Perhaps one of the most disturbing pieces of economic information released in last week’s news was that Goldman Sachs reported record profits of $4.9 billion for the fourth quarter of 2009 for a total of $13.4 billion for the year.
Meanwhile, 15.3 million Americans remain unemployed.
How, in what is definitively the worst economic recession in seventy years, is Goldman Sachs, one of the leading financial institutions who arguably caused the financial crisis and needed government assistance to prevent the world economy from collapsing, earning any profit?
To answer this question we need to look at the broader economic policy that has reigned for the last thirty five years-Free-Market Economics. The fundamental belief, stemming from Adam Smith to Milton Friedman, is that markets are self-correcting and work most efficiently when left to the forces of competition. Any form of government intervention, in the form of regulation or state run enterprise, impedes market growth, they say.
This was not always the dominant paradigm. In fact, after the Great Depression, Congress enacted lots of market regulation. The Glass-Steagall Act, in particular, separated commercial banks and financial institutions. That way banks could not gamble with other people’s money. Unfortunately, at the end of former President Clinton’s second term, Congress passed the Leach Graham Bailey Act, which repealed Glass-Steagall.
Enter Goldman Sachs, Bear Sterns, Lehman Brothers, Merrill Lynch, and Morgan Stanley – among others. At the turn of the century, these financial institutions came to comprise the “shadow” banking system. In this system, institutions, which perform bank-like functions without conventional bank deposits, were left unregulated to leverage assets-or make investments with borrowed money. At first glance, this may not seem harmful-except for the fact that over the last decade the assets traded became derivative based financial assets called Collateralized Debt Obligations, which are assets comprised of mortgages and other forms of collateral. This too, in theory, may not seem harmful except that the housing market had also become deregulated, issuing massive amounts of sub-prime mortgages and adjustable rate mortgages on over-valued houses.
In sum, investors would package sound assets with risky assets and sell them. Collectively this made for a highly profitable industry, so long as housing prices continued to increase and homeowners continued to pay their mortgages.
As it turns out, housing prices imploded and, when interest rates adjusted, mortgage owners defaulted, and economic catastrophe ensued.
In September 2008, at the height of the economic meltdown, AIG received an $85 billion bailout-$13.9 billion of which was paid directly to Goldman to cover some of its toxic assets.
Where did the free-market policy go?
Fast forward one year and Goldman is churning out record profits, some of which it plans to spend on “performance compensation,” or bonuses. Although Goldman paid back their loan with interest, there is no doubt they would not have made the record profits they did without the bailout – they most likely wouldn’t be around.
Most of their profits, it seems, have come from the massive sums Goldman received from the contracts with investors that stipulated fees to Goldman if bundles of risky mortgages defaulted. Strong investment banking activities, like equity and debt underwriting, also created revenue for Goldman.
Even more disturbing than record profits during the greatest recession in seventy years, is the surmounting information coming from investigations by the Senate Subcommittee-the Financial Crisis Inquiry Commission – and the Security and Exchange Commission.
Last week Greg Gordon’s article in McClatchy reported that it appears “the firm [Goldman Sachs] sold securities backed by risky home loans while it simultaneously bet that those bonds would lose value.”
McClatchy reported that while Goldman was the only major Wall Street firm to safely exit the sub-prime mortgage market, “Goldman sold off more than $40 billion in securities backed by over 200,000 risky home loans in 2006 and 2007 without telling investors of its secret bets on a sharp housing downturn.”
These acts left investigators and Americans outraged and questioning whether Goldman crossed any legal lines.
Around the same time Goldman’s profits hit the news, the New York Times reported that President Obama began grumbling about limiting FDIC insured banks from trading securities for their own accounts and from owning hedge funds and private equity funds. Others in Congress propose taxing profitable financial institutions as a way to refund taxpayers for the damage they caused to the economy.
The rhetoric is great, but, personally, I want to see more than just talk. If any kind of economic stability is going to rein over the world economy, legislation of our financial institutions needs to be reinstated or, at the very least, institutions and executives that were responsible need to be held accountable through indictment.
So yes, this may mean even bigger steps away from free-market economics.
Maybe then the incentive for investors to use the stock market as a mechanism to turn a quick profit will curb and investors will get back to using the market as an arena to invest in sound corporations helping to build a stable American economy. This may be the catalyst for the rebirth of heterodox economic policy.