Hungarian-born investor and philanthropist George Soros said in Budapest, Hungary, on Tuesday that the entire edifice of global financial markets that has been erected on the false premise that markets can be left to their own devices has to be rebuilt from the ground up and that a new economic paradigm is required.

Soros who came out of retirement in 2007 to help manage his hedge fund firm Soros Fund Management through the recent crisis, also announced that he will set up and sponsor an Institute for New Economic Thinking (INET) intended to foster research, workshops and curricula that will aim to develop an alternative to the prevailing economic system.

Soros said he will commit 50 million dollars over ten years and hopes that other donors will join. INET will be launched in Cambridge University, England, in April 2010. The Central European University in Budapest, which is hosting a series of lectures this week by Soros, will also be a hub of the INET network.

Blaming both regulators and participants in the financial markets, Soros said, "The recent crisis is comparable to a hundred-year storm. We had a number of crises leading up to this one, comparable to five-or ten-year storms. Regulators who had successfully dealt with the smaller storms were less successful when they applied the same methods to the hundred-year storm."

Soros outlined his theories of capitalism and its tendency to produce bubbles and described the crisis as he saw it. "Behind the 'ordinary' sub-prime housing bubble in 2007 was a much larger super-bubble growing over a longer period of time. The sub-prime collapse set off the explosion of the 'super-bubble', much as an ordinary bomb sets off a nuclear explosion. The misconception which inflated this super-bubble was the false belief that financial markets are self-correcting and should be left to their own devices which in turn led to the ever-increasing use of credit and leverage."

Soros believes fundamental regulatory reform is required. "The financial authorities have to accept responsibility for preventing bubbles from growing too fast."

Soros argues it is not enough to control the money supply, the availability of credit must also be monitored.

Not just monetary controls but credit controls must be applied such as margin requirements and minimum capital requirements which need to be varied in order to control asset bubbles.

"Market fundamentalists consider that crass interference with the market mechanism but they are wrong. When our central banks used to do it, we had no financial crises to speak of. The Chinese authorities do it today, and they have much better control over their banking system."

Other measures proposed by Soros include much tighter monitoring of all major participants in the financial markets, including hedge funds and sovereign wealth funds.

"Credit derivatives, like credit default swaps and knockout options, are particularly prone to hidden imbalances; therefore they must be regulated, and if appropriate, restricted or forbidden. The issuing of synthetic securities needs to be subject to regulatory approval, just as ordinary securities are."

Soros also believes financial authorities must impose regulations that will ensure that the implicit guarantee given to the largest institutions that they are "too big to fail" will not be invoked.

"The authorities, in carrying out their duty of preventing the system from collapsing, have extended this guarantee to all institutions that are too big to fail. Such institutions must use leverage and accept various restrictions on how they invest the depositors' money. Depositors should not be used to finance proprietary trading. Regulators must also monitor the compensation packages of proprietary traders to ensure that risks and rewards are properly aligned. This may push proprietary traders out of banks into hedge funds where they properly belong."

Soros warned, however, that this is not the right time to enact permanent reforms. First, short-term replacement of the evaporated credit is required by the only remaining credible source of credit, namely, the state, which can expand the national debt and the monetary base.

"The financial system and the economy are very far from equilibrium and they cannot be brought back to near-equilibrium conditions by a straightforward corrective move, just as when a car is skidding you must first turn the wheel in the direction of the skid before you right the car. As the economy stabilizes you must then shrink the monetary base as fast as credit revives otherwise, deflation will be replaced by inflation. We are still in the first phase of this delicate maneuver. Regulatory reform must wait for the second phase and it needs to be carefully phased so as not to disrupt recovery. But we cannot afford to forget about it."

Tuesday's lecture was broadcast via a video conference link with the Massachusetts Institute of Technology (MIT) in Boston, United States. Responding to a question from MIT on whether the crisis happened because markets weren't free enough, and that governments had interfered with the market by subsidizing cheap housing loans, Soros replied that without regulation, financial markets would have collapsed a long time ago.