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We Call Upon the Hedge Funds

Mises Daily: Wednesday, September 30, 2009 by

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The brains and talent of the financial industry have been moving enormous pools of wealth away from the highly regulated commercial and investment banks into the fast-paced, creative, and aggressive hedge funds. This is because, in many ways, the hedge funds represent a more pure capitalist system.

For instance, hedge funds are not micromanaged by the Federal Reserve, that great monolithic body that has expanded its power base across America (and the world) over the past hundred years.

Most people who work in hedge funds began their careers in the highly bureaucratic and regulated banks, which are historically very closely linked to the Federal Reserve and its 12 regional branches. It is often the most talented people within the investment banks who become tired of the bureaucracy and limitations. They then open up their own money-management operations or join other successful hedge funds where they are able to operate more freely and earn higher incomes. Indeed, higher levels of freedom and higher incomes often go hand-in-hand, as can be seen when comparing Hong Kong to mainland China, or South Korea to North Korea.

Hedge funds represent a more pure capitalist system in several other ways. Specifically, hedge funds operate under one of the most fundamental tenets of a capitalist system: they reap the enormous benefits of excellent investment decisions, but they also fail or completely collapse after making poor investment decisions.

What also separates the hedge funds from most of our financial system is that none of the hedge funds had their hands out in search of bailouts during the turmoil of 2008. In fact, a myriad of hedge funds went bust in this period. Some of them, worth billions of dollars, not only collapsed but did so in a very smooth fashion. Their collapse represents the natural process of liquidation, on which Mises and Hayek placed such a great emphasis in their analyses of the boom and bust periods historically caused by the expansion of money and credit.

Many of the more prescient hedge funds recognized the fact that 2006–2007 was an over-inflated boom period, specifically in the mortgage industry. Those who acknowledged this boom for what it was were able to shift their capital away from the mortgage industry or bet against it. Those companies that remained highly invested in the mortgage industry (e.g., AIG and Lehman Brothers) failed.

The hedge funds who failed underwent the natural process of liquidation — and so did Lehman Brothers. The bad assets naturally disappeared from their balance sheets and the good assets were bought up. They sold off their assets, closed up shop and drove back to their million-dollar homes.

"Short selling actually adds efficiency to the market, because it identifies weaker companies and filters them out."

It was during late 2008, when short selling was banned, that the hedge funds suffered their worst losses ever. Although data regarding hedge funds is difficult to acquire, partly due to their operations outside the scope of government, the losses to the hedge-fund industry can be estimated by the hundreds of funds that closed during this two-month period.

In late 2008, hedge funds were able to trade profitably in Hong Kong through the period of short-selling bans elsewhere, as Hong Kong was the only major financial center that did not place a ban on short selling. Short selling is one of the distinguishing advantages that hedge funds hold over the rest of the market, but this practice became suffocated by government restrictions, due to a fear that certain companies would fail in a period of excessive short selling.

The US government is deeply afraid of failure, which is in fact an integral part of a pure capitalist model. Many economists and politicians define America's economy as "capitalist" but one of the most essential aspects of capitalism, failure, is being blocked by government. Those who continue to criticize America's "capitalist" system need to realize how far the country has strayed from it.

Short selling actually adds efficiency to the market, because it identifies weaker companies and filters them out of the market more quickly. This increases competition and encourages companies to perform as best as they can. For example, if hedge funds short sell Britannica and buy Wikipedia long, this sort of market action only promotes a speedier way to filter out the obsolete player. If Britannica fears its stock being sold short, it is more likely to urgently shift up its business strategy in order to meet the changing needs and habits of consumers.

In 2003, The Economist noted that "constraints on short selling allowed stocks to become more overvalued during the most recent bull run.… More short selling then might have made the bear market less painful now." Suppressing short selling with tighter regulation of hedge funds also stifled the market's ability to police itself.

For many years, politicians have called upon the SEC to place more regulations upon the hedge funds, but these funds still remain outside the reach of the SEC's claws. If the SEC is able to place restrictions upon these prolific investors, they could become obsolete. They would become no different than other investment platforms, such as mutual funds or investment banks.

The SEC and the Fed are prepared to put pressure on hedge funds in order to make them

  1. disclose investment information to the public,
  2. manage funds with a certain ratio of leveraged capital,
  3. limit short selling, and
  4. remain within certain parameters of "risk" that the SEC or Fed warrant as "not too risky."

However, all of these objectives are counterproductive.

  1. Disclosing investment information to the public would only hurt the hedge funds. Their secrecy is their advantage and part of what separates them from the rest of the investment community.

  2. Leveraging capital, although it has backfired on many firms in recent years, is part of what allows investors to expand their resources; hedge funds have only two main resources, people and capital.

  3. The ability to short sell is part of a hedge — hence the word "hedge fund."

  4. Finally, capitalism is based on risk: if you take the risk, you gain the rewards and suffer the consequences.

In President Obama's 2008 campaign, he stated that, on the premise of "fairness," hedge fund managers shouldn't be able to earn so much money. Is it now the responsibility of a president to dictate fairness? Wasn't America founded on the ability to pursue happiness "freely"? If a hedge fund manager is happy earning millions of dollars, isn't that his right as guaranteed by the Declaration of Independence — America's first official national document?

In the near future, the Obama administration, led by Timothy Geithner — a very aggressive proponent of increased regulation — will probably launch numerous attempts to tame the financial community. In June, the president proposed to grant the Federal Reserve more power, creating a new agency to "protect" consumers, toughening oversight of exotic financial products, and giving the government the power to break up large, faltering firms.

On September 14, Barack told Wall Street to "embrace serious financial reform, not fight it." But are the president's reform efforts aimed in the right direction? This year, the Chinese government has strongly criticized excessive dollar pumping, the German Chancellor has railed against the operations of the Fed, and many of the world's top economists have blamed the Fed for causing the crisis.

Why doesn't President Obama take action against the Fed — the real culprit? Unfortunately, the administration intends to grant even greater authority to this ominous goliath.

Free-market economists can only hope that the hedge funds remain unregulated. Hedge funds are one of the last few bastions of capitalism left in the United States. Over the past hundred years, almost all industries across American society have become much worse off as a result of increased government regulation and intervention.

Hedge funds represent capitalism, not only in that they are free from government intervention, but also in that they happen to be one of the few industries in America where people can get rich without having to rely on nepotism, cronyism, coercion, or intellectual property protection. In fact, many of the world's most successful hedge-fund stars come from humble backgrounds. This represents the American dream of the 18th century, when many Europeans fled to the United States in pursuit of freedom and wealth.

We call upon the hedge funds, as one of the last few bastions of capitalism left in the United States, to become more proactive in protecting their own industry.

"Hedge funds are one of the last few bastions of capitalism left in the United States."

How should they do so? First of all, move away from Keynesian, interventionist economics, which is taught at most of America's top universities; it is flawed. The Austrian School has been the most consistent and prescient school of economics since before Ludwig von Mises began to criticize government inflationist policies, over a hundred years ago. Secondly, support libertarian candidates in local, state, and presidential elections. And thirdly, do not refer to our current economic structure as capitalism; it is not.

You, within the hedge-fund community, are amongst the few in American society who remain relatively free from the shackles of government. This is your gift. We are not asking you to share your earnings, but merely to use your talent, capital, and influence in order to protect your own industry and help strive towards a more free-market, capitalist system.