Goldman Sachs, Best in the Business

17 July 2009 at 9:29 am 10 comments

| Peter Klein |

goldman_sachs_logoThe business of political capitalism, that is. Like Enron, Goldman operates primarily in the nebulous world of public-private interaction. It is the US’s most politically powerful financial firm, skilled at navigating the byzantine regulations governing the virtually nationalized US financial sector. Goldman’s eye-popping $3.4 billion second-quarter earnings shouldn’t surprise anyone; as Craig Pirrong notes, these earnings reflect good old-fashioned moral hazard, with Goldman exploiting its too-big-to-fail status by taking on huge amounts of risk:

Goldman knows it is too big to fail. How does it know this?  Well, the government bailed out AIG not so much for AIG’s sake, but for the sake of big AIG counterparties — most notably Goldman. Moreover, given the conventional wisdom that the government’s primary error in the financial crisis was its failure to bail out Lehman — a piker compared to Goldman — it doesn’t take a rocket scientist to figure out that it won’t repeat that mistake in the future, and let Goldman go down. So Goldman knows it can get bigger, and take more risk. It is the classic heads Goldman wins, tails the sucker taxpayer eats the loss gambit. If nobody steps in to rein in the firm, it will continue to add risk, thereby enhancing the value of the Treasury put hiding in the equity entry on its balance sheet.

Somebody should be stepping in — but nobody is. Why not? Partly, no doubt, it is Goldman’s political heft. It is likely too that important policy makers don’t want to crack down on a major source of risk capital to the markets in the fear that this would impede a recovery. Even though in reality, that risk capital is your money and mine, with the exception that we have no chance of capturing the upside, and are left with a good chunk of the downside. This is a piece with the hair-of-the-dog strategy being pursued by Treasury and the Fed.

Entry filed under: - Klein -, Bailout / Financial Crisis, Financial Markets, Public Policy / Political Economy.

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10 Comments Add your own

  • 1. JC Spender  |  17 July 2009 at 12:17 pm

    Well, what can one say? It is a matter of action-directe?

    Once upon a time, long long ago, I worked in an investment bank called Slater-Walker. It eventually over-gobbled and more or less brought down the London investment banking system, after gathering Bank of England support, in 1975. (I left to begin my PhD in 1971, so claim clean hands). But the goings-on at the bank led Prime Minister Ted Heath (another Balliol boy) to call it the ‘unacceptable face of capitalism’.

    This is surely what we are looking at today only, like most things American, bigger and glossier.

    As I noted to my wife only yesterday, GS folks (just how many we may never know) are about to receive bonuses that exceed the lifetime earnings of many Americans, especially those now unemployed.

    The notion that these are the appropriate rewards to ‘super-smartness’ (see Krugman OpEd piece in the NYTimes today) not only denies the intelligence which can be found in Veblen, but is an insult to the rest of us. So the real questions range from ‘hang them from the lamposts’ to ‘reform the system’ to ‘do away with this kind of capitalism altogether’.

    Before we jump to conclusions (frankly I’m for the barricades, because I’m still a European at heart) we might want to consider not only the whole Hayekian, von Mises tradition, but also what I consider one of the most pertinent and thoughtful defenses of democratic capitalism – McCloskey’s Bourgeois Virtues (2006).

    As in Porter’s new On Competition (2008) which I happen to be skimming today, the argument (seemingly incontrovertible) is that the increasingly widespread capitalist property-owning and economic incentive system has raised a fantastic and historic proportion of the world’s population from poverty – even though it has some side-effects or faults which demand amelioration.

    These matters are surely central to this blog and to the generation of cool and insightful analyses which might both inform the public, the pundits and the Huffington Post, and restrain hotheads like myself.

  • 2. srp  |  17 July 2009 at 9:59 pm

    The doctrine of Too Big To Fail creates both first- and second-order distortions. The first-order distortion is the obvious moral hazard problem flagged in the post. The second-order distortion is the incentive to become big enough to qualify as TBTF, even if the growth process itself involves ignoring adverse selection problems (taking on worse and worse looking counterparties to grow the business).

    Where does TBTF come from? It is a combination (whose weights vary from case to case) of 1) fears of systemic risk when a bunch of people all want to cash in at the same time but their counterparties don’t hold enough cash to do that and so go bust simultaneously and 2) standard rent-seeking behavior among businesses and government.

