Private equity, derivatives, bubbles and busts

A current blog in Sydney put the question whether “What's good for Wall Street is good for …” well, the rest of us. It went on to ask: “Is Goldman Sachs' astounding $16.5 billion payout to its employees a triumph of capitalism or an obscene example of the greed-is-good philosophy?” It added the comment that “New York media can't decide”.

If the New York media can’t decide, I have suggested in America’s Suicidal Statecraft that, although Goldman Sachs - and other operators like Macquarie Bank and Texas Pacific - might deliver some short-term bonanzas for some people, the risks for the longer term and for most of us, are potentially - and it would seem inherently - terrifying.

At least one member of the European Union, though not a member of the currency Eurozone - the United Kingdom, has been eager to follow the United States into what many see as the minefield area of highly speculative finance-capitalism.

This is no less, of course, than Britain has done in following the United States into other economic, political and strategic escapades.

Britain is consequently exposed to much the same dangers as the United States. So is Australia. Indeed, the group of economies which the ever more threatening financial hurricane will particularly assail is that which we might loosely call the "Anglo-Saxon" economies, whose policies are modelled, in general terms and in much of the detail, on a wide range of American concepts and policies.

Those policies are set to be - in some ways and for some economies - as devastating for the “Anglo-Saxon” economies as they are at home in their place of origin in the US.

So we should be clear that, although so much of current finance capitalism has its genesis in the United States, the self-destruction that it threatens will not be confined there nor will it be only the Americans who are grievously hurt. Many countries outside the United States stand to be directly and indirectly affected by “the Goldman-Sachs” finance-capitalism phenomenon.

There are similarities in the market trends in housing in the US and the UK - as well as, to a large extent, in Australia. There has been a boom of quite extraordinary proportions in the UK centred particularly on London - and it continues. It continues for reasons that are at least partly distinct from the driving forces in the United States but the impact of the bubble when it bursts, is likely to be quite as sensational.

On December 2, 2006, the International Herald Tribune (IHT) reported, "Already the most expensive place in the world to buy a luxury property, this city [London] is expected to set a new price record with some apartments going on sale for as much as ₤4,000 a square foot".

Recently apartments have been selling for more than ₤3,000 pounds or about $US5,800 a square foot compared with $US5,100 for the equivalent in New York and, it is said, the next contenders for the most pricey accommodation are Tokyo at about $US1,700 and Hong Kong at $US1,300.

It can’t fail to remind us all of the heady days in Japan in the late 1980s when a studio in Tokyo, offering just about standing room only, could turn you into a millionaire overnight.

That boom went bust - along with the Nikkei stock-market bust - and led to a deflationary recession or near-recession lasting more than a decade.

Will the same happen in London and the UK?

There are similarities. The bubble will certainly deflate - and probably very fast, once it starts. The impact will be lasting but how wide will the implications be? How many people will it hit - hit severely?

Interestingly, the IHT report says "Driven by a surge in bonuses among London's financial traders, and an influx of wealthy foreigners, prices in central London have doubled and, in some cases, tripled over the last ten years while the market in New York has cooled."

So the property bubble in London is not fuelled in the same way as in the United States, where the main propellants have been loose credit, refinancing and extraction of equity.

In London, the propellant for one bubble - the housing bubble - seems to have been derived, significantly, from another bubble - the finance trading, derivatives, hedge-fund and private-equity bubble(s). So one might reasonably postulate that the housing boom in London and, at least to some extent, further afield in the United Kingdom - in the country-house market, for example - will go on as long as the finance-capitalism bubble keeps inflating or at least does not suffer from a significant bout of uncontainable flatulence.

Is the finance-capitalist boom based on those largely speculative devices of private equity, hedge funds, derivatives and the rest sustainable indefinitely?

In principle - not to claim any particular insights but as a matter of reasonable prediction - one has to say that it cannot. The only question is when severe flatulence will set in and the bubble - to be crude - will fart its way into the sorry records of economic and financial history.

So then presumably, if the IHT report is to be believed, much of the air will be emitted from the property bubble too. The "wealthy foreigners" who have been helping to inflate the property market will also in large part have derived the means to join in the property scramble by making money in the finance markets spread around the globe.

Thus it looks as though we could be facing the prospect that there will be a back and forth, repercussive effect from one bubble to another and, in a relatively short space of time, months rather than years. Those people who get those lovely, massive bonuses will presumably not be getting them any more. They have had it so good - and represent, I imagine, such a relatively small percentage of the population - that they will get little popular sympathy, even if and when they start jumping out of upper-storey windows.

But those who depend on the property market in a variety of ways will be hard hit too. More generally the City is likely to suffer terribly if the private-equity, derivatives and other markets collapse. One imagines that the FTSE will suffer catastrophically along with it.

What will happen to the UK economy as a whole? I'm not sure how far the rest of the economy - the non-financial corporate and general, traditional business economy - is able to stand up by itself. My impression is that it is the financial sector - the highly speculative sector - that has provided much if not most of the dynamism of the British economy for a long time now - perhaps ever since the Big Bang.

When it collapses in a heap, the devastation is likely to hit everything and everyone within the national borders - and have its impact beyond, within the Eurozone, within the larger EU and more widely within the global economy.

The impact probably won't be as great as that made by a major collapse of a bubble or clutch of bubbles in the United States, but my guess is that it could turn out to be pretty nasty.

