[Me:] "I guess the other thing to add is that not all financial games that make money for a hedge fund necessarily lead to more efficient resource allocation in the overall economy."
[Commenter:] Well, "all" is a high benchmark. But at least as high a percentage of the "financial games" that hedge funds use drives efficiency gains as whatever it is that start-ups do. In fact, because the winnowing process is more efficient (better measurement), I'd bet that the net increase in efficiency from hedge fund activities is greater than that generated by tech start-ups.
But, as always, specifics help. I can't think of a single major hedge fund strategy which does not improve efficiency for the economy as a whole.
I suspect the commenter, although anonymous, is a hedge fund manager, so we should take his opinion seriously :^)
Let me give a simple example of a case where financial activities that made hedge funds a lot of money did not in any way increase economic efficiency. At the end of the tech bubble, a lot of traders strongly believed that internet stocks were ridiculously overvalued. You might imagine that hedgies, with their ability to short, might play an important role in popping an obvious speculative bubble. But, the reality turned out to be the opposite: as long as they felt they could make a short term gain on riding the bubble, they were happy to do so, despite their strong belief that it was a bubble, with significant distortionary effects on the economy. I know from personal contacts that hedge funds actually behaved this way, and it is supported by subsequent academic studies. (See related discussion here; indeed, according to the famous Keynes observation about beauty contests, it matters not whether you think it's a bubble, but rather what you think others in the market believe!)
Of course, and this is the main point, a trader's job is not to "allocate resources most efficiently in the economy" but rather to make as much money for their investors as possible. Only an extreme interpretation of "efficient markets" would imply that these two goals are one and the same!
From the viewpoint of the old Adam Smith quip:
It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest
we might conclude that there is no reason to differentiate between forms of economic activity. However, some people are genuinely altruistic and take part of their compensation in satisfaction that their work helps others. For example, many people in startups are idealistic, and part of the attraction of their work is that they are changing the world for the better. The same goes for academic scientists.
Although financial activities play an important role in the economy, as I have emphasized, I suspect the prime motivation for finance as a career choice is maximization of remuneration, not altruism :-)
