“What kind of society gives that kind of money to people who create … nothing?”
That was Chris Matthews’s comment on his MSNBC program Hardball after reporting that “the top 25 hedge fund managers made $25 billion last year.” Most libertarians will have a natural reflex against a statement like that. Indeed, Matthews packs lots of fallacies into a few words, but there’s more to it than first appears, and advocates of freedom must get below the surface.
First, “society” doesn’t give money to anyone. Matthews may realize he’s used a metaphor, but we can’t be too sure. Nevertheless, the abstraction or group called “society” makes no decisions and, aside from tax revenues collected by government, there’s a no pot of money waiting for distribution.
Second, Matthews engages in a simple-minded populism when he says the people who made money running hedge funds create nothing. Later in his commentary, Matthews said that “all this money is being made by people who don’t seem to actually make anything, not steel, not cars, not computers, not even movies. They don’t even tell us jokes, like Leno or Letterman or Stewart or Colbert. They just make money, billions of it….”
It would have been interesting to see this explored. How would one go about making money creating nothing? Let’s ponder first this question in the context of a pure market economy. Since it’s not society that would be paying the money, it must be particular people doing so. Who would voluntarily pay a hedge fund manager to do nothing? Not I and not you. That pretty much rules everyone out.
So what about hedge funds? Do they make money doing nothing? Hardly. First, a word about the name. In finance, to hedge is to offset a risk so that any loss is to some extent countered by a gain. I’ve heard that Stephen Hawking, who formulated the theory of black holes, has made a bet that someone will demolish his theory. He hedged. If his theory falls apart it’s not a total loss.
Investment and risk
Investors can do the same thing. But, economist Warren Gibson writes, “Most present-day hedge funds don’t do much hedging, but the name persists.” In fact, they do the opposite of hedging; they speculate, seeking, rather than avoiding, high risk.
“[They] engage in a bewildering variety of trading methods, including buying on margin (using borrowed funds) and selling short (selling borrowed assets so as to profit from a price drop),” Gibson writes in The Freeman (November 2009). “They trade stocks, bonds, options, currencies, commodity futures, and sophisticated derivatives thereof. Some try to anticipate global political or economic events, while others seek opportunities in specific industries or companies.
“Hedge funds are like mutual funds in some ways…. [But] hedge fund shares are generally available only to ‘qualified investors,’ defined by an annual income of at least $200,000 and financial assets of $1,000,000.”
Matthews might still wonder what’s being created to justify whatever profits those investors make. Aren’t they just “paper pushers”? What good are they for the rest of us? Gibson writes, “As long as there is no fraud, hedge funds, like other market participants, produce social benefits. They provide market liquidity, the lubrication that makes markets work well. Successful funds help move capital to where it is most needed and help move prices in anticipation of future events.”
Now we’re getting somewhere. These funds are vehicles for transporting capital to where the market beckons. In other words, contrary, to Matthews, hedge funds, assuming a free and competitive economy, do produce steel, cars, computers, movies, or whatever the capital ultimately produces. But their activities are several steps removed from physical production. That makes the story more complicated, requiring some analysis to see what’s going on. But with a little effort Matthews ought to be able to trace the connections.
As noted, the process does even more than that, however. It also reallocates risk from more risk-averse to the less risk-averse market participants. The willingness to accept risk is not evenly distributed throughout the population. Risk avoiders are willing to take smaller returns on safer investments. Contrariwise, those with a taste for risk are willing to take big chances on extraordinary returns. Think of the farmer who sells futures in his crop at a fixed price. The eventual market price might be higher than the contract price, but it might be lower. So he locks in a price he can be satisfied with, limiting both his upside and downside.
“For the market to function, however, it cannot consist only of hedgers seeking to lay off risk. There must be someone who comes to market in order to take on risk. These are the ‘speculators.’ Speculators come to market to take risk, and to make money doing it,” economist Gregory Millman writes in The Concise Encyclopedia of Economics.
In a free market, then, the financial system redistributes risk appropriately and contractually. Ex ante, everyone is happy, though of course as the uncertain future unfolds and prediction errors are revealed, some make money, some lose, and some make less than they might had made with other investments. An authentically competitive market rewards the good prognosticators while persuading the bad ones to find other lines of work.
The unfree market
Unfortunately, we can’t leave things at that. Several times in my discussion I prefaced sentences with “in a free market.” That was deliberate, because it is crucial to distinguish practices and their effects in a truly open, competitive market economy from the same practices and their effects in a corporatist, or mixed, economy, in which policy and rule-making are often designed to benefit privileged business interests. Nowhere is this more the case than in American banking and finance. The Federal Reserve System functions as the hub of a national banking cartel, which, along with other government agencies, controls and channels competition into acceptable forms. Moreover, the politically induced business cycle can exaggerate and distort normal market practices, such as speculation, turning them from socially beneficial to socially destructive phenomena. For example, when the Fed expands the money supply to lower interest rates in order to create an economic boom, one consequence is to create incentives for speculative risk-taking aimed at high returns that would be deemed reckless and virtually impossible in the absence of the monetary stimulus. Add to this scenario implicit guarantees of bailouts under the “too big to fail” doctrine and the Fed’s newly flexed power to direct capital to favored firms — and the table is set for disaster.
Under these circumstances, one is well justified in wondering what social good speculation accomplishes. But it is important to emphasize that this question arises only because government has (1) limited competition, (2) greased the speculative process with fiat money and low interest rates, and (3) created moral hazard by implicitly guaranteeing bailouts, either for failing companies’ shareholders or, more commonly, their creditors (such as Goldman Sachs in the AIG case).
To sum up, considering all the worry in Washington over derivatives, the biggest, most dangerous derivative of all is totally ignored: namely, Big Finance’s power to imperil the entire economy, which is purely a derivative of the government’s power to create money, grant oligopolistic power, and rescue big players from bad decisions by socializing their losses. In other words, the systemic risk that today’s advocates of financial regulation promise to prevent is entirely the product of the government’s partnership with Wall Street in the management of money and banking.
To his credit, Matthews sees part of the picture. He says that the hedge funds make their money “in a financial system that’s backed up by billions of dollars from us. Billionaire-socialism, whatever you want to call it. It all rides atop the sweat of the worker bees, and of course the poor.”
That’s not a bad analysis after all.
But Matthews doesn’t see it all. He overlooks the cartel and the shelter it gives some businesses from the winds of competition, which is the only real disciplining force in a market economy. Since he doesn’t quite get it, he holds out hope for new regulation. “Anyway,” he says, “there’s a bill coming to the floor of the U.S. Congress that may do something about this. It’s called Financial Reg, a boring name, but let’s hope it does it.”
Since Washington and Wall Street, despite their marginal differences, are really in collusion and regulators are inevitably “captured” by those they regulate, Matthews is bound to be disappointed.
This article originally appeared in the July 2010 edition of Freedom Daily. Subscribe to the print or email version of Freedom Daily.