
not the case. Some of our collective needs are almost too obvious to
need mentioning: peace and security, law and order, human rights,
protection of the environment, and some element of social justice.
Market values express only what one participant is willing to pay
another in free exchange and do not give expression to their common interests. As a result, social values can be served only by social
and political arrangements, even if they are less efficient than markets.
Even in the service of individual interests, the market mechanism
has certain limitations and imperfections that market fundamentalists ignore. For one thing, financial markets are inherently unstable.
The theory of perfect competition takes the supply and demand
curves as independently given. Where the twain meet, equilibrium
is to be found. But the assumptions upon which the concept of equilibrium is built are rarely met in the real world. In the financial
sphere they are unattainable. Financial markets seek to discount a
future that is contingent on how it is discounted at present. Given
the imperfect understanding of the participants, the outcome is
inherently indeterminate. Thus, contrary to the idea of a self-equilibrating mechanism, the stability of financial markets needs to be
safeguarded by public policy.
Unfortunately, public policy is also imperfect, and so the history
xiii
Introduction
of financial markets is punctuated by periodic crises. Nevertheless,
by a process of trial and error, the advanced industrial countries
have evolved central banks and elaborate regulatory frameworks
that have been remarkably successful in keeping instability within
tolerable bounds. The last major breakdown in the advanced industrial countries occurred in the 1930s. Countries at the periphery of
the global capitalist system are less well situated: The financial crisis
of 1997-1999 wrought as much havoc in some of die emerging
markets as the Great Depression of the 1930s in the United States.
The international financial system can no longer be regulated on
a national basis. A set of international institutions were established
at the end of World War IT at Bretton Woods in 1945, but they were
designed for a world without the free movement of capital. These
institutions have tried valiantly to adapt to changing circumstances,
yet they have been unable to keep pace with the recent rapid growth
of international financial markets. They failed to stem the contagion. in tire international financial crisis of 1997-1999. Fortunately,
the countries at the center of the global capitalist system remained
unaffected (indeed, diey even benefited from the distress at the
periphery), and the world economy has recovered sooner than
could have been expected at the height of the crisis. This remarkable resilience has reinforced the faith in the self-correcting capacity of financial markets, and instead of strengthening the
International Monetary Fund (IMF), its power and influence have
been allowed to decline. This will leave the world economy more
vulnerable in the next crisis, if and when it arises. To think that we
shall not have another crisis is to defy history.
The weaknesses in the international financial architecture are
exceeded by weaknesses in the international political architecture.
The tragedy of World War II led to the establishment of the United
Nations (UN), designed to preserve peace and security in the
world. Unfortunately, the design was not equal to the noble goal.
No sooner was the United Nations born than the world broke into
XIV
Introduction
two opposing camps, one led by the United States, the other by the
Soviet Union. The two sides were locked in mortal combat, both
military and ideological; yet each side realized that it had to respect
the vital interests of the other, since both possessed the ability to
destroy the other with nuclear weapons. This turned the Cold War
into an instrument of stability based on the grim yet powerful concept of mutual assured destruction (MAD).
The MAD balance between East and West came to an end with
the internal collapse of the Soviet empire. There was a historic
moment when the United Nations could have started to function as
it was originally designed, yet that opportunity was lost when the
Western democracies failed to agree among themselves on how to
tackle the Bosnia crisis. The system became unstable.
The experience of two world wars has shown that a system based
on the sovereignty of states does not assure peace and stability.
Since sovereign states often abuse their powers, a decline in those
powers ought to be a welcome development. Up to this point the
current promarket, antistate sentiment is fully justified. But the
weakening of the sovereign state ought to be matched by the
strengthening of international institutions. This is where market
fundamentalism, which is opposed to international authority just as
much as to state authority, stands in the way.
To be sure, market fundamentalism is not the only culprit; the
enduring belief in national sovereignty is another. The United
States is even more strongly wedded to its sovereignty than most
other states. As the sole remaining military superpower and the
strongest economic power, it is willing to enter into arrangements,
such as the World Trade Organization, that open markets while
providing some protection to vested interests, but it strenuously
resists any infringement of its own sovereignty in other spheres. It is
willing to interfere in the internal affairs of other countries but is
not prepared to submit to the rules it seeks to impose on others.
While the United States views itself as the upholder of lofty prin-
xv
Introduction
ciples, others merely see the arrogance of power. It may be shocking
to say, but I believe that the current unilateralist posture of the
United States constitutes a serious threat to the peace and prosperity of the world. Yet the United States could easily become a powerful force for the good, simply by shifting from a unilateral to a
multilateral approach. The world needs some rules and standards of
behavior. If the United States were prepared to abide by the rules, it
could take the lead in establishing them.
Unfortunately, the aversion of the United States to multilateralism is not without justification. Most international institutions
don't work well. That is because they are associations of states and,
as Cardinal Richelieu said, states have no principles, only interests.
This finds expression in their behavior within international organizations. Whatever the faults of a state bureaucracy, they are multiplied in an international bureaucracy. International institutions
such as the United Nations are ill suited to safeguard universal principles. This can be seen in the record of the U N in protecting
human rights.
I believe that international institutions can be made to work better only with the help of civil society. It may be true that states have
no principles, but democratic states are responsive to the wishes of
their citizens. If the citizens have principles, they can impose them
on their governments. That is why I advocate an alliance of democratic states: It would have the active engagement of civil society to
ensure that governments remained true to tJhe principles of the
alliance. That is where the greatest difficulty lies. As the recent
demonstrations in Seattle and Washington have shown, civil society
can be mobilized in opposition to international institutions; a way
must be found to mobilize it in their favor.
The alliance would have two objectives: first, to strengthen international law and international institutions; second, to strengthen
democracy within individual countries. The two goals are, of
course, connected: The promotion of democracy must be carried
.177
Introduction
out by international institutions. No single state can be entrusted
with the protection of universal principles. Whenever there is a
conflict between universal principles and self-interest, self-interest
is likely to prevail. This point was well understood by the Founding
Fathers when they devised the Constitution of the United States.
Yet it is in the interest of all democracies to foster the development of democracies throughout the world. In today's interdependent global society most conflicts occur not between states but
within states. Democracies cannot tolerate the large-scale violation
of human rights, and sooner or later they are liable to be drawn into
such conflicts, as occurred in Yugoslavia. Even if they refuse to be
drawn in, they have to face the influx of refugees and various other
adverse consequences.
There is something contradictory about imposing democracy
from the outside. The contradiction can be avoided only if the
intervention brings benefits and is therefore voluntarily accepted.
To the greatest possible extent, intervention ought to take the form
of incentives and constructive engagement.
Once a conflict has erupted, it is very difficult to deal with it. Crisis prevention cannot start early enough. But in the early stages it is
difficult to identify what will lead to a crisis. That is why the best
way to prevent crises is to foster the development of what I call
open societies. That is what my network of Open Society Foundations has sought to do. By creating open societies, the chances of
crises requiring outside intervention can be greatly reduced. And if
punitive intervention becomes unavoidable it is more easily justified
when it has been preceded by constructive engagement.
At present we rely far too heavily on punitive measures. The only
effective alliance of democratic states is a military alliancethe
North Atlantic Treaty Organization (NATO). We need to complement NATO with a political alliance. Since the development of
open society is closely associated with economic prosperity, the
alliance must aim at affirmative action.
xrn
Introduction
These thoughts are particularly relevant today, after the NATO
intervention in Kosovo. I believe the intervention was necessary,
but it must be justified by ensuring a better future for the region.
This can be achieved only if the European Union can bring the
countries of the region closer to one another by bringing them
closer to Europe. This idea is now widely accepted, and it is given
expression in the Stability Pact for Southeastern Europe. Making it
work must be a top priority for the European Union. It is certainly a
top priority for me.
Going from the particular to the general, I advocate a concerted
effort by the developed democracies to foster the development of
democracy in the less-advanced parts of the world. It would take the
form of technical assistance and economic incentives. Economics
and politics cannot be separated. Amartya Sen makes a convincing
case that development should be defined in terms of freedom, not in
terms of gross national product.*
The membership of the alliance would include the United States,
the European Union, and a critical mass of democratic countries
from the periphery of the capitalist systemotherwise the alliance
could turn into an instrument of domination and exploitation. The
most problematic member would be the United States, because at
present it is unwilling to abide by the rules it seeks to impose on
others. It has nothing to fear from the kind of alliance I have in
mind, because such an alliance could not function without U.S. participation; nevertheless, it would require a radical reorientation in
U.S. policy from unilateralism to multilateralism.
I realize that my proposal goes against the grain of market fundamentalism. Foreign aid has been a dismal failure in Africa and more
recently in the Soviet Union and its successor states, and it threatens to fail also with the Stability Pact. The fact that it doesn't work
does not mean that we should abandon the idea. Rather, we must
'Amartya Sen, Droelopment as Freedom (New York: Alfred A- Knopf, 1999).
xvm
Introduction
examine the reasons for our failure and devise better ways. Foreign
aid, as it is administered today, is all too often directed at satisfying
the needs of the donors, not the needs of the recipients. I can assert,
based on my own experiences in countries such as Russia, that outside assistance can be effective.
The global capitalist system has produced a very uneven playing
field. The gap between rich and poor is getting wider. This is dangerous, because a system that does not offer some hope and benefit
to the losers is liable to be disrupted by acts of desperation. By contrast, if we offer economic incentives to countries that are eager to
take advantage of them we create a powerful tool for crisis prevention. Incentives foster economic and political development; the fact
that they can be withdrawn provides leverage that can be used
against recalcitrant governments.
Unfortunately, the global financial architecture that prevails
today offers practically no support to those who are less fortunate.
Current trends go in the opposite direction. After the recent financial crisis, tire aim has been to impose greater market discipline. But
if markets are inherently unstable, imposing market discipline
means imposing instabilityand how much instability can societies
tolerate?
Now that we have global financial markets, we also need a global
central bank and some otiier international financial institutions
whose explicit mission is to keep financial markets on an even keel.
But any lender-of-last-resort activity engenders some moral hazard,
and the current battle cry of market fundamentalists is to eliminate
moral hazard. The result is the downsizing of the IMF. Undoubtedly, that will reduce the danger of excessive lending to emerging
markets, but in my opinion the next crisis is likely to come from the
opposite direction: from inadequate capital flows to less-developed
countries.
The Meltzer Commission established by the United States Congress recommends that die World Bank be converted from a lend-
xix
Introduction
ing agency to a grant-giving agency aimed at the poorest countries
of the world. That is a splendid idea, but the way that the Meltzer
Commission would go about it is by downsizing the World Bank
and returning the unused capital to the shareholders in a major
resource transfer from the poor to the rich. I believe that the
unused capital ought to be put to more productive use by increasing
the grant-giving and guarantee-giving activities of the Bank. But
that is not what the Meltzer Commission has in mind.
I would urge a similar argument with regard to the World Trade
Organization. There is a crying need for labor standards and the
protection of the environment. But poor countries can't afford
these. Instead of punitive measures, there ought to be incentives
that would enable poor countries to comply.
An alliance of democracies could take many different forms. It
could try to reform existing institutions such as the World Bank or
even the UN, or it could operate more informally and address specific problem areas or problem countries. It would have a better
chance of reforming the UN than any previous effort, exactly
because it could operate either within the U N or outside it if the
other member states refuse to go along. But the alliance could succeed only if its members could agree among themselves. And that
means establishing some ground rules for a global open society.
Introduction
standing. Ideologies that lay claim to the ultimate truth constitute a
threat to open society because their claim can be imposed only by
compulsion.
Bergson's formulation is useful in understanding ethnic conflicts
such as those in Yugoslavia; Popper's formulation is useful in elucidating the threats posed by totalitarian regimes, such as those in
Nazi Germany and the Soviet Union. During and after World War
II, the concept of open society could be most readily understood bycontrasting it with closed societies based on totalitarian ideologies
such as fascism and communism. This remained true right up to the
collapse of the Soviet empire in 1989.
Since then, the situation has changed. The collapse of communism did not automatically lead to the establishment of open society.
The simple dichotomy between open and closed society is no longer
applicable. Open society is threatened from an unexpected direction: the unbridled pursuit of self-interest. We have come to think of
authorityin the form of a repressive government or an ideology
that lays claim to the ultimate truth and seeks to impose itself by
repressive measuresas the main obstacle to an open society. The
ideology concerned can be either religious or secular in nature. Now
it turns out that the lack of authority and the lack of social cohesion
can be equally debilitating. The disintegration of the Soviet Union
has shown that a weak state can also be a threat to liberty.*
As a student after World War II, I adopted Popper's concept of
open society with alacrity. As a Hungarian Jew who first escaped
extermination by the Nazis by adopting a false identity and then
escaped communism by emigrating, I learned at an early age how
important it is what kind of social organization prevails. Popper's
dichotomy between open and closed societies seemed to me profoundly important. Not only did it illuminate die fundamental flaw
in totalitarian ideologies but it also threw light on some basic philo*Stephen Holmes, "What Russia Teaches Us Now; How Weak States Threaten Freedom,"
The American Prospect (July-August 1097): 30-39.
XXI
Introduction
sophical issues. It is his philosophy that guided me in establishing
my network of Open Society Foundations.
I was an active participant in the revolution that swept away the
Soviet system, and the experience forced me to undertake a thorough reconsideration of the concept of open society. That brings
me to the philosophical aspects of the book.
Introduction
of history. I interpret financial markets as a historical process and I
use them as a laboratory for testing my theory. My experiments do
not produce determinate results comparable to the equations that
define the equilibrium in economic theory. This makes my interpretation unacceptable to economists, but I contend that it is better
to accept that financial markets are inherently unpredictable than to
abide by a false theory.
I interpret history as a reflexive process in which the participants'
biased decisions interact with a reality that is beyond their comprehension. The interaction can be self-reinforcing or self-correcting.
A self-reinforcing process cannot go on forever without running
into limits set by reality, but it can go on long enough and far
enough to bring about substantial changes in the real world. If and
when it becomes unsustainable, it may then set into motion a selfreinforcing process going in the opposite direction. Such boombust sequences are clearly observable in financial markets, but their
extent, duration, and actual course remain uncertain.
When I try to apply the boom-bust model to history in general,
my interpretation becomes more idiosyncratic and forced. Nevertheless, it can be illuminating, provided it is not taken too seriously.
Unfortunately, I have not always followed my own advice, as the
reader will see. More seriously, I try to formulate some ideas on
how society ought to be organized. I develop the concept of open
society, an association of free individuals respecting one another's
rights within a framework of law.*
Market fundamentalism is not diametrically opposed to open
society the way totalitarian ideologies such as fascism and communism were; rather, it represents a distortion of the concept, an
undue exaggeration of one of its aspects. That does not make it any
less dangerous. Market fundamentalism endangers the open society
inadvertently by misinterpreting how markets work and giving
them an unduly dominant role.
'Bryan iVlagee, Confessions ofa Philosopher. A Personal Journey Through Western Philosophy from
Plato to Popper (New York: Random House, 1990), p. rig.
xxiii
Introduction
Market fundamentalists believe in individual freedom, which is a
cornerstone of open society, but they exaggerate the merits of the
market mechanism. They believe that efficient markets assure the
best allocation of resources and that any intervention, whether it
comes from the state or from international institutions, is detrimental. Since market fundamentalism has become so influential, it
today constitutes a greater threat to a global open society than communism or socialism, because those ideologies have been thoroughly discredited.
As an advocate of open society, I want to make it clear that I am
not opposed to capitalism per se. The concepts of open society and
market economy are closely linked, and global capitalism has
brought us close to a global open society. But markets are not perfect. They can only cater to individual needs; taking care of social
needs is beyond their scope. And even as the allocators of resources,
they are less than perfect: Financial markets are inherently unstable.
That does not mean we should abolish capitalism; rather, we should
endeavor to correct its shortcomings.
Communism sought to abolish the market mechanism and to
impose collective control over all economic activities. Market fundamentalism seeks to abolish collective decisionmaking and to
impose the supremacy of market values over all political and social
values. Both extremes are wrong. We need to recognize that all
human constructs are flawed. Perfection is beyond our reach. We
must content ourselves with the second-best: an imperfect society
that holds itself open to improvement. Global capitalism is badly in
need of improvement.
xxw
Introduction
might have been more effective to concentrate on fewer points, but
the conceptual framework does hang together and I found it difficult to make one point without the others. I regard this as a weakness in the construction of the book, because in the light of my
working hypothesis of radical fallibility, it is unlikely that all my
points are equally persuasive.
The weakness is not inherent in the argument, because the various points are not logically dependent on each other; rather, it is the
result of my personal predilection. On a personal level, this book is
my life's work. I started working on it as a student and I have still
not completed it. 1 am reluctant to let go of it. Many of the points I
am making here I have made before, but I still feel I could have
made them better.
I have an uncle by marriage, Tamas Losonczy, who has been an
abstract expressionist painter in Hungary all his life. Abstract
expressionism was not allowed in Hungary until quite recently. As a
result, he felt compelled to repeat his major themes in all his paintings. This made his paintings more cluttered and complex tfian
those of the abstract expressionist masters in the West. I feel about
philosophy the way he feels about painting, and I'm afraid I may
suffer from the same syndrome: I feel obliged to repeat the arguments I made in previous books, because I do not sense that I got
my points across. I may be wrong. My statement that reflexivity is
not recognized in economic theory may have been valid in 1987,
when I first published The Alchemy of Finance, but I have been criticized by some economists who claim it is no longer valid. Yet I can
see from their criticism that the main point of reflexivitynamely,
that financial markets are inherently unpredictableis still not generally accepted, since they blame me for not producing a theory that
is capable of making valid predictions.
The fact that I have crowded the main ideas of a lifetime into this
book does not make for easy reading. I hope, however, that it will be
worth the effort. On the level of public discourse, I believe I am
XXV
Introduction
making some worthwhile contributions. Apart from the concept of
open society and my proposal for an alliance of democracies, I
would single out:
the concept of refiexivity;
the working hypothesis of radical fallibility;
die assessment of the cleavage between natural and social sciences;
the critique of equilibrium theory in economics and the outlines of a new paradigm;
the discussion of the ways market values penetrate into areas
where they do not properly belong;
die critique of market fundamentalism;
the concept of far-from-equilibrium situations;
the concept of fertile fallacies;
the interpretation of financial markets as a historical process in
which outcomes diverge from expectations;
the distinction between rulemaking and playing by the rules
and the proposition that in political participation (as distinct
from market participation) we ought to be guided by our conception of die common interest even if others are not;
die exploration of the difference between center and periphery
in the global capitalist system;
the examination of the new global financial and political architecture.
The difficulties presented by this book are compounded by the
way it came to be written. It has its origin in an article I published in
xxvi
Introduction
the February 1997 issue oiThe Atlantic Monthly under the title "The
Capitalist Threat." The fact that a prototypical capitalist was critical of capitalism created considerable stir, and I decided to expand
the article into a book. As I was writing, a major international financial crisis of the kind I was warning against erupted in July 1997,
and 1 felt I had something urgent and important to say on the subject. When Russia defaulted on its internal debt in August 1998, I
thought the global financial system was about to come apart at the
seams, and so I decided to rush the book into print.
The book was published in November 1998 under the title The
Crisis of Global Capitalism: Open Society Endangered. When the time
came to prepare a paperback edition, I started revising it, and the
revision soon became so substantial that it qualified as a new book. I
make the point by publishing it under a new title.
In retrospect, I was wrong to predict disaster, and now I have
some egg on my face. Looking back from the perspective of 2000, it
appears that I made two major miscalculations. One was to underestimate the capacity of the financial authorities to prevent a disaster
when it threatened the center of the global capitalist system. After
all, I was emphasizing the disparity between center and periphery.
The fact that the Federal Reserve was successful in protecting the
U.S. economy while the International xMonetary Fund failed to protect the economies at the periphery was a demonstration of that disparity. I should have been able to anticipate it.
The second miscalculation was to ignore the impact of the technological revolution. Clearly, it was a major factor in enabling the
center to shake off the troubles at the periphery. There was an
Internet boom concurrent to the bust in emerging markets. How
could I ignore that? I was misled by the fact that similar technological advancesrailroads, electricity, telephonehad taken place in
the nineteenth century, which was itself a period of global capitalism. Yet technologies caused booms and busts in those days as well.
This was a major error in my analysis, one that I shall not be able to
xxvu
Introduction
erase without falsifying the historical record. I can, however,
acknowledge it.
In spite of these mistakes, I feel that there is enough validity in
my approach to justify revising the book. For the first time in my
life, my ideas received serious critical attention, and I have greatly
benefited from it. Since recognizing mistakes is at the heart of my
approach, I incorporated all of the criticisms that I considered valid.
I also shifted the emphasis from the financial to the political. The
Crisis of Global Capitalism attracted attention mainly for what I had
to say about the financial crisis. This is understandable in view of
the then-prevailing conditions and my notoriety as a financial speculator. My discussion of what I call the "nonmarket sector" elicited
much less response. As I was revising the book, I felt a great sense of
urgency to elaborate my ideas on the global political and security
architectures in much greater depth.
The revision posed a problem: If I revised my original analysis of
the crisis of 1997-[999, I would falsify the historical record.
Accordingly, in that part of the book which deals with the crisis of
1997-1999, I decided to leave the original text intact and indicate
where I had made revisions. This solution has made the structure of
the book more cumbersome.
To make up for this, I should like to provide a simplified road
map. In Chapter 1 I begin with reflexivity and fallibility. This leads
me to a discussion of scientific method in Chapter 2.
In Chapter 3 I test the validity? and relevance of reflexivity in the
laboratory of the financial markets, relying largely on material
drawn from my previous book, The Alchemy ofFinance.
In Chapter 4 I try to develop a theory of history based on the
reflexive relationship between participants' thinking and the events
in which they participate. Fallibility renders equilibrium impossible, leaving three possibilities: the near-equilibrium of open society;
the static disequilibrium of closed society, and the dynamic disequilibrium of revolutionary regime change. This leads to a discussion
XXVIU
Introduction
of open society as an ideal in Chapter 5. In Chapter 6 I tackle the
problem of social values and introduce the distinction between rulemaking and playing by the rules. This completes the theoretical
framework.
Part II applies the theoretical framework to the present moment
in history. But time does not stand still. As I mentioned earlier, I had
started writing The Crisis of Global Capitalism before the financial
crisis of 1997-1999 erupted; I rushed the book into print just as the
crisis climaxed and have thoroughly rethought and revised it since
then: All this is reflected in the text. Chapter 7 provides an analytical overview of the global capitalist system. Chapter 8 addresses the
financial crisis of 1997-1999. Chapter 9 reviews the failure of Russia to make the transition from closed to open society. Chapter 10
examines the global financial architecture and makes some suggestions regarding possible improvements. Chapter 11 addresses the
global political architecture in the context of a test case: the disintegration of Yugoslavia. And Chapter 12 examines the prospects for a
global open society.
For the sake of historical accuracy, I kept the text of Chapters 7
and 8 largely unchanged, pointing out where my views have
changed. The remaining chapters express my current views.
Where the text has remained the same, it is because I could not
improve on it. I remain open to criticism, however, and am ready to
make further revisions. 1 should have liked to continue working on
the book, but in the end another deadline loomed and I have had to
rush it into print once again. As I said before, I consider this book
my life's work and I shall continue working on it as long as I am
alive.
it-ii'dt
P V 11 T
Conceptual Framework
C HA PT E R
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x u = 6[fx t I ].
As long as the two functions have a value other than i and both
functions are operating, neither the participants' views nor the
actual state of affairs remains the same with the passage of time and
neither is determined by what preceded it. Both functions yield
indeterminate results, and the element of indeterminacy in one
function can be attributed to its dependence on the other.
