Goldman Critics vs. Little Goldmans

October 20, 2009

by Chidem Kurdas

Goldman Sachs has become exhibit number one in attacks on Wall Street and capitalist greed. Last week’s announcement that the bank had strong third-quarter earnings and is on track to pay big bonuses added to the media feeding frenzy.

Let’s look at the logic – to the extent there is logic – in the mass fury.  The assault on Goldman contains at least three, related but distinct, complaints.

Since an investment bank’s function is to profit by taking on certain risks, this criticism implies that there should not be much in the way of investment banking. But to the extent investment banking is profitable, it will always attract people. If the activities are discouraged in the US, they will happen elsewhere. Is that what the left-liberal critics want?

Goldman paid back the public money that the government insisted it take when the failure of Lehman Brothers paralyzed financial markets last Fall. Interventions by the Federal Reserve and the Treasury probably did boost Goldman’s bottom line. Systemic risk is one rationale for the interventions—see below for the real solution.

Now, what does that observation imply?  That the bank should not earmark so much money for employee bonuses, in which case it would retain the earnings. If you think Goldman needs to add more capital to its balance sheet, that makes sense. But the populist critics don’t seem interested in whether Goldman needs to keep the money in its coffers.

Rather, they object to its having so much in the first place.  So the issue comes back to profits—if Goldman were not so profitable, it would not be able to pay outsized bonuses.

The way extraordinary profits erode is through competition. If instead of a single Goldman there were 30 Goldmanettes, they’d compete for business and in the process drive down returns. Moreover, no single one would be important enough to pose risk to the rest of the economy if it were to fail. No systemic risk; no need for government intervention.

The government, with its policy of encouraging consolidation, has of course fostered monopoly power and Goldman’s profits. Still, small investment banks are playing a greater role in the market, not just in the US but worldwide. In time, as long as government policies don’t inhibit competition, the mini-Goldmans will encroach upon Goldman’s money-making alchemy and its giant bonuses—incidentally depriving pundits of an ever-juicy topic to latch on to.

This is the way capitalism creates wealth; maybe not the best way, but better than anything else that mankind has discovered so far.

21 Responses to “Goldman Critics vs. Little Goldmans”

  1. Richard Schulman Says:

    Both Frank Rich and Chidem Kurdas seem oblivious to a principal source of Goldman Sachs’ profits — rent-seeking through intimate connections with top Treasury and Federal Reserve officials in both the preceding Republican and especially the present Democratic administration. Need I name names?

  2. TGGP Says:

    Russ Roberts is upset with Goldman also.

  3. chidemkurdas Says:

    Rent seeking is not specific to Goldman. With the government involved in so many economic activities, it is hard to think of a large firm in any industry that is not rent seeking in some way or another. Think of hospital complexes–just one example from the medical entitlement world. True, Goldman has intimate ties, but this is so common a situation that there is a term for it–the revolving door between government & industry.


  4. Chidem Kurdas is really making the case that we have evolved from a market economy to a corporatist one (at least in financial services). Rent seeking and ties to the government are “common” and Goldman is just one among many. If that is so, however, it means profitability is no longer a sign of having served consumers. Certainly such entities deserve no defense by classical liberals.

  5. Ned Baker Says:

    I second the charge of crony capitalism based on overwhelming evidence: the Paulson/Goldman Moscow meeting, the exclusive AIG/Treasury/Goldman negotiations in which Goldman had a $20 billion stake, Paulson’s phone logs from his Goldman days showing constant communication with Bush and Bernanke, Goldman front-running trades with special NYSE access and getting the Feds to jump when its program trading codes were stolen.

    Although most of our wrath should be directed at the Treasury and federal regulators for propping up this glorified hedge fund, and not holding Goldman accountable to banking regulations as a (now) bank holding company, and in general having a much too cozy (read: unethical) relationship, I’m not going to give Goldman a free pass. I hold them accountable to our laws and morals.

