AUERBACK: We Need Greater Financial Regulation After The GameStop Fiasco

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Editor’s note: We endeavor to bring you the top voices on current events representing a range of perspectives. Below is a column arguing that we need greater financial regulation after the GameStop fiasco. You can find a counterpoint here, where Steve Moore, a senior fellow at Freedom Works, argues that we should not create more regulations for hedge funds.

As the economist Michael Roberts has noted, “‘Hedging’ used to be a way of reducing the risk of selling or buying.  Farmers waiting for their harvest to come in are uncertain about what price per bushel they will get at the market: will they get a price that makes them a profit and a living for next year or will they be made destitute? To reduce that risk, hedge companies offer to buy the harvest in advance at a fixed price. The farmer is guaranteed a price and income whatever the price per bushel at the time of going to market.”

And hedge funds started off with a similar ostensible purpose — to hedge exposures to enable investors to generate gains no matter the actual direction of the market or, at a minimum, to minimize losses if and when market conditions became cataclysmic. The aim was to hunt for upside, regardless of directionality.

At least, that’s the theory and was one of the rationales for the hefty fees these funds charged wealthy individuals and institutions who were lucky enough to invest with this exclusive club of investors.

That may have been how it once work, but today’s markets are totally detached from economic reality, and hedge funds are more like high stakes players in the casino, the managers using other people’s money (and considerable amounts of leverage) to generate significant fees for themselves, whilst often generating returns which underperform the market.

Worse, it’s become a game: it’s called “casino capitalism” for a reason. And at times the casino blows up and creates collateral damage for the economy as a whole. Under those circumstances, shouldn’t governments be taking a more active role in overseeing/regulating hedge funds?

One of the principal roles of the government (here taken in the broad sense to include the central bank) is to promote economic stability. The essence of a government’s social contract is that taxpayers — as principals — award financial resources and coercive powers to governmental agents. Taxpayers hope that government officials will exercise the assigned powers to promote the “common good,” among these from a financial perspective being the mitigation of economic instability and systemic distress.

To be sure, too tight a control of the economy may remove the dynamism from entrepreneurship that gives rise to economic prosperity by excessively limiting choices and constraining possibilities. As Keynes noted, investment activity is highly uncertain and risky, but uncertainty is also a factor that promotes investment by leaving some space for human creativity and imagination. When speculation is not only inconsistent with broader public purpose but actually begins to contribute to substantial systemic instability, that’s usually a signal for the government to step in to regulate.

Does the recent saga of GameStop reach that threshold? To the extent that a few major players lost fortunes over the past month is not something per se that should concern regulators, unless GameStop is symptomatic of a broader problem that could lead to substantial economic damage to the rest of us.

In terms of regulation and supervision, market overseers will be effective at preventing the growth of financial fragility only if they are able to curtail the dangerous practices of financial institutions and if the government is willing to enforce them. In addition, a given set of regulations may rapidly become obsolete they are not flexible enough to deal with innovations, such as the sophisticated use of social media or financial technology (i.e. “FinTech”) of the kind that helped to create and sustain the gyrations in GameStop (and various other equities).

Innovations are usually used by hedge funds and other financial institutions (such as investment banks, whose activities often mirror those of the hedge funds) to bypass existing rules so unless innovations can be accounted for as they appear, regulations will not work properly to prevent the growth of financial fragility induced by the growth of leverage and/or the decline in the quality of leverage.

In the case of the GameStop saga, we had small traders using various forms of social media, notably Reddit, effectively colluding to drive up the GameStop stock price, forcing the hedge funds to cover their short positions, often at substantial losses.

“So what?” you might ask. A bunch of rich guys got a taste of their own medicine. And that would be fair and the resultant short squeeze per se may not in and of itself created problems. After all, most working households have little or no shares at all. The top 1% of households owned 53% of US stock market wealth, with the top 10% owning 93%. But it establishes a dangerously template that, if left unchecked, could store up future problems, especially given that many peoples’ pensions and retirement accounts are invested with these very same hedge funds who engage in these casino-like activities.

And to what end? Capital markets were established to provide funding to help companies secure funding so that they could grow and prosper, not as a platform for unbridled speculation. Poor regulation and too little supervision may also promote instability if they promote self-regulation by financial institutions and if supervision and enforcement are minimal.

Arguably a prolonged period of economic stability led to an increase in financial fragility precisely because the regulatory body became more willing to relax “old” rules that prevent business from thriving and “deserving customers” from getting what they want. And the result has been one major financial crisis after another.

We need to stop that. The ultimate goal of government regulatory policy is to design it to promote stability and shared prosperity. Financial innovation for innovation’s sake alone is not necessarily consistent with that aim and hence, financial innovations of the kind often developed by hedge funds should not be left alone on the simplistic grounds that the more innovations there are, the more efficient the financial system becomes, and the better the economy performs. What happened last month with GameStop was a warning, to which we would do well to pay heed.

Marshall Auerback is a researcher at Bard College’s Levy Economics Institute, a fellow of Economists for Peace and Security, and a writer for the Independent Media Institute.