This is, of course, a simplified presentation. Most situations have
more than one participant, so that instead of simply x we ought to
list i - j
" And the situation itself contains many variables
besides simply the participants' actions, so that the formula ought
to read
y = a,b,c... o(xlzh
/).
But that does not change the basic argument: When the two
functions connect die same variables at die same time, their interaction introduces an element of uncertainty into both. The participants' views cannot be determined by the situation because the
situation is contingent on the participants' views, and the situation
cannot be determined by the participants' decisions because the
participants act on the basis of inadequate knowledge. There is a
GEORGE
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need not correspond to the facts of the situation; indeed, they cannot do so because of the lack of correspondence that characterizes
the participants' thinking. Nevertheless, they will make an impact
on the situationalthough, on account of their imperfect understanding, the outcome is liable to diverge from expectations. There
is a two-way feedback mechanism at work that leaves neither the
participants' views nor the actual course of events unaffected. A
process that changes both thinking and reality qualifies as historical.
A Historical Process
The two-way feedback mechanism does not necessarily give rise
to a historical process. It merely has the potential to do so. There
are many cases in which the outcome does not diverge from expectations or the divergence does not trigger a change in the participants' expectations. But obviously those cases that set in motion a
dynamic process are more interesting.
The key to understanding such dynamics is to be found in the
element of judgment or bias that the participants must bring to bear
on their decisions. We have seen that they cannot do without introducing such a bias. In turn, the divergence between outcomes and
expectations is liable to affect the bias. The feedback can then be
positive or negative. A positive feedback would reinforce the initial
bias, which may in turn produce further positive feedback, but the
process cannot continue indefinitely because eventually the bias is
bound to become so pronounced that reality cannot possibly live up
to expectations.
Different participants have different biases, but in many situationsparticularly in financial marketsit is possible to speak of a
"prevailing" bias. Initially, the outcome may validate the prevailing
bias, but as tlie bias becomes more exaggerated its ability to influence the course of events may no longer be sufficient to ensure diat
10
11
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Indeterminacy
Although it is perhaps an obvious point, it needs to be emphasized that the element of uncertainty I speak about is not produced
by reflexivity on its own; reflexivity must be accompanied by imperfect
understanding. If by some fluke people were endowed with perfect
knowledge, the interaction between their thoughts and the outside
world could be ignored. The outcome of their actions would perfectly correspond to dieir expectations because the true state of the
world would be perfectly reflected in their views. Similarly, if the
participants' thinking were fully determined by external circumstances or internal impulses, the element of uncertainty would be
eliminated. This state of affairs is unrealistic, yet it has been seriously proposed. Karl Marx claimed that the material conditions of
production determined the ideological superstructure; Sigmund
Freud claimed that human behavior was dictated by the unconscious; and classical economic theory was based on the assumption
of perfect knowledge. In each case, the impulse was the same: to
provide a scientific explanation of human behavior. In accordance
with the standards prevailing in the nineteenth century, the explanation had to be deterministic in order to qualify as scientific.
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Reflexivity in Context
The concept of reflexivity is so fundamental that it would be hard
to believe that I am the first to discover it. Indeed, I am not. Reflexivity is merely a new label for the two-way interaction between
thinking and reality that is deeply ingrained in our common sense.
If we look outside the realm of social science, we find a widespread
awareness of reflexivity. The utterances of the Delphic oracle were
reflexive, and so were Greek dramas, in the sense that prophecies
were validated by the impact they made.
Even in social science, there were occasional acknowledgments:
Machiavelli introduced an element of indeterminacy into his analysis and called it fate; Robert Merton drew attention to self-fulfilling
prophecies and the bandwagon effect; and a concept akin to reflexivity was introduced into sociology by Alfred Schutz under the name
"intersubjectivity." Sociologists such as Anthony Giddens have been
using the term reflexivity in very much the same sense as I do.
More recently, a whole new science, evolutionary systems theory,
has grown up to study the two-way interaction between predator
and prey, or more generally between participant and environment.
The participant is not necessarily human and its behavior is not
necessarily guided by imperfect understanding, but the relationship
is similar insofar as it involves a two-way interaction. Evolutionary
systems theory has developed algorithms for studying the relationship. Game theory has also become evolutionary. It started out with
the assumption of rationality, but the assumption was gradually
abandoned and the study of rational behavior was replaced by that
of "adaptive behavior." Reflexivity is no longer a stranger even to
economic theory.
These are relatively recent developments. It is easy to forget that
until recently social scientists, particularly economists, have gone
out of their way to banish reflexivity from their subject matter. Why
that should be so will be discussed in Chapter 3.
4
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Logical positivists carried Bertrand Russell's argument to its logical conclusion and declared that statements whose truth value cannot be determined either by empirical facts or by their logical form
are meaningless. Remember, that was a time when science was providing deterministic explanations for an ever-expanding range of
phenomena while philosophy had become ever more removed from
reality. Logical positivism was a dogma that outlawed metaphysics
and exalted scientific knowledge as the sole form of understanding
worthy of tiie name. "Those who have understood my argument,"
said Ludwig Wittgenstein in the conclusion of his Tractates LogicoPhilosophicus, "must realize that everything I have said in the book is
meaningless." It seemed to be the end of the road for metaphysical
speculations and die total victory of the fact-based, deterministic
knowledge that characterized science.
Soon thereafter, however, the tide turned. Wittgenstein realized
that his judgment had been too severe, and he embarked on the
analysis of everyday language. Meanwhile, even natural science was
becoming less deterministic. It encountered boundaries beyond
which observations could not be kept apart from their subject matter. Scientists managed to penetrate the barrier, first with Einstein's
theory of relativity, then withi Heisenberg's uncertainty principle.
More recently, investigators using evolutionary systems theory
started exploring complex physical phenomena whose course cannot be determined by timelessly valid laws. Events follow an irreversible path in which even slight disturbances become magnified
with the passage of time. Chaos theory was built on this recognition
and was able to shed light on many complex phenomena, such as
the weather, that had previously proved impervious to scientific
treatment. These advances have made the idea of a path-dependent
rather than deterministic universe, where events follow a unique,
irreversible course, more acceptable. Gradually the idea has made
its way into the social sciences, where it really belongs because it
characterizes the path that reflexive phenomena follow.
16
'7
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t8
19
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we are part of that reality: That is why our understanding is inherently imperfect. Reality is unique and uniquely important. It cannot
be reduced or broken down into die views and beliefs of the participants, exactly because there is a lack of correspondence between what
people think and what actually happens. In other words, diere is
more to reality tiian the participants' views.
The lack of correspondence also thwarts the prediction of events
on the basis of universally valid generalizations. There is a reality,
even if it is unpredictable. This may be difficult to accept, but it is
futile, even downright dangerous, to deny itas any participant in
the financial markets who has lost money can testify. Markets rarely
gratify one's expectations, yet their verdict is real enough to cause
anguish and lossand there is no appeal.
It may strike readers as strange that I should present financial
markets as an example of reality; to most people they seem unreal.
But that only goes to show that our understanding of reality is
somehow warped. We think of reality as something independent of
human foibles, whereas our imperfect understanding is very much
part of reality. Financial markets reflect the biased views of the participants; they also play an important role in shaping die course of
events. The course of events cannot be understood simply by studying the participants' views; we must also study how the actual course
of events differs from those views. Otherwise we would leave out of
account the divergence between expectations and outcomesand
that would be a significant distortion of reality.
I seek to reconcile the contradictions inherent in being participant and observer at the same time by taking our fallibility as my
starting point. To rephrase Descartes, / am part of the world I seek to
understand, therefore my understanding is inherently imperfect. This
applies with particular force to those aspects of reality that have
thinking participants. It renders botii our understanding and the
course of events uncertain. Since the uncertainty cannot be
removed, we had better take it as our starting point. Doing so does
20
21
GEORGE
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the subject matter to which they refer. To ignore our use of reflexive
statements when we all do use them, or to force them into the categories of "true" and "false," misinterprets the role of thinking in
human affairs. Instead of categorizing statements solely as true or
false, it may be useful to introduce a third category: reflexive statements whose truth value is contingent on their impact.
All value statements are reflexive in character: "Blessed are the
poor, for theirs is the kingdom of heaven." If this statement is
believed, then the poor may indeed be blessed with the ability to
ignore their travails in this world but they will be less motivated to
get themselves out of their misery. By the same token, if the poor
are held to be guilty of their own misery, then they are less likely to
receive any relief and will have less reason to consider themselves
blessed. Most generalizations about history and society are similarly
reflexive in character: "The proletarians of the world have nothing
to lose but their chains" or "The common interest is best served by
allowing people to pursue their own interests." It may be appropriate to assert that such statements have no determinate truth value,
but it would be misleading (and historically it has been very dangerous) to treat them as meaningless. To the extent they are believed,
they affect the situation to which they refer.
I am not claiming that a third category of truth is indispensable
for dealing with reflexive phenomena. The time-hallowed distinction between true and false may suffice, provided we recognize that
statements need not be true or false in order to be meaningful. Predictions relating to singular events are true or false depending on
whether or not they come to pass. It is only when it comes to predictive theories that the uncertainty connected with reflexivity comes
into play. Perhaps it is best dealt with at the level of theories rather
than at the level of statements. The crucial point is that in reflexive
situations the facts do not necessarily provide an independent criterion by which the truth or validity of our theories can be judged.
We have come to treat correspondence as the hallmark of truth. But
22
2*
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24
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Radical Fallibility
At this point, I shall change my tack. Instead of discussing fallibility in general terms, I shall try to explain what it means to me
personally. It is the cornerstone not only of my view of the world
but also of my personal identity, and as such it is reflected in my
behavior. It has guided my actions both as a participant in financial
markets and as a philanthropist, and it is the foundation of my theory of history. If there is anything original in my thinking, it is this
"radical" version of fallibility.
I take a more stringent view of fallibility than my previous theoretical arguments would justify. I contend that all the constructs of
the human mindwhether confined to the inner recesses of our
thinking or expressed in die outside world in the form of disciplines, ideologies, and institutionsare deficient in one way or
another. The flaws may manifest themselves in the form of internal
inconsistencies or inconsistencies with the external world or inconsistencies with the purpose for which they were designed.
This proposition is, of course, much stronger than the recognition that all our constructs may be wrong. l a m not speaking of a
mere lack of correspondence but of an actual defect in our thinking
or an actual divergence between intentions and outcomes. As I
explained earlier, this proposition applies only to historic events
where the divergence sets in motion an initially self-reinforcing but
27
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30
3>
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A Personal Postscript
Radical fallibility is for me not only an abstract theory but also a
matter of deep personal conviction. As a fund manager, I depended
a great deal on my feelings, because I was aware of the inadequacies
of my knowledge. The predominant feelings I operated with were
uncertainty and fear. I had moments of hope, even euphoria, but
those emotions made me insecure; worrying made me feel safer. So
the only genuine joy I experienced was when I discovered what it
was that I had to worry about. By and large, I found managing a
hedge fund1 extremely painful. I could never acknowledge my successit might stop me from worryingbut I had no trouble
acknowledging my mistakes.
3*
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34
?5
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36
31
CHAPTER
A Critique of Economics
A Critique of Economics
ory of scientific method. Popper's simple and elegant model shows
how specific phenomena can be made to yield universally valid generalizations that in turn can be used to explain and predict specific
phenomena. The model contains three components and three
operations. The three components are specific initial conditions,
specific final conditions, and generalizations of a hypothetical character. The initial and final conditions can be verified by direct
observation; the hypotheses cannot be verified, only falsified. The
three basic scientific operations are prediction, explanation, and
testing. A hypothetical generalization can be combined with known
initial conditions to provide a specific prediction. It can be combined with specific final conditions to provide an explanation. Since
the hypothesis is timelessly valid, the two operationsprediction
and explanationare reversible. This allows testing, which involves
comparing any number of specific initial and final conditions to
establish whether they conform to the hypothesis. N o amount of
testing will verify a hypothesis, but as long as a hypothesis has not
been falsified it can be accepted as provisionally valid.
The model does not claim to describe how scientists work in
practice; it shows how, in theory, generalizations capable of predicting and explaining singular facts can be established. A generalization cannot be verified; it is enough if it has not been falsified,
provided that it can be falsified by testing. The main merit of this
construction is that it avoids the pitfalls of inductive reasoning. We
do not need to insist that the sun will always rise in the east just
because it has done so every day; it is enough if we accept the
hypothesis provisionallythat is, until it is falsified. This is an elegant solution to what would be an otherwise insuperable logical
problem. The trick is to distinguish between verification and falsification. It allows hypotheses to provide predictions and explanations
without insisting on verification. The predictions and explanations
themselves can be either deterministic or probabilistic, depending
on the nature of the hypothesis.
Recognizing the asymmetry between verification and falsificat9
GEORGE
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A Critique of Economics
both the natural and social sciences. This doctrine allowed him to
demonstrate that theories such as Marxism do not qualify as scientific because they cannot be falsified. I take a somewhat different
view. I contend that reflexive phenomena in general do not fit into
Popper's model of scientific methodand that it is not only Marxism that is unscientific. Market fundamentalism, which derives its
scientific justification from mainstream economics, is just as spurious an ideology as Marxism.
There is a fundamental difference between the natural and the
social sciences that has yet to be properly recognized. To understand it better, we must consider the second problem: the scientificobservers' relation to their subject matter.
4.1
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4-
A Critique of Economics
because experiments must be capable of being replicated by others.
Therefore it does not make sense to cheat. It is possible to select the
facts that are subjected to scientific examination, but even in this
regard it pays to get as close to reality as possible, because we can
benefit from our understanding much better if it relates to reality
rather than to some artificial universe.
Not so in the social sciences. When the universe of facts also
contains statements, statements and facts may interact reflexively,
which means that statements may alter the facts via the participants'
decisions. This holds true for social scientists as well as for the
people whom they study, because there is no built-in separation
between statements and facts, as in the case of natural science. Scientists must make a special effort to keep their statements from
affecting the subject matter to which they refer. That is where the
question about the purpose of science comes into play.
As long as the separation between statements and facts remains
watertight, there can be no doubt about the purpose of science: It is
to acquire knowledge. The goals of individual participants may differ. Some may pursue knowledge for its own sake, others for the
benefits it may bring to humanity, yet others for personal advancement. Whatever the motivation, however, the yardstick of success is
knowledge, and it is an objective criterion. Those who are seeking
personal advancement can do so only by making true statements; if
they falsify experiments, they are liable to be found out. Those who
are trying to bend nature to their will can do so only by acquiring
knowledge first. Nature follows its course irrespective of any theory
that relates to it; therefore we can make nature serve our needs only
by understanding the laws that govern its behavior. There are no
shortcuts.
Recognition of this fundamental principle was a long time in
coming. For thousands of years, people have tried every form of
magic, ritual, and wishful thinking to influence nature more
directly; they were reluctant to accept the harsh discipline that sci-
43
GEORGE
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44
A Critique of Economics
change the phenomena to which they relate; in social science, they
can. This gives rise to an additional element of uncertainty, which is
absent from the Heisenberg principle. This additional element of
uncertainty concerns the role of the scientific observer and the
impact of scientific theories.
Admittedly, scientists could take special precautions to insulate
their statements from their subject matter-for instance, by keeping their predictions secret. But why should they? Is the purpose of
science to acquire knowledge for its own sake or for some other
benefits? In natural science, the question does not arise because the
benefits can be realized only by first attaining knowledge. Not so in
social science: Reflexivity offers a shortcut. A theory does not need
to be true to affect human behavior. At the same time, the reliability
of the facts as an independent criterion is compromised. In this way,
it is possible to propound self-fulfilling prophecies.
Given the respect science commands, propounding a theory that
claims to be scientific can be an effective way to influence reality;
the more it affects die subject matter to which it refers, the better.
Karl Marx did that consciously, and his interpretation of history was
difficult to disprove. Indeed, Karl Popper had to develop an elaborate argument to discredit Marxist theory by showing that it is not
scientific. I subscribe to Popper's argument, but I want to carry it
one step further: I contend that the misuse of scientific theories for
political purposes is not confined to totalitarian ideologies; it
applies to market fundamentalism with equal force. Classical economic theory is as easily misused for political purposes as is (or was)
Marxist theory.
I am particularly suspicious of the concept of equilibrium. It
implies a desirable state of affairs, a resting point that cannot be
improved. Market fundamentalists claim that markets tend toward
equilibrium and that any political interference is harmful. It has
been shown that in many cases there is no uniquely determined
equilibrium point. John Maynard Keynes demonstrated that the
#5
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economy may reach equilibrium short of full employment. In modern economic theory, the possibility of multiple equilibria is widely
recognized. Still, the idea tiiat markets tend toward equilibrium
persists and serves as a purportedly scientific basis for market fundamentalism.*
The classic example of pseudoscientists trying to impose their
will upon their subject matter was the attempt to convert base metal
into gold. Alchemists toiled at the alembic until finally persuaded to
abandon die enterprise by their lack of success. Their failure was
inevitable because the behavior of base metals is governed by laws
of universal validity that cannot be modified by any statements,
incantations, or rituals. Medieval alchemists were barking up the
wrong tree. Base metals cannot be turned into gold by incantation,
but people can become wealthy in financial markets and powerful in
politics by propounding false theories and self-fulfilling prophecies.
Moreover, their chances of success are increased if they can cloak
themselves in scientific guise. It is noteworthy that both Marx and
Sigmund Freud were vocal in claiming scientific status for their theories and based many of their conclusions on the authority they
derived from being "scientific." Once this point sinks in, the very
expression "social science" becomes suspect; it becomes a magic
phrase employed by social alchemists to impose their will upon
dieir subject matter through learned incantations.
Social scientists have tried very hard to imitate the natural sciences but with remarkably little success. Their endeavors often
yielded little more than a parody of natural science. Only when they
abandoned the false analogy and pursued their subject matter wherever it would lead did they produce worthwhile results. Some of the
best work is set in a historical context instead of aiming at universal
*I should point out, however, that even though most economists espouse the concept of equilibrium, they are not necessarily market fundamentalists. Moreover, the concept of reflexivity is increasingly recognized in contemporary economic theory. See, for example, Maurice
Obstfeld, "Models of Currency Crises with Self-Fulfilling Features," European Economic
Review (April 1996).
46
A Critique of Econo?nics
validity, but it still does not meet the requirements of Popper's
model. Valid theories that fit that mold are few and far between.
The slavish imitation of natural science fits in well with my concept of radical fallibility. Radical fallibility rests on the admittedly
exaggerated claim that all human constructs are flawed. Scientific
method undermines that claim by producing generalizations that
predict and explain the markings of nature. Yet, exactly because natural science has been so amazingly successful, social science is
expected to be able to do the same for society. A method that works
in one area is extended to another where it is less appropriate.
There is a parallel here with the exaggerated claims made for the
market mechanism. Just because markets have been so useful in
organizing economic activity, they are now expected to provide the
answer to all the problems of social organization.
There is a crucial difference between the failures of social scientists and the failures of alchemists. Although the failure of the
alchemists was well-nigh total, social scientists usurping the authority of natural science have managed to make their mark on society.
The behavior of peopleexactly because it is not governed by realityis easily influenced by theories. In the field of natural phenomena, scientific method is effective only when theories are valid; but
in social, political, and economic matters, theories can be effective
without being valid. Although alchemy failed as science, social science can succeed as alchemy.
41
GEORGE
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pattern that does not lend itself to replication and testing. Economic theory has gone to great lengths to avoid reflexivity in order
to qualify as scientific, and it became rather far removed from reality in the process; even so, it could not avoid being exploited for
political purposes. For instance, economists have gone out of their
way to avoid introducing value judgments, but because of that very
fact their theories have been appropriated by the advocates of laissez-faire and used as the basis for the most pervasive value judgment
imaginable: that no better social outcomes than those available
under market competition can ever be achieved.
In my opinion, there is a better way to protect scientific method
than the one Popper suggests. All we need to do is to declare that
the social sciences are not entitled to the status that we accord the
natural sciences. This would stop pseudoscientific social theories
from masquerading in a borrowed suit of armor; it would also discourage the slavish imitation of natural science in areas where that
is not appropriate. It would not prohibit the scientific study of
human behavior, but it would help to scale down our expectations
about the results. My suggestion would also constitute a major loss
of status for social scientists, so it is unlikely to be very popular
among them.
The convention I proposedepriving the social sciences of their
scientific statuswould have the benefit of allowing us to come to
terms with the limitations of our knowledge. It would release social
science from the straitjacket into which it has been forced by the
pursuit of scientific status. That is what I advocated in The Alchemy
of Finance when I suggested that social science is a false metaphor.
Popper's model works with tunelessly valid generalizations. Reflexivity is a time-bound, irreversible processwhy should it fit Popper's model? There may be better ways of understanding social
phenomena than by proposing theories of universal validity. A particularly promising approach has emerged in recent years: the study
of irreversible evolutionary processes and the design of nonlinear
48
A Critique of Economics
models to represent them. These models do not fit Popper's model
of scientific methodthey do not allow the testing of universal
lawsbut they do provide algorithms that can be useful.
Recognizing the limitations of social science does not mean that
we must give up the pursuit of truth in exploring social phenomena.
It means only that the pursuit of truth requires us to recognize that
some aspects of human behavior are not governed by timelessly
valid laws. This should encourage us to explore other avenues to
understanding, as I do in this book. The pursuit of truth should also
force us to recognize that social phenomena may be influenced by
the theories put forward to explain them. As a consequence, the
study of social phenomena may be motivated by objectives other
than the pursuit of truth. That is the truth underlying the convention I have proposed. The best way to guard against the abuse of
scientific method is to recognize that social theories do not deserve
the status accorded to natural science. This would not prevent individual theories from establishing scientific status on their own
merit, but it would hinder ideologues from cloaking themselves
with the veil of science.
Looking at history, it is difficult to escape the conclusion that
there must be a fundamental difference between natural and social
science. Humankind's power over nature has increased by leaps and
bounds, but there has been no corresponding progress in resolving
political and social problems. Most advances in social conditions,
such as improvements in living standards or life expectancy, can be
attributed to natural science, not to social science. Indeed, social
conflicts have become more destructive because of the increased
control we enjoy over the forces of nature. Our ability to kill one
another has been greatly enhanced. It is high time we recognize diat
and look for new ways to resolve and contain conflicts.
49
GEORGE
SOROS
jo
A Critique of Economics
introduced. Geometry and astronomy are perfectly valid axiomatic
systems, yet they gave rise to false interpretations of reality, such as
the belief that the earth was flat or that it was the center of the universe (and we know what happened to those who questioned such
truths).
Economic theory starts by taking the demand and supply curves
as separately given; the intersection of the demand and supply
curves then determines the equilibrium point. This construction
presumes that demand and supply are definite and separately measurable quantities. They go on opposite sides of the scale, and an
adjustment process brings them into balance. When sellers know
how much they are willing to supply at each price and buyers know
how much they are willing to buy, all that needs to happen to
achieve equilibrium is for the market to find the unique price that
matches demand and supply- But what if price movements themselves change the willingness of buyers and sellers to trade their
goods at given prices, for example, because a fall in prices makes
them expect prices to fall even further in the near future? This possibility, which is the dominant fact of life in financial markets as well
as in industries with rapidly advancing technologies, is simply
assumed away.
