A word of sanity – from the usual suspect

The Joy of Sachs

By PAUL KRUGMAN
The American economy remains in dire straits, with one worker in six unemployed or underemployed. Yet Goldman Sachs just reported record quarterly profits and its preparing to hand out huge bonuses, comparable to what it was paying before the crisis. What does this contrast tell us?

First, it tells us that Goldman is very good at what it does. Unfortunately, what it does is bad for America.

Second, it shows that Wall Streets bad habits above all, the system of compensation that helped cause the financial crisis have not gone away.

Third, it shows that by rescuing the financial system without reforming it, Washington has done nothing to protect us from a new crisis, and, in fact, has made another crisis more likely.

Lets start by talking about how Goldman makes money.

Over the past generation ever since the banking deregulation of the Reagan years the U.S. economy has been financialized. The business of moving money around, of slicing, dicing and repackaging financial claims, has soared in importance compared with the actual production of useful stuff. The sector officially labeled securities, commodity contracts and investments has grown especially fast, from only 0.3 percent of G.D.P. in the late 1970s to 1.7 percent of G.D.P. in 2007.

Such growth would be fine if financialization really delivered on its promises if financial firms made money by directing capital to its most productive uses, by developing innovative ways to spread and reduce risk. But can anyone, at this point, make those claims with a straight face? Financial firms, we now know, directed vast quantities of capital into the construction of unsellable houses and empty shopping malls. They increased risk rather than reducing it, and concentrated risk rather than spreading it. In effect, the industry was selling dangerous patent medicine to gullible consumers.

Goldmans role in the financialization of America was similar to that of other players, except for one thing: Goldman didnt believe its own hype. Other banks invested heavily in the same toxic waste they were selling to the public at large. Goldman, famously, made a lot of money selling securities backed by subprime mortgages then made a lot more money by selling mortgage-backed securities short, just before their value crashed. All of this was perfectly legal, but the net effect was that Goldman made profits by playing the rest of us for suckers.

And Wall Streeters have every incentive to keep playing that kind of game.

The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. If youre a banker, and you generate big short-term profits, you get lavishly rewarded and you dont have to give the money back if and when those profits turn out to have been a mirage. You have every reason, then, to steer investors into taking risks they dont understand.

And the events of the past year have skewed those incentives even more, by putting taxpayers as well as investors on the hook if things go wrong.

I wont try to parse the competing claims about how much direct benefit Goldman received from recent financial bailouts, especially the governments assumption of A.I.G.s liabilities. Whats clear is that Wall Street in general, Goldman very much included, benefited hugely from the governments provision of a financial backstop an assurance that it will rescue major financial players whenever things go wrong.

You can argue that such rescues are necessary if were to avoid a replay of the Great Depression. In fact, I agree. But the result is that the financial systems liabilities are now backed by an implicit government guarantee.

Now the last time there was a comparable expansion of the financial safety net, the creation of federal deposit insurance in the 1930s, it was accompanied by much tighter regulation, to ensure that banks didnt abuse their privileges. This time, new regulations are still in the drawing-board stage and the finance lobby is already fighting against even the most basic protections for consumers.

If these lobbying efforts succeed, well have set the stage for an even bigger financial disaster a few years down the road. The next crisis could look something like the savings-and-loan mess of the 1980s, in which deregulated banks gambled with, or in some cases stole, taxpayers money except that it would involve the financial industry as a whole.

The bottom line is that Goldmans blowout quarter is good news for Goldman and the people who work there. Its good news for financial superstars in general, whose paychecks are rapidly climbing back to precrisis levels. But its bad news for almost everyone else.

This entry was posted in Uncategorised. Bookmark the permalink.

12 Responses to A word of sanity – from the usual suspect

  1. John Greenfield says:

    All this does is re-emphasize the idiocy and hubris of those who have spent the past 6 months shrieking about the re-throning pf “social democracy” and the regicide of free markets.

  2. FDB says:

    Can anyone think of a greater idiot than John Greenfield?

    I’m serious. Is there one?

  3. Yes, there are greater idiots. Sigh . . .

  4. FDB says:

    Honestly Nick?

    Is this person the subject of some study?

  5. conrad says:

    I think I want to become a banker..

