How Capitalism Will Save Us (29 page)

Some people might be tempted to believe that expelling the rich was such an economic disaster because Uganda was a small country. But as Thomas Sowell has written, other countries that have scapegoated and destroyed their merchant class—Sowell calls them “middleman minorities”—have suffered much the same effects:

The Jews of Spain five centuries ago were similarly resented for their affluence. In 1492, King Ferdinand and Queen Isabella gave them four months to leave Spain or else convert to Christianity. As many as four hundred thousand emigrated. Most went to the Ottoman Empire. Fortunately, Sultan Bayezid II was smarter than the Spanish king and queen and had a better understanding of the role wealth producers play in a Real World economy. According to historians, he knew it. “How can anyone call Ferdinand wise when he impoverishes his own kingdom to enrich mine?” he reportedly declared.
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The economic and cultural damage of the Jewish exodus is felt by Spain even today. A
New York Times
story marking the five-hundredth anniversary of the expulsion acknowledged, “Educated Spaniards commonly lament the 1492 expulsion as a horrible mistake that contributed to Spain’s later decline.”
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It was one reason that the development of the Spanish economy woefully lagged behind that of the others of Western Europe.

The Real World principle that rich people are critical to everyone’s prosperity is borne out by history. We will show in
chapter 4
that tax cuts enacted by both Republican and Democrat administrations, which opponents
said would mainly benefit “the rich,” have consistently produced more tax revenue, along with economic growth—not only for the upper income earners, but for everyone else.

As Lincoln also said: “You cannot help the wage earner by hurting the wage payer.”
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Or as author and economist Ben Stein puts it today, “No society ever got anywhere by using envy of the rich as a tool of social policy. No society has ever helped the poor by crusading against the rich.”
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H
edge funds and their close cousins, private equity funds, have become emblematic of the evils of great wealth and unfettered markets. These vast, unregulated pools of capital have faceless clients and employ mysterious-sounding high-risk trading strategies like arbitrage or short selling equities or derivatives. Critics portray them as invisible monsters run amok, “speculators” and short sellers wreaking untold havoc in markets.

Hedge funds in particular came under withering attack for helping to cause the financial meltdown of 2008 by trading in credit-default swaps and other financial instruments, and short selling the stocks of companies like Bear Stearns, Lehman Brothers, Washington Mutual, and AIG. Hedge-fund trading in oil futures contracts was also blamed for driving up oil prices when gas prices were at their height. Hedge funds have also been involved or associated with headline-making financial scandals and, occasionally, wrongdoing—such as the implosion of the fraudulent Bayou Group of funds, which defrauded investors of some $450 million.

This dubious image has been exacerbated by media portraits over the
past decade of the out-of-this-world wealth of “hedge-fund billionaires” who make obscene fortunes even higher than those of overpaid CEOs of public companies. The top twenty private-equity and hedge-fund managers pocketed an average of $657.5 million in 2007, a sum inconceivable even to many highly paid executives.

Hedge funds are unregulated because clients are supposed to be financially sophisticated, high-net-worth individuals or pension funds that can take care of themselves. The minimum investment that most funds accept is $1 million. For their services, hedge funds will charge high fees, usually 2 percent of assets under management and 20 percent of all gains. The idea is that high-risk investments, capably managed, will produce high returns.

In contrast to hedge funds, the primary focus of private equity funds is longer-term positions in undervalued companies. They will often install a new management team, turn the companies around, and then sell them at a much higher price.

Equity and hedge funds get criticized for “looting” companies, ruthlessly eliminating jobs or moving them out of the country for short-term profit. As UCLA law professor Lynn Stout complained in the
Wall Street Journal
, such funds “use their ownership position to pressure boards into strategies they claim unlock ‘shareholder value,’ and then dump their stock as soon as the price rises.”
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In this way, investors, such as Carl Icahn and others, launch “activist attacks” against companies “to make money quick.” Not only do these funds lower the returns of other investors in a particular stock, she asserted, but they exert downward pressure on the market as a whole.

There have been calls to regulate or to raise taxes on both hedge and equity funds. Equity funds are also criticized because their gains are taxed at capital gains rates instead of regular income-tax rates.

Hedge funds and equity funds play a very useful role in the investment world. By providing clients, particularly investment funds, with exceptionally high returns on their money, they’ve become a critical source of capital—not only for Wall Street, but, indirectly, for Main Street.

Between 1991 and 2006, private equity firms worldwide created more than $430 billion in net value for investors—which include universities, charitable organizations, and pension plans covering tens of millions of Americans. Thus, the superior investments of private equity firms translate
into stronger pension plans, more financial aid, and scholarships at public and private colleges and more funds for research to cure or treat diseases.

The biggest customers of hedge and private equity funds are pension funds, particularly public pension funds like CalPERS. In 2006, the twenty largest pension funds invested in private equity represented some 10.5 million retirees, including plans from California, New York, Texas, Florida, New Jersey, Ohio, Pennsylvania, and Michigan. Their collective private equity investment: $111 billion.

Without these vehicles, there would be less capital available to fund the retirement of these state and union employees. In the case of public employees, that would very likely compel states to resort to higher taxes. It’s worth noting that until the crash, states had been able to avoid the budget cuts or tax increases that would have been required to meet their legally mandated pension obligations. There’s no protection from tough times and overspending politicians. But without the returns from these funds, many state governments would be in an even deeper financial hole than they are today.

Private equity funds are a critical source of capital for charitable foundations as well as higher education. University endowment funds, most notably those of Harvard and Yale, have received considerable publicity for the rapid growth of their endowment funds thanks to these nontraditional vehicles. In fact, some institutions like Harvard and Yale overdid a good thing in using these funds too extensively. When the downturn came they overcommitted their cash to these funds and thus had to cut back on what they could provide for their operational budgets.

Students at public and private universities get tuition assistance from the return on their universities’ private equity fund investments. Schools also use investment income to hire faculty, construct buildings, and fund programs. The University of California, the University of Minnesota, Cornell, Pepperdine, and Emory are just some of the many institutions of higher learning that rely on private equity investment returns to bolster the educational experience they provide their students.

Private equity funds have also been instrumental in the turnarounds of major companies such as Burger King and Continental Airlines, among others.

Another benefit of hedge funds is that their massive pools of capital
help reduce the cost of equity trading by increasing market volume and liquidity. For example, if you want to sell a big block of stock, there are more traders capable of handling that volume. Greater trading volume makes it more likely that there will be a buyer when someone wishes to sell, or conversely, that there will be a seller when someone wishes to buy—which is also good for investors.

Under normal conditions, hedge funds can be said to have a moderating effect on markets. The larger trading volume they help produce causes big transactions to have less of an impact. In a market with fewer trades, selling or buying large positions has a bigger impact on price.

Added to all this, as we explained earlier, the activity of hedge-fund short sellers usually provides a vital signal to other investors that a market may be overheating.

Hedge funds did not cause the financial meltdown of 2008. Nor were hedge funds and equity funds the prime movers driving prior commodities bubbles. They did not create subprime mortgages or package them as did Wall Street investment houses. And they did not print the excess money that created the commodities bubble in 2004. After all, there were several commodities bubbles in the 1970s, long before today’s hedge funds existed. As previously noted, these events were the consequences of monumental monetary and regulatory mistakes, not to mention the resulting excesses on the part of Wall Street firms and banks.