Classical economic theory is the child of the Enlightenment. We
have seen that the Enlightenment sought to establish the authority
of reason by treating reality as something passively waiting to be
understood. Reason could then gain knowledge by making statements tJiat corresponded to the facts. The outstanding scientific
accomplishment of the Enlightenment was Newtonian physics, and
economic theory sought to imitate it. Equilibrium was a Newtonian
concept, and economic theoty adopted it with alacrity. If thinkingcould be separated from reality, then so could demand, which was
largely a subjective factor, from supply, which was mainly an objective one. Aggregating the behavior of various participants presented
difficulties, but these could be overcome by postulating perfect
>'
GEORGE
SOKOS
5-
A Critique of Economics
dently given is needed to determine market prices. Without it,
prices would cease to be uniquely determined. Economists would
be deprived of their ability to provide generalizations comparable to
those of natural science. The idea that the conditions of supply and
demand may be in some ways interdependent or dependent on the
behavior of the market may seem incongruous to those who have
been reared on economic theory; yet that is exactly what the concept of reflexivity implies and what the behavior of financial markets demonstrates.
The assumption of independently given conditions of supply and
demand eliminates the possibility of any reflexive interaction. How
significant is the omission? How important is reflexivity in the
behavior of markets and economies? In microeconomic analysis,
reflexivity can be safely disregarded; when it comes to macroeconomics, the omission is more serious. This corresponds to the distinction we have drawn between humdrum and historic events. I
shall test this proposition in the next chapter, using the financial
markets as my laboratory.
S3
GEOBGE SOROS
issues other than the market price. How society should be organized, how people ought to live their livesthese questions ought
not to be answered on the basis of market values.
Still, that is precisely what is happening. The scope and influence
of economic theory have expanded beyond the confines that the
postulates of an axiomatic system ought to impose. Market fundamentalists have transformed an axiomatic, value-neutral theory into
an ideology that has influenced political and business behavior in
powerful and dangerous ways. That is one of the key issues I want to
address in this book: How market values penetrate into areas of
society where they do not properly belong.
The values taken as given by economic theory always involve a
choice between alternatives: So much of one thing can be equated
to so much of another. The idea that some values may not be negotiable is not recognized, or, more exactly, such values are excluded
from consideration. Generally speaking, only individual preferences are studied; collective needs are disregarded. This means that
the entire social and political realm is left out of account. If the
argument of market fundamentaliststhat the common interest is
best served by the un trammeled pursuit of self-interestwere valid,
then no great harm would be done; but the fact that the conclusion
was reached by disregarding collective needs does beg the question.
Empirical studies in decisionmaking have shown that, even
in matters of individual preference, peoples' behavior does not
conform to the requirements of economic theory. The evidence
indicates that instead of being consistent and constant, peoples'
preferences vary depending on how they frame their decision problems. For example, economic theory has assumed ever since Daniel
Bernoulli (circa 1738) that economic agents evaluate the outcomes
of their choices in terms of final states of wealth. In fact, agents generally frame outcomes as gains and losses relative to some reference
point. Furthermore, these variations in framing can have a profound effect on decisions: Agents who frame their outcomes in
54
A Critique of Economics
terms of wealth will tend to be less averse to risk than agents who
think in terms of losses.*
I go further than the behavioral economists. I contend tJiat
people behave differently depending on the frame of reference they
employ. While there is some consistency in the choice of frames, it
is far from dependable, and there is often a noticeable discontinuity
between different frames. I can speak from personal experience. I
have often felt as if I had multiple personalities: one for business,
one for social responsibility, and one (or more) for private use.
Often the roles get confused, causing me no end of embarrassment.
I have made a conscious effort to integrate the various aspects of my
existence, and I am happy to report that I have been successful, I
really mean that: Integrating the various facets of my personality
has been a major accomplishment and a source of great satisfaction.
I must confess, however, that I could not have achieved this if I
had remained an active participant in the financial markets. Managing money requires a single-minded devotion to the cause of making money; all other considerations must be subordinated to it. In
contrast to other forms of employment, managing a hedge fund is
liable to produce losses as well as profits, and you can never take
your eye off the ball. It is noteworthy that die values tJiat guided me
in my moneymaking activities did resemble the values postulated by
economic theory: They involved a careful weighing of alternatives,
they were cardinal rather than ordinal in character/ they were continuous and gradual, and they were single-mindedly directed at
optimizing the ratio between risk and rewardincluding accepting
higher risks at times when the ratio was favorable.
I am ready to generalize from my personal experience and admit
*Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision Under
Risk," Econonietrka47 (i979); 263-91.
'This is an important point. In contrast to most fund managers, who are concerned with relative performance, I was guided by and rewarded according to absolute performance. T h e
pursuit of relative performance is a source of instability in financial markets that may not be
Sufficiently well recognized. I shall revert to this point in Chapter 7.
ft
GEORGE
SOROS
56
A Critique of Economics
description may be appropriate to market behavior, there must be
some other values at work to sustain society-indeed, to sustain
human life. It is difficult to see how the values pertaining to these
other spheres could be subjected to differential calculus as if they
were indifference curves.
What are these other values, and how can they be reconciled
with market values? That question preoccupies me, and it baffles
my mind. Studying economics is not a good preparation for dealing
with itwe must go beyond economic theory. Instead of taking values as given, we must treat them as reflexive. That means that different values prevail in different conditions, and there exists a
two-way feedback mechanism that connects them with actual conditions, thereby creating a unique historical path. We must also
treat values as fallible. That means that the prevailing values at any
moment in history are liable to prove inadequate and inappropriate
at some other point. I contend that at the present moment market
values have assumed an importance that is way beyond anything
that is appropriate and sustainable.
I must point out that if we want to apply the concept of reflexivity
to values as well as expectations we must use the concept somewhat
differently than described in Chapter i. In the case of expectations,
the outcome serves as a reality check; in the case of values, it does
not. The Christian martyrs did not abandon their faith even when
they were thrown to the lions. This renders a discussion of values
much more difficult than a discussion of expectations. In the case of
expectations, we can speak of a divergence between outcomes and
expectations; in the case of values, the divergence is difficult to formulate.
I return to this dilemma in Chapter 4.
S7
C 11 A P T E R
have made a very bold claim to the effect that economic theory has fundamentally misrepresented how markets operate.
Like every fertile fallacy, this claim is exaggerated. There are
many instances where the assumption that the conditions of
supply and demand are independently given does not do any violence to reality; in these cases, classical economic theory provides
valuable insights. But there is at least one important area where
economic analysis has produced profoundly misleading results. I
have in mind the financial markets.
Financial markets differ from other markets in that the participants do not deal with known quantities; they are trying to discount
a future which is contingent on how the market discounts it at present. This makes the conditions of supply and demand not only
unknown but also unknowable. In the absence of knowledge, par-
vY
GEORGE
SOROS
An Alternative View
I envision a two-way connection between flunking and reality.
The fundamentals influence the values that participants attribute to
financial instruments, and the valuations can also influence the fundamentals. The two-way interaction engenders a never-ending
process that does not necessarily lead to equilibrium. Price fluctuations lead toward a theoretical equilibrium part of the time and
away from it at other times, but the actual equilibrium remains
indeterminate because it is itself at least partially affected by the
price fluctuations.
The relationship between fundamentals and valuations is problematic. Apart from the point I have already made, namely that the
fundamentals may be influenced by the prices prevailing in financial
markets, there is another complication: In buying and selling financial instruments, market participants are not trying to discount fun-
60
6t
GEORGE
SOROS
GEORGE
SOROS
moving target, and the reflexive interaction may render it altogether elusive because the movement in stock prices may push the
fundamentals in the same direction in which the stocks are moving.
The recent craze for Internet stocks is a case in point.
Boom-Bust Sequences
The two-way connection between stock prices and fundamentals
can set in motion a self-reinforcing process that can carry both the
fundamentals and stock prices quite far from where they would be
under a conventional equilibrium. This would justify trend-following behavior that could carry financial markets into what 1 call ufarfrom-equilibrium territory." Eventually the divergence between
image and reality, between expectations and outcomes, is bound to
become unsustainable, and the process is bound to be reversed. The
important point is that trend-following behavior is not necessarily
irrational. Just as certain animals have good reasons to move in
herds, so do investors. Only at inflection points where the prevailing trend is reversed will the mindless trend-follower get hurt. By
the same token, lone investors who hitch their fortune to the fundamentals are liable to get trampled by the herd. I have always been
on the lookout for inflection points.
It is only occasionally that the price of an individual company's
stock can affect that company's fundamentals in a self-reinforcing
manner, like a dog chasing its own tail. But when we look at the
larger, macroeconomic picture, we find that reflexive interactions
are the rule, not the exception. For instance, currency movements
tend to be self-validating; credit expansion and contraction tend to
follow a boom-bust sequence. Self-reinforcing but eventually selfdefeating processes are endemic in financial markets.
In The Alchemy of Finance, I identified and analyzed several cases
of reflexivity that cannot be properly accounted for by equilibrium
64
6%
G E O R G E S O BOS
66
67
GEORGE
SOROS
Graph 3.1
I
-
r1
4
Time
6
>-
68
'
69
GEORGE
SOROS
panies engaged in Internet commerce went public. These companies offered valuable services greatly appreciated by the public. T h e
stocks were also appreciated by the public, and the popularity of the
stocks helped to promote the popularity of the services being provided. The prevailing trend and the prevailing bias became mutually self-reinforcing, and the boom accelerated. As the Internet
spread, the number of potential investors increased exponentially,
and the supply of stock could not keep pace. T h e demand for stock
was boosted by brokers offering online trading, while the supply
was limited by the various legal restrictions on the sale of stock by
insiders who bought them before a public offering. Valuations
reached outlandish levels. Few of the companies were profitable,
but investors did not mind. They were looking at the number of
customers or subscribers as the basis for valuing the stocks. Companies started giving away services, realizing that if they increased the
number of customers they could raise capital on more advantageous
terms. The name of the game became raising capital, not making
profits. That is an unsustainable business model, and it did not take
a Bnancial genius to realize that the boom was bound to be followed
by a bust, but it was much harder to guess when it would occur. The
Internet boom refused to follow the pattern of the conglomerate
boom illustrated in Graph 3.1. The moment of truth ought to have
arrived on July 28, 1999, when the Wall Street Journal published a
page-one article* explaining the flaw in the business model. This
happened to coincide with a flood of new issues and the expiration
of the holding period for original investors in some of the industry
leaders such as America Online. The insiders could hardly wait to
unload their holdings. Internet stocks fell by more than 50 percent.
I was convinced diat the crossover point had been reached and that
a crash was imminent. Yet Internet stocks recovered, and some rose
to new highs. Institutions that live and die by relative performance
'George Anders, "Internet Firms Offer (roods in a Bid to Increase Traffic," Wall Strettjourtf/,Juiy 28, 1999.
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GEORGE
SOROS
bear market. Just as the boom had a positive effect on the fundamentals, the bust will have a negative one. Rising stock prices stimulated consumption through the so-called wealth effect, and they
stimulated capital spending on technology even more. The boom
had the effect of speeding up time. Companies could not afford to
wait in getting aboard the latest innovations for fear of being penalized by the stock market. For instance, John Kay pointed out in the
Financial Times* that Vodafone had to pay top dollar for the largest
third-generation wireless franchise in the United Kingdom in order
to validate its current stock price. The speeding up tilted the balance of demand and supply in favor of technology companies,
boosting their profit margins; it also allowed fledgling companies
with the latest technologies to capture market share to an extent
unimaginable in more normal times. All this is liable to reverse
when the market cools off, but this reflexive feedback is not factored
into current stock prices. In my opinion, the music has stopped, but
most people are still dancing. I am not. I announced the conversion
of my Quantum Fund into a more conservative vehicle called
Quantum Endowment Fund on April 30, 2000.
This example is instructive in showing that my boom-bust theory
is far from foolproof in predicting the course of events. The crisis of
1997-1999, which I discuss in greater detail in Part II, is another
case in point. I lost a lot of money on both. So what is the use of a
theory if it does not yield reliable predictions? The answer is tfiat if
markets are genuinely unpredictable, then it is better to have a theory that brings this point home; one that claims to provide a scientific explanation is bound to be false. That is certainly the case with
die so-called random-walk hypothesis.
My theory has been dismissed as useless by economists such as
Robert Solow because it fails to meet the criteria of scientific
methods I readily admit that my theory does not qualify as scien*Ma>' 1, 2000.
'Robert Soiow, "The False Economies of George Soros," Ne~di Republic, February 8, 1909.
14
7^
GEORGE
SOBOS
GEORGE
SOROS
That is what produces market fluctuations. It occurs at various levels of significance, and the patterns produced are recursive, very
much like Mandelbrot's fractals (that is, recursive structures in
which irregular configurations are repeated at all scales).
This has led me to the working hypothesis that markets are in
constant disequilibrium. I do not rule out equilibrium, but I regard
it as a limiting case. I go even further: I believe that prices do not
clear the market. There are always unsatisfied buyers and sellers in
the wings, either because they cannot execute the entire order at the
last sale or because they cannot make up their minds. Either way,
they are bound to be influenced by market action. Economic theory
tells us that a rise in prices tends to reduce demand and increase supply. Not so in the stock market. A rise in prices may increase the anxiety of buyers, and vice versa, giving rise to the phenomenon of
trend-following behavior. This was systematically exploited by the
professional jobbers in the old London stock market, where brokers
were obliged to deal through jobbers. When the jobbers wanted to
cover their short positions they did not bid up for stocks; on die contrary, they lowered their prices. "Shaking the tree," tiiey called it.
This has important theoretical implications, for it justifies technical analysis.* For instance, upticks and downticks become important predictors of price trends. Needless to say, this view is in direct
contradiction to the prevailing view, which maintains that the market is in permanent short-term equilibrium.
T h e thesis adopted by the market is often trivial; it may not
amount to much more than saying that the prices of certain companies, groups, even entire markets are going to move up or down. In
these cases, by the time a participant figures out why the market
adopted a certain thesis it may be too latethe thesis has already
been discarded. It is much better to anticipate the fluctuations by
"The two main approaches to security analysis are the "fundamental" and the "technical."
Fundamental analysis follows the precepts of economic theory and treats share prices as a
reflection of the fundamental value of the company. Technical analysis ignores economic theory and studies the dynamics of price movements and patterns of market behavior.
7*
GEORGE
SOEOS
GEORGE
SOROS
GEORGE
SOROS
84
SS
GEORGE
SOROS
not have the necessary mathematical skills. Still, the shape of the
new paradigm is fairly clear in my mind, and I shall try to describe it
in words.
A New Paradigm
We must abandon two of the cherished preconceptions of economic theory with regard to financial markets. One is rational
behavior; the other is equilibrium, including the contention that
prices clear the market.
Rational expectations are appropriate to a world where the participants' expectations have no impact on the events to which they
relate. The participant is then in the position of an observer who can
gather all the available information and reach her decision on the
basis of that information. Her decisions have something definitive
to correspond tonamely, the prospective equilibrium. Naturally,
no participant is in possession of all the available information, but
by definition some other participant isotherwise the information
would not be available. So the market knows more than any individual participant; it knows everything there is to be known; therefore
the market is always right. Participants are assumed to be rational
enough to recognize this fact and act accordingly. That is the justification, for instance, for investing in index funds. If reality deviates
from the equilibrium there must be a reason for it; the reason is usually to be found in asymmetric information. For instance, the multiple equilibria associated with credit crises can be attributed to the
asymmetric information available to different classes of creditors.
That is not how the world works. Participants are not merely
observers; their decisions influence the future. They base their decisions on hunches, not on information, and the information about
the hunches becomes available only after they have made their
effects felt. In these circumstances, it is not rational to act on die
basis of rational expectations. Some people may do so, but others
86
*7
(I I O R 0 E S O K O S
88
89
GEORGE
SOROS
be dismissed on account of it not being scientific; one must, however, beware of its alchemical nature,
Economists have started to apply comparative analysis to various
phenomena other than financial markets. For instance, economists
at the World Bank are trying to analyze phenomena like corruption* and armed insurrection* by treating them as economic activities. Their approach is subject to the same limitations as technical
analysis: In trying to calculate probabilities, they lose the context in
which each particular instance occurs. They suffer from an additional disadvantage: They have to find a way to quantify their data
while the students of financial markets have ready-made quantified
data at their disposal. Nevertheless, I find these pioneering efforts
fascinating. I consider them as fertile fallacies: They offer insights
which help to understand the problems but they fall short of providing a comprehensive framework for dealing with them. Generalizations need to be combined with local knowledge* and the
combination of the two holds out promise for improving the performance of policymakers. Even so, social engineering will never be
able to attain the reliability of mechanical engineering. There is a
parallel here with the radical uncertainty confronting participants
in financial markets.
To sum up: Within the new paradigm of adaptive as distinct from
rational behavior, there is room for a longitudinal approach studying the evolution of systems over time and a latitudinal approach
comparing similar situations. The first approach tends to use nonlinear programming, the second, regression analysis. Both disciplines need to be complemented by local knowledge.
'Daniel Kaufmann, Aart Kraay and Pablo Zoido-Lobaton, "Governance Matters" (Washington DC: World Bank Policy' Research Working Paper No. 2196, August 1999). See also
Daniel Kaufmann, "Corruption: The Facts" (Washington DC: Foreign Policy, Summer
I997)'Paul Collier, "Economic Causes of Civil Conflict and their Implications for Policy" (Washington DC: World Bank, June 15, 2000).
'A point well made by Ivan Krustev in "The Strange (Re)Discovcry of Corruption" in The
Paradoxes of Unintended Consequences (Budapest: CEU Press, 2000).
90
CH A PT E H
Reflexivity in History
have interpreted financial markets as an irreversible, historical process; hence my interpretation must also have some relevance to history at large. I have classified events into two
categories: humdrum, everyday events that do not provoke a
change in perceptions, and unique, historic events that affect the
participants' bias and, in turn, lead to changes in the fundamentals.
The distinction is tautological but useful. The first kind of event is
susceptible to equilibrium analysis, the second is not: It can be
understood only as part of a historical process.
Dialectics
In everyday events, neither the participating function nor the
cognitive function undergo any significant change. In die case of
<>i
GEORGE
SOROS
unique, irreversible developments, both functions operate simultaneously in such a way that neither the participants' views nor the
situation remains the same. That is what justifies describing such
developments as historic.
The historical process is, as I see it, open-ended. When a situation has thinking participants, the sequence of events does not lead
directly from one set of facts to the next; rather, it connects facts to
perceptions and perceptions to facts in a shoelace pattern. But history is a very peculiar kind of shoelace. The two sides of the shoe are
not made of the same material; indeed, only one side is material
the other consists of the ideas of the participants. The two sides do
not match, and the divergences between them determine the shape
of the events that tit: them together. The knots that have already
been tied have a determinate shape, but the future is open-ended.
This is rather different from a mechanism whose functioning can
be explained and predicted by universally valid laws. In historical
developments, past and future are not reversible, as they are in Karl
Popper's model of scientific method. What makes the future different from the past is the choice that the participants are obliged (and
privileged) to exercise on the basis of their imperfect understanding. That choice introduces an element of uncertainty into the
course of events. Attempts to eliminate it by establishing scientific
laws of human behavior are doomed to failure.
This shoelace theory of history is a kind of dialectic between our
thoughts and reality. As such, it can be interpreted as a synthesis of
Hegel's dialectic of ideas and Marx's dialectical materialism. Georg
Wilhelm Friedrich Hegel propounded the thesis that ideas develop
in a dialectical fashion and lead eventually to the end of history
freedom. Karl Marx, or more exactly Friedrich Engels, provided the
antithesis by claiming that the development of ideas is determined
by the conditions and relations of production; the ideological
superstructure is merely a reflection of the material base. The
shoelace theory7 could then be regarded as a synthesis. Instead of
92
Reflexivity in Histoiy
either thoughts or material conditions evolving in a dialectic fashion on their own, it is the interplay between the two that produces a
dialectic process. I call this interplay reflexivity, and the only reason
I do not use the word "dialectic" more prominently is that I do not
want to be burdened by the excess baggage that comes with it. After
all, Marx propounded a deterministic theory of history that is diametrically opposed to my own interpretation. The interplay
between the material and the ideal is interesting exactly because
they do not correspond to or determine each other. The lack of correspondence renders the participants' bias a causal force in history.
Fallibilitywhich finds expression in the mistakes, misinterpretations, and misconceptions of the participantsplays the same role
in historical events as genetic mutations in biological events: It
makes history.
93
GEORGE
SOROS
94
Reflexivity in History
turning humans into robots, we shall not be able to eliminate the
uncertainty inherent in human behavior. I believe the concept of
reflexivity and the shoelace theoiy of history give a better expression of this uncertainty than does the selfish-gene theoiy.
There is a divergence between intentions and outcomes; the outcomes modify the intentions, which in turn modify the outcomes in
a never-ending process that is in some ways akin to biological evolution but in some ways different. This is what I mean when I say that
biological change consists in the mutation of genes and can be measured by the propagation of genes while historical change consists
in misconceptions and can be measured by the gap between intentions and outcomes.
When it comes to human behavior, it is questionable to what
extent history can be explained by the rules of the selfish gene.
Sometimes people harbor intentions that correspond to the interests of the selfish gene, but not always. The selfish gene plays an
obviously important role in dynastic succession, but even there
Shakespeare offers some interesting observationssuch as Hamlet's "to be or not to be"that go well beyond the confines of the
selfish-gene theory.
A Boom-Bust Model
The interesting question is how historical change could be modeled. As I mentioned in Chapter 3,1 believe evolutionary game theory points the way: Studying adaptive behavior seems to make more
sense than assuming rational behavior.
As I readily confessed in that chapter, I am unable to develop a
new paradigm. Both evolutionary biology and evolutionary game
theory follow the evolution of populations pursuing certain strategies: Cartesian and pragmatic fishermen in the case of Canadian
fisheries, value investors and momentum traders in the case of the
95
GEORGE
SOROS
stock market. I consider this approach more promising than rational expectations theory, but I lack the skills to develop it. I have proposed a boom-bust model for financial markets, although it is more
an illustration of the workings of reflexivity than it is a scientific
theory. I have found it useful as a prop in my investment decisions,
but it can easily collapse if one puts too much weight on it. I shall
now extend that model to history at large by offering a boom-bust
interpretation of the rise and fall of the Soviet system. This will be
more a flight of fancy than an illustration, but it has the advantage
of allowing me to introduce my conceptual framework by using a
concrete example that may come as welcome relief from abstract
discussions. In doing this I am merely living up to trie postulate of
radical fallibility by pushing a fertile fallacy to its limits.
Reflexivity in History
After Stalin's death, there was a brief momentthe moment of
truthwhen Nikita Khrushchev revealed some of the secrets of
Stalin's rule, but eventually the hierarchy reasserted itself. A twilight period began, when dogma was preserved by administrative
methods but was no longer reinforced by a belief in its validity.
Interestingly, the rigidity of the system increased. As long as there
had been a live totalitarian at the helm, the Communist Party line
could be changed at his whim. But now that the regime was run by
bureaucrats, that flexibility was lost. At the same time, the terror
that forced people to accept the communist dogma also abated, and
a subtle process of decay set in. Institutions jockeyed for position.
Since none enjoyed any real autonomy, each had to engage in a
form of barter with other institutions. Gradually an elaborate system of institutional bargaining replaced what was supposed to be
central planning. Simultaneously, an informal economy developed
that supplemented and filled in the gaps left by the formal system.
The planned economy would have broken down without it. This
twilight period was what is now called the "period of stagnation."
The inadequacy of the system became increasingly evident, and
pressure for reform mounted.
