February 8, 2011--The New Mercantilism

I was reading recently about hedge fund manager John Paulson. The last time I remember his being in the headlines was during the Congressional hearings about Goldman Sachs. How Goldman, with Paulson right in the middle of the action, constructed an investment fund that they pitched to their best clients as triple-A rated while they, since they knew it was set up to collapse, bet against it and made many millions first in commissions from their duped clients and then more millions by selling the fund short.

Now in the news is how Paulson's gold fund, which up to now has made billions, is now in retreat as the price of gold has been slipping. According to the New York Times (article linked below), we do not need to worry too much about him. His Paulson Advantage Fund is worth about $36 billion and grew at the rate of 11.1 percent last year, while the gold component of it shot up 30.8 percent. Because of the way hedge fund managers are paid (see below), he personally pocketed about $5.0 billion in 2010 as compared with "only" $4.0 billion the year before.

The gold his fund owns, by the way, is the equivalent of 96 metric tons, more than all the gold assets of the country of Australia. His personal gold stake amounts to more than Bulgaria's.

Intrigued, I wondered about how hedge funds like Paulson's operate. But to tell the truth, I had no idea what one is except that their managers seem to make billions, pay little in taxes, and once in awhile a very few of them wind up in jail. So I did some research. I learned that . . .

A hedge fund is a lightly federally regulated investment operation that is typically open to a limited number of very wealthy investors who pay a performance fee to the fund's investment manager.

Every hedge fund has its own strategy that determines the type of investments it undertakes and these strategies are highly individual. As a class, hedge funds undertake a wider range of investment and trading activities than traditional buy-and-hold funds, and invest in a broader range of assets, including long and short positions in shares, bonds, and commodities. As the name implies, hedge funds often seek to hedge some of the risks inherent in their investments, using a variety of methods, notably short selling and buying those infamous derivatives that have recently proved so troublesome.

Paulson gained his reputation and much of his money by anticipating that the real-estate-based derivatives business was in effect a giant Ponzi scheme and as early as 2006 began to sell his derivatives and pocket billions. Case in point, the scam he worked out with Goldman.

Typically, the manager of the hedge fund is compensated with a fee based on 2 percent of the gross assets of the fund and 20 percent of the fund's profits.

Best of all from a hedge fund manager's perspective, and to me most questionable, with the approval of Congress and a series of U.S. presidents, they get to keep almost all they earn because the manager is compensated with profits from the growth of the assets in the fund; and thus through various and well-protected tax loopholes the bulk of the manager's income from the fund is taxed, not as compensation for services or as salary, but at a much lower rate as a return on investment.

With this new understanding about hedge funds, I returned to thinking about Paulson's gold horde and more widely, about gold itself.

Down here in Florida, where many see Doomsday right around the corner (anyone owning real estate in South Florida has already had a glimpse of it), out of suspicion of the government and fear of an even worse impending global economic collapse, having gold is on many people's minds. And increasingly in one's portfolio or, as in the case of some of my local friends, literally hidden under their mattresses.

I keep asking, "If all hell breaks loose, what good will gold do for you?"

They say, "More good than your stocks and bonds and paper money."

"You mean," I ask, "that you'll fill your gas tank by paying with gold coins or shop at Publix using gold bullion?"

They just shake their heads at my naiveté and smile at me.

So, again, not understanding, I did a little more research about gold and other forms of bullion and was reminded about Mercantilism--the dominant European economy theory of the 16th through late-18th century. I came to realize, that though it was totally discredited by the Industrial Revolution and the expansive capitalist economy that saw its full bloom during the 19th and 20th centuries, what we are seeing now among Gold Bugs is a new form of Mercantilism.

For those whose history is as foggy as mine, Mercantilism is a theory that held that the prosperity of a state is dependent upon its supply of capital, that the total global volume of international trade is unchangeable, and that one party may benefit only at the expense of another. By this theory, this means that the European and global economies were in effect zero-sum games. According to Mercantilists, economic assets were represented by bullion (gold, silver, and trade value), which was best increased through a positive balance of trade with other states--exports minus imports.

The theory assumed that wealth and monetary assets are identical. It suggested that the ruling government should advance these goals by playing a protectionist role in the economy by encouraging exports and discouraging imports, notably through the use of subsidies and tariffs.

Mercantilism dominated Western European economic policy for nearly two centuries but then industrial capitalism demonstrated that the world's economy is far from a zero-sum game and could be seemingly infinitely expanded. And thus gold and other forms of bullion, though they loomed as of ultimate value in the imaginations of some because of their relative rarity and the value placed on them by others, did not for long retain the currency (pun intended) that they did in the past.

That is until now when so many are plagued by suspicion and fear and as a result, as with the Mercantilists, gold is the secure-feeling answer.