Robert Murphy

How exactly do financial speculators provide a service, not only to their investors but the general public? To understand, we must first realize that market prices serve a definite purpose. It really means something that (as of this writing) an ounce of gold is $677 while an ounce of silver is only $13. Because of the relative supplies and desires of human beings for their possible applications, it just so happens that gold is much scarcer and so commands a far higher price in the market. If market participants couldn’t rely on the “signals” provided by commodity and other prices, the economy wouldn’t function nearly as smoothly as it does. Gold would be channeled into uses that were far too unimportant (given its scarcity) while silver might be needlessly hoarded.

Yet a similar principle holds for the price of a company, or the price of a share of publicly traded stock. Contrary to the views of socialists, the frenzied trading in New York, London, and other financial centers every day really accomplishes something. Those speculators are trying to anticipate the future, as reflected in the earnings and other performance characteristics of firms. Successful hedge funds and private equity firms are precisely those that notice mistakes in the appraisement of other experts—and that’s why they swoop in to buy up the “cheap” companies and resell them later at a significant gain.

In a market economy, we don’t have government “experts” planning our various industries, making investment, production, and personnel decisions. No, we have a decentralized system where anyone with the requisite savings (or financial backers) can start a business and try to please customers better than the competition. But the system only works if the numbers behind it—i.e. the market prices—are the right ones.

Private equity and hedge funds contribute to the success of the economy by correcting mistakes in the prices of major companies. However we want to define their earnings (i.e. the philosophical question), the economic issue is clear: If we raise the effective tax rates on these funds, it will only discourage their socially beneficial behavior. If the status quo is considered “unfair,” then by all means let’s cut income tax rates down to 15%!

Robert Murphy

Robert Murphy has a Ph.D. in economics and is the author of The Politically Incorrect Guide to Capitalism (Regnery 2007).

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