Most people reading Ben Stein, the NYT's Sunday business columnist, probably just think that the man has no idea what he's talking about and got his column through connections. I used to think this myself, until I read, and then reread, this Sunday's column. Mr. Stein notes the fabulous return that some hedge fund managers have been able to reap on their portfolios, and in particular the 40 percent annual returns earned by Steven A. Cohen, the founder of SAC Capital. Stein suggests that the federal government issue enough bonds to raise $10 billion, and then let Cohen manage the money. Stein points out that if Cohen gets his usual 40 percent return, then the return, net of interest, would be 36 percent. In two years, this would net the government $8.5 trillion, almost enough to pay off the national debt. He then suggests that if Stein continued to manage the money, we could eliminate taxes and still have enough money to run the government. Unenlightened readers are undoubtedly wincing at this painfully silly idea. But grasshopper, Stein has a very important lesson to teach us. Where do hedge fund profits come from? Stein has hit us in the face with a story that would quickly have Mr. Cohen's income consuming the entire GDP of the country. This is troubling for those of us committed to arithmetic truths. If Cohen's income takes up the entire GDP, what is left for the rest of us? One answer to this question is that Cohen's hedge fund dealings will actually provide a huge boost to GDP so that he can earn an income equal to projected future GDP and, due to his contribution to GDP growth, there will still be as much or more left for everyone else. Is this story plausible? Well Cohen's modus operandi is to make bets ahead of the market. He finds the winners just before they start winning and dumps the losers just before they start losing. The economic benefit from Cohen's actions is that prices adjust somewhat quicker than they otherwise would. In other words, if the proper price for IBM stock is 116, instead of the current price of 113.75, it will get to 116 somewhat more quickly because of Mr. Cohen's trades. While getting prices right somewhat more quickly undoubtedly provides a benefit to the economy, this gain is probably too small to measure. After all, we had stock prices hugely wrong in 2000 (perhaps over-valued by 100 percent) and how much economic damage did that cause? While this massive and sustained over-valuation undoubtedly did cause harm, it is very difficult to see much damage being caused by a stock being under or over valued by 1-2 percent for a few days. In other words, it is implausible to believe that the vast majority of Mr. Cohen's income is coming from the gains that his work contributes to the economy. Rather, Mr. Cohen's gains come from other shareholders. If he buys IBM stock before it rises, he helps to bring the stock price to its proper level, but he gets the gain rather than some other potential stock purchaser. By being faster and better informed than other traders, Cohen is able to garner earnings that would otherwise have gone to other shareholders. Higher returns for Cohen mean lower returns for everyone else. As Cohen and other hedge fund whizzes comprise a larger share of the market, returns for everyone else will fall. (Actually, the returns on the hedge funds, many of which are bogus to begin with, will probably fall, but let's just play along for the moment.) Imagine that these folks aren't whizzes, but just inside traders -- it's the same story for everyone on the outside. To take Stein's example, suppose that Cohen got a $10 trillion check from the government to invest in the stock market, as he suggested. Let's assume that Cohen invests this money in the stock market and gets his usual 40 percent return. The total value of the stock market is currently about $20 trillion. Given current stock valuations and an inflation rate of 3 percent, we should expect an 8 percent nominal return on this money, or about $1.6 trillion in dividends and capital gains. But, Cohen will have generated $4 trillion in earnings on his $10 trillion fund. That leaves the rest of us with losses of $2.4 trillion on our holdings. Because Cohen was quicker than the rest of us, we ended up buying high and selling low. So, this is the true lesson that Ben Stein wanted us to learn from his column and he had to use the absurd example of having the government lend $10 trillion to a hedge fund manager to make his point. Hedge funds make their returns at the expense of other investors. The more money taken by the hedge fund boys and girls, the less for everyone else. Understand grasshopper?
--Dean Baker
