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You May Not Want To ... But It Is Time to Hug a Hedgie

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics and Director of the Maurice R. Greenberg Center for Geoeconomic Studies
January 13, 2012
Financial Times

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Contemplating the huge sums needed to bail out peripheral Europe, Gideon Rachman writes that he is feeling "strangely Austrian". I confess to a similar sensation when contemplating banks. Eighteen months after the passage of the Dodd-Frank law, three-quarters of its Byzantine rules have yet to be implemented and there is little progress on the basic problem, which is that banks will take excessive risks with taxpayers' money so long as they remain too big to fail. Meanwhile the Austrian antidote gets little attention. If you do not like government-underwritten, too-big-to-fail behemoths, you better embrace small-enough-to-fail hedge funds.

Most critiques of modern finance miss the mark. There is no point hoping, for example, that armies of Dodd-Frank enforcers will ever render finance truly stable. Finance is a system of promises about an uncertain future; barring the advent of some magical prediction machine, regulation cannot change that. Currencies will rise and fall; interest rates will fluctuate; some companies will succeed while others go bust. A good financial system will absorb these risks without taxpayers picking up the pieces. But the risks will still be there; financial firms will still blow up.

Nor is it easy to see how finance can be divided into stable, old-school activities and wild, casino stuff. Traditional bank lending is, in fact, conspicuously unstable, which is why governments are obliged to underwrite it with deposit insurance and lender-of-last-resort safety nets. Indeed, traditional bank lending frequently contrives to be both subsidised and uncompetitive. Companies can often raise capital more efficiently by issuing equities and bonds.

If securities markets are useful to nonfinancial companies, it follows that the fashionable contempt for traders makes absolutely no sense. Markets need experts who are paid to judge the value of securities, so improving the chances that society's scarce capital will be allocated to the companies that use it best. Markets also need buyers and sellers, so that holders of securities can sell them when they need cash. If there were no actively traded market in which to off-load the shares of a new tech company, investors would buy those shares only if they received a discount. The higher cost of capital would mean fewer tech companies, less innovation and less growth.

Some critics concede that traders may be useful, but complain that modern capitalism creates too many of them. We need enough traders to reprice markets at, say, five-second intervals, according to this view; but vast armies of high-frequency paper shufflers represent a shocking waste of human capital. Yet this critique is also pointless. Should government get into the business of deciding how many architects or therapists we need? The socially optimal number of fashion designers is surely a fraction of the number sketching buttons in the Quadrilatero della Moda in Milan.

The fact is that we do need traders, and the market is the best mechanism for deciding how many we should have. Except, of course, that the market is distorted: much trading goes on inside too-big-to-fail behemoths that have an implicit government backstop. If you subsidise the risk in trading, naturally it will be copious and, worse, dangerous. That is why the disasters of 2008 were concentrated inside large, systemic institutions. The problem is not the trading; it lies with the corrupted incentives of the financial hypermarkets in which trading is done.

Hedge funds provide at least part of the answer to this distortion. With the half-exception of Long-Term Capital Management, which got regulators' attention but still received no government bail-out, hedge funds rise and fall without threatening taxpayers. Because their creation and destruction are not subsidised, their risk-taking tends to be more prudent – in the years before the crisis, hedge funds cut leverage while the big investment banks went nuts. Even when they do go wrong, hedge funds generally pose little risk to creditors, limiting the risk of financial contagion. Failing hedge funds almost always close before their equity goes negative. Creditors get all their money back.

And yet, despite these virtues, hedge funds remain unpopular, a phenomenon that speaks volumes about the confused critique of capitalism in the rich world. Yes, hedge-fund moguls are absurdly wealthy and doubtless should be taxed more – as should Wayne Rooney of Manchester United, for that matter. However, the unequal distribution of the fruits of growth must be separated from the question of how to secure growth. When it comes to the second challenge, the rich guys can be the good guys, however strange that sounds.

The writer is a senior fellow at the Council on Foreign Relations and the author of More Money Than God: Hedge Funds and the Making of a New Elite.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here (Subscription required).

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