The Hedge Fund Hegemon Kenneth Rogoff The recent volatility in global capital markets should give pause to those who say German leaders, who have been arguing for greater transparency in global hedge funds, are just sore losers US and UK policymakers, in particular, say the German whining is nonsense, and that hedge funds, along with other new age financial entities such as private equity firms are key innovators in todays global economy. This debate is at the cutting edge of todays globalization, yet it is clouded by a healthy dose of national self-interest. With New York and London the centers of global finance, the United States and Britain have enormous profits at stake. So it is convenient for them to downplay the likelihood that risks to the worlds financial system will be spread more evenly than the benefits. German leaders, by contrast, must reckon with a populace that is deeply resistant to rapid change, particularly when it involves job cuts. Many German workers believe, as one trade unionist recently lamented, that takeovers are being driven by a philosophy of buy it, strip it, and flip it. To be sure, the profits currently being earned by the leading financial firms are dizzyingly high. Goldman Sachs, the venerable Wall Street firm at the epicenter of financial globalization, paid more than $16 billion dollars in compensation to its 25,000 employees in 2006, and spun out another $9 billion for its shareholders a total that is greater than the annual income of most African countries. The spectacular profits on Wall Street and elsewhere in the financial industry also have a huge macroeconomic impact. The US is running an $800 billion annual trade deficit in traditional goods and services. Yet, because Americans consistently earn a higher return on their investments abroad than foreigners earn on their US investments, US debt is rising at perhaps only half the rate that it might otherwise. Even we economists who believe that global financial innovation yields huge net benefits must admit that todays hedge fund boom is becoming like the tech bubble. My own recent experience is perhaps emblematic. An Eddie in Los Angeles sent me an email asking if I wanted to serve on the advisory board to his new hedge fund. Eddies accompanying flattery aside, I would normally trash such a letter, figuring it was a fraud or scam of some kind. However, my curiosity was piqued when I noticed a missing attachment outlining the firms planned investment strategy. I shot a line back, requesting the missing attachment. I should have stifled myself: Eddie, figuring he had a live one, sent the missing attachment with a note saying We are so glad someone of your stature might be interested and, by the way, if you have any friends or colleagues who might be interested, could you please forward this email to them also? The point is that in todays go-go ultra-high liquidity environment, Eddie was probably successful in raising money with similar techniques. Of course, roughly 1,000 of the worlds 9,000 hedge funds went out of business last year. The big question is whether this Wild West mentality poses broader risks to the global financial system, particularly given circumstances where a large number of firms are all collectively making the same bet. If they lose, a long string of bankruptcies can cut deeply into banking systems that had generated huge profits by lending to these same hedge funds. At the moment, the most glaring weakness is the so-called yen carry trade. Hedge funds have borrowed hundreds of billions of dollars at ultra-low interest rate in Japan, and invested the proceeds in countries like Brazil and Turkey, where interest rates are high. As long as the yen remains weak, this investment strategy will be a money machine. But if the yen appreciates sharply, as it easily could given Japans huge current account surplus, some hedge funds will suffer huge capital losses and the yen carry trade will implode. And, while todays main risk is the yen, in a couple months it could be something completely different. So pressure outside the US and Britain to put the hedge fund industry on a tighter regulatory leash is hardly surprising. The Germans, for example, want to reduce risk by forcing hedge funds to adhere to stricter reporting requirements. The funds respond to such proposals by arguing that if they are required to reveal their investment strategies, they will lose their incentive to innovate, and a recent US government report a multi-agency effort headed by Treasury Secretary Hank Paulson (formerly of Goldman Sachs) supports that position. Greater regulation would be a mistake, the report argues, because the global economys best defense against systemic risk is the exercise of common sense and due diligence by each and every person who invests or interacts with hedge funds. In other words, the US is telling investors to carry their own guns, because, as in the Wild West, there might not be a sheriff around to help. But frankly, as we are reminded by recent events, it is hard to see how at least a small increase in transparency can hurt. The Germans, in chairing the G8 this year, should not surrender on this issue. No country wants to put itself at the mercy of the likes of Eddie. ** Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF. Copyright: Project Syndicate, 2007. http://www.project-syndicate.org/commentary/rogoff28
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