The Hedge Fund and the Stimulus

New York City -- On October 3, the day President Bush signed the $700 billion bailout package that Hank Paulson called vital to saving American capitalism, the Dow closed at 10,325. Yesterday it closed at 8,424. In the six unhappy weeks of the bailout fund's life, the Dow has shed close to 2,000 points or about 20% of its value. Almost as soon as the fund was authorized, the Treasury and the Fed shifted gears and followed Gordon Brown in using the first slice to invest in banks. Capitulating last week to the fund's dubious impact on markets, Secretary Paulson announced that the Troubled Assets fund would not be used, after all, to buy troubled assets. Yesterday, he announced he does not plan to use the unspent funds of about $410 billion at all but will instead leave it as dry powder for the Obama Administration. Some have unkindly called this fund a slush fund. However, launched by a former Goldman star, levered at close to 100% and with the goal of making opportunistic investments, it really resembles nothing so much as a Hedge Fund.

So what's wrong with a government hedge fund?

The advantage of a Hedge Fund over a more constrained capital allocation process is that the fund manager can make the decisions quickly. If the manager is a genius, the fund does well. However, a genius one year can turn out to be not so smart the next. And as the limited partners in this hedge fund, the public should have the right to withdraw its money if the fund manager does not have a strategy.

In a world of constrained debt, one cost of the public's commitment to this hedge fund is that it has used up a healthy amount of the public's credit -- something that has not gone unnoticed by markets. As an article in the current Barrons observes, the yield curve, or the premium for borrowing for a longer period, has stiffened, recalling the famous inflation premium on long-term debt that drove the Clinton Administration's fiscal restraint. That premium disappeared during the Bush years, thanks to supercharged global liquidity from the Asian savings glut and expansion that followed the Asian financial crisis. Its reappearance, however, bears noting. More ominously, perhaps, a little known derivative, the credit default swap for long-term U.S. government bonds -- a derivative that should not exist since it represents insurance against a Treasury default -- has risen in price. In other words, some are now betting against the full faith and credit of the U.S. government. 

However, this hedge fund poses another problem for the economy and government policy that is impacting the proposed government stimulus, its opportunity cost. Any focused stimulus package now pales in comparison with the TARP hedge fund. Of what stimulative impact is $2 billion for weatherization or $10 billion to extend unemployment benefits when the Treasury is giving out chunks of $30 billion or $50 billion at a time to AIG? 

The hedge fund -- while it may have served a purpose in helping the banks stay solvent --threatens to interfere with needed stimulus.

As we have argued at NDN, the unbridled use of monetary tools last year left the Fed empty handed as we enter a recession and a fiscal stimulus is now the primary tool left to policy makers with which to address the slowdown. But we have also argued this fiscal stimulus should work for the long term as well as the short term.

We suggested a substantial share go into clean infrastructure projects that get money out onto the street but also address our long-term energy, environmental and economic challenges. Clean infrastructure projects can not only can create jobs and exert a large multiplier effect, but also pave the way for future prosperity. As President-elect Obama said over the weekend and again yesterday, clean energy is his top priority next year because it has the ability to address so many of our challenges at once. 

However, as long as the Hedge Fund overshadows any proposed stimulus, it will be difficult for Congress to make these needed investments.  What, then, is the answer?

Now that the immediate challenge of stabilizing the banks has been met, Congress and the incoming Administration should reassert their authority over the second half of the hedge fund. A portion of this money might be better allocated to stimulus than loans to banks.  In any case, it should not stand in the way of a meaningful stimulus package. 

The hedge fund may have served a short term purpose, but it is no way over the long term to allocate public funds. The sooner we begin making real investments, not just backstopping financial institutions, the sooner we will get America's economy moving again.


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