Is capitalism heading for breakdown?

News Analysis: George Soros's new book says that speculators threaten to destabilise the world economy

"AS A fund manager, I depended a great deal on my emotions. The predominant feelings I operated with were doubt, uncertainty and fear," writes George Soros in his new book, The Crisis of Global Capitalism. Wrecking ball, bubonic plague, depression, total breakdown - these are just a few of the emotional phrases Mr Soros uses in his analysis of global financial markets.

When someone who has benefited to the tune of billions of dollars from the financial markets says that destabilising speculation threatens a complete breakdown of the capitalist system - which has delivered such amazing advances in prosperity over the past five decades - it is worth paying attention. Certainly, opponents of free market economics have hailed Mr Soros's recantation with glee. But is there analytical substance behind the emotional gloss of the Soros critique?

Financial markets have always been prone to crises. Human nature seems to contain a herd instinct, and besides, it can be rational for investors to create a bubble so long as they are confident about getting out before it bursts.

There is nothing inherently damaging about such self-fulfiling speculation. Indeed, in his Tract on Monetary Reform, John Maynard Keynes - usually quoted for his condemnation of "casino capitalism" - emphasises the importance of speculators to healthy capital markets. Speculators provide liquidity and reinforce existing trends rather than bucking them, he argued. The speculation has to have something to feed on in the first place.

Even so, the financial markets have clearly been a destabilising force in the world economy since the Asian crisis first erupted in July 1997. It raises the question of whether, as capital flows have grown larger and more footloose, the speculative froth has reached unacceptable proportions. In particular, would it be sensible to reintroduce capital controls, which have been steadily dismantled over the past three decades?

Although some economists - notably Paul Krugman of the Massachusetts Institute of Technology - think there is a good case for capital controls, Mr Soros is clearly against them "Capital controls are an invitation for evasion, corruption and the abuse of power," he writes.

Certainly, the first regime to reach for controls, post-crisis, was the authoritarian Malaysian government. Meanwhile Chile, which did have restrictions on capital inflows, has recently lifted them. Exchange controls were effective after the war, when so much economic activity was subject to planning and restriction, but by the early 1970s they were all but useless. So, while one lesson of the Asian crisis is that developing countries should liberalise slowly and cautiously, it must not be forgotten that there were good reasons for the abolition of capital controls in the first place.

But if this type of restriction is not the answer, what can be done? Mr Soros concludes that there should be international financial regulation, but not by the International Monetary Fund. The IMF is part of the problem, he says. Rather, he puts the onus on the Group of Seven countries but concludes that the prospects of the G7 taking effective action are dim as it has not yet intervened in Russia.

However, it is difficult to see the G7 as the right vehicle for international financial management, important as it might be in the case of a large and politically important country such as Russia. Apart from anything else the G7 itself is in flux, with the introduction of the euro in January likely to see the rapid emergence of a G3. In addition, the biggest countries cannot practically be involved in overseeing all of the rest of the world, which is why the IMF and other such bodies exist.

In the end, it is not the institutional arrangements that matter. If the IMF did not exist, there would be calls for its creation after this year's crisis. The two key problems are whether the response to financial market turbulence should include genuine international co-ordination through the creation of a worldwide lender-of-last-resort, and what sort of exchange rate regime should exist.

As Mr Soros knows, fixed exchange rates can easily become sitting ducks for speculators. They are sustainable only if the countries locking their currencies to another are prepared to adjust their domestic economic policies for the sake of the exchange rate. The gold standard survived only as long as they were. But the UK in 1992 was not prepared to match its macroeconomic policy to Germany's, and the pound's exchange rate mechanism link was doomed.

The only viable alternatives in a world of huge capital flows are freely floating exchange rates and currency union. Europe has opted for the latter. If the rest of the world is stuck with floating rates, how can governments hope to counter the instability of the financial markets?

One solution is to have perfect domestic policies at all times, giving speculators nothing to run against. But this is a touch utopian - even if they all had first-rate policy makers, economies are buffeted by all sorts of shocks.

Another would be to create a genuine international authority with the task of stabilising the world economy and markets. At present the work of adjusting to crisis is forced on to a combination of the IMF and national central banks.

