Kenneth Rogoff: Hedge Fund Transparency

Ken Rogoff says German leaders should not give up on their push for greater hedge fund transparency even though Treasury Secretary Paulson objects to such regulation:

Hegemony through global hedge funds, Kenneth Rogoff, Project Syndicate: The recent volatility in global capital markets should give pause to those who say German leaders, who have been arguing for greater transparency in global hedge funds, are just sore losers.

American and British policymakers, in particular, say the German whining is nonsense, and that hedge funds, along with other New Age financial entities such as private equity firms, are key innovators in today’s global economy.

This debate is ... clouded by a healthy dose of national self-interest. With New York and London the centres of global finance, the United States and Britain have enormous profits at stake. So it is convenient for them to downplay the likelihood that risks to the world’s financial system will be spread more evenly than the benefits.

German leaders, by contrast, must reckon with a populace that is deeply resistant to rapid change, particularly when it involves job cuts. Many German workers believe, as one trade unionist recently lamented, that takeovers are being driven by a philosophy of "buy it, strip it and flip it".

To be sure, the profits currently being earned by the leading financial firms are dizzyingly high. ... Even we economists who believe that global financial innovation yields huge net benefits must admit that today’s hedge fund boom is becoming like the tech bubble. ... [I]n today’s go-go ultra-high liquidity environment, ... roughly 1,000 of the world’s 9,000 hedge funds went out of business last year.

The big question is whether this Wild West mentality poses broader risks to the global financial system, particularly given circumstances where a large number of firms are all collectively making the same bet. If they lose, a long string of bankruptcies can cut deeply into banking systems...

At the moment, the most glaring weakness is the so-called "yen carry trade". Hedge funds have borrowed hundreds of billions of dollars at ultra-low interest rates in Japan, and invested the proceeds in countries such as Brazil and Turkey, where interest rates are high.

As long as the yen remains weak, this investment strategy will be a money machine. But if the yen appreciates sharply, as it easily could given Japan’s huge current account surplus, some hedge funds will suffer huge capital losses and the yen carry trade will implode.

And while today’s main risk is the yen, in a couple months it could be something completely different. So pressure outside the US and Britain to put the hedge fund industry on a tighter regulatory leash is hardly surprising. The Germans, for example, want to reduce risk by forcing hedge funds to adhere to stricter reporting requirements.

The funds respond to such proposals by arguing that if they are required to reveal their investment strategies, they will lose their incentive to innovate, and a recent US government report — a multi-agency effort headed by Treasury Secretary Hank Paulson (formerly of Goldman Sachs) — supports that position.

Greater regulation would be a mistake, the report argues, because the global economy’s best defence against systemic risk is the exercise of common sense and "due diligence" by each and every person who invests or interacts with hedge funds.

In other words, the US is telling investors to carry their own guns, because, as in the Wild West, there might not be a sheriff around to help. But frankly, as we are reminded by recent events, it is hard to see how at least a small increase in transparency can hurt. The Germans, in chairing the G8 this year, should not surrender on this issue. ...