    One set of prescriptions for dealing with the first- and second-order consequences of TBTF tries to regulate the activities of large financial entities by restricting the kind of trades they can undertake. Some of these proposals are quite far-reaching–Leamer, for example, has proposed turning all financial entities into mutual associations–but most rely on “diligent” regulators to a) identify the class of TBTF entities and then b) ride herd on them to keep their risk-taking under control. Radical proposals suffer from institutional defects–they require outlawing a whole set of impossible-to-predict-in-advance contractual forms that would go outside the new “safe” boundaries, for example. The incremental proposals, on the other hand, ignore the problem of political influence as well as the difficulty in deciding just who is TBTF. Not encouraging.

    Some people want to get out of the trap by prohibiting or penalizing bigness itself, saying “if it’s too big to fail then it’s too big.” Either an outright size limit or a set of progressive fees or capital requirements could prevent financial entities from getting too big, in this view. Problems: The more-skilled financiers would not grow relative to the less-skilled, resulting in less-efficient capital allocation; it would be hard to stop firms from circumventing the rules by starting up new and ostensibly “independent” entities but having them act in a correlated way; and even a zillion truly independent entities that get linked up by cross-entity contracts under conditions of correlated risk (like an asset bubble) could still end up generating the same amount of systemic risk as before.

    From a classical-liberal point of view, a “no government bailouts” constitutional rule is attractive. The idea is that a credible commitment to eschew TBTF policy will eliminate the implicit guarantees that players like Goldman are currently exploiting. Providers of capital, especially debt capital, would then have an incentive to perform due diligence and not lend to riverboat gamblers. It isn’t clear how this policy would apply to deposit insurance; it seems hard to square the two to me. I don’t see how to implement this proposal in a clear and credible way that wouldn’t be eroded when the first crisis came along.

    Given all these considerations, I am therefore inclined to look at changing the way debt contracts are enforced. The way they work now, if an entity is unable to pay up on schedule for any reason, a discrete crisis is created in which the firm is liquidated or restructured. This disruption of the entity can then spread to the creditors of its creditors and so on. If these rules were altered so that debt holders would have to take a sliding-scale haircut if they try to get their money out when the system is in crisis mode (defined according to some objective aggregate measures, such as spreads or volumes), then failure would be more gentle and the disruptive shock and contagion would be much reduced. Obviously lots of details would have to be worked out to make this idea practical, but given the bleak alternatives this is where I would put my resources.

  • 3. JC Spender  |  18 July 2009 at 2:16 pm

    Clearly many of our readers are enjoying time away from the keyboard … but tectonic-dimensioned things are surely happening within our system. Too little for some, too much for others.

    Today’s Joe Nocera piece “Looking Back in Anger” in the NY Times (Saturday July 18) puts some of the key events in historical perspective. It helps illuminate why ‘someone isn’t stepping in’ – in part because there are several radically different views of what happened and, therefore, what ‘might be done about it’.

    This is the trouble with history – stuff happens – and as it does so no-one really knows what to make of it.

    TBTF is simply a rhetorical device to justify a political move, one that shifts risk and reward around inside a polity – on the assumption that it can survive this. History’s strength is to show when such assumptions fail – but that is for later.

  • 4. JC Spender  |  18 July 2009 at 2:59 pm

    Peter’s originating post, and srp’s followup on TBTF implies an agency problem between GS and – who? – the taxpayers who gave GS a head-start in the race to the honeypot? – the rest of the economy? – entrepreneurs looking for funding to start new enterprises?

    There’s is also the public rage being stoked by the perceived agency issues of the GS execs and – who again? – those that do not get bumper bonuses? – those are unemployed?

    Erturk, I., Froud, J., Johal, S., Leaver, A., & Williams, K. (2007). Against agency: a positional critique. Economy and Society, 36(1), 51 – 77. is especially interesting re the second. They argue for a distinction between shareholders who ‘value-surf’ and execs who ‘value-skim’.

  • 5. John Steinsvold  |  21 July 2009 at 7:32 pm

    An Alternative to Capitalism?

    The following link, takes you to a “utopian” article, entitled “Home of the Brave?” which I wrote and appeared in the Athenaeum Library of Philosophy:

    John Steinsvold

  • 6. JC Spender  |  21 July 2009 at 8:35 pm

    Hey, this is fun! No-one can say this is not a bold and courageous initiative – bravo John!

    Whether it could ‘work’ or not depends on what one thinks ‘work’ might mean.

    Given the notions of Knightian uncertainty that are this blog’s mother’s milk, there is a slight question. My sense is that the allocation mechanisms John proposed here would work only so long as ‘work’ is confined to that about which there is system-wide agreement – say health-care needs, which could be ‘scientifically’ evaluated – medically and socially, along with actuarial tables of each person’s human capital i.e. social value and potential, and so on.