The IMF, which has meagre resources, effectively bails out banks that face the risk of default by a borrower by providing liquidity to the borrower, while national central banks bail them out by providing liquidity to the lender within their own boundaries if there looks to be a serious threat to the domestic banking system.

Perhaps the creation of an international lender of last resort would be preferable to this messy ad hoc response. Mr Soros seems to think some such source of finance is needed to resolve the crisis in the markets he helped destabilise. So, too, do some G7 officials. But the proposal is controversial.

Others believe that lending to borrowers in emerging markets is a risky business whose risk should fall directly on the speculators themselves - not least Soros Fund Management.

Start your day with The Independent, sign up for daily news emails
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Retirement Coordinator - Financial Services

Negotiable: Recruitment Genius: To provide a prompt, friendly and efficient se...

Recruitment Genius: Annuities / Pensions Administrator

Negotiable: Recruitment Genius: You will be the first point of contact for all...

Ashdown Group: HR, Payroll & Benefits Officer - Altrincham - up to £24,000.

£18000 - £24000 per annum + benefits: Ashdown Group: HR, Payroll & Benefits Of...

Ashdown Group: Learning and Development Programme Manager

£35000 - £38000 per annum + benefits : Ashdown Group: A highly successful, int...

Day In a Page

The saffron censorship that governs India: Why national pride and religious sentiment trump freedom of expression

The saffron censorship that governs India

Zareer Masani reveals why national pride and religious sentiment trump freedom of expression
Prince Charles' 'black spider' letters to be published 'within weeks'

Prince Charles' 'black spider' letters to be published 'within weeks'

Supreme Court rules Dominic Grieve's ministerial veto was invalid
Distressed Zayn Malik fans are cutting themselves - how did fandom get so dark?

How did fandom get so dark?

Grief over Zayn Malik's exit from One Direction seemed amusing until stories of mass 'cutting' emerged. Experts tell Gillian Orr the distress is real, and the girls need support
The galaxy collisions that shed light on unseen parallel Universe

The cosmic collisions that have shed light on unseen parallel Universe

Dark matter study gives scientists insight into mystery of space
The Swedes are adding a gender-neutral pronoun to their dictionary

Swedes introduce gender-neutral pronoun

Why, asks Simon Usborne, must English still struggle awkwardly with the likes of 's/he' and 'they'?
Disney's mega money-making formula: 'Human' remakes of cartoon classics are part of a lucrative, long-term creative plan

Disney's mega money-making formula

'Human' remakes of cartoon classics are part of a lucrative, long-term creative plan
Lobster has gone mainstream with supermarket bargains for £10 or less - but is it any good?

Lobster has gone mainstream

Anthea Gerrie, raised on meaty specimens from the waters around Maine, reveals how to cook up an affordable feast
Easter 2015: 14 best decorations

14 best Easter decorations

Get into the Easter spirit with our pick of accessories, ornaments and tableware
Paul Scholes column: Gareth Bale would be a perfect fit at Manchester United and could turn them into serious title contenders next season

Paul Scholes column

Gareth Bale would be a perfect fit at Manchester United and could turn them into serious title contenders next season
Inside the Kansas greenhouses where Monsanto is 'playing God' with the future of the planet

The future of GM

The greenhouses where Monsanto 'plays God' with the future of the planet
Britain's mild winters could be numbered: why global warming is leaving UK chillier

Britain's mild winters could be numbered

Gulf Stream is slowing down faster than ever, scientists say
Government gives £250,000 to Independent appeal

Government gives £250,000 to Independent appeal

Donation brings total raised by Homeless Veterans campaign to at least £1.25m
Oh dear, the most borrowed book at Bank of England library doesn't inspire confidence

The most borrowed book at Bank of England library? Oh dear

The book's fifth edition is used for Edexcel exams
Cowslips vs honeysuckle: The hunt for the UK’s favourite wildflower

Cowslips vs honeysuckle

It's the hunt for UK’s favourite wildflower
Child abuse scandal: Did a botched blackmail attempt by South African intelligence help Cyril Smith escape justice?

Did a botched blackmail attempt help Cyril Smith escape justice?

A fresh twist reveals the Liberal MP was targeted by the notorious South African intelligence agency Boss