How Capitalism Will Save Us

by Steve Forbes

  Paulson did not really “keep his own counsel.” His massive investment of client money in positions predicated on a market decline constituted a powerful signal to other big investors that trouble was brewing.

  Short sellers traditionally play an important role in helping to cool overheated markets. Without traders like Paulson signaling to more traditional investors that a decline is coming and it’s time to slow down, markets would be prone to even more violent swings. Had he remained on the sidelines, the overheated trading in mortgage-backed securities would likely have gone on longer than it did, funding more bad mortgage lending.

  If more people had the foresight of John Paulson, some of the excesses that produced the financial crisis might have been avoided.

  As we explain elsewhere in this chapter, the wealth created by hedge funds like Paulson’s benefits not only the “fat cats” on Wall Street. It quickly makes its way to Main Street, boosting the coffers of pension funds that support millions of retired employees, as well as endowments that fund university budgets.

  Paulson made money for his clients in a dangerous market at a time when other hedge funds were racking up losses. He may have netted a multibillion-dollar reward. But he’s one in a million in terms of his acumen, the wealth he created, and his critical role in the economy.

  Some observers have complained that short sellers like Paulson benefited from the weakness in financial stocks artificially created by the removal of the uptick rule and the advent of mark-to-market accounting. It’s true that these short sellers made immense amounts of money because of those two factors. But you can’t blame the short sellers for successfully responding to distorted market conditions that the government created.

  REAL WORLD LESSON

  There’s a world of difference between lotteries, slot machines, and other gaming activities and investing. Gambling is a form of entertainment; investing is how we finance future innovation and growth.

  Q DOES SOCIETY REALLY NEED RICH PEOPLE?

  A YES. EXPERIENCES OF NATIONS THAT HAVE DESTROYED THEIR MERCHANT CLASS ILLUSTRATE THE IMPORTANCE OF WEALTH BUILDERS IN AN ECONOMY.

  The title of author Hunter Lewis’s recent book posed a question that has been asked by the critics of capitalism: Are the Rich Necessary? The book, which looks at both sides of the debate, offers a good explanation of why, in the Real World, “rich people” are not only necessary but essential:

  An economy expands by becoming more productive. We become more productive by learning how to produce more and more, better and better, with the same number of workers. Productivity increases as we give workers better tools. In order to afford these tools, we need…to save, so that we can invest the savings in the tools we need.26

  The poor cannot be expected to save, because they need every dollar for basic needs such as food and shelter. Middle class people will save something for emergencies, children’s education, or old age. The rich, however, are different. They have so much money that, in aggregate, they simply cannot spend it all. They are, in effect, forced to save.27

  The author is essentially saying that because they are “forced” to save, the rich have the capital to invest in the tools—the businesses and innovations—that increase productivity and economic growth. What happens when there aren’t enough rich people? There isn’t enough investment capital. The economy suffers.

  People who buy into the Rap on capitalism fail to see the role that the rich play in an economy as society’s entrepreneurs and investors. All too often, they see “rich” and “poor” as fixed groups with opposing interests. In her 2007 essay in the Nation on the “bloated overclass,” Barbara Ehrenreich angrily declared that “it no longer takes a Marxist, real or alleged, to see that America is being polarized between the superrich and the sub-rich everyone else.”28 Ehrenreich, as we saw earlier in this chapter, holds rich people culpable for countless sins, ranging from “exploiting” low-wage labor and displacing people through gentrification to enriching themselves and not others through their fortunes.

  Society would be better off, she says, if these selfish rich people weren’t around. In her piece, Ehrenreich quotes a fellow writer, Roger Lowenstein, who, while more accepting of inequality, acknowledged that the nation might be a more “egalitarian” place if “the upper crust were banished to a Caribbean island.”29

  Ehrenreich does him one better. The Caribbean, she insists, is not a sufficiently remote location: “why give the upper crust an island in the Caribbean? After all they’ve done for us recently, I think the Aleutians should be more than adequate.”30

  Well, about thirtyfive years ago, Idi Amin, the dictator of Uganda, more or less did what Ehrenreich is proposing. In 1972, the dictator expelled the nation’s population of Indians, who made up the merchant class. Amin accused them of being “bloodsuckers” who had undermined the nation’s economy, avoiding taxes and not investing their profits back in the economy. He gave them ninety days to leave. Some eighty thousand did.

