Is private equity a good thing for the economy? Is it an institution that, as its supporters claim, promotes value-optimizing change, creates jobs, and encourages innovation and entrepreneurial risk-taking? Or are the critics correct that private equity is merely a game of “trading ownership claims,” as Vanderbilt law professor Margaret Blair has suggested, in which the dealmakers themselves may be enriched, but only at the expense of the rest of society? In this two-part essay, I will examine the nature and role of private equity in a modern capital-using economy.

As the 2008 fiscal year dawns, the United States continues to stand astride the global economy. In spite of the housing slump and recent gyrations in the mortgage market, U.S. financial assets are approaching a record high of $50 trillion, having grown by about 15 percent in the last year, according to the McKinsey Global Institute. Government figures indicate that real GDP—the primary measure of inflation-adjusted national output—will reach a record of roughly $13.7 trillion this year, with the unemployment rate hovering around 4.7 percent. (In the Eurozone, total unemployment is about 7.2 percent.) America’s federal budget deficit has dropped all the way down to 1.15 percent of GDP, compared to the post-1970 annual average of 2.3 percent.

As Brian Wesbury, chief economist at First Trust Advisors, points out, recent years have brought war, rising international tensions, spiraling oil prices combined with uncertain supplies, and unpredictable budget shocks such as Hurricane Katrina—and yet the underlying resiliency of the U.S. economy remains a wonder to behold. We have witnessed record gains for the Dow Jones Industrial Average, U.S. exports, industrial production, real hourly compensation, corporate profits, federal tax revenues, retail sales, productivity, employment, university enrollment, and even airline passenger traffic.

We have also seen a boom in private equity. This past summer, the powerhouse firm Blackstone Group sold a 12.3 percent stake in the company in an initial public offering, just a few months after completing the buyout of Equity Office Properties, a Chicago real estate investment trust, for $39.3 billion (which, in absolute terms, was the largest buyout in U.S. history). It was the first time a significant private equity partnership had gone public on U.S. markets, and it came at the end of a 12-month period that saw nine of the ten largest buyouts ever recorded. Blackstone set a record in 2006 by completing $101 billion in buyouts, amid historic levels of fundraising and deal activity in the U.S. and global private equity sectors. Indeed, at $487 billion, buyout deals comprised over 31 percent of all announced mergers and acquisitions (M&A) in the United States in 2006, a year in which the combined value of global M&A totaled over $4 trillion.

Some economists believe this is no coincidence—that the continuing health of the U.S. economy is indelibly related to a vibrant and dynamic private equity sector. According to this view, private equity is an integral institution in modern finance that is highly conducive to both superior corporate governance and job creation; an important segment of financial markets, channeling capital to value-creating uses ever more effectively due to superior specific knowledge; and a key driver of an unfettered market for corporate control, which promotes flexible change and greater efficiency in this capital-allocation process.

Critics largely deny these benefits. They assert that private equity investing is not a case of wealth creation, but rather one of wealth redistribution (from “Main Street to Wall Street,” as the adage goes, or from bondholders, taxpayers, and employees to shareholders and private equity dealmakers). This has long been the caricature presented in Hollywood movies such as “Wall Street,” in which Michael Douglas popularized the expression “greed is good,” or in books such as Barbarians at the Gate, in which buyout artists were described as rapacious con men and a new breed of robber baron. They fare little better in the mainstream media; writing in Time Magazine recently, Michael Kinsley labeled them “private equity pigs.” Indeed, Blackstone CEO Stephen Schwarzman has had his personal financial situation highlighted in unflattering detail by The Wall Street Journal,Fortune magazine, and other publications. (Schwarzman has a net worth estimated at over $9 billion.)

So which storyline is correct? To answer this question, we must consider what drives growth in a market economy, and what role financial institutions play in the process. We must also define private equity as one such key growth-enhancing institution, and differentiate it from other “alternative assets,”such as venture capital and hedge funds.

