Hedge funds, speculation and capitalism

Original article by Mick Brooks via Socialist Appeal.

Hedge funds are in the news again. They don’t much like being in the public gaze. We wonder why. Does their speculation cause prices to go up? Do they drive firms into bankruptcy so workers lose their jobs? These are the questions being asked. Let’s see what they get up to.

John Edward’s favorite financial instrument is quite complicated.  Mick Brooks looks at hedge funds and how they impact our lives.

Where does the name ‘hedge fund’ come from? It has a bucolic feel to it, and that’s the way they want us to think of them. ‘Hedging your bets’ means trying to minimise risk. If a farmer wants to know where he stands, he may sell his 2009 crop, which he hasn’t planted yet, on the futures market. This will give him the money to buy the seedcorn up front and a feeling of security about the future. He’ll get a known price whether the harvest turns out to be good or bad. He hasn’t eliminated risk, just let someone else take it on. If you’ve sent a cheque in for the ‘Reformism or revolution’ book (which is still being printed) you’re playing the futures market! Futures are the simplest form of derivative. The derivatives market is called this because the instrument is derived from another transaction. It is contrasted to the spot market, where goods and money change hands at the same time.

Now, isn’t that simple!  I suppose everybody sending their hard earned cash to support the presumptive Democratic nominee are playing the futures market!  

This ‘everyday story of country folk’ is a long way from the reality of what modern-day hedge funds get up to. Some of the derivatives they deal in are so complicated that they need a bank of linked computers to work out the odds. Nobel prize-winning mathematicians have been sucked into the City to feed this tide of ‘financial innovation.’ And the sums of money that they deal with are awesome. Hedge funds are already playing with $2 trillion of other people’s money. There are $600trn of derivatives floating around the globe.  They are a form of what Marx called fictitious capital. By way of comparison, the world produces less than $50trn in new goods and services each year. (See http://www.socialist.net/wishf… by Michael Roberts)

Think of it!  $600 trillion in derivatives.  Let’s see: 1, 10, 1000000, 1000000000, 1000000000000, 600000000000000.  Gosh, keep adding zeros and you start to talk about some real money.  Six hundred thousand billion dollars in derivatives.  Bill Gates must be drooling.

The scale of operation is bigger but the principle is the same as before. The farmer didn’t want to bet on whether the 2009 harvest will be good or bad. But that meant somebody else did take a bet – the hedge fund. That’s what hedge funds do – bet with other people’s money. And bets can get more and more complicated. Ever heard of forecasts, trifectas, jackpots, placepots or pool bets? These are all ways of betting on horses. Usually they make it possible to win more money for a smaller stake. (This is called leverage in the financial markets.) Provided…always provided the horse you pick runs a bit faster than the others. And, as we shall see, leverage makes it possible to augment losses in the same way.

Maybe we should send the hedge fund managers to gamblers anonymous.  Of course, the markets are a bet anyway.  Hmmm…it’s amazing how rarely you hear about the fundies complaining about the markets, isn’t it?

The attraction for rich people in ‘investing’ in hedge funds is that they promise, and deliver, returns of 30% a year. How is this possible? It’s a grisly story. Recently hedge funds have been betting on banks failing. After all you can win money betting on which horse comes last the same as which horse comes in first. Everyone knows the banks have been leaking profits since the credit crunch started last year.

Rich pickings there!  Brooks goes on to give examples from the British financial sector.  He then writes about ‘our’ fiancial sector:

In the USA Lehman Brothers bank claims rumours are maliciously being circulated that they are virtually bankrupt and will soon be pulled to pieces like Bear Stearns was a few months ago. The fall of Bear Stearns Bank became a self-fulfilling prophecy once enough money got on the story. Is the threat to Lehman really just a case of incompetent managers blaming others for their firm’s misfortunes? Or are the hedge funds really up to something? Your guess is as good as mine.

Market manipulation by rumor!  Just what we need in this ever so much more interconnected globalized economy.  A hedger starts a rumor in Shanghai about the Red Army (Capitalist Division) pulling money from one of their American financial institutions, and like a butterfly flapping its wing to cause a storm on the other side of the world, a financial hurricane can hit the world’s financial markets.

So are hedge funds the bad guys? There is a different point of view, given by headlines such as ‘Hedge funds bail out ailing corporate world.’ (Financial Times 02.07.08) The article shows hedge funds rallying round Barclays in its search for funds and underwriting, not sabotaging, HBOS’ rights issue. Angels or assassins? Hedge funds are just capitalists. They will tear a firm to pieces if it makes money and then put it back together again if it makes more money.

Just captitalists.  Pure, simple, ruthless, bottom-line, bottom feeding capitalists!

But hedge funds work in the dark. And they’re now so mighty that, if they shout ‘fire’ in a crowded theatre, they can create a panic and amuse themselves later by looting the dead bodies of those caught in the crush. A wall of money can make things happen.

Brooks then writes about short selling and how it can be manipulated by, in this case, hedge funds.

Will Hutton fingers the hedge funds in an article ‘As we suffer, City speculators are moving in for the kill.’ (Observer 29.06.08) “The hedge funds weren’t even buying back the shares, they were ‘borrowing’ them from pension funds to manipulate the market,” he complains.

Here’s the fun part from Hutton:

“What then happens is the opposite of a bubble, a kind of financial black hole. The hedge funds sell the shares simultaneously, and the downward movement becomes self-reinforcing, with companies raising money during a rights issue particularly vulnerable. This is why the government forced disclosure. The hedgies reacted as if they were in Stalin’s Russia; their freedom to kill a company stone dead was being challenged. Let’s not mince words, that is the aim, and it gets ugly and personal. A senior official told me that in one case some hedge funds had allegedly warned the banks underwriting one rights issue to abandon it or face speculative attack – mafia practice.”