In all of this, we need to keep in mind the essential nature of private-equity and other financing identified with what I have called the “Goldman Sachs phenomenon”. In America’s Suicidal Statecraft, I have suggested that the crucial consideration is the quality of the investment represented by the phenomenon. Is it new real fixed-capital investment or is it simply transfer of ownership? I suggested that:

If it were the latter, it was another example of that redefinition of investment so common in the last quarter century, especially in the larger Anglo-Saxon economies, whereby transfer of ownership supplanted fixed-capital investment as the most common form of what purported to be “investment”. Investment became a means of making a fast buck, not by entrepreneurial effort, construction of factories and installation of productive equipment, but by gambling to add market value through mergers and acquisitions including privatisations that would lead to higher shareholder value in the marketplace. Those higher values might be short-term and would have to be gathered quickly before more fundamental disabilities became apparent and prompted longer-term declines in values. Despite the higher, short-term market values, they would not necessarily add anything to productivity or to the volume or value of final output (pp. 383-4).

Inevitably, there are social impacts from this deal-maker, day-trader, casino-like type of ownership investment, especially to the extent that it spreads over a more and more major part of the economy. There has always been some speculation at the margin but, long ago, Keynes warned that there were dangers if speculation grew so much as to dominate or characterise the economy. Among the social effects would be, at least in the short term, growing inequality of incomes. Again, in America’s Suicidal Statecraft, I have written:

Inequality is dramatically intensified by generous bonuses for senior executives and others in financial firms in the United States and such other financial centres as London. The 2005 bonuses in Wall Street set new records of $21.5 billion in aggregate and $125,000 on average for individuals. Thousands received bonuses of $1 million and more in New York and 3,000 pocketed one million or more pounds each in London. The chief executive of Goldman Sachs earned a compensation package of $38 million for 2005, the head of Lehman Brothers $15 million and just six months’ work at Morgan Stanley brought its new head $11.5 million. The bonuses would, it was said, be spent largely on “multimillion-dollar estates, rare art, luxury cars and fractional shares in private jets” (page 435).

Even these handsome rewards appear almost Spartan compared with the huge fortunes amassed so quickly by those who manage - and collect the fees from - private-equity deals:

In the midst of the junk-bond craze of the 1980s, the $500 million made by Michael Milken on his junk-bond deals was novel and shocking; but now, as hedge and private-equity funds have moved to the Wall-Street mainstream, rewards of such magnitude are closer to the everyday norm. For 2005, the two highest earners are reported to have been Steven Cohen who manages a $6.5 billion pool of assets for wealthy investors in SAC Capital Advisers and Stephen Schwarzman whose Blackstone fund handles private assets of a similar size. The rewards, mostly in cash, for their year’s work are calculated to be $500 million for Cohen and $300 million for Schwarzman. Milken’s takings were so huge that, in his day, it was thought that they must have been ill-gotten. Nothing of the kind is imagined today. “These big paydays are based on performance,” former hedge manager Andy Kessler is reported to have said. “For capitalism, it’s great these guys are taking a piece of the upside and saying we took the risk so we get the reward” (page 436).

Of course, there is justice in rewarding effort and enterprise. That is historically one of the ways in which a capitalist system has justified and maintained itself; but there are other considerations too. Indeed, if our present essentially democratic capitalism is to survive - and survive securely - it must pay attention to social outcomes.

Poverty in the midst of plenty is not a comfortable social situation. Some inequality there will always be but gross and growing inequalities must, over time, be a threat to social, political and even strategic stability, as well as economic and financial stability. So we might reasonably contend that:

… given the contrast with the wages of the ordinary worker and the poverty of the millions of people with and without jobs in the United States, such huge rewards [for private-equity managers and dealers] seem to be obscene. They are the more so in the light of the tax cuts awarded to high-income earners by the current Bush administration; but the most extraordinary feature is their magnitude at a time when the American economy has such enormous and such intractable problems to many of which the financial sector has contributed so unstintingly. The freakish asymmetry of the whole financial picture suggests that it cannot persist - but so far it has and it seems to get more firmly embedded year after year (page 436).

In a succinct comment on the Sydney blog, Leonardo Gasparre took no prisoners in his condemnation of the “Goldman Sachs phenomenon” and his prediction of the way we will feel when the house of cards tumbles down. He said that the situation was “Disgusting. As will be demonstrated after the Qantas take over and the debt they've been burdened with. Under a regime of slashing wages and outsourcing our future skills pool these guys engorge themselves. When the business hits trouble we'll look back at these and marvel at the greed and how we ever let it get to this.”

What the outcome of all of this will be, we cannot know yet with any precision.

In several respects, although the basic model that Australia has chosen is American, the details of the outcome will be different in Australia from the US, the UK or Europe. Nevertheless, the odds are that we will suffer severely and perhaps tragically when our Goldman-Sachs-type and related bubbles, as I’ve said, "fart" their way into the sorry annals of economic and financial history.

However, even at this late stage, we just don’t know how great and widespread the suffering will be. So there may be little point for us, as individuals, to be either optimistic or pessimistic about our current finance capitalism and all the smart financial devices created by clever, mostly young, seriously ambitious, highly paid and extravagantly bonus-ed British ladies and gentlemen and Yankee guys and dolls - as well as, of course, the relatively small band of blokes and sheilas sitting at dealers’ tables and computer desks around Australia. All that we can do - we who are not making the deals and sharing in the take - is to be fatalistic.

As the song says, "Que sera sera".

At the same time, some of us might be dusting off our book of prayers!