The apparent arbitrariness and irrationality of financial markets do not inspire the admiration of liberal-inclined people. But many professionals in the financial markets also accept that there are structural failings in the system. Financial capitalism needs reform if it is to have popular legitimacy, but it needs the right kind of reform. Tighter regulation to constrain footloose capital is mainly a chimera.
Recent events have intensified popular suspicion of financial markets. Since the collapse of the bull market of the late 1990s, the most newsworthy financial stories have concerned corporate scandal and market abuse. The failures of Enron and WorldCom amid huge fraud are notorious. A few weeks ago a large US broker, Refco, filed for bankruptcy as news emerged that its chief executive had been charged with concealing a $430m debt.
The charge sheet against the US/ British model of shareholder capitalism is longer than the issue of malpractice. Commentators such as the Financial Times columnist John Plender, in his book Going Off the Rails, argue that the debacle of the dotcoms merely served to emphasise structural weaknesses in the system.
The most prominent academic critic of excessive faith in stock markets, the Yale economist Robert Shiller, has long been associated with the judgement that stock markets exhibit "excess volatility"—that is, prices are more volatile than would be justified by the variability of corporate dividends over the long term. At the peak of the bull market, he argued prophetically that "there is a whiff of extravagant expectation, if not irrational exuberance, in the air." His public policy advice has been to modify schemes that encourage people to devote their personal pension schemes to the stock market, and against proposals to privatise social security.
Moreover, there is evidence that successful businesses are reluctant to seek stock market listings because of the unrealistic demands of shareholders. It is the opposite of what liquid stock markets are supposed to do, and provides retrospective weight for the thesis argued a decade ago by Will Hutton, in The State We're In, that stock markets are too short-term in their investment horizons. The danger, however, is that because financial markets are the most visible part of the economy, public opinion may infer that the financial sector is parasitic on the real economy, or even that the market economy itself is a rapacious and anarchic force.
Takeover activity tends to reinforce this view. And there has been a quiet boom in mergers and acquisitions this year in the US and Europe, driven by low interest rates and surplus corporate cash. The value of M&A deals announced in 2005 to date (early November) exceeded $2 trillion worldwide—the highest level since the internet boom. Deal activity includes high-profile contested European bids, such as Gas Natural's $26bn cash and stock offer for Endesa in Spain.
These are huge sums. Yet dispiritingly few takeovers benefit a wider constituency than the shareholders of target companies and the advisers who earn fees. The targets of contested bids are not necessarily inefficient, and there is some academic evidence that friendly bids more often destroy value than create it. The problem is not the stereotype of greedy plutocrats, but a system in which the interests of managers, investment bankers and corporate lawyers are too tightly aligned.
The "short-termist" critique has had something of a revival owing to the obsessive focus by stock markets on single measures of profitability (notably a fad known inaccurately as "shareholder value"). There is little evidence, however, that the collaborative capitalism of continental Europe has performed better in recent years in allocating capital to productive uses.
In this context, critics of financial capitalism need a better understanding of the role of the newer investment institutions. In particular, hedge funds (otherwise known as absolute return funds) have become the focus of a powerful new mythology. Hedge funds use investment techniques such as short-selling (borrowing stock and selling it in the hope that a profit can be made by buying it back later at a lower price) and leverage (using borrowed funds) to boost returns and manage risk. They became entrenched in the popular imagination through two major events. The first was the profit made by George Soros's funds in 1992 when betting on the imminent departure of sterling from the European exchange rate mechanism. The second was the huge leveraged bets taken by one hedge fund, the inaptly named Long-Term Capital Management (LTCM), in 1998; these precipitated a rescue scheme by the commercial banks, orchestrated by the Federal Reserve, in order to defuse a systemic financial risk.
Yet the mythology of arrogant, unaccountable and unstable forces in the capital markets is mistaken. Soros made large profits because public policy itself was incoherent. And there is a plausible argument that the US monetary authorities overreacted to the LTCM debacle, and that merely allowing commercial banks to absorb LTCM's trading positions into their proprietary trading books, rather than arranging a full-blown rescue, would have been an effective recourse.
The most important reason for welcoming the activities of absolute-return funds is that they help break open the cosier aspects of finance capitalism. They are often accused of being disruptive speculative vehicles, but there is evidence that they are in a better position to take a contrary view of market fashions than pension funds or unit trusts that are measured against the performance of a benchmark (such as a stock market index). They may thereby narrow the gap between speculative prices and intrinsic values. Being able to sell short in principle makes the returns of a fund uncorrelated with the overall stock market, thereby adding a valuable element of diversification to an investment portfolio. There are regulatory challenges posed by hedge funds, particularly the concern that some institutions may not have the means to monitor the credit risk of their exposure to hedge fund clients. But overall, hedge funds help financial markets to operate as they ought to. They assist the efficient allocation of capital and the management of risk. They make a profit to the extent that they provide this useful service; in doing so they allow society to become richer. For all their faults, speculative markets do the job better than any conceivable alternative. Those who make a living from them may not all be philanthropists, but they are a deceptively progressive social force.
