Last year 26 hedge fund managers took home over $110 million dollars each while median real wages actually declined. Maybe it is just a coincidence. Or maybe not. American economic history since Reagan is notable for two seemingly contradictory trends. On the one hand, growth of the real economy has been at historical lows while the growth of the financial economy has been spectacular. GDP and labor productivity growth was higher in the 1970s, now lambasted as the age of stagflation than it has been during the era of the stock market boom. Investment in productive capital goods as a percentage of GDP was considerably higher under Carter than it is today. It seems that real investment was greater under a falling market than it has been during the financial boom.
Modern finance began in the mid 19th century when the construction of railroads required massive amounts of capital. Before then, if an entrepreneur needed funds to build, say a textile mill, he would generally access the assets of his family, or retained profits from another venture, or find a group of partners who would either lend him the money or buy a share of the prospective project. But railroads were massively more expensive and returns from them were years away. No group of acquaintances could possibly have enough cash to build a railroad so capital markets expanded to allow investors who did not know each other to put money into the project.
The financing of railroads was straightforward, right out of Econ 101. Investors staked their money into the creation of physical assets that would then create a cash flow that they hoped would repay them handsomely for their investment. Society as a whole profited as the railroad reduced transportation costs allowing the entire economy to expand. The railroad and the means of financing it transformed America and made it rich.
Now, lets look at a basic hedge fund strategy used by investors today. Long-short is powerful in that it allows investors to neutralize market risk. It works like this: lets say you think Exxon is a very well run company. A traditional investor would then just buy their stock. But buying Exxon by itself leaves him vulnerable to the risk that oil companies (or the market itself) are overvalued. If oil prices fall he will lose money no matter how well Exxon is managed. So if he buys Exxon but simultaneously shorts (sell without actually owning) an equivalent amount of Shell, if the market (or oil companies) lose value his loss on his purchase of Exxon is compensated by his profit on his Shell short. Thus he has managed to make his bet purely on his belief that Exxon will outperform the other oil companies while being indifferent to whether the market as a whole (or oil companies in particular) go up or down.
In practice, hedge fund strategies are more complicated than just buying Exxon and selling Shell. A few months ago, the New Yorker ran a story about a young very successful hedge fund manager, and explained his concept. As a finance student, looking at data stretching back to 1920, he noted that companies that had low p/e ratios, generally out-performed the market and that companies with "momentum" i.e. that had already been going up, also out- performed the market.
Armed with this knowledge, and a bank of computers, he set up a hedge fund which analyzed a large data base of securities and gave buy signals whenever a low p/e company started going up and sell signals whenever a high p/e company started going down, keeping the buys and sells equal so as to remain market neutral.
After a few difficult months waiting to acquire funds to invest, he has made himself and his clients a lot of money. Since low P/E high momentum stocks continued to outperform high P/E low momentum stocks (thus yet again disproving the efficient market thesis that the market already has discounted all relevant information), he and his investors make money whether the Dow Jones Industrial Average skyrockets or collapses. What the New Yorker article never even thought to mention is how his activities have any social benefit
We can see that our hedge fund manager and his wealthy investors might make some money from his long-short strategy, but what does it mean for the rest of us? The answer that apologists for finance proffer is that by increasing the amount of stock trading, hedge funds deepen and make capital markets more liquid but this is not nearly as obviously beneficial as building a railroad. And there is a risk that all of us may have to subsidize.
If you are betting on the difference in price between two oil companies, you are not going to be talking about big numbers. To make money, hedge funds have to employ massive leverage. That is to say, they make their bets with borrowed money. More than their own capital is at risk, so is the capital of the banks that lend to them.
Long Term Capital Management was founded by some of the most brilliant minds on Wall Street. Its team included two Nobel Prize winners in economics. Their basic strategy was to arbitrage the difference between two similar bonds, assuming that the spread between them would decrease. So, they would go long in the cheaper bond and short the more expensive bond and as the bond spread declined, they would take their profit. These arbitrage spreads were miniscule so they would have to buy massively to make any profit. They borrowed over 100 times their own capital, putting it all at risk. For a number of years they did very well, as did the big banks lending them funds.
But in 1998, global markets got nervous. Spreads LTCM assumed from their models would narrow instead expanded and in a short amount of time, their whole edifice came tumbling down. So what you say. Why should we care if a bunch of rich guys lose their stake? Because they didn't just lose their money, they also put the money of the money center banks at risk and if those banks go down, our economy could collapse.
Greenspan's success as a central banker in large part is due to his willingness to abandon his free market beliefs in times of financial crisis and do what it takes to protect the stability of the financial system. After the stock market debacle of 1987, he immediately told the markets that the Fed would provide all needed liquidity and so the economy did not go into recession and after a short respite the stock market was able to continue its rise. When banks balance sheets were shaky in the late 80s after junk bonds lost their luster, he kept the Federal Funds Rate very low while longer rates remained high, thus allowing banks to borrow cheaply from the taxpayers while lending at much higher rates to their customers. Within a few years of this unacknowledged subsidy, the banks regained healthy balance sheets.
And so in 1998, Greenspan and the US treasury stepped into the breach again to orchestrate a buyout of LTCM positions and thus protect the stability of our financial system. Ever since the Latin American debt crisis of the early 80s, the position of our government has been in part to socialize the risk of financial speculation for the biggest players while allowing the gains to remain private. This "moral hazard" may well be a factor in the long boom in our financial markets.
We are taught in Econ 101 that the social function of stock and bond markets is that they connect most efficiently societies savings and productive investments. That is to say, a company, needing funds to build a plant, will either issue stock or sell bonds in the expectation that the plant will create a cash flow sufficient to pay interest or dividends and still leave a profit for the original owners. This story was certainly true with railroads back in the mid 19th century. Now it is a myth.
For one thing almost all the trading of stocks and bonds is in the secondary market. Just as GM gets nothing when you sell your used Corvette, it gets nothing from the sale of its stock and bonds. Only the IPO and the primary issue of a bond goes to the corporation that issued it. Apologists for the system say, correctly, that no one would buy a stock or bond unless there existed a deep secondary market so that they could be confident of being able to liquidate their purchase.
But even IPOs rarely are used to fund productive expansion. Usually, they are the means that owners use to cash out. They spend their IPO earnings not on new plant or equipment but rather on lavish consumption, or perhaps the purchase of a basketball team. Bonds these days are more often used for leveraged buyouts than to build a factory. In fact 92% of all capital expenditures, are funded by retained profits. This means that the entire huge superstructure of finance is only a minor player in the creation of productive investments for the real economy.
Indeed, if you combine interest payments, dividends, stock buybacks, and mergers and acquisitions, since 1985 non-financial corporations have transferred more cash to investors than they have invested in plant or machinery. The myth is that the financial markets exist to create productive investment that will allow the economy to grow. The truth is the financial markets, with their lust for consistent short term profit growth instead shift corporate funds that could have been used to fund capital goods investment (and jobs) into the pockets of the very richest among us. Never forget that while many of us own financial assets, in comparison with the very rich, we hold them in relatively trivial amounts. The top 0.5% of Americans own more stocks and bonds than do the bottom 98%.
It is my thesis that the tremendous rise in value of financial assets over the past quarter century is due in large part to 3 factors:
1. Wage stagnation has given owners of capital a much larger slice of the economic pie
2. A Federal Reserve ready to add liquidity whenever danger threatens has protected markets from their exuberance.
3. Added liquidity raises asset prices while globalization keeps wages and goods prices low.
The domination of our economy by financial interests has increased income and wealth stratification, lowered real investment, and doomed those of us not working in the financial markets to a lower standard of living.