Sunday, September 28, 2008

Hedge funds, the financial collapse, and the Paulson Plan

To what extent are hedge funds responsible for the finanical collapse of 2008? Unfortunately, the answer to that question is: We don't know. In fact, very little is known about the operation of hedge funds, much less about what they mean in broader terms. The only people who know much about hedge funds are the ones running them. Most economists and businessmen -- the men and women best positioned to know something about the economics of hedge funds -- are not wealthy enough to actually participate in them.

So what do we do? How does a society or an investor gain a semblance of control over something we know little about?

The answer is, we can't. Therefore, one way we might want to evaluate the Paulson Plan is whether it furthers hedge fund knowledge. That is, whether the Paulson Plan initiates a process by which we can grow our collective knowledge of hedge funds, how they operate, and what they mean for the workings of our country's economy. Under the Paulson Plan, will they be further regulated? Will they come under more scrutiny? Will we have a better idea of their economic and social effects?

For the time being we must depend on experts. Timothy F. Geithner has been the president and CEO of the Federal Reserve Bank of New York since late in 2003. In 2004, a year into his presidency, Mr. Geithner gave a keynote address on hedge funds. Read the whole thing here. Remember, he wrote this over four years ago. The number of hedge funds, the wealth of hedge funds, and the power of hedge funds can only have grown since then. As such, I have highlighted the final sentence of this introduction.

Keynote address by President Timothy F. Geithner on the Hedge Funds and Their Implications for the Financial System.

I want to use this opportunity to share some perspectives on hedge funds and the policy implications of their evolving role in the financial system.

The term hedge fund is used to describe a diverse group of financial institutions, which together play an increasingly important role in our financial system. The rapid growth in their numbers and their assets under management suggests they provide, or are perceived to provide, significant economic value to investors that is not available in other investment vehicles. If hedge funds demonstrate continued value as investment vehicles, then given the relatively small share of the world's savings they account for today, we could see meaningful further increases both in the aggregate size of the hedge fund sector and in the relative significance of their role in financial markets.

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