    Although Goldman repaid the forced bailout cash, they owe the US government for their continued existence. Am I to believe Goldman would have survived writing off $20 billion in AIG CDS exposure? And what would their losses have been if the Fed hadn’t purchased $763 billion in mortgage-backed securities? And yet Goldman cannot even pay lip service these facts. As a US taxpayer I am disgusted.

    I also reject the idea that, if only our banks were smaller, there would be no need for a bailout. In the past two years or so, the global economy has written off something like $3 trillion of mortgage debt. Some extra competition wouldn’t have smoothed that one over.

  6. chidemkurdas Says:

    Believe me, I sympathize with your sentiments as a taxpayer. Nevertheless, the solution is more competition. Smaller investment banks are not bailed out because their going under does not have the impact of one of the giants falling. No hedge fund was bailed out in 2008, and even the Long-Term Capital Management debacle in 1998 did not involve taxpayer money. The banks took over and sold the hedge fund’s portfolio.

  7. Zach C Says:

    Amen to Dr. O’Driscoll above!

  8. Ned Baker Says:

    I’m not an economist, but I have a hard time believing that if the world’s “banks” were just subdivided, then we could have endured this crisis without significant concerns over credit contraction and deflation — which I think were the arguments for expanding the Fed’s balance sheet by buying up (often toxic) debt. This debt would simply have been spread across many more banks. And relieving banks of this debt is a type of bailout. The crux is that the scale of this crisis is unlike anything before, so I believe intervention was unavoidable unless the course of history had been different. I also think that intelligent people can disagree. Now, if you want to split up Goldman, please feel free to give me a call. I’ll get out my pitchfork🙂

  9. Jim Says:

    Ned,

    The point is that it was prior intervention that encouraged the growth of institutions to the point where they were “to big to fail”. The very existence of the these “to big to fail” institutions contributed (along with other interventions) to the unprecedented scale of the crisis.

    In the absence of these interventions, there would be many smaller banks, in competition with one another and lacking any kind of subsidy or “too big to fail” gaurantee. Without these, the banks, collectively, would not have been able to generate or sustain the amounts or riskiness of debt that “too big to fail” banks could and did.

    Any that tried to would have quickly been shunned by investors, in favor of their sounder competitors. The pressure of competition would impose a hard limit of the total amount of debt and overall riskiness of the banks.

    The debt wouldn’t just have been spread out among more banks. It couldn’t have grown to anywhere near the size (or degree of risk) that it, and intervention would certainly not have been unavoidable.

  10. Zach C Says:

    A good example of the sentiment above are the Government-sponsored-enterprises Fannie Mae and Freddie Mac, which held about half the mortgages in America (somewhere around $5 trillion or so). A bankruptcy of this magnitude is surely unprecedented… but surely such a consolidation would not have emerged in the first place barring government interference.

  11. Ned Baker Says:

    Jim,

    What you’re saying could be true. We’ll probably never know. However, when I look at any sector, I see massive consolidation. Aren’t all industries run by a small handful of megacorporations? Can government intervention explain all of this? Or is this just the steady-state of the free-market?

  12. chidemkurdas Says:

    It is not a matter of defending Goldman. After all, more competition will not be good for Goldman. They’d probably prefer to face 1,000 barbs from pundits than have a competitor take business away. I’d think that competitive markets are the mainstay of classical liberalism. But no need to split anything up. This is an evolutionary process that happens on its own power. The rivals are already flexing their muscles.

  13. Paul McMahon Says:

    I’m having trouble with the argument that Goldman is earning outsized profits because there is too little competition in the investment banking world. Only 20 years ago there many, many more competitors in investment banking (anybody remember Salomon Brothers?). Most of them have gone away (Lehman, Barings) or been swallowed up by erstwhile commercial banks (Salomon, Smith Barney, Shroeders, First Boston, Morgan Grenfell, Bear Stearns, etc. etc.). Goldman (and to a much lesser extent, Morgan Stanley) just happens to be a successful survivor. And I’m not clear on the barriers to entry in this world, esp. post Glass-Steagal. So, why exactly is it that we don’t have lots of little Goldmanettes? What are the specifics of the government policy that encourages consolidation that you refer to?

