The current conventional wisdom on hedge funds—which have rapidly emerged as a major force in the world economy—is that they are dangerous and should be subject to much broader regulation. Sebastian Mallaby, economist for the American Council on Foreign Relations, offers a different view. Mallaby challenges the image of hedge funds as a threat to market stability and argues that they mitigate financial insecurities, rather than increasing them.
Mallaby claims that there is a public misunderstanding of hedge funds, which he attributes to a few basic factors. Foremost is the response of international politicians and policy makers when major funds collapse. Public statements, such as Alan Greenspan’s warning that the 1998 implosion of Long-Term Capital Management “could have potentially impaired the economies of many nations including our own,” have resonated quite loudly. And on the European side, skeptics have taken to the claim by Germany’s deputy chancellor Franz Müntefering that hedge funds “remain anonymous, have no face, fall like a plague of locusts over our companies, devour everything, then fly on to the next one.”
Mallaby makes no effort to deny the increased influence of hedge fund investment (assets have quintupled in the last eight years),but points out that generalizations about hedge fund practices, simplistic caricatures, and blanket condemnations by politicians and the press reveal an ignorance of the vast variations within the sector. Another point of contention is the sense that hedge funds make too much money: the fact that founder-owners sometimes pull in hundreds of millions annually contributes to the idea that markets are being exploited at the expense of the common investor.
Mallaby’s argument in favor of status quo regulation is grounded in the idea that the proliferation of hedge funds is an organic response to market needs: “By buying irrationally cheap assets and selling irrationally expensive ones, they shift market prices until the irrationalities disappear, thus ultimately facilitating the efficient allocation of the world’s capital.” Hedge funds also reduce shocks created by huge market swings, because of their capacity to wait until falls have evened out or bubbles have burst. While a common investor might pull the plug on a falling stock, a hedge fund can afford to withhold judgment, to “bet against the hype.” Mallaby responds to the call for more regulation with three main arguments:
- Rules already exist to quell insider trading;
- Limiting a hedge fund’s ability to borrow would destroy the nature of the fund itself; and
- More disclosure of investment would undermine the fund managers’ capacity to find otherwise unnoticed inconsistencies in the market.