Reform accelerated the process of disintegration, because it
introduced or legitimized alternatives (whereas the system depended
on the lack of alternatives for its survival). Economic reform
enjoyed an initial period of success in every communist country,
with the notable exception of the Soviet Union itself. The Chinese
reformers called this phase the "golden period," when the existing
capital stock was redirected to meet consumer needs. The Soviet
Union failed to accomplish even this relatively easy task.
Attempts at reforming the communist system are based on a misconception: The system cannot be reformed, because it does not
permit the economic allocation of capital. More radical change is
needed. When existing capacity has been reoriented, the reform
process starts running out of resources. It is understandable why
this should be so. Communism was meant to be an antidote to capi91
G E O R G E S O BOS
talism, which had alienated the worker from the means of production. All property was taken over by the state, and the state was an
embodiment of the collective interest as defined by the party.
Therefore the party was put in charge of the allocation of capital.
This meant tfiat capital was allocated not on economic grounds but
on the grounds of a political, quasireligious dogma. The best analogy is with the pyramid-building of the pharaohs: The portion of
resources devoted to investment was maximized, while the economic benefit derived from it remained at a minimum. Another
point of similarity was that investments took the form of monumental projects. We may view the gigantic hydroelectric dams, the steel
mills, the marble halls of the Moscow subway, and the skyscrapers
of Stalinist architecture as so many pyramids built by a modern
pharaoh. Hydroelectric plants do produce energy, and steel mills do
turn out steel, but if the steel and energy are used to produce more
dams and steel mills, the effect on the economy is not very different
from diat of building pyramids.
Our theoretical framework tells us that in the far-from-equilibrium conditions of a closed society there must be distortions that
would be inconceivable in an open society. What better demonstration could one ask for than the Soviet economy? The communist
system attributes no value to capital; more exactly, it does not recognize the concept of property. As a result, economic activity under
the Soviet system is simply not economic. To make it so, the party
must be removed from its role as die guardian and allocator of capital. It was on this point that all reform attempts were bound to come
to grief.
Interestingly, the failure of economic reforms served to accelerate the process of disintegration because it demonstrated the need
for political reforms. With the advent of perestroika in the Soviet
Union, the process of disintegration entered its terminal phase
because the reform was primarily political and, as I have mentioned
previously, the golden period was missing so that the reform pro-
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Reflexivity in History
duced little or no economic benefit. As living standards started to
decline, public opinion turned against the regime, leading to a catastrophic disintegration that culminated in the total collapse of the
Soviet Union.
The pattern is almost identical with the one we can observe in
financial marketswith one major difference: In financial markets,
the boom-bust process seems to manifest itself as a process of acceleration, whereas in the case of the Soviet system the complete cycle
comprised two phases, one a process of slowdown culminating in
the static disequilibrium of the Stalin regime, the other a process of
acceleration leading to a catastrophic collapse.*
I then went on to point out that it is possible to find a similar
two-phase boom-bust process in financial markets. That is where
the illustration turned into a flight of fancy. I cited the case of the
U.S. banking system, which became rigidly regulated after it collapsed in 1933. It remained in hibernation for about thirty-five
years. In 1972 I wrote an investment memorandum entitled "The
Case for Growth Banks" contending that a moribund industry was
about to come to life. The industry was highly regulated, managements were stodgy and risk-averse, and stock prices did not reflect
earnings, but all that was about to change. A new breed of bankers
was incubating at Citibank, and they were slowly fanning out into
the country. Under their management, banks started using their
capital more aggressively, and soon they would need to stimulate
their stock prices in order to raise additional capital and pursue
acquisitions. The signal was given when Citibank hosted a meeting
for security analystsan unheard-of event. My bouquet of recommended stocks rose by 50 percent within a year. Soon thereafter
came the oil crisis of 1973, and international banks recycled the surplus of the oil-producing countries, which led to the international
lending boom of the 1970s. The banking system swung over into
'Condensed from Chapter 4 of George Soros, Opening the Soviet System (London: Weidenfeld and Nicolson, 1990; reprinted by CEU Press, Budapest).
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A Conceptual Framework
The foregoing discussion is helpful in establishing a conceptual
framework that divides historical situations into three categories:
static disequilibrium, near-equilibrium, and dynamic disequilibrium. The possibility of static equilibrium is ruled out by die fact
*I ran into a similar case in Sweden in the 1960s. The Swedish stock market was totally isolated from the rest of the world; one had to sell Swedish shares held abroad to buy Swedish
shares in Sweden. Companies were allowed to retain their earnings without paying taxes by
setting up various reserves, but they could not use those reserves to increase dividends. Shares
were valued on the basis of dividend yields. As a result, there were tremendous divergences in
price-earnings ratios, and the best companies were tremendously undervalued (until 1 came
along and pointed out the undervaluation in several reports). Swedish shares held abroad rose
to hefty premiums, but due to the restrictions on trading, the interest I awakened could not
be satisfied, and eventually the market went back to sleep until regulations were changed.
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Reflexivity in History
that participants always base their decisions on a biased interpretation of reality. Correspondence between outcomes and expectations
is hard to come by, and even if it occurs it may be due to the prevailing bias influencing the prevailing state of affairs rather than participants acting on the basis of perfect knowledge. This leaves three
possibilities.
One is that the reflexive interplay between the cognitive and participating functions prevents thinking and reality from drifting too
far apart. People learn from experience; they act on the basis of
biased views, but there is a critical process at work that tends to correct the bias. Perfect knowledge remains unattainable, but there is
at least a tendency for thinking and reality to come closer together.
The participating function ensures that the real world, as experienced by the participants, is constantly changing, yet people are sufficiently well grounded in a set of fundamental values that the
participants' bias cannot get too far out of line with real eventsin
other words, near-equilibrium. This state of affairs characterizes
open society, as in the West. This kind of society is closely associated with a critical mode of thinking. We may call this the "normal"
relationship between thinking and reality, because we are familiar
with it from our own experience.
We can encounter a second set of conditions in which the participants' views are quite far removed from the way things really are
and the two show no tendency to come closer togetherin some
circumstances they may be driven even farther apart. At one
extreme, there are regimes that operate with an ideological bias,
and they are unwilling to adjust to changing circumstances. They
try to force reality into their conceptual framework even though
they cannot possibly succeed. Under the pressure of the prevailing
dogma, social conditions may also become quite rigid, but reality is
liable to remain quite far removed from its authorized interpretation. Indeed, in the absence of a corrective mechanism the two are
liable to drift even further apart, because no amount of coercion can
prevent changes in the real world, while the dogma is liable to
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Reflexrvity in History
forty years ago, in the early 1960s, under the influence of Karl Popper's Open Society and Its Enemies. *
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found in the other. Closed society offers the certainty and permanence that is lacking in open society, and open society offers the
freedom that is denied to the individual in closed society. As a consequence, the two principles of social organization stand in opposition to each other. Open society recognizes our fallibility; closed
society denies it.
When I established this conceptual framework, in the early
1960s,* I did not dare to assert the superiority of open society,
because I could not prove it and it was not supported by the evidence: Communism was still gaining ground. I asserted that a genuine choice is involved (which is true), and I came down firmly on
the side of open society. 1 believed in open society strongly enough
that, when the opportunity presented itself, I translated my conviction into action. I shall summarize my philanthropic activities
because they are relevant.
I established the Open Society Fund in 1979. Its mission, as I formulated it at the time, was to help open up closed societies, to help
make open societies more viable, and to foster a critical mode of
thinking. After an abortive start in South Africa, I concentrated on
the countries under communist ruleespecially my native country,
Hungary. The formula was simple: Any activity or association that
was not under the supervision or control of the authorities created
alternatives and thereby weakened the monopoly of dogma. My
foundation in Hungary, established in 1985 as a joint venture with
the Elungarian Academy of Science, acted as the sponsor of civil
society. Not only did it support civil society, but civil society supported it; as a result, it was exempt from many of the unintended
adverse consequences from which foundations usually suffer. Charity tends to turn the recipients into objects of charity; applicants tell
the foundation what it wants to hear, and if they receive a grant they
'Reproduced almost verbatim in Opening the Soviet System.
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Reflexivity in History
proceed to do what they wanted to do in the first place. In Hungary,
none of this applied. The foundation empowered civil society to do
what it wanted to do in any case, and there was no need for controls:
Civil society protected the foundation by alerting us when our
funds were misused. I remember one occasion when we were
warned that the association for the blind, which received a grant for
talking books, misused the grant. Who could ask for better monitoring with no effort on our part?
Encouraged by the success of the Hungarian foundation, I
became a philanthropist in spite of my critical attitude toward philanthropy. As the Soviet empire started to crumble, I threw myself
into the fray. I realized that in a revolutionary period many things
become possible that would be inconceivable at other times. I felt
that with the help of my boom-bust modeJ I understood the situation better than most others; I had a strong commitment to open
society; and I had the financial means to back it up. This put me in a
unique position, and I spared no effort. I increased the size of my
foundations a hundredfoldfrom $3 million to $300 million annuallyin the space of a couple of years.
Only in the course of the Soviet collapse did I discover a flaw in
my conceptual framework: It treated open and closed society as
alternatives. The dichotomy might have been appropriate during
the Cold War, when two diametrically opposed principles of social
organization were confronting each other in deadly conflict, but it
does not fit the conditions that have prevailed since the Cold War
ended.
I was forced to realize that the collapse of a closed society does
not automatically lead to the establishment of an open society; on
the contrary, it may lead to the breakdown of authority and the disintegration of society. A weak state may be as much a threat to open
society as an authoritarian state.*
I made another discovery: People living in open societies do not
*Stephen Holmes, "What Russia Teaches Us Now: How Weak States Threaten Freedom,"
TheAmerican Prospect (July-August 1997): 30-39.
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really believe in open society as a universal idea. They may be willing to defend democratic institutions in their own country, but they
are not necessarily willing to make any great sacrifices to establish
democratic institutions in other countries. This was a bitter pill to
swallow. When I rushed in to establish Open Society Foundations
in one country after another, I thought T was blazing a trail that
others would follow; when I looked back, nobody was behind me.
This was not only a disappointment but also a flaw in my conceptual
framework, indeed the worst error in my analysis. I was forced to
painstakingly reexamine the concept of open society; the framework I present here is the result of that reexamination.
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Reflexivity in History
occurs. That is what I did when, under the influence of Karl Popper, I distinguished between open and closed society. Today, in the
light of experience, I need to redefine the space in which history
unfolds and recognize an additional category: dynamic disequilibrium. This leads to a tripartite division similar to water, ice, and
steam: open society (near-equilibrium), closed society (static disequilibrium), and chaos or revolution (dynamic disequilibrium).
Therefore, in occupying that precarious middle ground, open society is threatened from two sides: by dynamic disequilibrium as well
as by static disequilibrium. This is a rather different framework
from the simple dichotomy between open and closed society with
which I had started. The analogy with water, ice, and steam is apt,
because open society is fluid, closed society rigid, and revolution
chaotic.
These three cases constitute ideal typesor "strange attractors,"
to borrow another term from chaos theory. Events take on a different character within their orbit. If we can learn nothing else about
history but this, we have learned something valuable. Financial
markets behave one way near equilibrium and another way far from
equilibrium, and the same is true of history' in general. For instance,
many things are possible in revolutionary situations that would be
inconceivable in normal times. Recognizing the opportunities when
they arise is the height of statesmanship, as well as the key to success
in financial markets.
I have been fortunate to have a pointed understanding of the difference between near-equilibrium and far-from-equilibrium conditions, something I learned from my father. He had been a prisoner
of war during World War I, and he escaped from a camp in Siberia
during the Russian Revolution. Fie went through incredible adventures that taught him the difference between normal and revolutionary conditions. He regaled me with his stories when I was a
child. When I was fourteen, in 1944, the Germans occupied Hungary and engaged in genocide against the Jews; I might not have
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survived had it not been for my father. He realized that this was a
far-from-equilibrium situation in which the normal rules did not
apply. He made arrangementsnot only for his family but for many
others around himto assume false identities.* Most of us survived.
At the same time, I saw what happened to those who were less well
prepared to cope with these exceptional conditions: They were put
in labor camps, deported to Auschwitz, or shot on the banks of the
Danube. This was the formative experience of my life, the reason
why I take the concept of open society so seriously.
I learned that the same rules do not apply at all times. It is not
simply that different rules apply in revolutionary conditions than in
normal times; it is the distinguishing feature of dynamic disequilibrium that the rules are also subject to change, and what is the right
decision at one moment may be wrong the next. It is difficult to
appreciate the full import of this statement, and it is even more difficult to arrive at the right decisions at the right moments. Bureaucratic institutions, in particular, are constitutionally ill-suited for
the task. That is why they tend to break down and collapse if the
dynamic disequilibrium becomes too severe and events slip out of
control.
I am acutely aware that the view of history that I have presented
here is highly personal and idiosyncratic. The fact that I had to
revise a dichotomy and replace it with a tripartite division should
warn us how precarious these divisions are. That does not detract
from the value of the insights they provide, but it reminds us forcefully that the categories have been introduced by us and are not
found in reality.
This raises the question whether the categories I have introduced, especially the concept of open society, has any relevance to
today's conditions. I have no doubt that die distinction between
open and closed society was relevant to the Cold War; indeed, it
*Tivadar Soros, Maskerado: Dancing around Death in Nazi Hungary (Edinburgh: Cannongate
Books, October 2000).
1()8
Reflexivity in History
provides a better insight into what was at stake than the distinction
between capitalism and communism. I also know that the concept
of open society is meaningful to me personally. The crucial question is whether it does or should have a meaning for society at large.
The purpose of this book is to show that it should.
Demarcation Lines
Let me now return to die question I posed earlier: What separates near-equilibrium from far-from-equilibrium conditions?
When does a boom-bust sequence or some other disequilibrium
process destroy the near-equilibrium conditions of open society?
We have seen that the two-way interaction between thinking and
reality can easily lead to excesses that can push the situation in the
direction of either rigidity or chaos. For open society to prevail,
there must be some anchor that prevents the participants' thinking
from being dragged too far away from reality. What is that anchor?
In answering the question, we first must distinguish between
expectations and values. After all, decisions are based not only on
people's perceptions of reality but also on the values they bring to
bear. In the case of expectations, the anchor is easy to identify: It is
reality itself. As long as people realize that there is a difference
between thinking and reality, the facts provide a criterion by which
the validity of peoples' expectations can be judged. Reflexivity may
render events unpredictable, but once they come to pass they
become uniquely determined, so they can be used to decide whether
our predictions were correct. As we have seen, predictions can influence die outcome, so the outcome is not a fully independent criterion for judging the validity of the theories on which the
expectations were based. That is why our understanding is fallible
and we can speak only of near-equilibrium conditions. Nevertheless, reality constitutes a useful criterion.
10 (J
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Reflexivity in History
the relationship between market values and social values in particular. So the subjective difficulty merges into an objective one. Let me
state the problem as I see it, first on the theoretical and then on the
practical level.
On the theoretical level, cognition has an objective criterion
namely, realityby which it can be judged. As we have seen, the criterion is not totally independent, but it is independent enough to be
called objective: No participant is in a position to impose his or her
will on the course of events. By contrast, values cannot be judged by
any objective criterion because they are not supposed to correspond
to reality: The criteria by which things are to be judged are selected
by the person or group that adopts them. In other words, values are
valid because we believe in them. This makes them much more
reflexive than expectations. Not all expectations can validate themselves because they relate to reality, and the factsas they evolve
impose an iron constraint on the validity of expectations. But values
are not constrained by reality. Compared to cognitive notions, they
can vary over a much wider range. They do not even need to be
consistent, as long as people can persuade themselves of their validity at the time they act upon them. They do not even need to relate
to this world. Many^ religions attribute greater importance to the
other world than to this one. This is what makes any discussion of
values so difficult. Economic theory did well to take them as given.
With the help of that methodological device, economic theory
established the concept of equilibrium. Although I have been critical of the concept, it has been indispensable for my analysis. I could
show how far-from-equilibrium conditions could arise in financial
markets only because the concept of equilibrium (from which reality could diverge) was well developed. No similar concept is available for the nonrnarket sector of society.
I have defined "equilibrium" as the correspondence between
expectations and outcomes. How can I apply that definition to the
values that are supposed to hold together open society? I shall try to
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IT2
Reflexivity in History
Second, national economies have been superseded by an international economy, but the international community, insofar as it
exists, shares few social values.
Transactional Society
The replacement of relationships by transactions is an ongoing,
historical process that will never be carried to its logical conclusion,
but it is well advancedfar more advanced than in the early 1960s,
when I arrived in this country and first observed it. I came from
England and was struck by the difference: Relations in the United
States were much easier to establish and abandon. The trend has
progressed even farther since then. There are still marriages and
families, but in investment banking, for instance, transactions have
almost completely superseded relationships. This offers a clear
example of the changes occurring in many other spheres of activity.
When I started work in the City of London in the 1950s, it was
almost impossible to transact any business without having a prior
relationship. It was not a question of what you knew but of whom
you knew. That was the main reason why I left London: Since I was
not well connected there, my chances were much better in New
York. In a short time, I established regular trading contacts with
leading firms even though I was working in a relatively unknown
brokerage house; I could not have done that in London. But even in
New York the underwriting of securities was still entirely governed
by relationships: Firms participated in syndicates in a certain pecking order, and it was a major event when a firm moved up or down a
bracket. All this has changed. Each transaction now stands on its
own, and investment bankers compete for every piece of business.
The difference between transactions and relationships has been
well analyzed by game theory in the form of the prisoners' dilemma:
Two suspected crooks have been caught and are interrogated. If one
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suspect provides evidence against the other she can earn a reduced
sentence, but the accomplice is more certain to be convicted. Taken
together they will do better if they remain loyal to each other, but
separately each can profit at the other's expense. The analysis shows
that in the case of an individual transaction it may be rational to
betray but in a lasting relationship it pays to be loyal. This can be
taken as a demonstration of how cooperative behavior can develop
with the passage of time, but it can also be used to show how cooperation and loyalty can be undermined by replacing relationships
with transactions.* Cilobalization works in the same direction by
increasing the scope for transactions and diminishing the dependence on relationships.
All of this relates to the deficiency of shared values in contemporary society. We are inclined to take social or moral values for
granted. We refer to tliern as "intrinsic" or "fundamental," implying
that their validity is somehow independent of prevailing conditions.
Nothing could be farther from the truth. If we could take social values as givenas economic theory does with market valueswe
would have no difficulty in establishing something approaching
equilibrium conditions. But that is not the case. Social values are
reflexive. They are influenced by social conditions and, in turn, play
a role in making social conditions what they are. People may believe
that God handed down the Ten Commandments and, doing so,
may make society more just and stable. Conversely, the absence of
moral constraints is liable to generate injustice and instability.
A transactional society undermines social values and loosens
moral constraints. Social values express a concern for others. They
imply that the individual belongs to a communitybe it family,
tribe, nation, or humankindwhose common interest takes prece*Robert Axelrod, The Complexity ofCooperation: Agent-Based Models of Competition and Collaboration (Princeton: Princeton Studies in Complexity-, Princeton University Press, 1997) and
The Evolution of Cooperation (New York: Basic Books, 1984); Anatol Rapoport and Albert M.
Chammah, with Carol J. Orwant, Prisoner's Dilemma: A Study in Conflict and Cooperation (Ann
Arbor: University of Michigan Press, 1965).
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Reftexivity in History
dence over individual self-interests. Yet a global economy is anything but a community. It contains people of different traditions for
whom most other people represent the other, not the community to
which one belongs. In a tough competitive environment, it is hard
enough to have consideration for others; to extend that consideration to all humanity is asking for the impossible. The situation is
aggravated by the prevailing creed of market fundamentalism. It
maintains that the common interest is best served by everyone pursuing her own self-interest. This gives the pursuit of self-interest a
moral blessing. Those who adopt the creed tend to come out ahead
because they are not encumbered by moral scruples in a dog-eatdog worldand such success can be self-rein forcing.
We should not exaggerate. The external constraints imposed by
the community may have been undermined by the development of
a global, transactional economy, and the pursuit of self-interest may
have been endowed with moral justification, yet some internal constraints are bound to remain. Even if people have been transformed
into single-minded competitors, they were not born tiiat way. The
transformation has occurred quite recently, and it remains incomplete. Although we are closer to a transactional society than at any
time in history, a purely transactional society could never exist.
People seem to have an innate need for social values. As sentient
beings, they cannot avoid being aware of their own ephemeral
nature, their mortality. They tend to reach out for values that
extend beyond their narrow selves. Even when they pursue their
self-interest, they seem to have a need to justify their behavior by
appealing to principles that go beyond themselves. As Henri Bergson pointed out, morality can have two sources: tribal belonging
and the universal human condition. It is in the latter that open society must be anchored. I shall try to develop this argument in the
next chapter,
"5
CHAPTER
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it could be accomplished. Popper advocated "piecemeal social engineering"; Hayek put his faith in the market mechanism because he
was preoccupied with die unintended adverse consequences of state
controls. His preoccupation was carried to extremes by his followers in the "Chicago school." The pursuit of self-interest has been
promoted into a universal principle that permeates all aspects of
existence: not just individual choice as expressed in markets but also
social choice as expressed in politics. It even extends its reach to the
law of contracts; it governs not just individual behavior but also the
behavior of states, not to mention the selfish gene. There is an
uncomfortable similarity between market fundamentalism and
communism: Both have a foundation in social sciencemarket economics in the one case, Marxism (which is a more comprehensive
theory of social systems, including economics) in the other.
I regard market fundamentalism as a greater threat to open society today than communism. Communism and even socialism are
discredited, but market fundamentalism is ascendant. If there are
any shared values in the world today, they are based on the belief
that people should be allowed to pursue their self-interests and that
it is both futile and counterproductive to expect them to be motivated by the common interest. Of course, there is no general agreement on diis point, but it is certainly more popular than the belief in
open society. Moreover, market fundamentalism is receiving powerful reinforcement from the positive results that market-oriented
policies are producing, particularly among those who are the beneficiaries of diose policies. To the extent that politics is influenced by
money, these people tend to be the most influential.
So my task in this chapter is twofold: to demonstrate the errors of
market fundamentalism, and to establish the principles of open
society. The first part is relatively easy. I have already shown that
financial markets do not necessarily tend toward equilibrium. All I
need to point out now is that social values do not find expression in
markets. Markets reflect the existing distribution of assets; they are
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7 20
The Erilightemnent
Here I ran into insuperable difficulties. The recognition of our
fallibility is what makes a society open; but it is not sufficient, by
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Scientific
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124
Moral Philosophy
We need to begin the reconstruction of morality and social values by accepting their reflexive character. This is self-consistent and
leaves ample scope for trial and error. It will be a sound foundation
for the kind of global society we need.
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if the state were in fact the best agency for taking care of economic
needs. But that proposition has been tried and turned out a flop. I
prefer to recognize the need to alleviate poverty more directly by
introducing some sense of social justice as one of the core principles
of open society. This approach has the advantage that it cuts across
borders. We must recognize that under global capitalism individual
states have limited capacity to look after the welfare of their citizens
yet it behooves the rich to come to the aid of the poor; therefore
social justice is a matter of international concern.
Social justice emphatically does not mean equality, because that
would take us right back to communism. 1 prefer the Rawlsian concept of social justice, which holds that an increase in total wealth
must also bring some benefit to the most disadvantaged. What
"some" means has to be defined by each society for itself, and the
definition is liable to vary over time. But creating a more level playing field must be clearly established as an objective of international
institutions. I shall develop this thought in Chapter 12.