Recent years have brought war, rising international tensions, spiraling oil prices, and unpredictable budget shocks—and yet the U.S. economy remains resilient. Does private equity deserve some of the credit?

The hallmark of a capitalist economy is the institutional framework that guarantees human progress: private ownership of the means of production, which ensures the accumulation of capital; entrepreneurship and the division of labor; exchange on markets guided by the price system; and a stable monetary system. For Adam Smith, the division of labor was especially critical to economic growth: it develops via the guidance of an “invisible hand,” he famously wrote, directing resources toward satisfying human wants. Additionally, it promotes specialization, which in turn advances the productivity of labor, the primordial driver of material progress and wealth creation. In our 21st-century economy, specialization is also driven by a division of knowledge, which yields further gains in productivity.

As former Bush administration chief economist Glenn Hubbard points out, financial institutions and markets offer one such example of specialization. They facilitate exchange and production in three categorical ways: by promoting an efficient bearing of risk; by enhancing liquidity; and by encouraging the best development and use of relevant market or technological information.

For example, in complex markets, borrowers and lenders not only face difficulty in identifying each other, they also face insurmountable gaps in the knowledge necessary to adequately evaluate each other. Banking firms arose as an institutional response to mediate such desired transactions and to specialize as efficient repositories for the information needed on both sides of a transaction. Financial markets provide similar intermediary services in channeling funds from savers and investors to firms in need of growth capital.

Financial markets and institutions thus play a crucial role in the process of wealth creation. Given this, why did the private equity sector even arise? The short answer is: because there are inherent limitations to public capital markets and financial intermediaries. The continual refinement and specialization of financial institutions according to varying investor circumstances regarding risk, liquidity, and specific market or technological knowledge led to the evolution of the modern private equity sector.

“Private equity” is a term that actually connotes two distinct types of investment: early-stage venture capital and later-stage investment in mature companies. Private equity firms are formed as “limited” partnerships, in which entrepreneurial promoters, acting as “general” partners, raise capital from institutional investors, such as pension funds and insurance companies, and then plow this capital into multiple companies. In both venture capital and buyout deals, the managers of these companies have significant incentives to create value prior to an exit or liquidity event (such as an initial public offering).

Today there are over 2,700 private equity firms in the United States, managing over $2 trillion in leveraged capital. While they may appear small when compared to the titans of the public equity markets, venture capital and buyout firms have an outsized influence on American business and finance. In recent years, over one-third of all M&A deals have involved private equity firms, and some of America’s most storied companies are venture-backed, including Google and Genentech. Private equity firms have also had a substantial indirect effect on business practices and productivity. For example, they have encouraged significant changes in corporate governance.

In terms of institutional investing, private equity funds (both buyouts and venture capital) are now seen as alternative assets to traditional public equities and bonds, along with hedge funds, real estate, and other assets. Hedge funds are sometimes confused with private equity firms, perhaps because their structures and compensation schemes are exactly the same. Both are considered to be “active” investors—in contrast to “passive”investors such as trust fiduciaries or individuals with minority shares—because they often obtain board seats on investee companies and influence corporate strategy, whether controlling the firm or not.

However, private equity firms and hedge funds are categorically different. Hedge funds typically are far more liquid, and they either actively trade securities or they invest in exotic securities such as derivatives and currencies. Private equity firms, meanwhile, invest in a portfolio of individual companies and then control these firms for up to ten years, significantly influencing firm direction and providing financial, operating, and strategic oversight.

In sum, private equity and venture capital firms evolved as a separate institutional sector to accommodate companies with differing risk profiles, liquidity preferences, and knowledge. The private equity sector is uniquely geared to support companies via long-term “patient” capital and other growth-promoting resources, and thus leads directly to the creation of corporate value.

John L. Chapman is an NRI fellow in economics at the American Enterprise Institute. This is the first in a two-part series, concluding tomorrow.

Image by Getty Images/Darren Wamboldt.