The Arbitary Ways of Arbitrageurs

The more you look at the way John Meriwether’s hedge fund, Long-Term Capital Management, was investing, the more perplexing its implications for the global capitalist system seem. That sounds overblown, I know. But the Federal Reserve orchestrated, and 14 of Wall Street’s largest financial-services companies participated in, the bailout of Long-Term precisely because they feared–with some justification–that the collapse of the hedge fund, and the resultant fire sale of its positions, could send financial markets around the world into a dramatic tailspin. So it’s not too much of a stretch to think that the way Long-Term was doing business has something important to tell us about the way capitalism works in today’s world.

What’s perplexing, though, is that it’s hard to see how what Long-Term was doing has much to do with capitalism as it’s been traditionally defined. A central pillar of free-market theory is that the individual and uncoordinated decisions of many different people about the proper allocation of capital will create a more productive use of that capital than would the dictates of a small group of central planners. From a Hayekian perspective, no group of central planners can know as much as the market does, so that a reliance on the invisible hand is the best way of dealing with the unavoidable uncertainty and contingency of economic life. And a reliance on markets also avoids the seemingly inevitable corruption of planning by political considerations.

All well and good and, in the long run, correct. But underlying this theory is the assumption that capitalists make their decisions about the allocation of capital based on their evaluation of the future prospects of whatever it is they’re allocating capital to: a company, a currency, or a country. (The boundaries between these three investments are, of course, fuzzy in today’s world.) That’s why Milton Friedman talks about the “discipline and knowledge” that the market imparts. When a hedge-fund manager decides to invest in Telebras–the Brazilian phone company, which was just recently privatized–or to short the Hong Kong stock market, he obviously does so because he thinks he can make a profit. But ultimately his expectations of profit should rest on some deeper faith in the future value–or lack thereof–of Telebras and Hong Kong.

The hedge fund manager may be wrong. What’s important, though, is that the collective effect of all these different money managers making individual decisions about the underlying value of all these different assets will be the allocation of capital to companies that will use it efficiently and the withdrawal of capital from those that will use it inefficiently. (Ideally, the inefficient companies–or countries–will become more efficient in response.)

Here’s what’s perplexing about Long-Term Capital, though. By all accounts, Long-Term Capital did not think for a moment about whether the companies and countries that it invested in–or shorted–were using capital efficiently or inefficiently. It made no judgments about the underlying value of the assets it purchased. Every single one of its dollars was invested based on computer models that rigorously excluded any kind of fundamental analysis of companies and currencies. All Long-Term was interested in was whether the historical relationships between the prices of different assets had changed. It was completely uninterested in whether those relationships had changed for a very good reason.

There’s always been a place in markets for price arbitrage, of course. Arbitrageurs provide liquidity (which just means they make sure there are always buyers and sellers). And they work to harmonize artificial price differences. Arbitrageurs are therefore parasitic on the market as a whole. They don’t need to engage in fundamental analysis because they assume the broader market is doing that work for them, and they’re, in some sense, just tying up the loose ends.

The problem with applying this description to Long-Term Capital is that the fund was not parasitic on the market. It was, instead, a crucial component of the market. As I’ve suggested before, most foreign markets are still so tiny that one highly-leveraged hedge fund can have a huge impact on the fate of an entire country, while the impact of a hedge-fund investment on individual companies here and abroad can be similarly immense. Obviously, that raises the question: Do hedge funds occupy the role of central planners? (That certainly seemed to be the case in Hong Kong before the government stepped in to fight them off.) But even setting that aside, the disturbing reality is that Long-Term was shaping the fate of companies and countries without giving even a thought to the underlying fundamentals of either. In those circumstances, can the invisible hand really work?

Now, we might say yes, since Long-Term wasn’t controlling the market, which is why it lost $4 billion making bad bets. But the result of that loss was a tremendous magnification of the swings in value of the last three months. And had Long-Term been forced to liquidate its positions, we don’t really know how bad it might have gotten. There are and should be no guarantees against bad investments, of course. But it’d be easier to feel comfortable about the world’s suffering from bad investments if you felt as if the people who made them were being guided by something more than just a computer printout.