What Can We Learn From the Goldman Sachs Affair?

June 13th, 2010

Investment-banking giant Goldman Sachs is facing a federal indictment.

By far the most significant thing about this indictment is the public reaction to it. Press accounts have not focused on the issue of fraud, which is what Goldman Sachs is actually charged with. Instead, the headlines screamed that Goldman Sachs’ managers “gloated” when housing prices plummeted in 2007 because the firm had sold mortgage securities instruments short – essentially betting that their value would decline. The clear implication in the news stories was that millions of people were economically devastated by the price declines and that Goldman Sachs employees were rejoicing in the public’s misery.

What are the facts relating to the indictment? Goldman Sachs was indicted on one (1) count of fraud. Allegedly, the firm failed to inform its own clients about the material facts of a hedge-fund transaction in which it participated and that might have affected their welfare. In short, the “crime” with which Goldman Sachs was “charged” by the press had nothing to do with the crime with which it was charged by the SEC.

What is going on here?

Economics As Morality Play

It is not difficult to discern the press’s motives. Years of experience tell them that the public knows virtually nothing about economics – not even basic principles of supply and demand, let alone more abstruse points of corporate finance or investment. Thus, the press can misstate or distort economic reality with no fear of losing subscribers.

What the public can understand is a simple morality play – the kind that movies have been selling even the days of silent films. This is the plot summary: “The current Great Recession was caused by evil, greedy financiers. We know they are greedy because they made money at the same time that lots of other people were losing money. We know they are evil because they gloated about it – only evil people derive pleasure (let alone money) from the misery of others.”

The duty of a critic is to evaluate the artistic merits of art, regardless of its popularity. This morality play cries out for critical scrutiny.

The Financial Crisis Did Not Cause the Recession

The first plot point to evaluate is the claim that the recession was engineered in financial markets by financiers. The causes of the business cycle have bedeviled economists for a couple of centuries. But this particular claim is not difficult to refute. According to the National Bureau of Economic Research, the official arbiter of business cycles, the recession began in December, 2007. This means that the underlying causes of the recession were operating for months or years prior to that date.

The so-called “financial crisis” (“so-called” because both its origins and its impact are suspect) did not mature until nearly a year later, in September, 2008. Even if one dated it to the government bailout of Bear Stearns in March, 2008, it must have occurred after recession was under way. If “post hoc, ergo propter hoc” is considered a logical fallacy, than “ante hoc, ergo propter hoc” must be even more fallacious.

This doesn’t mean that the financial crisis didn’t worsen a recession already under way; it almost certainly did. This doesn’t mean that the financial crisis is not interesting in its own right; it definitely is. But financial markets and financiers did not cause the recession. The implication that they did is unfounded.

“Profiting from the Misery of Others” Is a Dubious Concept

 The idea that it is evil or even slightly disreputable to “profit from the misery of others” is intellectually and analytically vacuous. People do it all the time. Doctors make money owing to the sickness of other people. Repair companies make money from car accidents and home fires. Tow services make money from automobile breakdowns. The list of examples is endless.

It is certainly evil to profit from misery caused by one’s own illegal or immoral conduct. But the conduct would be just as evil even if there had been no profits; the presence or absence of profits is purely a byproduct of circumstances. If Goldman Sachs’ employees committed fraud, they would be just as liable even if the company lost money as a result of it. In fact, there is no evidence that the company’s actions caused the recession or even contributed to it.

Why Shouldn’t Goldman Sachs’ Employees Be Happy About Successful Trades?

Suppose I foresaw, years in advance of the event, that recession was inevitable. Suppose I tried vainly to persuade others of the soundness of my analysis. Suppose I sold my mortgage-backed securities and bought gold, pursuant to my belief. Wouldn’t I have been crazy not to take that action? Am I required to lose my shirt despite my foresight, in order not to “profit from the misery of others?” If events vindicated my analysis, don’t I have the right to be happy about that? After all, if people had listened to me, lots of misery could have been averted.

Goldman Sachs employees have a duty to their shareholders that overrides all other duties, including that to their customers. (That is why stockbrokers have not been considered fiduciaries.) If the company profited from trades premised on a mortgage-market collapse, there is no earthly reason why they shouldn’t celebrate that fact.

Goldman Sachs’ employees deserve criticism for what they did wrong, legally and/or morally – not for what they did right. If they defrauded customers through lack of disclosure, that is legally wrong. If they exercised undue political influence to engineer the bailout of the firm by the federal government, that is morally wrong (at the very least). Making money for their shareholders is what the firm was created to do. Goldman Sachs has no reason to apologize for having done so.

The “Conflict of Interest” Bogey

Some members of the press have attempted to salvage the case against Goldman Sachs by positing a conflict of interest between Goldman – trading for its own account – and its customers – ostensibly taking the other side of trades; e.g., betting that housing prices would continue to rise. As Jacob Goldstein notes in “Planet Money,” this is silly. “In a sense, a company like Goldman – which is in the middle of all sorts of transactions and is also making its own bets in the market – is always betting in the same direction as some of its clients, and betting in the opposite direction as others.”

The conflict-of-interest bogey is merely an arbitrary attempt to find a crime with which to indict Goldman and other investment banks. In reality, Goldman’s successful trades were economically beneficial, not harmful. They drove securities prices toward their long-run intrinsic value, which is one way of defining financial-market efficiency.

Envy-Based Prosecution is Immoral

Recent years have seen a spate of celebrity prosecutions. The case of Martha Stewart is illustrative. She is widely believed to have committed securities’ fraud by trading on inside information. Insider-trading cases are difficult to make and seldom succeed in court. In fact, Martha Stewart was prosecuted for obstruction of justice – lying to police. If everybody who lied to the police were incarcerated, there might be more people inside jails than outside. There is every reason to believe that she was, in effect, prosecuted for being Martha Stewart. The visceral suspicion that her snobbishness merited imprisonment was encouraged by authorities and the press.

Using envy or disapproval as the de-facto basis for criminal prosecution is immoral. Far more immoral than anything Goldman Sachs has been charged with by prosecutors or by the public.

Category: Economic Analysis, Economic News, Investment Strategy | Tags: , , ,

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