    But as Hayek and others noted, such agreements can never be arrived at through free negotiation – power must be applied that constrains all freedoms into the State’s chosen framework.

    Along these lines we might think of money as the lubricant that embodies our freedom – allowing us to make our own choices within a framework in which there is the opposite of system-wide agreement. Money allows us to buy the freedom to do our own thing.

    So the conclusion might be the very opposite of John’s – to make sure that every socially-contributing citizen has sufficient funds to ‘buy’ enough personal choice to endorse their sense of freedom, and thereby their incentives to contribute socially rather than free-ride – never complete, of course, because that would deny society itself, of which money is merely one manifestation.

    Hmm … round in circles.

  • 7. Peter Klein  |  21 July 2009 at 11:44 pm

    Um, wasn’t this problem addressed pretty cogently by Ludwig von Mises in 1920? You can dream up all the Utopian schemes you like but you cannot have a rational allocation of resources in a complex economy with heterogeneous resources and a division of labor without monetary calculation. I assume Mr. Steinsvold is just pulling our leg.

  • 8. JC Spender  |  22 July 2009 at 8:02 am

    It is tricky to tell who is pulling whose leg … but Mr Steinsvold puts it in the convincing non-academic way made familiar by folks like Gladwell and Friedman (Tom, that is).

    Incidentally the data in Erturk et al (2007) on the pay of execs and intermediaries is very interesting.

  • 9. jc spender  |  22 July 2009 at 9:24 pm

    On doing without money altogether – here’s:

  • 10. John Steinsvold  |  6 September 2009 at 10:37 pm

    Thanks for your comments on my essay: ‘Home of the Brave?” which appeared in the Athenaeum Library of Philosopy. I would like to add some comments which may give a better picture as to how I envision a way of life without money:

    In some respects, our economy will be the same. Our free enterprise system will remain in place as it is today; but no money will be exchanged. Profit will no longer be a factor and cooperation will replace competition. Government, industry and the people will work together as a team toward common goals.

    Yes, the administration of a way of life without money is a huge problem. As proposed in my essay, a web of “economic bodies” would be created; one for the federal, one for each state and one for each local level. These economic bodies will coordinate the economic traffic in our nation. They will interact with each other as much as modern technology will allow. A balance of supply and demand will be achieved taking every conceivable factor into consideration including conservation and our environment as well as the needs of the people and their craving for luxuries. The amount of bureaucracy required will be considerable; but, in my opinion, will be a whole lot less than the mess we have today.

    In short, these economic bodies will be coordinating what is now our free enterprise system to fulfill the economic needs of our nation.

    JC Spender noted: “Whether it could ‘work’ or not depends on what one thinks ‘work’ might mean.”

    Today, the word “work” implies a means to “make a living”. In a way of life without money, the meaning of the word “work” will change completely. Work will become a stairway to learning, creating and achieving our goals in life without any economic fear.

    The best way to motivate people is to allow them to do the work they love to do. One of the goals of a way of life without money is to provide everyone with the opportunity to find a match between their abilities and the opportunity to serve society. If training is necessary, a free education is provided. Every effort will be made for each individual to find the work they love doing. There will be no pressure. I believe everyone has an ability or talent they want to use for the benefit of society. If I’m wrong, a way of life without money will fail. You could argue that there will be slackers who perhaps have given up on themselves; but they will probably be looked on as people with disabilities by their friends and neighbors. I believe that gaining the proper balance between work and pleasure is essential for a complete life.

    Another advantage of a way of life without money is to offer people who are physically or mentally disabled to utilize what they can do for the benefit of society. It is essential that these people feel good about themselves and giving them a way to contribute to society will do exactly that. However, there will be no coercion whatsoever.

    Yes, some sort of measuring device (in the absence of money) would be convenient to measure efficiency or to evaluate how much material and labor it takes to build a car, house, plane or a tank. How do we know the value of something if we don ‘t have some sort of measuring device to use in place of money? I don’t think this is an insurmountable problem. Americans can be ingenious when they have to be. It will be a challenge to our accountants & economists. Today, we use money as a standard of value. As I envision a way of life without money, we can still use this system although no money is exchanged. For example, You need a raincoat. You walk into a store and select one you like with the help of a clerk who is happy to assist you. Perhaps the tag on the coat may read: “This raincoat would have cost you $79.00 in year 2009”. At least, we could still use the prices of today as a starting point.

    John Steinsvold

    “But we’re not a democracy. It’s a terrible misunderstanding and a slander to the idea of democracy to call us that. In reality, we’re a plutocracy: a government by the wealthy.”
    – Ramsey Clark, former U.S. Attorney General interview in The Sun magazine, August 2001

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