B…but…but they’re just out to make a quid!  What’s wrong with that?

The core of Hutton’s argument, and it has been raised by others, is that the wall of money moved by modern hedge funds can actually make things happen. Share prices go down because hedge funds sell, and not for any other reason, he argues. In that case they are just parasitic plunderers. But Marxists believe that capitalism is an inherently unstable system, and the operations of hedge funds and other speculators are merely the executors of the market forces through which the laws of capitalist anarchy work.

I think it’s just that they’re parasitic plunderers (but, then, many (if not most) modern day capitalists are just that: Parasitic plunderers.

This point is at the heart of a controversy among capitalists and capitalist economists. Milton Friedman asserted that destabilising speculation was impossible. This was supposed to be the case because speculators who ‘got it wrong’ would be buying dear and selling cheap. They would lose money and soon disappear. Friedman, a notorious apologist for capitalism whose disciples advised General Pinochet’s regime of torturers in Chile, assumed that capitalism is a stable system. In that case the market just nudges people and things in the ‘right’ direction. But what is the ‘right’ direction?  

Milton Friedman was speahead of the Chicago School of Economics.  That’s as in the University of Chicago.  Where a presumptive nominee taught law school.  A presumptive nominee who has said he loves the markets.  Hmmmm….

Friedman totally ignores the fact that markets can systematically move in ‘wrong’ direction’ – the opposite directions to the economic ‘fundamentals.’ (Whatever they are and whether or not they exist.)  This is proved by the existence of financial bubbles. Bubbles have been a feature of capitalism since its inception. For instance during the 1630s Holland was seizes by a mania for tulips. Tulips passed from hand to hand at ever-increasing prices. A rare tulip could sell for more than a farm. Why? Because each speculator assumed that, since prices were going up, they would be able to get more for the bulb than they paid for it. And why were prices going up? Because people were buying bulbs. The whole thing was a classic bubble, based not on ‘market fundamentals’ but on speculative mania.

Bubbles are made to be popped.  Either by themselves, or because something pricks them.  Lately, our economy has been one bubble after another.  And don’t think that the Dems are immune to allowing bubbles.  Just remember the tech bubble at the turn of the century.

Charles Kindleberger defines a bubble as “A sharp rise in the price of an asset or a range of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers – generally speculators interests in profits from trading in the asset rather than its use or earning capacity.” His book ‘Manias, panics and crashes’ is a cracking good read and an expose of the follies and villainies of capitalists over hundreds of years. Manias, panics and crashes have all been constant features of capitalism since its dawn – from the South Sea bubble that popped in 1720 to the housing bubble in the USA, Britain, Spain and Ireland that has just been pricked over the past year.

Bubbles are something to keep your eyes on.  You might be able to get an economy to shake off one bubble popping, but if several go off at once: Pow.  Of course, the derivatives market is a bubble ‘worth’ roughly 600000000000000 dollars.

Can speculators make money by putting up prices or destroying the livelihood of firms? Some argue that it’s all a zero sum game. If one speculator buys a piece of paper and makes money, then somebody else must have sold and lost money. Certainly society as a whole is not made one penny richer from speculation, a parasitic activity that burns up wealth. But if there are a group of people with inside information such as hedge funds, then they can profit at the expense of the savings of widows, orphans and others not in the know.

B…but…but it provides some people for their mistresses and alleged love children!  Grrrrrr….

Secondly, hedge funds are not just gamblers. They are also the bookies. In addition to a share of the winnings, (made with other people’s money) they charge a management fee.  As we know, whichever horse comes in first, the bookies always take their cut.

Screw with the markets, damn wherever they end up and what harm those changes make, we gotta get our fees!

And we (as a society) buy into it.

Brooks then writes about the American ‘Left’s’ favorite capitalist, George Soros.  Apparently Soros made a good bit of his fortune through hedge funds.

Soros argues that a wall of money ($200 billion at last count) is powering up the future price of oil in particular. “The institutions are piling in on one side of the market and they have sufficient weight to unbalance it. If the trend were reversed and the institutions as a group headed for the exit as they did in 1987 there would be a crash,” he warned the US Senate.

It would be their undoing, except that various governments (including our own) have stepped in the keep the system afloat.

So the problem is capitalism, not speculation. Prices go up anyway because capitalism is unplanned. Capitalism inevitably creates shortages at some points and gluts elsewhere. Firms go bust and workers lose their jobs because that’s how capitalist ‘competition’ works. Let’s kill it.

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  1. Pony Pens are hedges against the possibility of, sometime in the future, pissing of the readers of DD!

  2. Not addressed is the issue of “naked” short selling, or failure to deliver, that is a huge problem. Hedgies short sell stock without ever borrowing the stock first, in violation of the 1932 and 1933, which dilutes the value of the stock (like printing money), rinse and repeat until the targeted company ceases to exist, never buy back in and (maybe) get away with the booty tax-free! And this practice is being facilitated by the SEC, who are supposed to be the watch dog (yeah, in the Bush era?).

    Oh, and you all should be very, very concerned with Hank Paulson, former CEO of Goldman Sachs, as Secretary of Treasury.

    Good diary, thanks!

  3. ….I’ll point out that much of the reason they operate in the dark is because the regulation of financial markets encourages them to.

    “Hedge” funds are a specific form of legal partnership which is only available, by law, to small numbers of investors of an exceedingly high net worth.  By definition, a hedge fund can have at the very most 999 investors.  For entering into such a limited partnership, the government agrees to allow permissive regulatory conditions which no only financial partnership is allowed to have.

    If you want to break the hedge fund system, there are two easy ways to do it: regulate hedge fund partnerships the same way as all other investment partnerships, or allow unlimited numbers of investors of any financial means to invest.

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