Soros: Recent gains a likely 'bear market rally'

Fed's rate cuts export U.S. recession to Europe, hedge fund legend says
By William L. Watts, MarketWatch
Last update: 2:04 p.m. EDT May 21, 2008

LONDON (MarketWatch) - Billionaire hedge-fund legend George Soros said Wednesday that recent market gains mark a "bear-market rally" that will wilt as the global credit crunch continues to run its course.

The rebound is likely "just a bear-market rally based on the false conception that the authorities can handle all these crises," Soros said in remarks at the London School of Economics.

Soros highlighted arguments made in his new book, "The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means." In the book, Soros describes the current financial crisis as the worst since the Great Depression.

The current crisis follows the building of a 25-year "super bubble," an explosion of credit creation that accompanied increased deregulation of financial markets, Soros said. Authorities have been quick over that period to bail out markets during periods of distress, but are now overwhelmed by the fallout from the credit crunch.

Soros said he wasn't predicting a return to the Great Depression of the 1930s, but argued that the likely path for the U.S. economy lies between two extremes: In the best-case scenario, growth begins to revive by the end of 2008. In the worst-case scenario, the U.S. experience echoes Japan's long-running bout of subpar growth in the wake of its burst real-estate bubble and damage to the Japanese banking system.

"I think reality is somewhere between those two extremes," Soros said.

Soros said the U.S. economy will likely be dogged by several factors, including the prospect that house prices will "overshoot" to the downside much as they had overshot to the upside during the build-up of the housing bubble.

As a result, U.S. consumers, who had grown increasingly reliant on home equity to fund consumption, will no longer be an engine of growth for the U.S. or world economy, he said. The banking system, meanwhile, is "severely impacted" but has shown a remarkable ability to raise capital, he said. Still, banks are likely to prove reluctant to lend.

Finally, the U.S. economy now faces the prospect of inflation and recession at the same time, "partly because the dollar has ceased to be accepted as the reserve currency it has been" in the past, Soros said.

Troubles for euro-zone

Turning to Europe, Soros said the United Kingdom's housing woes aren't as severe as those in the United States but noted that the troubled financial sector weighs "quite more heavily" on the overall British economy.

The 15-nation euro-zone, meanwhile, is likely to see "serious, serious tensions" emerge as past trends toward economic convergence now move toward divergence, Soros said. This is exacerbated by the European Central Bank's "asymmetric" mandate to hold down inflation without paying heed to growth, he said.

Data has pointed to signs of a significant slowdown in Italy, Spain and other southern economies in the euro zone, while France and Germany, the two biggest economies, have so far proven relatively resilient to a slowing global economy.

Meanwhile, the U.S. Federal Reserve's interest-rate cuts have served to pressure the U.S. dollar versus the euro, effectively exporting "recession from the United States to Europe," Soros said.
Soros warned that authorities shouldn't let the pendulum swing too far toward re-regulation, because regulators tend to be overly bureaucratic and slow to adjust to changing circumstances.
Authorities should aim to "improve the quality of regulation rather than the overall quantity of regulation," he said.


William L. Watts is a reporter for MarketWatch in London.