  Amin rid his country of most of the people who were supposedly the cause of its woes. The result? Deprived of the services and capital produced by these entrepreneurs, Uganda’s economy collapsed. An account in the British daily The Independent describes what happened:

  After the expulsion, Uganda’s inflation soared and imported goods became impossible to get hold of. Few Ugandans saw material benefits from the expulsion. Instead of equally distributing the property and land the [Ugandans of Asian descent] left behind, Amin gave the confiscated property to a handful of his favourite soldiers who had no business skills or money for investment. Uncared for, the shop fronts crumbled and farmlands returned to the jungle, and international investors became increasingly reluctant to put their money in the country.31

  More than a decade later, the bloodthirsty Amin, a man who had butchered tens of thousands of his own people, had gone into exile and a new regime attempted to undo the damage that the Asian exodus had done, returning confiscated property and inviting the exiled Asian Ugandans back. So much for the notion of the rich being a drag on the economy.

  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:

  In many times and places, middleman minorities have been forced to flee for their lives from mobs or have been expelled en masse by political authorities. Yet the departure of these supposed “parasites” and “exploiters” has not been followed by a more prosperous life by the rest of the population but usually by economic decline—sometimes catastrophic decline.32

  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.33

  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.”34 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 up
per income earners, but for everyone else.

  As Lincoln also said: “You cannot help the wage earner by hurting the wage payer.”35 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.”36

  REAL WORLD LESSON

  Rich people are essential to economic growth because they can amass and invest the capital needed to create and develop businesses, jobs, and innovations.

  Q DON’T THE RECENT FINANCIAL CRISIS AND HIGH OIL PRICES SHOW HOW HEDGE FUNDS AND PRIVATE EQUITY INVESTORS, WITH THEIR CONCENTRATED POOLS OF UNREGULATED WEALTH, END UP HURTING THE ECONOMY?

  A NO. HEDGE AND EQUITY FUNDS PROVIDE A VITAL SOURCE OF CAPITAL IN THE ECONOMY. WITH PROPER OVERSIGHT, THEIR TRADING ACTIVITY CAN IN FACT HELP MODERATE MARKETS.

  Hedge 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.”37 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.

  Hedge funds were also mistakenly blamed for helping to propel the steep rise in the price of oil—another example of shooting the messenger. Hedge funds alone couldn�
�t set the value of a commodity traded worldwide in so many markets. They went along for the ride. Their speculation was prompted by the Federal Reserve Bank’s easy-money policy, which sent the prices of all commodities rocketing upward. When the Fed tightened up that policy in the summer of 2008 by not printing excess dollars, commodities, including oil, crashed—and hedge funds were powerless to prevent it.

  Given the current economic disaster, there will certainly be new rules and regulations for equity and hedge funds. Whether they will be constructive or destructive remains to be seen. Suffice it to say that big collapses of “underregulated” hedge and equity funds have been far fewer than those of highly regulated banks and insurance companies.

  REAL WORLD LESSON

  Hedge funds and equity funds, with proper oversight, are a critical source of investment capital, providing important information about the direction of markets, and increasing the efficiency and precision of commodity and equity pricing.

  Q ISN’T IT HARDER FOR A TWO-INCOME FAMILY TO GET BY TODAY THAN IT WAS FOR A ONE-INCOME FAMILY IN THE 1970s?

  A IT IS HARDER MAINLY BECAUSE OF THE INCREASED TAX BURDEN ON TWO-INCOME HOUSEHOLDS AND THE RAPID INCREASE IN HEALTHCARE COSTS.

  Harvard Law School professor Elizabeth Warren and her daughter Amelia Tyagi did a study comparing an average middle-class family who lived on one income in the 1970s with the two-income family of today. They claimed that even though today’s two-income family brings in 75 percent more income than yesterday’s one-income wage-earning family, they actually have less disposable income. Why?