What about property rights? Should they be recognized as a core
principle similar to human rights? I could answer the question
either way. I have no doubt that private property is basic to individual freedom and autonomy and as such an indispensable part of
open society; but I also believe that there are no rights without
obligations. That is true of human rights as well as property rights;
but in the case of property, the rights and obligations fall on the
same person, whereas in human rights there is a clear distinction
between the individual who enjoys die rights and the authorities
that are bound to respect them. We may include property among
the freedoms and rights, but we must not forget the flip side: social
responsibility as manifested, for instance, in the payment of taxes
and death duties.
Generally speaking, there is an ongoing conflict between rights
and obligations that requires compromises that need to be worked
out and reconsidered all the time. Isaiah Berlin referred to this
IJI
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these criteria, but our global society does not. The most glaring
deficiency is the absence of the international rule of law; and we are
bereft of the most elementary arrangements for the preservation of
peace.
Exactly what shape these arrangements should take cannot be
derived from first principles. To redesign reality from the top down
would violate the principles of open society. That is where fallibility
differs from rationality. Fallibility means that we don't know what
the common interest is. Nevertheless, I believe that fallibility and
the encumbered individual provide a better basis for establishing
die ground rules for a global open society than reason and the
unencumbered individual.
Pure reason and a moral code based on the value of the individual
are inventions of Western culture; they have little resonance in
other cultures. For instance, Confucian ethics are based on family
and relationships and do not sit well with the universal concepts
imported from the West. Fallibility allows for a broad range of cultural divergences, and the encumbered individual gives due weight
to relationships. The Western intellectual tradition ought not to be
imposed indiscriminately on the rest of the world in the name of
universal values. The Western form of representative democracy
may not be the only form of government compatible with an open
society.
Nevertheless, there must be some universal values that are generally accepted. Open society may be pluralistic in conception, but
it cannot go so far in the pursuit of pluralism diat it should fail to
distinguish between right and wrong. Toleration and moderation
can also be carried to extremes. Exactly what is right can be discovered only by a process of trial and error. The definition is liable to
vary with time and place, but there must be a definition at any one
time and place.
Whereas the Enlightenment held out the prospect of eternal verities, open society recognizes that values are reflexive and subject to
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14.1
A Vital Distinction
Market participation and rulemaking are two different functions.
It would be a mistake to equate the profit motive that guides individual participants with the social considerations that ought to
guide the setting of rules. This is exactly the mistake that some market fundamentalists make when they try to extend the economic calculus to other spheres of activity, such as politics or the law of
contracts. How can they get away with it? Their first line of defense
is that they are merely modeling how people behave: "People may
talk about right and wrong, but when the chips are down they act
according to their interests." Unfortunately, there is a large element
of truth in this contention. Collective decisionmaking in contemporary democracies is largely a power play between competing interests. People try to bend the rules to their own advantage.
But the market-fundamentalist argument does not hold water.
First, they are not modeling actual behavior; rather, they are building models on a peculiar assumption of rationality. Second, values
are reflexive, and market fundamentalism tends to reinforce selfserving behavior in politics. The greater the influence of market
fundamentalism, the more realistic their model of human behavior
becomes. Third, even if their models corresponded to reality, that
would not make their argument right. Economic actions have social
consequences that cannot be dismissed on the grounds that people
are selfish.
That is where the market fundamentalists' second line of defense
kicks in: "Markets tend toward equilibrium, so the pursuit of selfinterest also serves the public interest." Market fundamentalists
claim that they are as concerned with the public welfare as anyone,
and general equilibrium theory is a discovery about welfare. It is
supposed to be value-free, but it gives free markets a strong moral
undertone by arguing that general equilibrium is welfare-maximiz-
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All this is plain enough; the real difficulties begin once the distinction between market values and social values has been made.
How do they relate to each other? Clearly market values reflect the
interests of the individual market participant, whereas social values
touch upon tbe interests of society as perceived by its members.
xMarket values can be measured in monetary terms, but social values
are more problematic: They are difficult to observe and even more
difficult to measure. Measuring profits is easyjust look at the bottom line. But how to measure the social consequences of a course of
action? Actions have intentional or unintended consequences scattered among all the lines above the bottom line. They cannot be
reduced to a single line, because they affect different people in different ways. That makes it much harder to evaluate die results. The
H4
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Representative Democracy
Democracy provides a mechanism for making collective decisions. It is meant to achieve the same objective for collective choice
as the market mechanism achieves for individual choice. Citizens
elect representatives who gather in assemblies to make collective
decisions by casting votes. This is the principle of representation.
Representative democracy presupposes a certain kind of relationship between citizens and representatives. Candidates go on the
stump and tell citizens what they stand for; citizens then choose the
person whom they trust and respect most. That is the sort of repre-
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The confusion of functions is particularly pronounced in international affairs. Foreign policy tends to be dictated by domestic
policy considerations. The tendency is particularly strong in the
United States with its ethnic voting blocs. There is also a tradition
of pushing business interests by political means. The president of
an Eastern European country told me how shocked he was when in
a meeting with President Jacques Chirac, the French president
spent most of their time together pushing him to favor a French
buyer in the sale of the state-owned cement company. I shall not
even mention arms sales.
There has always been corruption in politics, but people are supposed to be ashamed of it and try to hide it. Now that die profit
motive has been promoted into a moral principle, politicians in
some countries feel positively ashamed when they fail to take advantage of their position. I observe this first-hand in countries where I
have foundations. Ukraine, it has been said, has given corruption a
bad name. I also made a study of African countries and found that
people in resource-rich and resource-poor countries are equally
poor; the only difference is that the governments of the resourcerich countries are more corrupt.
And yet to discard collective decisionmaking just because it is
inefficient and corrupt is comparable to abandoning the market
mechanism just because it is unstable and unjust. The impulse in
both cases comes from the same source: a yearning for perfection
and an inability to accept that all human constructs are flawed.
Our ideas about both the market mechanism and representative
democracy were formed under the influence of the Enlightenment.
We are inclined to treat the participants' views and the reality to
which tiiey relate as if they were independent of each other. Financial markets are supposed to discount a future that is independent of
present valuations; elected representatives are supposed to represent certain values independent of any aspiration to be elected. But
that is not how the world works. Values are reflexive. Consequently,
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Take the issue of abolishing the estate tax, which arose just at the
time of writing. As a citizen I argued against abolition; as a player I
take advantage of all the legal loopholes.*
It should be emphasized that I am proposing my rule as a moral
precept, not as the rational choice that people are bound to follow
as long as they are rational. It would be disastrous if in our rulemaking function we assumed that people are in fact prepared to abide by
this moral precept. The founders of the American republic did not
make that mistake. They assumed that people are selfish, and established checks and balances designed to blunt the disruptive effects
of self-interest.
Nevertheless, the founders could take a modicum of civic virtue
for granted. They did not reckon with the rise of highly competitive. transactional markets. The ascendancy of the profit motive
over civic virtue undermines the political process. That would not
matter if we could rely on the market mechanism to the extent that
market fundamentalists claim. But actions do have social consequences. The spread of market fundamentalism and the penetration
of the profit motive into areas where it does not properly belong
expose the institutions of American democracy to dangers that have
been largely absent during its two-hundred-year history.
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Pope and the Holy Roman Emperor. Today, when markets have
become so influential, a different kind of accommodation is required, one built on the distinction between rulemaking and competing.
People should be able to pursue their self-interest as long as they
compete by the rulesand they need not be sanctimonious about it.
When it comes to rulemaking, however, the common interest
ought to take precedence. True, an element of hypocrisy would
creep in as people affected public-spiritedness in arguing their case,
but that is preferable to the blatant pursuit of self-interest that prevails in politics today.
The trouble is that people cannot afford to pay attention to die
public interest. The global capitalist system is based on competition. and competition has become so intense that even the most
successful are reduced to having to fight for survival. Indeed, it is
the most successful who are under the most intense pressure, as the
case of Microsoft illustrates.* This is a sorry state of affairs. Under
previous dispensations, the rich and successful enjoyed a large
degree of autonomy and leisure. The landowning aristocracy could
devote itself to the finer things in life. Even John D. Rockefeller
could take off for an extended European tour at the height of his
success. But today's capitalists are slaves of the financial markets:
They have to perform every quarter. There used to be a large number of people who were not caught up in competition: professionals,
intellectuals, civil servants, rentiers, peasants; their numbers have
diminished. Our society is wealthier, but I believe we are all poorer
for it. There ought to be more to life than survival, yet survival of
the fittest has become the hallmark of our civilization.
I believe all this has distorted what ought to be an open society,
'People used to reproach Bill Gates, the chairman of Microsoft, for not giving away more of
his wealth. They did not realize that the demands of his business absorbed all of his energies.
Now that he is fighting against a Justice Department antitrust judgment, philanthropy is part
of his business strategy.
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A Reconsideration
I have discovered from the reaction to the original version of this
book that people have difficulties in accepting that markets are
amoral. Many people who care about morality (and some journalists
who are looking for a good angle) consider financial markets
immoral. The idea that market behavior is amoral is outside their
frame of reference. They suspect that my argument is self-serving: I
am using it as an excuse to justify my immoral activities as a financial speculator. The fact that I encounter this reaction so often
makes me think that I may be saying something novel and important. It should be remembered that the development of morality
and religion predates the development of financial markets. As a
financial speculator [ may have a different perspective from other
people who think about these matters.
I have engaged in a running battle on the subject with Frederik
van Zyl Slabbert, chairman of the Open Society Initiative for
Southern Africa (OSISA). He is a deeply religious man who cannot
accept the idea that any activity can be amoral. Indeed, he considers
amorality a worse sin than immorality. This raises the question of
whether morality is concerned with intentions or outcomes; given
the law of unintended consequences, the two are not identical. I am
willing to grant him the point that morality has to apply to intentions, because the outcome cannot be known in advance. Even so, I
insist that there is no point in applying moral judgments to decisions that have no outcomeand that is the case regarding the
social effects of individual investment decisions. Those decisions
affect only the profits of the individual, not the prices prevailing in
the market. That is what I mean when I say that markets are amoral:
The anonymous participant need not be concerned with the social
consequences of her decisions. By contrast, political actions, such as
voting or lobbying or even arguing, do have social consequences.
That is why we need to distinguish between our role as market pari58
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II
PART _
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the failings of the global capitalist system, the last three (Chapters
10-12) to the creation of a global open society. This chapter provides a general analysis of the global capitalist system in light of the
theoretical framework established earlier. Chapter 8 analyzes the
financial crisis of 1997-1999. Chapter 9 examines the way the capitalist system handled the collapse of the Soviet system. Chapter 10
proposes a new financial architecture that would make the global
capitalist system more stable and equitable. Chapter 11 discusses
one of the toughest tests we face at the present moment in history
namely, stability in thie Balkans. If we cannot tackle that problem in
accordance with the principles of open society, there is not much
point in discussing such principles in the abstract. Chapter 12
moves from the particular to the general and seeks to develop a
political architecture appropriate to a global open society.
170
An Abstract Empire
The first question that needs to be answered is whether there is
such a thing as a global capitalist system. My answer is yes, but it is
not a thing. We have an innate tendency to reify or personify
abstract conceptsit is built into our languageand doing so can
have unfortunate consequences. Abstract concepts take on a life of
their own, and it is only too easy to go off on the wrong track and
become far removed from reality; yet we cannot avoid thinking in
abstract terms, because reality is just too complex to be understood
in its entirety. That is why ideas play such an important role in historymore important than we realize.
Having warned against reification, I shall now proceed to engage
in it. The capitalist system can be compared to an empire that is
more global in its coverage than any previous empire. It rules an
entire civilization, and those outside its walls are considered barbarians. It is not a territorial empire, for it lacks sovereignty and all its
trappings; indeed the sovereignty of the state represents the main
limit on its power and influence. Therefore the empire is almost
invisible, possessing no formal structure.
The empire analogy is apt because die global capitalist system
governs those who belong to itand it is not easy to opt out. Moreover, it has a center and a periphery like every empire, the center
benefiting at the expense of the periphery. Most important, global
capitalism exhibits expansionist tendencies. Far from seeking equilibrium, it is hell-bent on conquest. It cannot rest as long as there
are markets and resources that remain unincorporated into the system. When I speak of "expansion," I do not mean it only geographi-
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cally but also in terms of its scope and influence. This is another way
of saying that market values are extending their sway over spheres of
activity that were previously governed by nonmarket values.
Although the empire analogy is apt, it is also dangerous. The
dominance of market values has aroused fierce opposition from various quartersnationalist, religious, cultural, and intellectual.
There is talk of a new kind of imperialism. It may sound subversive
to American and European ears, but it is important to understand
the emotions behind it. Global capitalism looks and feels very different at the periphery than at the center.
In contrast to the nineteenth century, when imperialism found a
literal, territorial expression in the form of colonies, the current
global capitalist system is almost: completely nonterritorialeven
extraterritorialin character. Territories are governed by states,
and states often pose obstacles to the expansion of capitalism. This is
true even of the United States, the most capitalist of countries. As a
consequence, the ownership of capital has a tendency to go offshore.
The global capitalist system is purely functional in nature, and
not surprisingly the function it serves is economic: the production,
consumption, and exchange of goods and services. It is important to
note that exchange involves not only goods and services but also die
factors of production. As Marx and Engels pointed out some 150
years ago, the capitalist system turns land, labor, and capital into
commodities.* As the system expands, the economic function
comes to dominate the lives of people and societies. It penetrates
areas not previously considered economicculture, politics, medicine, education, and law. Of course, the excessive influence of
money is nothing new. Perhaps the first instance was when Moses
returned from Mount Sinai and smashed the tablets upon discovering that people had started to worship Moloch in his absence.
Despite its nonterritorial nature, the system does have a center
and a periphery. Although the exact location of the center is nebu*In writing this section, I was greatly influenced by Karl Polanyi, The Great Transformation
(Boston: Beacon Press, 1989).
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Global financial markets started to emerge in the 1970s. The oilproducing countries banded together under OPEC and raised the
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price of oil, first in 1973 from $1.90 to $9.76 per barrel, then in
1979 (in response to political events in Iran and Iraq) from $12.70
to $28.76 per barrel. The oil exporters enjoyed sudden large surpluses, while importing countries had to finance large deficits. It
was left to commercial banks, with behind-the-scenes encouragement from Western governments, to recycle the funds. Eurodollars
were invented, and large offshore markets developed. Governments
started to make tax and other concessions to international financial
capital to entice it back onshore. Ironically these measures gave offshore capital even more room to maneuver. The international lending boom ended in a bust in 1982, but by that time the freedom of
movement for financial capital was well established.
The development of international financial markets received a big
boost around 1980 when xMargaret Thatcher and Ronald Reagan
came to power with a program of removing the state from the economy and allowing the market mechanism to do its work. This meant
imposing strict monetary discipline, which had the initial effect: of
plunging the world into recession and precipitating the international
debt crisis of 1982. It took several years for the world economy to
recoverin Latin America they speak of the "lost decade"but
recover it did. From then on the global economy has enjoyed a long
period of practically uninterrupted expansion. In spite of periodic
crises, the development of international capital markets has accelerated to a point where they can be described as truly global. Movements in exchange rates, interest rates, and stock prices in various
countries are intimately interconnected. In this respect, the character of the financial markets has changed beyond all recognition during the forty-five years tliat I have been involved in them.
When did the current capitalist regime begin? Was it in the
1970s, when the offshore market in Eurodollars was established?
Was it around 1980, when Thatcher and Reagan ascended to
power? Or was it in 1989, when the Soviet empire disintegrated and
capitalism became truly global? 1 opt for 1980, because that is when
market fundamentalism became the dominant creed at the center.
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Today the ability of the state to provide for the welfare of its citizens has been severely impaired by the mobility of capital. Countries that have overhauled their social security and employment
regimesthe United States and United Kingdom foremost among
themhave flourished economically, while others that have sought
to preserve themexemplified by France and Germany-have
lagged behind.*
The dismantling of the welfare state is a relatively new phenomenon, and its full effect has not yet been felt. Since the end of World
War II, the state's share of GNP in the industrialized countries
taken as a group has almost doubled.' Only after 1980 did the tide
turn. Interestingly, the state's share of GNP has not declined perceptibly. What has happened instead is that the taxes on capital and
employment have come down while other forms of taxation (particularly on consumption) have continued to ratchet upward. In other
words, the burden of taxation has shifted from the owners of capital
to the consumers, from the rich to the poor and the middle classes.
That is not exactly what had been promised, but one cannot say
they are unintended consequences because that was exactly what
the market fundamentalists intended.
An Incomplete Regime
Although we can describe global capitalism as a regime, it is an
incomplete regime: It governs only the economic function, even if
the latter has come to take precedence over others; political and
social functions remain grounded in die sovereign state.
The balance of advantage has swung so far in favor of financial
T h e same is not true for health care. France ranks first, the United Kingdom eighteenth,
and die United States thirty-seventh.
'Dani Rodrik, Has Globalization Gone Too Far? (Washington, D.C.: Institute for International
Economics, 1997).
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capital that it is often said that multinational corporations and international financial markets have somehow supplanted the sovereignty of the state. That is not the case. States retain their
sovereignty and wield legal and enforcement authority that no individual or corporation can hope to possess. The days of the East
India Company and the Hudson's Bay Company are gone forever.
There is an encroachment upon sovereignty, however, that is more
subtle.
Although governments retain the power to interfere in the economy, they have become increasingly subject to the forces of global
competition. If a government imposes conditions that are unfavorable to capital, then capital will go elsewhere. Conversely if a government keeps down wages and provides incentives for favored
businesses it can foster the accumulation of capital. So the global
capitalist system consists of many sovereign states, each with its
own policies, but each subject to international competition not only
for trade but also for capital. This is one of the features that makes
the system so complicated: Although we can identify a global
regime in economic and financial matters, there is no global regime
in politics; each state maintains its own regime. In mature democracies, enforcement powers are under civilian control, but in other
parts of the world that is not the case.
There is nothing new in the combination of a global economy
with political arrangements based on the sovereignty of the state.
The same applied a century ago. The difference is that a whole century has passed and both states and markets have changed. For
instance, a century ago states provided only rudimentary social services; after World War II the idea of the welfare state took root
throughout the West, and some countries find it difficult to abandon it. A century ago colonies proliferated; today colonialism is
unacceptable. Moreover, we enjoy a hundred years of hindsight. We
can see that the previous global capitalist regime ended in world
war, followed by revolutions, dictatorships, and another world war.
Can we not do better?
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on the value of the goods and services for which it can be exchanged.
But what are the intrinsic values that economic activities are supposed to serve? Nineteenth-century economists spoke in terms of
"utility," but the concept did not survive critical examination. Eventually economists decided that they need not resolve the issuethey
took economic agents' values as given. Their preferences can be expressed in the form of "indifference curves," and indifference curves
can be used to determine prices.
The trouble is that in the real world values are not given. In a
market economy, people are free to choose, but they do not necessarily know what they want. In conditions of rapid change, when
traditions have lost their sway and people are assailed with suggestions from all sides, exchange values may well come to replace
intrinsic values. Money has certain attributes that intrinsic values
lack: It has a common denominator, it can be quantified, and it is
almost uniformly appreciated by others. These are the attributes
that qualify money as a medium of exchangebut not necessarily as
the ultimate goal. Most of the benefits attached to money accrue
from spending it; in this respect money serves as a means to an end.
But money can also serve as a store of value. To the extent that other
people want money and are willing to do almost anything to get it,
money is power, and power can be an end in itself. Those who succeed may not know what to do with their money, but at least they
can be sure that other people envy their success, and wealth gives
them a sense of power. This may be enough to keep them going
indefinitely even in the absence of any other motivation. The ones
who keep it up wield the most power and influence in the capitalist
system.
Far be it for me to belittle the benefits of wealth; but to make the
accumulation of wealth the ultimate goal disregards many other
aspects of existence that also deserve consideration, especially if the
material needs for survival have been satisfied. I cannot specify what
those other aspects are; it is in the nature of intrinsic values that
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Boom-Bust
I am reluctant to apply the boom-bust model to the global capitalist system because I consider the system too open-ended and incomplete
to fit die pattern. Almost against my better judgmentnot everything should be interpreted as a boom-bust phenomenon-I can
identify the makings of a boom-bust pattern: a prevailing trend
namely, international competition for capital; and a prevailing b i a s namely, an excessive belief in the market mechanism. In the boom,
both bias and trend reinforce each odier; in the bust, both of diem
will fall apart. What would bring about die bust? T believe die answer
is to be found in die tension between die global scope of the financial
markets and die national scope of politics. Earlier I described the
global capitalist system as a gigantic circulatory system sucking capital
into die center and pushing it out into the periphery. The sovereign
states act like valves within the system. While die global financial
markets are expanding, die valves are open, but if and when the flow
of funds is reversed diey may close, causing die system to break
down. To follow up this hypothesis, I shall examine the prevailing
ideology first, die prevailing trend second.
Market Fundamentalism
The global capitalist system is supported by an ideology rooted
in the theory of perfect competition. According to this theory markets tend toward equilibrium, and the equilibrium position represents the most efficient allocation of resources. Any constraints on
free competition interfere with the efficiency' of markets; therefore
they should be resisted. This ideology was called "laissez-faire" in
the nineteenth century, but I have found a better term for it: "market fundamentalism." Fundamentalism implies a belief that has
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200
If the global capitalist system survives the current period of testing, this period will be followed by one of further acceleration that
will carry the system into far-from-equilibrium territory (indeed if
it is not there already). One of the features of this new, more
extreme form of global capitalism will be the elimination of one
plausible alternative to free-market ideology that recendy emerged:
the so-called Asian, or Confucian, model. As a result of the current
crisis, overseas Chinese and Korean capitalists whose wealth has
been severely impaired will have to give up family control. Those
who are willing to do so will survive economically; the odiers will
likely perish. The crisis has also aggravated the situation of heavily
indebted companies in all Asian countries. Those with foreign debts
have seen their debt-to-equity ratios deteriorate; those with domestic debt have been hit by the combination of rising interest rates and
declining earnings. The only way out is to convert debt to equity or
to raise additional equity. This cannot be done by the family; usually it cannot even be done locally. There will be no alternative but
to sell out to foreigners.
The net result will be the end of the Asian model and the beginning of a new era in which periphery countries will be more closely
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ticipant, I must maintain an open mind. I have no hesitation, however, in asserting that the global capitalist system will succumb to its
defects, if not on this occasion then on the nextunless we recognize that it is defective and act in time to correct the deficiencies.
I can already discern the contours of the final crisis. It will be
political in character. Indigenous political movements are likely to
arise that will seek to expropriate the multinational corporations
and recapture national wealth. Some of them may succeed in die
manner of the Boxer Rebellion in China or the Zapatista Revolution in Mexico. Their success may then shake the confidence of
financial markets, engendering a self-reinforcing process on the
downside. Whether it will happen on this occasion or the next is an
open question.
As long as a boom-bust process survives testing, it emerges reinforced. The more stringent the test, the greater the reinforcement.
After each successful test comes a period of acceleration; after a
period of acceleration comes the moment of truth. Exactly where
we are in this sequence it is impossible to determine except in retrospect.
A Critical Postscript
This text was written in the fall of 1998. The global economy has
weathered the storm much better than I expected. Looking back
from the perspective of 2000, we see the financial crisis of
1997-1999 as a glitch in the triumphant march of capitalism. If I
want to stick with my boom-bust approach I would have to say that
the global capitalist system has survived a severe test, thereby reinforcing the market-fundamentalist bias. But I shall argue in Chapter 10 that the heightened reliance on market discipline has
weakened the global financial architecture for the next test.