    And not to quibble, but there is another alternative to all the billions in bonuses, besides retaining it in the firm: the money could be returned to shareholders (Goldman is a public company, after all)!

    Don’t get me wrong, I’m a red-blooded capitalist and have no aversion to individuals or firms making lots of money when they create value for their customers. But I do have a lingering worry about the basis on which bonuses in the financial sector are paid, and whether they are really consistent with shareholder value maximization.


  14. Chidem, you must be kidding, right? GS “profits” are from relaxed accounting and banking rules, from various sources of cheap guvamint money, and mostly from its “special” connections with Treasury.

    Don’t cite Frank Rich on this… try
    Simon Johnson or Edward Harrison.

    This isn’t capitalism, it’s mercantilism.

  15. erichosemann Says:

    Sigh…as a neophyte, I’ve been waiting to read something like this since reading Russ Robert’s critique.

    I assumed that the compensation of Goldman execs was just marginal revenue from doing the kind of risk management necessary for growth. Why would we want to give Goldman the impression that that revenue should be smaller? And don’t we want profits to be large enough to attract more firms?

    Productive punditry would focus not on the scales of profits or bonuses, but on the resources Goldman and any other firms spend on rent seeking. That’s where the waste is.

  16. chidemkurdas Says:

    Absolutely, Eric. The waste is in the rent seeking. The criticism should focus on the government interventions that create rent opportunities. Once those exist, any profit-seeking business will look to make money from them. None of the mainstream critics are saying that, for instance, GM should not take advantage of taxpayer largesse. And when GM makes profits — admittedly a rare event — it is congratulated, not excoriated. Why the discrimination against GS?

  17. Jim Says:

    Ned,

    There is indeed a good case to be made that highly concentrated markets in any industry are often, even usually, the result of legal and regulatory barriers to entry that arise through rent-seeking and political entrepreuership. It is all too common (and increasingly so today) that the handful of megacorporations that control a given (highly concentrated) market achieve and/or maintain their dominant market positions through regulatory capture and political influence.

    There are examples of this everywhere in just about every industry. Observe how the very interventions in question (bailouts and “too big to fail”) apply not just to banking but to the insurance and auto industries, and in more subtle ways to many others.

    So, yes many industries are controlled by a few dominant megacorporations, yes government intervention can explain much, maybe most, of this, and no this is not at all a market outcome but the direct result of collusion between big government and big business.

  18. chidemkurdas Says:

    Jim’s point, “Not a Market Outcome”, needs to be made again and again, because these days the market is blamed for everything that goes wrong. We can only hope that competitive market forces will re-emerge.

  19. Mark Says:

    GS’s profits derive mostly from the “bets” it placed with AIG, which was bailed out by the government. Both GS and AIG acted with reckless disregard and, because AIG was bailed out and that money passed on to GS, both survive.

    Neither company should be in operation today. That’s the complaint!


  20. Mark is correct, except that federal government financial aid to GS goes beyond just the AIG bailout. Here’s a list that includes another $40 billion they received.

    Also, while a Bank Holding Company they received special Fed dispensation to ignore rules on risky trading that applied to competitors.

    It’s beyond me why anyone thinks GS has been earning “profits.” Economic profits arise from creating value by spotting and pursuing neglected opportunities. OTOH, GS has thrived of late on getting funding and special favors from its agents in Treasury and Fed.

  21. chidemkurdas Says:

    Government interventions boosted Goldman’s income, but this was a highly profitable firm for decades with no such intervention. It almost certainly would have survived the crunch without government help, though with a larger loss. I don’t think the government’s actions were justified and that should be the target of criticism.


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