Perceptive deception? Deceptive perception?

Posted: July 18, 2010 in Hedge funds

The melancholic wallowing in the financial crisis triggered by the Big Bust of 2008 has given market Goats enough time to scratch their beards and ruminate over things that caused economic indigestion. Trust the Goats to digest the indigestible, even if the only way to achieve that is by indulging in…scapegoating. The path of least resistance is to externalize everything and hopefully, if one is lucky, a goat will stick its fat neck out, ready to be guillotined. An intellectual pow-wow session saw hedge funds and Germany emerging as two current consensus scapegoats. (I’m cautiously steering clear of investment banks. That would be too big a Pandora’s Box for me to handle…)

It behooves me to declare at the outset that there might be traces of conflict of interest here, and like most humans, I probably overestimate my capacity of objective thinking. But…it takes two hands to clap and while hedge funds are definitely no Saints, I think pinning the blame on them for the ills of the world is a little far-fetched.

ScapeGoat #1: Germany

So, Germany is leading Europe into a deflationary spiral with its severe wage-restraint policy over the past decade. No less than hedge fund god George Soros feels this way. Germany runs a current-account surplus and as the King Kong of the Euro, it is expected to do more to bailout the rest of the peripheral chimpanzees. Everyone looks askance and with oodles of trepidation on Germany’s apparent lack of contribution. Never mind that the periphery thought little before spending (and borrowing) beyond its means, with even less thought on how to repay the debt mountain. So even as Germany – hurt by its hyper-inflationary history – judiciously built up a strong moat by keeping wages in check and increasing competitiveness, the periphery was busy building a mirror image. And when the eventual bust shattered the mirror, the dazed periphery ganged up against King Kong. Some chimps even go as far as subtly blaming King Kong’s rumblings for the broken mirror. Now you gotta do more big guy! The periphery conveniently seem to have forgotten the implicit safety net that King Kong provided in the go-go years. Lower borrowing costs and benefits of a unified market are now conveniently replaced by a deflation-happy Germany that’s apparently hell-bent on destroying the Euro.

Achievement of long-term economic alignment and correction of imbalances can be realized in two basic ways, (i) devalue the currency, (ii) take the hard road to improving competitiveness. Oh, I forgot a third; blame King Kong for your ills. (i) is off-limits as the periphery obsessively looks to cling on to the Euro. (ii) seems prohibitively tough and (iii) is the path of least resistance. Attractive, intuitively easy to grasp, package and sell to a mass audience. (iii) is also a politically strong card to play in the current circumstances. I can’t see how the Euro can survive in its current setup even if Germany were to launch a massive blanket bailout. As always, rather than focus on cleaning internal muck, economies prefer donning an Armani and sophisticatedly blaming King Kong.

ScapeGoat #2: Hedge funds

So hedge funds are the bad guys. Daemons who repeatedly wield the Brahmastra called Shorting. Those who profit from other people’s misfortunes surely can’t be good, can they? They caused the crisis and have much to blame for Europe’s (and others’) ills.

I’m not about to launch into an exposition off the premise that hedge funds are saints. Yes they indulge in speculative activity that often leads to unintended negative effects. Yes, they seem to profit from other people’s misfortunes. But as allocators of capital, hedge funds most often react to events that are dynamically set in motion independent of their actions. Can hedge funds be held responsible if Greece spends it way to hell? Or if an US home buyer leverages to the moon and flips homes faster than he flips the pages of the Wall Street Journal? Or if the proverbial shoe-polish guys and grandmas pass on stock tips?

Some quick numbers to put hedge funds in perspective. Global funds under management in 2008 were ~$90 trillion, and hedge funds made up $1.5 trillion of this. The skeptic might point to the leverage component in hedge funds to get a truer picture. Assuming a 3x leverage (which is roughly the levels now), hedge fund screwing power (pardon that term) is $4.5 trillion, a fat 5% of global money guards

Textiles are a rather messy business. Long-term economics do not lend themselves to sustained generation of high returns on invested capital. It’s a pit that keeps growing over time, band-aided by periodic injections of cash. Only to come back for more as time goes by. The deteriorating economics of the business results in destruction of capital and since the latter is a scarce resource, it will eventually end up in places where it is most useful. And one can think of several businesses that utilize capital better. So, if a hedge fund short sells a textile company leading to an exacerbation (and sometimes annihilation) in the already falling stock price, how is the hedge fund responsible for the destruction of the textile business and its associated loss of jobs?

Darwinian Theory works in businesses too. And as much as it sounds altruistic to try to save chronically leaking boats, nature will run its course eventually. The smarter thing to do under the circumstances is to devote energies to switching boats, as Warren Buffet keeps reminding the world. Again, the path of least resistance is to blame hedge funds that are adept at boat-hopping for destroying economies and businesses.

Hedge funds. Fat head? sometimes, yes. But, guillotine? No…

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