Private equity, derivatives, bubbles and busts

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.