I feel obliged, however, to point out a flaw in my own analysis. I
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productivity, economic growth, and a stock market boom.* Technological innovations, of which the Internet protocol is only one, are
also reflexively connected witli the abolition of regulated monopolies in the telephone industry. And the penetration of the profit
motive into biological research has accelerated the revolution in
biotechnology. It has to be acknowledged that removing regulations
and giving the profit motive free reign can release creative energieslike letting a genie out of the bottle.
It was a serious error not to give this factor greater weight. It
ought to have been an integral part of my boom-bust analysis. I
argued that the financial collapse in periphery countries gave center
countries breathing space from the onset of inflation. There was an
element of truth in that argument, and it carried a lot of weight with
the monetary authorities. But the world economy has now recovered and inflation has still not raised its ugly head. The Federal
Reserve finds itself in practically the same position as before the
onset of the 1997-1999 financial crisis: It feels obliged to raise
interest rates, partly to prevent inflationary pressures from developing, but mainly to preempt an eventual bust in the stock market.
As I pointed out earlier, what makes financial markets inherently
unpredictable is that the boom-bust process is grounded in something real, and the reality that interacts with the participants' perceptions takes a different shape on each occasion. If financial
markets were a closed system they would be more predictable. On
this occasion the influence of technological innovations was real
and significant, and I made a serious mistake in leaving it out of my
analysis. It does not change my view that the stock market boom is
liable to be followed by a bust, and the Federal Reserve is right in
*I must confess a bias with regard to the Internet that amounts to blindness. I was aware of
the Internet before it was born because I was an investor in Bolt, Beranek, and Newman,
which designed its precursor, Arpanet, in die late 1970s. I saw the potential of Internet technology as a means to promote open society, and I spent tens of millions of dollars introducing
it to the former Soviet Union; yet I did not invest in it during the early stages when it went
commercial.
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afraid that Mahathir would impose capital controls. He did so, but
much later.)
If it was clear to us in January 1997 that the situation was untenable, it must have been clear to others. Still, the crisis did not break
out until July 1997, when the Thai authorities abandoned the peg
and floated the currency. The crisis came later than we had expected
because the local monetary authorities continued to support their
currencies far too long and international banks continued to extend
credit, although they must have seen the writing on the wall. The
delay undoubtedly contributed to the severity of the crisis. Reserves
were depleted, and the break, when it came, was bigger than necessary. From Thailand, the breakdown of the currency pegs quickly
spread to Malaysia, Indonesia, the Philippines, South Korea, and
other countries. But some other countries that became engulfed in
the Asian crisis did not have an informal dollar peg. What, then, did
the stricken economies have in common? Some argue that the
problem was their common dependence on a distorted or immature
form of the capitalist regime now described pejoratively as "crony
capitalism" but previously extolled as the "Asian model." There is
some truth to that claim, but attributing the crisis to specifically
Asian characteristics obviously does not give the full picture, as the
crisis then spread to Latin America, Russia, and Eastern Europe.
Practically all periphery countries were affected, although those
with closed capital markets and those that allowed their currencies
to depreciate fared better.
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antee the debt of other members of the group, thereby violating the
rights of minority shareholders. To make matters worse, Korean
companies operated with very low profit margins: The interest coverage of the thirty largest chaebol in 1996 was 1.3 times but only .94
by 1997 (meaning that interest charges were not covered by earnings). Korean banks extended easy credit as part of industrial policy.
The government decided to encourage certain industries, and die
chaebol rushed in, fearing they would be left out. This led to headlong expansion without regard to profits. In this respect, Korea was
consciously imitating the Japan of earlier days, but it turned out to
be a crude imitation of a much more subtle model. As I mentioned
before, Japan had the benefit of democratic institutions, whereas
South Korea had a military dictatorship during much of its postwar
history. The consensus-building tradition of Japan and the checks
and balances that characterize a democracy were missing.
When nonperforming loans began to accumulate, Korean banks
tried to earn their way out of the hole by borrowing even more
money abroad and investing it in high-yield, high-risk instruments
in countries like Indonesia, Russia, Ukraine, and Brazil. This was an
important contributing factor in the Korean crisis.
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to the dollar, in-country banks and borrowers assumed that the peg
would hold. Often they failed to hedge against the currency risk.
Therefore when the peg finally broke they found themselves with
large uncovered currency exposures. Scrambling for cover, they
put tremendous pressure on local currencies by buying the currencies in which the loans were denominated. The currencies overshot
on the downside, causing a sudden deterioration in the balance
sheets of the borrowers. For instance, Siam Cement, the largest
and strongest company in Thailand, incurred a loss of 52.6 billion
Thai baht in 1997 compared to its beginning equity of 42.3 billion
and 1996 profits of 6.8 billion.* Weaker companies fared much
worse. Many of the borrowers had used the loans to finance real
estate, and real-estate values were already declining when the peg
broke. Suddenly there was a credit risk as well as a currency risk,
which reduced the willingness of lenders to extend credit. Together
with foreign investors fleeing from declining markets, this set up a
self-reinforcing process that resulted in a 42 percent decline in the
Thai currency and a 59 percent decline in the Thai stock market
(expressed in local currency) between June 1997 and the end of
August 1998. The combined result was a 76 percent loss in dollar
terms over fourteen months. (Compare Wall Street's 86 percent
loss over three years between October 1929 and April 1933.)
The panic was spread to the neighboring countries by the financial marketsI used the image of a wrecking ball; others have
described financial contagion as a modern version of the bubonic
plague. The imbalances in some of the newly stricken economies
were less pronounced, The Malaysian economy was overheating,
but the monetary expansion had been mainly internal; the trade
deficit wras quite modest. Nevertheless, Malaysia was hit just as hard
as Thailand. The fundamentals in Indonesia seemed quite sound;
the main problem was that Indonesia had borrowed heavily from
*The exchange rate was 24-35 Thai baht to the U.S. dollar before the currency peg was abandoned on July 2,1997; it was at 45.9 at the end of the year.
zi8
199J-1999
Korean and Japanese banks that had their own problems and were
not in a position to renew their loans. Nevertheless, the devastation
in Indonesia was much greater than in Thailand. When the Hong
Kong dollar came under attack, the currency-board system caused a
rise in local interest rates that in turn depressed the value of real
estate and stocks. International banks doing business with Hong
Kong banks discovered a heretofore unknown credit risk. When
they entered back-to-back interest-rate swaps,* they had assumed
that the exposure was the same on both sides, so the credit risks canceled each other out; soon they realized that if the exchange rate
changed their Hong Kong counterparty would suddenly owe them
more money than they owed to the Hong Kong counterparty. This
forced international banks to curtail their credit lines to Hong
Kong. The Hong Kong market fell by 62 percent before the
authorities intervened to stabilize the market.
Credit risk became an even bigger issue in Korea, where some
banks actually defaulted on their guarantees. It was not long before
the financial crisis forced Thailand, and then Korea and Indonesia,
to seek the assistance of the IMF.
*Such a swap occurs when one bank switches between a fixed-rate and variable-rate loan for
its customer against the inverse switch by its correspondent bank abroad.
zig
GEORGE
SOROS
ferent from any previous one was that it originated in the private
sector; the public sector was in relatively good shape.
The IMF prescribed the traditional medicine used when the
public sector is in trouble: raise interest rates and reduce government spending in order to stabilize the currency and restore the
confidence of international investors. It did recognize the structural
defects in individual countries and also imposed tailor-made conditions, such as the closing of unsound financial institutions. But the
IMF programs did not restore the confidence of international
investors because they addressed only some aspects of the crisis, not
all. Since those aspects were interrelated, none could be cured separately. Specifically, currencies could not be stabilized until debt
problems were tackled, because debtors rushing to cover their
exposure depressed the currency, and currency weakness in turn
increased the debtors' exposure in a vicious circle.
Why did the IMF not realize this? Perhaps the answer is that the
IMF had not developed a methodology for dealing with imbalances
in the private sector; certainly some IMF officials had an inadequate
understanding of how financial markets operate. This was demonstrated in Indonesia, where the IMF insisted on closing some banks
without making provisions for the protection of depositors, provoking a classic run on practically all banks. (A similar lack of understanding was shown later in Russia.)
In Indonesia, the financial panic weakened President Suharto's
resolve to abide by die conditions of the IMF rescue program,
which he already found distasteful because it encroached upon the
privileges of his family and friends. The squabble between Suharto
and the IMF pushed the Indonesian rupiah into a free fall. Soros
Fund Management was badly hurt because we had bought Indonesian rupiah at around four thousand to the dollar, thinking that the
currency had already overshot when it had fallen from 2,430 as of
July 1997. It proceeded to fall to more than 16,000 in short order
a chastening experience. I had been fully aware of the corruption of
220
iyyj-iyyy
221
GEORGE
SOROS
222
0/1997-1999
refused to roll over their loans to Korean banks. The central banks
had to intervene and strong-arm the commercial banks under their
jurisdiction to renew their loans. A second IMF rescue package was
put together. Soon afterward the panic started to abate. Federal
Reserve Chairman Alan Greenspan made it clear that the Asian
troubles ruled out any possibility of an interest-rate increase, and
the bond and stock markets took heart. The wrecking ball stopped
swinging without having penetrated Latin America, with the
exception of the initial hit on Brazil. Both Korea and Thailand
benefited from the election of new governments dedicated to
reform. Only Indonesia continued to deteriorate, and eventually
Suharto was forced out of power. Bargain-hunters appeared; currencies strengthened; and by the end of March 1998 Asian stock
markets, including Indonesia's, recovered between a third and a
half of their losses (again, measured in local currencies). This is a
typical rebound after a major market break.
It was a false dawn. The financial collapse was followed by economic decline. Domestic demand in the heavily indebted countries
came to a standstill and imports shrank, yet exports did not expand
in dollar terms because of die fall in currencies. A high proportion
of exports was directed toward countries that were also affected. In
addition, exports were concentrated in a limited number of commodities where increased selling pressure drove down prices. Semiconductors, in which Korea, Taiwan, and, to a lesser extent, Japan
vied for the world market, wrere particularly hard-hit. The economic decline quickly spread to countries that originally had not
been involved. Japan slipped into a recession, and the economic situation in China worsened. Hong Kong also came under renewed
pressure. The fall in commodity prices, especially oil, hurt Russia
and other commodity-producing countries.
The problem in Japan was almost entirely internal. Given the
tremendous currency reserves and a large and growing trade surplus, it was within the power of the Japanese government to recapi-
22 3
GEORGE
SOROS
224
The global financial crisis reached its final culmination in the fall
of 1998 when Russia defaulted on its internal debt, thereby shaking
the international banking system to its core and causing the nearfailure of Long Term Capital Management (LTCM), a highly leveraged hedge fund.
I shall analyze the Russian experience in greater detail in Chapter
225-
GEORGE
SOROS
0/1997-1999
were willing to trade with them without asking for any margin. In
addition, they were able to obtain a large unsecured standby credit.
At the beginning of 1998 they dividended out a significant portion
of their investors' capital in order to increase the return on their
remaining capital. They ran a balance sheet of over $100 billion and offbalance sheet obligations of more than $1 trillion with equity capital
of $5 billion. They now suffered major losses, and their equity capital
had shrunk to around $600 million by the time the Federal Reserve
Bank of New York brought together in a room LTCM's major counterparties, who had the most to lose from its default, and encouraged
them to form a large enough pool to prevent a meltdown. Had they
not done so, the counterparties would have suffered major losses
both on their exposure to LTCM and on their own proprietary
accounts. Had it come to a liquidation of the outstanding positions,
it would have been difficult to find buyers; moreover, the creditworthiness of counterparties would have been brought into question,
precipitating a classic panic. But the Federal Reserve Bank of New
York did step in. The stock markets suffered a temporary sinking
spell, but the Federal Reserve lowered interest rates three times in
quick succession, and markets regained their composure. It was the
closest the international financial system has come to a meltdown,
and it was the only occasion that the stock markets at the center were
adversely affected by the global financial crisis.
I was finishing The Crisis of Global Capitalism just after the Russian default and just before the near-failure of LTCM. I saw it coming and was greatly affected by it. It pushed me overboard and made
me predict the imminent demise of the global capitalist system.
This is exactly what I wrote:
The global capitalist system was severely tested in the Mexican
crisis of 1994-1995, but it survived and came back stronger than
ever. That is when the period of acceleration occurred and the
boom became increasingly unsound. The fact that the holders of
Mexican treasury bills emerged from the crisis unscathed set a
227
GEORGE
SOROS
igpj-ip^p
GEORGE
SOROS
international financial system is likely to wear off; the forced liquidation of positions will be absorbed. One of the main sources of
tension, the strength of the dollar and the weakness of the yen,
has already been corrected. Another trouble spot, Hong Kong,
seems to have found a way to regain control over its destiny. Russia has been written off. An interest rate cut is in prospect. Stocks
have fallen far enough that many of them appear attractive. The
public has learned that it pays to buy dips in an everlasting bull
market and it will take time before it discovers that the bull market does not last forever. Therefore it will take time for the three
main negative forces to make their effect felt.
But the false dawn will be followed by a prolonged bear market, just as in the 1930s and in Asia currently. The public will stop
buying dips and start moving out of stocks into money market
funds or treasury bills. The wealth effect will take its toll and consumer demand will decline. Investment demand will also decline,
for a number of reasons: Profits are under pressure, United States
imports are rising and exports falling, and the supply of capital for
the less well established enterprises and for real estate deals has
dried up. Reductions in interest rates will cushion the market
decline and the economy would eventually recover if the global
capitalist system held together. But the chances of it falling apart
have greatly increased. If and when the U.S. domestic economy
slows down, the willingness to tolerate a large trade deficit will
decrease and free trade may be endangered.
Earlier I had thought that the Asian crisis would lead to the
ultimate triumph of capitalism: Multinational corporations
would replace the overseas Chinese families and the Asian model
would be assimilated into the global capitalist model. That could
still happen, but it is now more likely that countries at the periphery will increasingly opt out of the system as their prospects for
attracting capital from the center fade away. Banks and portfolio
investors have suffered severe losses and diere are more to come.
2^0
lyyj-njcjy
231
GEORGE
SOROS
1997-1999
*It is interesting to conjecture that the writing of The Crisis of Global Capitalism left me with a
bearish bias that hindered us in the subsequent boom. A similar connection occurred in 1987
when I was too busy discussing The Alchemy of Finance with economists in Boston to take evasive action just before the crash. In my heydey I used to have a rule against public pronouncements.
233
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SOROS
34
C II A P T E R
235
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SOROS
2-J<5
2J7
GEORGE
SOROS
238
239
GEORGE
SOROS
it was the most successful. Sundry private armies and mafias were
set up, and they took charge where they could. The managements
of state-owned enterprises formed private companies, mainly in
Cyprus, which entered into contracts with the state enterprises.
The factories ran at a loss, did not pay taxes, and fell into arrears in
paying wages and settling debts with other companies. The cash
flow was siphoned off to Cyprus. New banks were formed, partly by
state-owned companies and state-owned banks, partly by newly
emerging trading groups. Some banks made fortunes by handling
the accounts of various state agencies, including the Russian Treasury.
Then, in connection with the scheme for privatizing state companies by the distribution of vouchers, a market for stocks was born
before the mechanisms for registering stocks and efficiently settling
transactions were properly in placeand long before the enterprises whose stocks were traded started to behave like companies. A
culture of lawbreaking became engrained long before appropriate
laws and regulations could be enacted. The proceeds from the
voucher scheme did not accrue either to the state or to the companies themselves. At first the managers had to consolidate their control and service the debts they had incurred in the process of
acquiring control; only afterward could they begin to generate earnings within the companies. Even then, it was to their advantage to
hide rather than report earnings unless they could hope to raise capital by selling shares. But only a few companies reached that stage.
These arrangements could be justly described as "robber capitalism," because the most effective way to accumulate private capital if
one had hardly anything to start with was to appropriate the assets
of the state. There were, of course, some exceptions. In an economy
starved of services, it was possible to make money more or less legitimately by providing them, for example, through repair work or
running hotels and restaurants.
Foreign aid was left largely to two international financial institu-
240
241
GEORGE
SOROS
rists must have published three articles in the leading scientific publications. The distribution was accomplished in a few months, with
an expense ratio of less than 10 percent, and die scheme assured
payments in dollars to each recipient throughout the former Soviet
Union. This proved that my proposal for controlling the disbursement of funds was practical.
The rest of die money was spent to support research on the basis
of an internationally organized peer-review process in which the
most famous scientists of the world participated. (Boris Berezovsky,
who later became an infamous oligarch, contributed $1.5 million
for travel grants for reasons of his own. This was the only Russian
contribution.) All the funds were committed in less than two years.
My reasons for supporting scientists were complex. I wanted to
demonstrate that foreign aid could be successful, and I selected science as die field of demonstration because I could count on support
from members of the international scientific community, who were
willing to donate their time and energy for evaluating the research
projects. But the mechanics of the emergency aid distribution could
have been made to work for pensioners as well as scientists.
There were odier arguments in favor of helping scientists. During the Soviet regime many of the best brains had joined research
institutes where independent thinking was more tolerated than in
the rest of Soviet society, and they produced science that was at the
cutting edge of human accomplishments. It was a somewhat different strain from Western sciencemore speculative and less advanced technically except in a few priority areas. Scientists were also
in die forefront of political reform. Andrei Sakharov was particularly well known and admired, but there were many others. In addition, diere was die danger that nuclear scientists would be enticed
away by rogue states.
The entire undertaking was a resounding success and gave my
foundation an unassailable reputation. There were many attacks
against us because we engaged in controversial programs. For
instance, we ran a competition for new textbooks free of Marxist242
GEORGE
SOROS
It was against this background that I decided in 1997 to participate in the auction of Svyazinvest, the state telephone holding company. I agonized over the decision, being all too aware of the
244
GEORGE
SOKOS
246
A Real-Time Experiment
Sunday, August 9,1998
Ruble (spot)
6.29
Ruble Forwards*
GKO f
Prins1
S&P
U.S. 30-year Treasury-Bond
=
=
=
=
=
45%
94.52%
21.79%
1,089.45
5.63%
I had not been following developments in Russia closely until the last
two or tiiree daysI was too busy writing this book. I was aware that
the situation remained desperate even after the IMF agreed to an
$18 billion bailout package. Interest rates on Russian government
debt remained at astronomical levelsbetween 70 percent and 90
percent for one-year ruble-denominated treasury bills (GKOs). The
syndicate which had bought 25.1 percent of Svyazinvestthe Russian telephone holding companyand of which we were the largest
foreign participants, was approached by the Russian government to
provide a temporary bridge loan leading to the sale of the next
tranche of 24.9 percent in Svyazinvest. It was in our interest to make
the sale a success but I did not like the idea of throwing good money
after badthat is why I decided to focus on the situation.
It soon became obvious that the refinancing of the government
debt presented a seemingly insurmountable problem. The IMF
program had assumed that the domestic holders of the debt would
roll over (reinvest) their holdings when they matured; the only
question was at what price. If the government was successful in col"Implicit interest rates on one month nondeliverable forward contracts for rubles traded in
dollars.
'Yield on ruble-denominated Russian government treasury bills.
:
Yield on dollar-denominated Russian government bonds.
HI
GEORGE
SOROS
leering taxes, interest rates would eventually come down to tolerable levels, say 25 percent, and the crisis would be over. What this
line of reasoning left out of account was that much of the debt was
held by domestic holders who were not in a position to roll over
their maturing GKOs at any price. Corporations were being forced
to pay taxes, and what they paid in taxes could not be reinvested in
GKOs. More importantly, the banking sector, with the exception of
Sberbank, the state-owned savings bank, had bought GKOs with
borrowed money. Due to the decline in the Russian stock and bond
markets most of these banks were insolvent and even those which
were solvent were unable to renew their credit lines. As a result, not
only were they not buyers, some of their existing holdings had to be
liquidated in order to meet margin calls. Much of the credit had
come from foreign banks, some of whom tried to liquidate their
own positions as well. Waves of selling depressed the dollar-denominated Russian debt to record low levels. There was a full-blown
banking crisis in progress.
A banking crisis is usually contained by the central bank intervening and providing liquidity, for instance by lending money
against collateral at concessionary rates; but in this case the central
bank was prevented from doing so by the terms of the IMF agreement. That is what made the situation seemingly insoluble.
On Friday, August: 7,1 telephoned Anatoly Chubais, who was on
vacation, and Yegor Gaidar, who was minding the store. I told them
that in my view the situation was terminal: the government would
be unable to roll over its debt after September even if the second
tranche of the IMF loan was released. To aggravate the situation,
the Ukrainian government wras on the verge of defaulting on a $450
million loan arranged by Nomura Securities coming due next Tuesday. In these circumstances I could not justify participating in a
bridge loan: die risk of default was too great. I saw only one way
out: to put together a large enough syndicate to cover the Russian
government's needs until the end of the year. It would have to be a
public and private partnership. The Svyazinvest group could partic248
GEORGE
SOROS
6.30
91%
=
-
147%
23.92%
1,068.98
5.60%
GEORGE
SOROS
Thursday, August 13
Ruble (spot)
Ruble Forwards
GKO
Prins
S&P
U.S. 30-year Treasury Bond
m
=
=
6.35
162%
149%
23.76%
1,074.91
5.65%
Friday, August 14
Ruble (spot)
Ruble Forwards
GKO
Prins
S&P
-35
162.7%
172%
23.01%
SB
1,062.75
5.54%
GEORGE
SOROS
Ruble (spot)
Ruble Forwards
GKO
Prins
S&P
U.S. 30-year Treasury Bond
6.35
162.7%
172%
23.01%
1,062.75
5-54%
= 6.80
= 305%
=
29.41%
S&P
1,101.20
5.56%
= 7.15
= 443%
= defaulted
= 36.05%
"-55
GEORGE
SOROS
S&P
1,081.18
5.43%
Wednesday, August 26
Ruble (spot)
Ruble Forwards
GKO
Prins
= 10.00
= 458%
= defaulted
= 42.83%
z56
1,084.19
5.42%
There is no limit to how far a meltdown can go. The disintegration of the Russian banking system is occurring in a disorderly fashion. Banks have suspended payments and the public has panicked.
The terms of the GKO conversion offer were announced and at
first they were quite well received but the ruble has gone into a free
fall, making the offer practically worthless. The international financial system is experiencing a few disruptions. There may be
$75-100 billion of currency contracts outstanding and it is unclear
which of them will be honored. A credit agency has downgraded
Germany's largest commercial bank. A faint element of credit risk
has been introduced into international inter-bank swap transactions. It is likely to be temporary but it may reveal other weaknesses
because of the high degree of leverage employed. European and
U.S. stock markets have shuddered but are likely to regain their
composure. The meltdown in Russia is terminal with incalculable
political and social consequences.
That is the end of the diary.
GEORGE
SOROS
Russia's political and social evolution has been far less satisfactory.
Yeltsin's family, under the guidance of Boris Berezovsky, had been
looking for a successor who would protect them against prosecution
after the presidential election. They finally found one in Vladimir
Putin, director of the Federal Security Service. In the summer of
1999, he was made prime minister and selected as Yeltsin's candidate
for the presidency. There was a flare-up in Chechen terrorist activity. When Shamil Basayev, a Chechen guerrilla leader, invaded
neighboring Dagestan, Putin reacted vigorously. Russian security
forces attacked the Chechens and Putin issued an ultimatum,
announcing that Dagestan would be cleansed of terrorists by August
25. The target date was met. The Russian population responded to
Putin's handling of the situation enthusiastically, and his popularity
skyrocketed.
Then a series of mysterious explosions in Moscow destroyed
entire apartment houses, killing some three hundred people as they
slept. In the panic that ensued, fear and anger were directed against
the Chechens, assisted by a carefully orchestrated campaign among
the print and T V media. Putin invaded Chechnya, and the Duma
elections were held in an atmosphere of war hysteria. Very few candidates dared to oppose the invasion.
