Hedge Funds Make A Political Mistake

The political flavor of the month is to push back against even the Obama adminstration’s mildly reformist inclinations on finance (e.g., Peter Weinberg in today’s FT is a nice example).  And, of course, once you hire a lobbyist, he or she tells you that “winning” means stirring up Congress in favor of the status quo.  Measured in these terms, the hedge fund industry has had a string of notable recent victories effectively preventing tighter regulation.
Advocates have a point, of course, when they argue that big banks rather than hedge funds were primarily responsible for crisis.  But this misses where we are in the long-cycle of regulation/deregulation.  Look at this picture (source: WSJ; more on Ariell Reshef’s webpage).
If we’re at the top of the long deregulation wave and likely headed for tighter control of the financial sector – if not this year, then soon – where do you want to be in the political equation?
You can resist change, but this is just asking for trouble.  You know that individual (lightly regulated) funds – whether or not these are officially “hedge funds” is irrelevant - will have high profile trouble. The latest alleged tunneling details in the case of Danny Pang are a precursor to broader social fascination with this phenomenon – you know that a dozen screenwriters are already at work.  Sooner or later, there will be a more focused backlash against specific practices revealed or implied in this kind of case.
At the same time, the broader Treasury attempt to respond with only milder controls over big banks will likely also run into trouble (see my latest Economix column), so more social pressure will appear from that direction also.  Big banks repeatedly get into serious scrapes, but their political clout consistently allows them to deflect attention onto others.  The idea that big banks and hedge funds have some natural congruence of political interests in this space is simply wrong.
In fact, if hedge funds dig in too deeply with “the crisis was not our fault” position, that is just asking for trouble – and to be scapegoated – down the road.  It would be much smarter to get out ahead of the political dynamic, and to propose ways to measure, control, and regulate risk. 
Voluntarily keeping hedge funds “small enough to fail,” without endangering the system, would also make sense – particularly if accompanied by a complementary political strategy that emphasizes that it is big banks that have done almost all the damage.
By Simon Johnson