  6. John Greenfield says:

    FDB

    THAT is your counter-argument? Oh dear.

  7. JC says:

    then made a lot more money by selling mortgage-backed securities short, just before their value crashed. All of this was perfectly legal, but the net effect was that Goldman made profits by playing the rest of us for suckers.

    Actually they didn’t, Nic. Overall they probably lost money, as net/net the prop book gained what they lost on the MBS/origination desk. It’s not only perfectly legal but also indicative of good management, as they allowed the prop traders to think freely and take reasonable latitude in terms of how they expressed their view/risk. It’s really not surprising that one section of the bank had a contrary position to another. Even single trading desks have traders with opposing positions and risk expressed that way. That how we worked and there was never anything unusual about that.

    Goldman’s P&L looks good because they had far less write downs this quarter compared to the rest of the street. Take Bank of America that reported last night our time. They reported a profit of around $3.2 billion after massive write downs of around 8 billion. Normalized earnings for Bof would have been around $8 billion for the quarter. So looking at Goldman’s profit from that perspective doesn’t seem extraordinary.

    The bottom line is that Goldmans blowout quarter is good news for Goldman and the people who work there. Its good news for financial superstars in general, whose paychecks are rapidly climbing back to precrisis levels. But its bad news for almost everyone else.

    These large normalized earnings being reported on Wall street this quarter have a lot to do with advisory, recapitalization and bond issuance, which means the capital markets are thawing out. This is a good thing and it’s certainly not bad news for Main street as firms are being funded again. There was something like $300 billion new equity issuance this quarter alone which is terrific news. Of course banks make make on that…. around 3 to 6% on am equity issues and perhaps 1 to 2% on advisory.

  8. Tel_ says:

    Goldmans role in the financialization of America was similar to that of other players, except for one thing: Goldman didnt believe its own hype. Other banks invested heavily in the same toxic waste they were selling to the public at large. Goldman, famously, made a lot of money selling securities backed by subprime mortgages then made a lot more money by selling mortgage-backed securities short, just before their value crashed. All of this was perfectly legal, but the net effect was that Goldman made profits by playing the rest of us for suckers.

    It was widely known that the house of cards would fall down, but no one ever knows exactly how high it will build before it does fall, nor exactly when. Like a game of musical chairs, timing is the key. The only way to get your timing perfect is to be the guy who yanks the card out from the bottom of the pile and triggers the collapse.

    Conclusion: you want to be that guy.

  9. cjoye says:

    I agree with JC that PK is probably over-simplifying this, if that is what he is saying. One of the peculiarities of the system-wide deleveraging process is that companies are raising massive amounts of equity to replace debt. I assume that PK is in violent agreement with us that that is a very good thing. Of course, somebody needs to raise that equity for those companies–you guessed it, the i-banks. And since competition has declined materially, there is less pressure on fees. In fact, I am sure GS argues that given the generally adverse market conditions they need just as high, or higher fees, to raise large amounts of equity these days. I have not parsed the results to see the contribution from their investment banking advisory and ECM businesses. But if GS is making a lot of money out of its advisory work, that is another good thing: they should be shifting back to their original knitting and moving away from making the big prop bets that cruelled so many of these institutions. I agree with PK on compensation though–GS are very smart, so I would expect them to surprise us on the upside with a new REM system that addresses the short-termist call-option like payoffs that have been the cause for so much concern (and appear to be the focus on PKs attentions).

  10. pedro says:

    Fraid that looks more like the partisan shlock that lately seems to be flowing ever moe freely from Krugman’s pen. It is hardly Goldman’s fault that the govt has bailed out the finance industry and he doesn’t mention that GS has repaid its TARP funds.

  11. FDB says:

    Counter-argument to what, John?

    The day you present an actual argument, on anything at all, let’s worry about that, shall we?

  12. John Quiggin says:

    Just a note that “John Greenfield” is not only an idiot but a sockpuppeteer

    Evidence here

    http://johnquiggin.com/index.php/archives/2009/07/26/sockpuppet-ban/

    Obviously, each site has its own comments policy, but I’d suggest that in this case mine (immediate and permanent ban) is appropriate.

Comments are closed.