Grigory Yavlinsky was among the few. He supported the antiterrorist campaign in Dagestan but drew the line at invading Chechnya
proper. The popularity of his party (Yabloko) dropped precipitously
and barely met the threshold 5 percent vote required for representation in the Duma. A hastily concocted government party, Unity,
without any coherent program, came in second to the Communists,
with 23 percent. The Union of Rightist Forces, led by Chubais,
Sergei Kiriyenko, and other reformers, embraced Putin and scored
quite well with 8.6 percent. Yevgeni Primakov, who with the backing of Moscow Mayor Yuri Luzhkov had been considered the
favorite candidate for the presidency, was decisively defeated; their
party got only 13 percent. Using the momentum generated by the
victory in the Duma elections, Yeltsin announced his resignation on
258
GEORGE
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260
261
GEORGE
SOROS
of the Russian population strongly contrasted with its previous attitude. Admittedly the Chechen terrorists must bear a large share of
the blame; they captured aid workers and journalists, held them for
ransom, and often killed them. Fred Cuny, the hero of Sarajevo, perished in this way. There is hardly anybody left who dares to get
involved with helping Chechens or with publicizing the atrocities
they have suffered. There has also been a masterful manipulation of
public sentiment against mem. The fact remains that the attitude of the
Russian population is very different from what it was a few years ago.
At the beginning of the post-Gorbachev era, Russians had a positive aversion to violence. In fact, very little blood was spilled in the
early days, and on the rare occasions when people were killedin
Tblisi, Georgia, in Vilnius, Lithuania, and in the October 1993
siege of the Dumapublic opinion turned against those who used
force. Not anymore. By electing Putin in March 2000, the Russian
people have become implicated in the bloodshed in Chechnya.
There is a theory that a victim who has been sufficiendy brutalized
can become drawn to violence. The pattern seems to fit the case of
many violent criminals and it also seems to apply to ethnic violence.*
The Serbs have long considered themselves victims, and Slobodan
Milosevic could exploit this sentiment in pursuing a policy of ethnic
cleansing. Something similar seems to have happened in Russia.
Putin will try to reestablish a strong state, and he may well succeed. In many ways, that would be a desirable development. As the
Russian experience taught us, a weak state can be a threat to liberty.
An authority that can enforce the rules is indispensable for the functioning of a market economy. By accomplishing the transition from
robber capitalism to legitimate capitalism, Putin may well preside
over Russian economic recovery; my investments in Russia
including Svyazinvestmight finally pay off.
But Putin's state is unlikely to be built upon the principles of
*See Richard Rhodes, Why They Kill: The Discoveries of a Maverick Criminologist (New York:
Knopf, 1999).
262
263
GEORGE
SOROS
264
CHAPTER
10
A New Global
Financial Architecture
265
GEORGE
SOROS
capitalist system is far from stable. It is true that some of the disparities that prevailed before the crisis erupted are being corrected, but
new disparities have taken their place. Going into the crisis, IMF
intervention served to bail out international creditors, creating
what is now recognized as a moral hazard. Now the tables are
turned: The emphasis is on "bailing in" the private sectorthat is,
getting creditors to share the burden of rescue operations. This will
solve the moral-hazard problem and prevent excessive lending, but
no arrangements have been made to make up for the looming inadequacy of capital flows to periphery countries. On balance, the global
financial system has become less robust because the IMF has lost
much of its authority and reputation.
At the height of the crisis there was much talk about die global
financial architecture and the need for a new Bretton Woods. The
urge for radical reform has now subsided, and any reform that has
not already been put into motion is unlikely to be considered. The
only radical reform proposal has come from an advisory commission appointed by the U.S. Congress, the so-called Meltzer Commission.* It advocates a drastic downsizing of international financial
institutions. While it is unlikely to be implementedinternational
institutions are not so easy to changeit is likely to exert a constraining, negative effect on their operations. That is a pity. We
need stronger, better functioning international institutions, not
weaker, beleaguered ones.
Historically, financial crises have always led to the strengthening
of regulations. That is how central banking evolved to its present,
highly sophisticated stage. Financial markets have become global,
and we must strengthen international regulation. But the crisis of
1997-1999 promises to be an exception: The tendency now is to
reduce regulation. That is perhaps because the crisis hurt only the
periphery, not the center.
T h e International Financial Institution Advisory Commission (The Meltzer Commission),
Allan H. Meltzer, Chairman, submitted its final report to the United States Congress and
Department of Treasury on March 8, 2000.
266
GEORGE
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GEORGE
SOROS
270
27/
GEORGE
SOROS
272
275
GEORGE
SOROS
Here I would like to introduce another catchphrase to counterbalance die moral hazard: a level playing field. In global finance, the
field was anything but level prior to the recent crisis. The switch
from bailing out to bailing in will further tilt the playing field
against the periphery. The idea of bailing in involves some kind of
sacrifice from the private sectorextending the duration of loans or
promising to maintain credit lines. But the private sector is not in
the habit of making sacrifices without charging for it. The expectation of being bailed in will make credit more expensive.
The cost of capital is one of the most important variables in competitiveness. So tfie gap between center and periphery gets even
wider. This has already happened. The spreads charged to periphery countries are much higher than they were before the crisis of
1997-1999.
It is widely argued that this is all for the better, as spreads were far
too low and periphery countries borrowed far too much. It would
be much healthier if borrowings were replaced by direct investments. This argument is valid as far as it goes. Spreads were indeed
far too low, and direct investments are more stable and less likely to
cause a crash than either portfolio investment or short-term lending. But the problem of an uneven playing field remains; indeed, it
274
275
GEORGE
SOROS
A Modest Proposal
How can we create a more level playing field? I have been concerned about facilitating the flow of funds from the center to the
periphery ever since the crisis erupted. I wrote an article in the
Financial Times (London) on December 31, 1997,* advocating an
international credit gxiaranty scheme. I enlarged on the idea in the
original version of this book, arguing that the institution providing
the guarantee would have to function as a kind of international central bank. On January 4, 1999,1 wrote another article in the Financial Times,1 arguing the case for an international central bank. I must
acknowledge that since the crisis has subsided, these ideas are far
* "Avoiding a Breakdown: Asia's Crisis Demands a Rethink of International Regulation,"
Financial Times (London), December 31, 1907.
' "To Avert the Next Crisis," Financial Times (London), January 4, 1999.
276"
277
GEORGE
SOROS
z78
Yet the need remains. The success of the Federal Reserve in preserving prosperity in the United States stands in stark contrast to
the failure of the IMF to do the same for periphery countries. In die
recent crisis, the IMF imposed punitive interest rates, and the countries concerned were plunged into deep recession. But when the cri-
219
GEORGE
SOROS
sis threatened the United States the Federal Reserve lowered interest
rates, and the U.S. economy escaped unscathed.
Admittedly, the situation of the two institutions is far from analogous. The Federal Reserve is in charge of a financial system over
which it, and other federal authorities, can exercise control; the
FMF has to deal with sovereign states over which it has no authority.
One cannot expect the IMF to have provided liquidity to Russian
banks in August 1998 the way the Federal Reserve provided liquidity to Wall Street in October 1987. An international financial
authority in charge of maintaining the stability of the global financial system has to operate along lines radically different from a
national central bank. This does not obviate the need for such an
authority.
The most potent objection to strengthening the IMF is that it
lacks the methodology for distinguishing between sound and
unsound economic policies.* I accept the validity of this objection,
especially in light of recent developments. Both the IMF and the
United States Treasury, which calls the tune at the IMF, have gone
out of their way to appease the market-fundamentalist tendencies of
Congress. This bodes ill for the IMF's capacity to set correct policy
guidelines for individual countries. After a flawed performance in
the 1997-1999 crisis and now under attack, the IMF seems to have
lost its way.
I am not in a position to design the methodology the IMF ought
to use if it were to act as a kind of international central bank, but I
believe the IMF itself would be able to do so if it were given the
resources and responsibility. Let's keep in mind that national central
banks also lacked the appropriate methodology when they were first
entrusted with preventing financial crises and keeping their
economies on an even keel, but they developed it and became very
successful at their job; the same would happen with the IMF.
"The same objection applies to the Meltter Commission's recommendations that the IMF
should "establish 3 proper fiscal requirement" for countries eligible for IMF loans.
2 So
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Currency Regimes
The great unresolved problem of the international financial system is the currency regime. We do not have a clearly defined
exchange-rate system at present. The major currencies are free to
fluctuate against each other, but we do not have a free float, because
it is often felt that the authorities ought to intervene (occasionally
they do). The minor currencies range from a totally free float to a
totally fixed exchange rate backed by a currency board, with most
currencies situated somewhere between.
Experience shows that whatever currency regime prevails it is
bound to be flawed. Freely floating currencies are inherently unstable because of trend-following speculation; moreover, the instability is cumulative, because trend-following speculation tends to
grow in importance over time. Yet fixed exchange-rate regimes are
dangerous because they are too rigid, and breakdowns, when they
occur, can be catastrophic. The in-between arrangements are particularly troublesome. Currency pegs were the immediate cause of
the Asian crisis. 1 often compare currency arrangements with matrimonial arrangements: Whatever regime prevails, its opposite looks
more attractive.
The effect of the [997-1999 crisis has been to discredit the inbetween arrangements. Currency boards have held, but any less rigorously fixed exchange-rate system failed to withstand attack. Most
of the currency pegs have broken, and countries that tried to protect
their currencies have fared less well than those that allowed them to
depreciate. As a result, we are left with two extremes: currency
boards and floating exchange rates, with a preponderance of the latter.
Many experts try to justify this polarization, but they have a difficult
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Volcker, former chairman of the Federal Reserve, advocates introducing target zones for major currencies. While the intention is
admirable, the method proposed is not. Formal target zones provide
exactly what the name implies: targets for speculators to shoot at.
Exchange-rate stability is desirable, but it is impossible to determine what the equilibrium or central rate ought to be. Take the current circumstances. The United States has a trade deficit in excess
of 3 percent of GNP and rising, suggesting that the dollar should
fall; yet the economy is in danger of overheating, suggesting the
need for a strong dollar. Conversely, Euroland (the eleven members
of the euro zone) and Japan both have trade surpluses, adding
strength to the currencies, but weak economies, indicating currency
weakness. Correction of the economic imbalance and the trade
imbalance would therefore require currency moves in opposite
directions. The likelihood is that the currencies will in fact move,
first in one direction and then in the other. The trick is to figure out
when the changes in direction will occurand in what order
because they will be intimately interconnected with the fortunes of
the various financial markets and economies. The actions of the
authorities will have great influence on the outcome without actually determining it because of the unintended consequences. One
thing is certain: The situation cannot be understood in terms of
equilibrium.
l b impose a target zone on the authorities would be counterproductive because it would reduce their room to maneuver. Stability
needs to be pursued by more subtle means, and an important part of
the balancing act is to adjust the methods to prevailing conditions.
Authorities and markets are engaged in a never-ending cat-andmouse game: Both sides need to adjust to each other's behavior. The
authorities need to keep markets and economies on an even keel.
But tfiat is not their only goal. They want to assure growth, control
inflation, and, depending on the political complexion of die government, promote their vision of social justice. They also want to pull
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In the longer term, there could be a permanent solution: abolishing national currencies. The creation of the euro is showing the
way. It is increasingly realized that having a national currency is a
handicap for a small economy. In their distress, some Latin American countries are moving toward adapting the dollar as their
national currency; but that will make their dependence on policy
decisions made in the United States even more apparent. National
currencies cannot be abolished without creating an international
central bank, and that is a long way away. Right nowr the trend is in
the opposite direction.
igo
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which reinforces the trend that caused the loss in the first place. The
dangers of risk management as it is currently practiced became evident when Long Term Capital Management got into its difficulties.
Trend-following behavior in general and delta hedging in particular tend to increase the volatility of markets, but the market makers benefit from volatility because they can charge a higher
premium on options; the buyers of the options cannot complain
because the higher premium is justified by the higher volatility.
There may be hidden costs to the public, but they are well hidden.
As former Fed Chairman Paul Volcker has said, everybody complains about volatility but nobody will do anything about it because
the public cannot complain and the market makers in derivatives
make a profit coming and goingby creating volatility and by selling insurance against it.
Derivatives have become increasingly sophisticated, and some
carry a higher risk of causing a discontinuity than others. The 1987
stock market crash was precipitated by the widespread use of a
delta-hedging technique marketed under the name of portfolio
insurance. Those who bought the insurance became more heavily
invested in the market than they would have been otherwise. When
a market decline activated the insurance, the sudden volume of selling created a discontinuity, and the market crashed. To prevent a
recurrence, regulators introduced so-called circuit breakerstemporary trading suspensions that destroy the assumption of continuity upon which delta-hedging programs are based.
Similarly dangerous derivative instruments are in widespread use in
currency markets, but nothing has been done to discourage their
use. For instance, "knockout" options expire when a certain price
limit is reached, leaving the buyer of the option without insurance.
Knockout options used to be rather popular among Japanese
exporters because they are much cheaper than regular options.
When they were all knocked out at the same time, in February 1995,
a stampede ensued that drove the yen from about 100 yen to the
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that as long as the price clears the market it is in permanent equilibrium. I work with the opposite idea: In my view, markets are in permanent disequilibrium because of the radical uncertainty that
participants must cope with. I think the very idea of measuring risk
is flawed because it disregards reflexivity. Long Term Capital Management believed in the idea that risks can be measured, and diat
belief changed the magnitude of die risk that LTCM encountered
in its operations.
Perhaps derivatives and other synthetic financial instruments
ought to be licensed in the way new issues of securities must be registered with die Securities and Exchange Commission. It goes
against the grain that the creative energies of innovators should be
subjected to constraints administered by plodding bureaucrats, but
that is precisely what I suggest. Innovations bring intellectual
excitement and profit to the innovators, but maintaining stability
or, more exactly, preventing excesses ought to take precedence.
When I say diis I speak against my own personal interests and
predilections. I am a man of the markets, and I abhor bureaucraticrestrictions. I try to find my way around them. For instance, I limit
the number of funds I advise so I do not have to register with the
Securities and Exchange Commission. But I do believe that financial markets are inherently unstable; I also recognize that regulations are inherently flawed: Therefore stability ultimately depends
on a cat-and-mouse game between markets and regulators. Given
the ineptitude of regulators, there is some merit in narrowing the
scope and slowing down the rate of financial innovations.
The Russian meltdown in August 1998 revealed some of die systemic risks. The failure of LTCM, a hedge fund that pioneered the
use of risk management techniques based on efficient market theory, demonstrates the failure of the theory. The fact that a rescue
effort had to be orchestrated by the Federal Reserve indicates that a
systemic risk was involved. As I mentioned before, LTCM carried a
balance sheet of over $100 billion on an equity base of less than $5
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196
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Capital Controls
It used to be an article of faith that capital controls should be
abolished and the financial markets of individual countries, including the banking system, opened up to international competition.
Prior to die recent crisis, the IMF had even proposed amending its
charter to make these goals more explicit. The experience of the
Asian crisis has given us pause. The countries that kept their financial markets closed weathered the storm better than those that were
open. India was less affected than the Southeast Asian countries;
China was better insulated than Hong Kong. Opinion is now more
divided.
It is widely recognized that short-term capital flows can be destabilizing,* and there is much praise for the so-called Chilean model.
Chile imposed deposit requirements on capital inflows that penalized short-term capital movements. Chile also reformed its social
security system, which provided a domestic source of long-term
capital. As a result, it was relatively unscadied by the Mexican crisis
of 1994-1995 and the global crisis of 1997-1999.
On their own, short-term capital movements probably do more
harm than good. As the Asian crisis demonstrated, it is risky for a
recipient country to allow short-term capital inflows to be used for
long-term purposes. The proper policy is to sterilize the inflow.
That is usually done by accumulating reserves, which is costly and
tends to attract further inflows. The main justification for keeping
capital markets open, then, is to facilitate international trade and
the free flow of long-term financial instruments such as stocks and
bonds.
*No surprise. As a student I read studies detailing the destabilizing effect of "hot money"
movements during the interwar period.
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CHAPTER
11
n the wake of the global financial crisis, there has been much
talk about the global financial architecture. Practically no discussion has taken place on die global political architecture.
This is a strange omission, given that international politics is
full of conflicts, and arrangements designed to address them are
much weaker compared to the financial arena.
We have not had a political upheaval comparable to the global
financial crisis, but we have had a plethora of local conflicts, and in
the absence of an effective peacemaking mechanism some of them
proved rather devastating. If we look at a single continent
Africathe conflicts have been too countless to enumerate. Admittedly they do not endanger the global capitalist system, but the
same cannot be said of the nuclear-arms race between India and
Pakistan or the tensions in the Middle East and the Balkans, not to
501
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Geopolitical Realism
International relations are not well understood. They do not
have a scientific discipline to rely on, although there is a doctrine
303
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34
No World Order
Turning from ideology to reality, let us look at the actual state of
affairs in international relations. The distinguishing feature of the
current situation is that it cannot be described as a "regime." There
is no political system to correspond to the global financial system;
moreover, there is no consensus that a global political system is
either feasible or desirable.
This is a relatively recent state of affairs. Until the collapse of the
Soviet empire, one could point to a regime in international relationsthe Cold Warand it was remarkably stable: Two superpowers representing two different forms of social organization were
locked in deadly conflict. Each wanted to destroy the other, and
both prepared for it by engaging in a nuclear-arms race. As a consequence, each became strong enough to wreak havoc on the other if
attacked. This prevented the outbreak of outright war, although it
did not prevent skirmishes at the margin and jockeying for position.
305
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306
307
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the United Nations. After the debacle in Rwanda, it is no exaggeration to say that the United Nations is less effective today than it was
during the Cold War. At the same time, the United States has been
reluctant to take the lead on most international issues, lacking
domestic support. As a result, problems fester until they reach a crisis point where they can no longer be ignored. This state of affairs is
clearly unsatisfactory. There is an urgent need for the profound
rethinking and reorganization of international relations.
308
309
GEORGE
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310
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2'2
ip
G E0 ROE S0 BO8
around time in Sarajevo. They were then installed inside a road tunnel alongside the river; the water was drawn from the river and
purified. Cuny even found a disused reservoir on a nearby hill left
over from the Austro-Hungarian monarchy where water could be
stored and distributed by gravity. Unfortunately the local authorities did not give permission for the water to be turned on. We never
found out whyeither because it would have interfered with a
water-distribution racket or because the government needed gory
pictures on C N N showing people being killed while they waited for
water. I had to threaten going public with my protest before permission was granted.
The Open Society Foundation in Bosnia and Herzegovina had a
separate identity from the humanitarian relief operation. Its goal
was to support civil society, and it kept a distance from the authorities. It sustained the spirit of resistance that appealed to the conscience of the world. It certainly appealed to my conscience. My
visit merely confirmed wrhat I already knew from a distance: their
heroic commitment to the values of open society.
On my return I stopped off in Zagreb and had my one and only
meeting with President Franjo Tudjman. He accused me of supporting traitors in his country and spreading a dangerous new ideology called open society. The foundation continued to incur the
enmity of the government for its support of independent media.
Government control over the media was more complete in Croatia
than in Yugoslavia, and there was less opprobrium from Europe
because of religious and historical links. It left the foundation somewhat isolated and exposed.
I also became deeply involved in Macedonia. Greece had
imposed an embargo on Macedonia, in a dispute over its name, that
severely disrupted the Macedonian economy. Macedonia is landlocked and gets its oil supplies from Greece. At the beginning of
1993,1 gave Macedonia a loan of $25 million to enable it to buy sufficient oil to see it through the winter. Macedonia was a multiethnic
314
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gro, and Kosovo. The Kosovo branch supported the parallel system
of education that the Albanian population established when it was
excluded from die official system. Although most of the foundation's
support went to Albanian causesincluding Albanian-language
mediait did not operate along ethnic lines, and when I visited
Kosovo in 1997 I met at the foundation people drawn from all elements of civil society. The Albanian member of the foundation
board, Veton Surroi, was-and remainsan important voice for
reason and moderation. He played a crucial role in saving the Rambouillet Conference (February 6 to 23, 1999), which preceded the
military intervention in Kosovo, from total failure.
I should also mention my involvement in Albania and Bulgaria.
In Albania, I became engaged in the physical reconstruction of
schools. This was a deviation from our usual approach, which is
confined to what goes on inside schools, but it was rendered necessary by the fact that many schools had been destroyed when the
communist regime was overturned. We managed to establish an
efficient construction operation that was free of corruption and
engaged the communities in the rebuilding effort. I knew we had
succeeded when a contractor donated money to rebuild the school
in his home village. Subsequently, when the Berisha regime was violently overthrown in 1997, many buildings were again destroyed,
but not one of our buildings was touched. Our computers were
looted from the warehouse, but not from the schools. Those events
taught me that the Albanians have strong ethical standards and that
the rejection of government should not be equated with a lack of
public morality. On the whole, I had a very positive experience in
Albania, and the foundation enjoys widespread support and respect.
The same is true in Bulgaria.
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making under the U N Charter. This was also true in the Kosovo
crisis, in which the United States explored every avenue to Milosevic. When in the fall of 1998 Milosevic engaged in a large-scale
anti-insurgency campaign against the Kosovo Liberation Army
(KLA), displacing some 400,000 Kosovo Albanian villagers, U.S.
envoy Richard Holbrooke reached an agreement with Milosevic
that introduced into Kosovo unarmed observers from the Organization for Security and Cooperation in Europe (OSCE). The
observers were withdrawn and the Rambouillet Conference
arranged only after Milosevic broke the agreement and allowed the
atrocities to continue in the presence of the observers. Close study
of the events leads me to die conclusion that Milosevic wanted to be
bombed in order to carry out a well-prepared, large-scale ethnic
cleansing that would prepare the ground for de facto partitioning of
Kosovo.
Generally speaking, Western democracies were relatively insensitive to the interna] political conditions prevailing in the various
republics; they were much more influenced by religious, historical,
and national considerations. For instance, Germany insisted on die
recognition of Croatia and Slovenia as independent countries without making adequate provisions for die protection of Serbian
minorities. France, Greece, and to a lesser extent the United Kingdom sympathized with the Serbs. Prejudice against Muslims was
widespread in Europe. The United States concluded the Dayton
Accords without dealing with the festering problem of Kosovo. The
leader of the Kosovo Albanians, Ibrahim Rugova, believed in nonviolent resistance, putting his faith in the Western democracies; after
Dayton he started losing influence, and die KLA gained ground. It
is no exaggeration to say that the Kosovo crisis in 1999 was a direct
consequence of the Dayton Accords in 1995.
Western policymakers should have recognized that the conflict
in Yugoslavia was not only between Serbs, Croats, Bosnians, and
Albanians but also between open and closed society. This recognition would have made policymakers more sensitive to issues like die
3i8
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320
321
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Foreign Aid
When I advocate constructive intervention for the sake of building open societies, I am advocating foreign aid. In a sense, that is
GEORGE
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decide what the foundation ought to do, and they take responsibility for their actions. I am often surprised by what they do. Some of
the best programs are those that I never envisioned. Admittedly it is
a hit-and-miss affair. We have had some great successes, some indifferent results, and occasional failures that require a change of personnel.
1 wish this approach could be replicated on a larger scale, but I
realize it cannot be done. Indeed, my own foundation network has
reached a scale where it has lost some of its erstwhile flexibility and
begun to take on the character of a bureaucracy. Still, I am an independent agent. I can afford to admit and correct my mistakes; that is
why my efforts have been for the most part successful. Politicians
and public servants do not enjoy such luxury, for they must justify
their actions in the eyes of a hostile public. This makes them riskaverse in situations where it is difficult to produce positive results
without taking risks.
Official foreign aid cannot possibly be as effective as my philanthropic endeavors (although it can make up in quantity what it lacks
in quality). Still, we cannot do without it if we want to build a global
open society. The same argument applies to other forms of official
intervention: The fact that it is ineffective does not mean that it is
unnecessary; it means that we should try to make it more effective.
Rule-based incentives are preferable to government-administered
programs. That is why the global political and financial architecture
becomes so important. But even in administered programs it should
be possible to unleash the creative energies of people who care
there is no reason why entrepreneurship should be confined to the
pursuit of profit.
GEORGE
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two main reasons: The territory is too small, and the political
authorities have their dirty fingers in every pie. The regional
approach would eliminate both shortcomings. A common market
and a common currency, buttressed by the infrastructure of a market economy, would allow economic development. There is a lot
more to be done on the social and political side and in coming to
terms with the sins and traumas of the past, but the way to a better
future is clearly mapped out.
It is not difficult to generate local support for this plan, because
Europe holds tremendous appeal for the region. My network of
foundations is mobilizing civil society behind it. The various governments (with the obvious exception of Milosevic) are eager to
cooperate. There is also a lot of support within the European
Union. In addition to Romano Prodi, government figures in Germany, Italy, Britain, and other countries have spoken along these
same lines. The U.S. government is also supportive, especially as
the costs would be borne primarily by the European Union.
Although the plan is reminiscent of the Marshall Plan, the costs
would be quite modest because the region is tiny in economic
terms, smaller than the Netherlands. Nevertheless, money is a
problem. Member countries are strongly opposed to increasing the
budget of the European Union; they want to retain control over
their funds by going through donor conferences. This would
undermine one of the key ideas behind the plan: Countries in the
region should compete for support, rather than donors competing
with each other and allowing gatekeepers to divert the funds to
their own purposes.
The other problem is organization. In translating the concept
into reality, the foreign ministries of the European Union countries
devised the Stability Pact, which is nothing but an empty framework waiting to be filled with content; the finance ministries don't
like the framework and refuse to provide funds. The bureaucrats of
the European Union don't like it either. They are used to bilateral,
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328
3*9
CHAPTER
12
_l_ ^ H J
33'
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tem and the implosion of the Soviet empire. This was seen as a great
victory for the United States. But the nature of the victory was
never properly understood because the two rolessuperpower and
leader of the free worldwere fused. Neither was it clear what the
free world stood for: capitalism or open society. Was the collapse
brought about by aggressive U.S. pursuit of the Strategic Defense
Initiative (the so-called Star Wars scheme), the superiority of capitalism, or the yearning for freedom within the Soviet empire? The
response to tbe collapse was equally confused.
U.S. foreign policy has remained confused ever since. There can
be no doubt that we like being the sole remaining superpower. But
we also wish to be the leader of die free world, as during the Cold
War, and that is where confusion creeps into the picture. During
the Cold War the free world was threatened in its very existence
and sought the protection of a superpower. Western democracies
banded together in NATO, which was under United States domination. But the Cold War is over, and the threat has been removed.
Other countries no longer have the same reasons to submit to tbe
will of a superpower. Therefore to remain the leader of the free
world we ought to change our behavior. We ought to lead by building a genuine partnership and abide by the rules that we seek to
apply to others.
We have chosen a different way. We feel that our superpower status ought to confer special privileges and we are entitled to dominate the international institutions to which we belong. We were
eager to expand NATO; we belong to the World Trade Organization, the International Monetary Fund, and the World Bank, but
only because we can dominate them.* We have gone out of our way
to bash the United Nations. And under the influence of hard-line
conservative leaders like Senator Jesse Helms we are absolutely
*Compared to the IMF, the World Bank is more independent of U.S. influence; even so, its
outspoken senior vice president and chief economist, Joe Stiglitz, found it appropriate to
resign when his views annoyed the United States.
332
333
GEORGE
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grip over their subjects, but in projecting their power abroad they
are acutely aware that they might awaken a slumbering giant. The
United States is anything but repressive at home, yet it flaunts its
power internationally more than any other country. It does act
occasionally as an aggressor when it sees no danger of body bags
bombing a pharmaceutical factory in Sudan, for example. Even
more to the point, it is aggressive in refusing to cooperate. It refuses
to make good on its dues to the United Nations; it hesitated to
replenish the IMF during the global financial crisis; and it imposes
sanctions unilaterally at the drop of a hat or, more exactly, at the
instigation of domestic constituencies. The United States was one
of only seven countries that voted against establishing the International Criminal Court (ICC). The other recalcitrants were China,
Iraq, Israel, Libya, Qatar, and Yemen. The Pentagon, which objected toU.S. military personnel coming under international jurisdiction, went so far as to instruct U.S. military attaches based in
U.S. embassies around the world to enlist the military leaders of
their host governments to lobby against the International Criminal
Court. This was a particularly questionable tactic in countries
where civilian authority over the armed forces is not firmly established.
The United States has at least a plausible argument against the
ICC, namely that the ICC might not provide the same guarantees
to American citizens as the United States Constitution.* But there
is no justification for Congress' failure to ratify uncontroversial
international agreements such as the Law of the Sea Convention
and the Convention on Biological Diversity. The United States is
one of only nine nations who have not ratified the latter Conventionalong with Afghanistan, Kuwait, Liberia, Libya, Malta, Thailand, Tuvalu, and Yugoslavianot very distinguished company."
It does not go without saying that the United States should cooperate with others. Those who are guided by geopolitical realism or
*I disagree with this argument because the issue does not arise as long as a U.S. court is willing to try the case as for instance in the My Lai massacre.
334
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336
331
GEORGE
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33*
339
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NATO
It so happens that there already is an alliance with an appropriate
membership: NATO. But NATO is a military alliance, and the task
of fostering open societies is anything but military. NATO does
have a political dimension, and its political objectives are stated
explicitly in terms of fostering democracy. That is not surprising,
because NATO is a creature of the Cold War. But the political
dimension was never activated and remained an unused appendage
of the military alliance.
After the end of the Cold War, NATO became an institution
without a mission. Its objectives had to be rethought. An intense
discussion ensued, but it was framed by the military nature of the
alliance. There were voices that argued for a new kind of alliance
that would also include Russia, but there were others that were
dominated by geopolitical considerations. In the end, a compromise
was reached: NATO would expand eastward, incorporating some
former members of die Warsaw Pact, establish a Partnership for
Peace with other former communist countries, and keep the possibility of additional future members open-ended. Eventually three
new members were added: Poland, Hungary, and the Czech Republic. Romania and Slovenia campaigned hard for inclusion but failed;
341
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GEORGE
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troops on the ground, and when they engaged the Yugoslav army it
became vulnerable to air attack. Albanian fighters on the ground
turned out to be more threatening to the Yugoslav army than
NATO troops would have been. Russia played a double role. On
the one hand, Viktor Chernomyrdin was immensely helpful by disabusing Milosevic of any hope of Russian support; NATO owes him
a debt of gratitude. On the other hand, the Russian army surprised
NATO by moving in to the Pristina airport ahead of it; it took some
maneuvering to finesse the Russian military presence. This schizophrenia reflected a split between political and military considerations: Politically Russia needed to earn points with the West
because of its economic and financial dependency; militarily,
NATO was considered a threat.
GEORGE
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341
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348
349
GEORGE
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35
35i
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GEORGE
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354
355
GEORGE
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356
357
GEORGE
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I do not want to go on elaborating the features of an Open Society Alliance because the further I go the more I feel enveloped in an
air of unreality. The details would have to be worked out by the participants. The Alliance could take many forms, ranging from a formal alliance to ad hoc coalitions addressing special countries or
issues. Viewed in this light, the idea is far from unrealistic; indeed, it
is already in the process of being implemented. My foundation network is participating in a number of ad hoc coalitions, ranging from
the Landmines Treaty to the Media Development Loan Fund,
devoted to fostering independent media in countries where they are
needed.
The initiative to create a global open society cannot be expected
to come from governments; it must have the support of the electorates. Democratic governments are supposed to be responsive to
the wishes of the electorate; unless people genuinely care about the
principles of open society, those principles will not prevail.
It may be asked, How can this statement be reconciled with my
earlier unkind remarks about the self-appointed and self-righteous
guardians of civil society? Very easily. While the impulse for promoting the principles of open society must come from the people,
civil society cannot do the job on its own; it must enlist the support
of governments. My foundations have found thiat they can have
358
359
Conclusion
August zooo
360
Index
2 0 1 - 2 0 3 , 211-215
361
Index
Brazil (amt.)
Russian investments, 246
and World Bank, 282, 284
Brerton Woods institutions, xiv, 174, 189,
190, 266, 287, 352
Bulgaria, foundation in, 316
Bundesbank, 289, 300
Burma
fascism in, xi
foundations banned in, x
See also Myanmar (Burma)
Bush, George, 236, 336
Canadian fisheries, 87-88
Capital
controls on, 175,298-300
free movement of, x, 167-168, 174
Capitalist system. See global capitalist system
Catholic Church, 31,156
Centre for European Policy Studies (CEPS),
y-s
Chechnya
political situation, 328
Russian invasion, 261-262, 313
terrorist activities, 258-259
Chernomyrdin, Viktor, 246, 256, 259, 344
Chile
capital controls, 298
debt crisis of 1982, 191,192
China
banking system, 216
Boxer Rebellion, 204, 275
controls on information, 181
economic reform, 202, 203
economic situation, 223, 224-225, 298
state-owned enterprises (SOEs), 225
Tiananmen Square massacre, 224
and World Bank, 282
Chirac, Jacques, 150
Christianity, 57, 123
Chubais, Anatoly, 239,244, 245, 246,248,
258,259,260
Citibank, 99
Citigroup, 226
Clark, Wesley, 342-343
Clinton, Bill, 307, 336, 343
Closed society, vs. open society, 103-109
Cold War, xv, 105, 302, 305-307, 331, 332,
341
362
Index
Encumbered individual, 127-1 30
Engels, Friedrich, 92, 172
Enlightenment, 51, 52, 121-125
Entrepreneurship, and global capitalist system, 205-206
Epimenides the Cretan, 15
Equilibrium, definition, 63, 76, 111
Equilibrium theory, xiii, jowi, 19,45-46,
50-51
long-term vs. short-term equilibrium, 63
E R M See exchange-rate mechanism (ERM)
European Commission, 325, 338-339
European Community, 307, 312
European Union (EU), xviii, 184, 287, 325,
3- :6 . 33. 337-34' 344. 349
EU. See European Union
Evolutionary biology, 94
Evolutionary systems theory. 14, 16, 17, 87,
89
Exchange-rate mechanism (ERM), 193,289,
300
Exchange Stabilization Fund, 249
Fallibility, xxii, xxviii, 25, 26-27, 309
and historical events, 93
as a universal idea, 121
Seeako Age of Fallibility; radical fallibility
Far-from-equilibrium conditions, xxvi, 64,
79, 80, 81, 107-108, 148, 208
Fascism, xi
Federal Reserve
and interest rates, 71, 191, 206, 223, 280
monetary policy, 187
and Russian economic collapse, 294-295
and U.S. economy, xxvii, 152, 279-280,
289
Ferghana Valley, 320-322, 328, 348
Fertile fallacy, xxvi, 25, 30, 31-32, 58
Feyerabend, Paul, 42
Fidelity, 200
Financial architecture. See global financial
architecture
Financial crisis of 1997-1999, xiv, xxviii, 65,
69, 74, 77, 142, 152, 170, 208-234
IMF role in, 219-222
instability of international finance,
215-219
reasons for, 194
recovery from, 194
unfolding of the crisis, 222-234
Financial hypothesis, 30
Financial markets
as amoral, 138-141, 160
as a historical process, xxvi
reflexivity in, 58-90
stability of, xiii
Fischer, Stan, 239
F'oreign aid, 237, 240-241, 322-324
Frankel,Jeffrey, 87
"Free-rider" problem, 154-155
French Revolution, 123
Freud, Sigmund, 13,46
Friedman, Milton, 187,198
Froot, Kenneth, 87
Fundamentals, 75-76
and participants' bias, 62
and stock prices, 63-64
and valuations, 60-61
Gaidar, Yegor, 238, 239, 248, 249, 254
Game theory, 14,87,88, 113-114
Gates, Bill, 156
Genscher, Hans-Dietrich, 340
Geopolitical realism, 303-305
German reunification, 65, 193, 237
Germany
business motivations, 184
stock market rise, 199
Giddens, Anthony, 14
Glass-Steagal Act, repealed, 188
Gligorov, Kiro, 315
Global capitalist system, 167-207
as an incomplete regime, 177-181
asymmetry between lenders and borrowers, 190-194
boom-bust model and, 196
center and periphery, relationship
between, xxvi, xxvii, 168-169,172-173
Confucian/Asian model and, 201-203
credit, role in, 185190
and economic incentives, xix
empire analogy, 171-173
entrepreneurship and, 205-206
expansionism and, 171-173
future of, 195
market fundamentalism and, 196-198
money, role in, 181-185
triumph of capitalism, 198-204
Global financial architecture, 265-300
capital controls, 298-300
3 (>3
Index
Global financial architecture (cant.)
derivatives, 290-295
hedge funds and banking regulations,
296-298
a level playing field, 274, 276
a modest reform proposal, 276-280
moral hazard, 273, 274
new architecture (reform proposals),
270-276
and the World Bank, 281-286
Global political architecture, 301-329
geopolitical realism, 303-305
Godel's numbers, 24-25
Goldfarb, Alex, 259
Gorbachev, Mikhail, 23, 237, 306-3078
Gore, Albert, 336
Grameen Bank (Bangladesh), 163
Great Depression (1930s), xiv, 100,187,197,
203
Greenspan, Alan, 187, 223
Group of Seven (G7), 251-252, 255
Hayek, Friedrich, 117-118
Hedge funds, 32, 55, 56,81-82, 215-216,
296-298
Hegel, Wilhelm Friedrich, 92
Heisenberg's uncertainty principle, 16,40,
44-45> 8 3
Helms, Jesse, 332, 335
Historical process, reflexivity in, 10-13,
91-115
Historic events, 12-13,91
Holbrooke, Richard, 318
Hong Kong
banking and financial system, 216, 219
economic development, :8o
financial crisis, 223, 229, 298
Hudson, Richard, 353
Human behavior
scientific explanation of, 13
selfish gene, 93-95
Human condition, 2 5
Humdruni/everyday events, 12-13, 26, 28,
91
Hungarian Academy of Science, 104
Hungary
democratic elections of 1990, 192
during World War II, 107-108
foundation in, 104-105
364
Index
Japan
banking and financial system, 212-214,
297. 299
business motivations, 184
during Asian financial crisis, 212-214,222
economic development, 179
interest rates, 191
recession, 223
U.S. relations, 203
Jefferson, Thomas, 147
Jesus Christ, 31
Kant, Immanuel, 122, 124, 126, 127
Kay, John, 74
Kennedy, John F., 175
Keynesian economics, 197-198
Keynes, JohnMaynard, 45, 186, 187, 287,
300
Khrushchev, Nikita, 12, 97
KimDaeJung, 202, 221
Kiriyenko, Sergei, 246, 253, 258
Kissinger, Henry, 304, 33'
Kohl, Helmut, 236-237
Korea
business motivations, 184
economic development, 179, 223
economic policy, 202, 223
financial crisis, 186,191, 222,297, 299
LMF loans, 271
Russian investments, 246
Kosovo crisis
Dayton Accords (1995), 318
NATO intervention, xviii, 310-311,
319-320,327-328,343-345
UN peacekeeping mission, 317, 327
See also Yugoslavia
Kosovo Liberation Army (KLA), 318,343
Kovalev, Sergei, 155,261, 322
Krugman, Paul, 299
Kuhn, Thomas, 42
Kyrgyzstan, 320-321
Lack of correspondence, 8-9, 20, 26,93
Lafont3ine, Oscar, xiii
"Laissez-faire" doctrine, 196, 197,304
Land mines ban, 140, 358
Law of the Sea Convention, 334
Laws of mathematics, 24-25
League of Nations, 306
365
Index
Merriweather,John, 226
Meiton, Robert, 14
Mexico
financial crisis of 1982,66, 191
financial crisis of 1994, 186, 269-270, 298
tesobonos (treasury bills), 270
Zapatista Revolution, 204
Michelson-Morley experiment, 82
Microsoft, 199
Military alliances, xvii
Milosevic, Slobodan, 262, 310-512, 317,
318,319,320,343,344
Milutinovic, Milan, 315
Money
major functions of, 181
role in global capitalist system, 181-185
Moralitycategorical imperatives, 126, 127
universal principles of, 124-125
Moral philosophy, 125-127
Mortgage Guarantee Insurance Corporation ("Magic"), 76
Multilateral Investment Guarantee Agency,
283
Mutual assured destruction (MAD), xv
Myanmar (Burma), 214
NATO. See North Atlantic Treaty Organization (NATO)
Natural selection, 94
Nazism, xxi, 107-108
Near-equilibrium conditions, 79, 81, 107
Neier, Aryeh, 133
Nemtsov, Boris, 244, 259
Newton-Smith, William, 25
NGOs. See nongovernmental organizations
(NGOs)
Nongovernmental organizations (NGOs),
161-162, 282, 283, 349, 357-358
Nonmarket sector, 169
North Atlantic Treaty Organization
(NATO), xvii, 341-344
during the Cold War, 332
expansion, 341-342, 348
intervention in Kosovo, xviii, 310-311,
319-320, 327-328, 343-545
Northrop, 139
Novgorod, Nishny, 244
Nunn-Lugar Act, 263
(OAS)
OPEC. See Organization of Petroleum
Exporting Countries (OPEC)
Opening the Soviet System (Soros), 96
Open societydefinition, 130
origin of term, xx
specific conditions of, 133
Open Society Alliance, 330-359
Open Societ)1 and Its Enemies (Popper), xx, 15,
103,136
Open Society Foundations, ix-x, xvii, xxii,
104-106, 236
in the Balkans, 311
in Bosnia and Herzegovina, 314
and definition of open society, 122
missions vs. self interest, 34
Open Society Fund, 104
Open Society Initiative for Southern Africa
(OSISA), 158
Open Society Institute, in the U.S., ix
Organization for Economic Cooperation
and Development, 297
Organization for Security and Cooperation
in Europe (OSCE), 318, 344
Organization of American States (OAS), 347
Organization of Petroleum Exporting
Countries (OPEC), 174-176
Paradigm shift, origin of term, 42
Paradox of the liar, 15
Paris Club, 190
Participants, vs. observers, 9-10, 19
Participants' bias, 10-11, 60, 61-64
Partnership for Peace, 342
Partnership for Prosperity, 342
Perfect competition, theory of, xiii, 52, 183,
196,304
Performance funds, 32
Peru, fascism in, xi
Philanthropy, 33-34
Philippines, financial crisis of 1997, 2 10
Playing by the rules, xxvi
Poland, open society foundations, 311-312
Political architecture, weaknesses in, xiv
Political architecture. See global political
architecture
Polyani, Karl, 172
366
Index
Rulemaking, and playing by the rules, xxvi,
'S3. r 54
Russell, Bertrand, 15, 16
Russia
and default on internal debt, xxvii, 221,
225-231,270
economic reform efforts, 237-239
excessive lending, 186
financial collapse, 235-264, 294-295
financial crisis, 222, 223, 225-231
foreign aid, 237, 240-241
investments in, 244-247
investments in, a real-time experiment,
247-2 57
privatization in, 239-240
Shatalin Plan, 238
support of scientific research, 241-243
and World Bank, 282,284
Rwanda, 308
Ryzhkov, Nikolai, 238
367
Index
Social values (com.)
in an open society, 152-163
and the common interest, 141,147, 149
shared social values, 112-113, 114
in a transactional society, 113-115
vs. market values, 138-142
in well-defined communities, 149
Solana,Javier, 325, 340
Solow, Robert, 74,82
Somalia, U N intervention, 307
Soros Fund Management, 208,209, 232,
234,296
Soudi Africa
foundation in, 104
nonprofit enterprises, 162-163
South Korea
chaebol (conglomerates), 211-212
financial crisis, 210, 211-212
Sovereign state
conflicts in, xv, 302
and national interests, 303, 308, 333
Sovereignty, nation-state, 124, 168
Soviet Union
collapse of, xxi, xxii, 96-100, 105, 235,
23 6 >34.33i-33 2
economic reforms, failure of, 97-98
foreign aid, xviii
See also Russia
Special Drawing Rights (SDRs), 273, 278
Stability Pact for Soudieastern Europe, xviii,
287,324-329,340,346,359
Steinberg, Saul, 67
Stepashin, Sergei, 260
Stock market
crash of 1929, 188
crash of 1987, 189
equity leveraging, 65
in Germany, 199-200
Japan Nikkei index, 213
and mutual funds, 200-201
in Sweden, 100
technical analysis and, 78-79, 88-89
thesis about, 77
Suharto, 202, 214, 221, 223
Surroi, Veton, 316
Svyazinvest group (Russian telephone holding company), 244-245, 247, 248, 259,
260
Sweden, stock market, 100
Taiwan
economic development, 180
financial crisis, 223
political situation, 302
reunification with mainland China, 2 2 5
Tajikistan, 320-321
Technical analysis, 78, 88-89
Thailand
economic policy, 202, 223
financial crisis of 1997, 208, 210, 216,
218, 299
financial situation, 287
IMF loans, 271
political situation, 180
Thatcher, Margaret, 176, 198, 236
Theory of relativity, 16, 82
Thinking, and reality, 3-37
Tractatus Ij>gico-Philosopbims (Wittgenstein),
16
Transactional society, 113-115
Transportation revolution, of the 19th century, 173
True or false statements, 2 2
Truth
correspondence theory of, 5-7,15
definition of, 15
reflexive concept of, 21-23
Tudjman, Franjo, 314, 317, 319
Two Sources of Religion and Morality (Bergson), xx
Ukraine
financial crisis, 222
loan defaults, 248
and political corruption, 150
Uncertainty, element of, 13
Uncertainty principle, 16, 40,44,45,83
United Kingdom, 307
See also London
United Nations (UN), 350-355
Bosnia crisis and, xv, 307, 313,351
establishment of, xiv, 306
General Assembly, 351-352, 354, 356
human rights protections, xvi
reforming, xx, 306-308
Russian support of, 306-307
Security Council, 307, 351-352, 354, 356
Somalia incident, 307
specialized agencies, 352
3 68
Index
United States, foreign policy, 331-337
Universal Declaration of Human Rights,
303
Universal principles
relevance of, 120-121
safeguarding, xii, xvii
UN. See United Nations (UN)
Uzbekistan, 320-321
Value pluralism, 133, 157
Values, 53-57, i i o - n 3
Asian vs. Western, 214
exchange vs. intrinsic values, 182-183
nonmonetary values, 185
universal values, 134
See also market values; social values
Value statements, 22
Vietnam War, 304, 331
Vinikjeff, 200
Volcker, Paul, 287-288, 292, 293
Wahid, Abdurrahman, 203
Waldegrave, William, 236
Warsaw Pact, 341
Wealth effect, 200
Welfare state, 177, r78
Westphalia, Treaty of (1648), 303
Wilson, Woodrow, 331
Wittgenstein, Ludwig, 16
Wolfensohn, Jim, 282, 283
World Bankcomparative analysis studies, 90
establishment of, 174
369
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