The “Goldman Sachs Phenomenon”

04/19/10 Laguna Beach, California – Editor’s Note: This article first appeared in The Rude Awakening in 2008

Now that the American financial sector is safe and unsound once again, has the threat of serious economic crisis genuinely passed? And has the structure of American capitalism actually improved? Or did the Fed merely dress a sow in lingerie and call her a raving beauty?

In other words, what did the Fed accomplish by lavishing billions of dollars upon the financial sector? Was the Fed’s inflationary rescue mission really worth all the trouble? Or would the nation have been better off if Bernanke and Paulson had simply gone golfing while Bear Stearns failed?

At first glance, the Fed’s rescue seems to have halted a serious crisis in its tracks. The rescue also seems to have preserved the viability of the American banking system. But upon closer inspection, we discover that the Fed’s rescue also preserved at least one dysfunctional characteristic of our economic system – namely, an over-reliance on “asset-swapping” activities, rather than “asset-producing” activities.

Australian author, James Cumes, asserts that the US economy has become overly dependent on trading things back and forth, rather than manufacturing goods and selling them. He calls this new reality the “Goldman Sachs Phenomenon.”

“In the larger Anglo-Saxon economies,” says Cumes, “transfer of ownership [has] supplanted fixed-capital investment as the most common form of what purported to be ‘investment.’ Investment has become a means of making a fast buck, not by entrepreneurial effort, construction of factories and installation of productive equipment, but by gambling to add market value through mergers and acquisitions…that would lead to higher shareholder value in the marketplace…

“Despite the higher, short-term market values [that might ensue], they would not necessarily add anything to productivity or to the volume or value of final output” – “Inevitably,” Cumes continues, “there are social impacts from this deal-maker, day-trader, casino-like type of ownership investment, especially to the extent that it spreads over a more and more major part of the economy…Inequality is dramatically intensified by generous bonuses for senior executives and others in financial firms in the United States and such other financial centres as London.”

The Fed’s bailout of the financial sector seems to have supercharged the Goldman Sachs phenomenon. Not only do the top dogs at publicly traded financial firms “make bank,” they continue to make bank even after destroying billions of dollars of shareholder wealth. And the top dogs enjoy their privileged positions under the watchful, doting eyes of the Federal Reserve and Treasury. No bad deed goes unrewarded.

“Of course, there is justice in rewarding effort and enterprise,” Cumes concludes. “That is historically one of the ways in which a capitalist system has justified and maintained itself; but there are other considerations too. “Indeed, if our present essentially democratic capitalism is to survive – and survive securely – it must pay attention to social outcomes. Poverty in the midst of plenty is not a comfortable social situation. Some inequality there will always be but gross and growing inequalities must, over time, be a threat to social, political and even strategic stability, as well as economic and financial stability.”

But these “big picture” concerns do not seem to concern the head of the Fed and Treasury. In fact, throughout this crisis, Bernanke and Paulson have assiduously avoided implementing (or even suggesting) any regulatory changes that would impinge upon the limitless liberties of Wall Street’s investment banks. The perpetrators of the crisis remain in power and the corporate structures that supported their recklessness remain in place. Instead, incredibly, Treasury Secretary Paulson wags his regulatory finger at hedge funds.

Huh? Why? Hedge funds did not create the crisis, they merely profited from it. Aren’t the investment banks the ones who created trillions of dollars of crazy derivatives? And aren’t they the ones who loaded their balance sheets with suicidal quantities of leverage? And aren’t they the ones who are now receiving billions of dollars of government support?

So here’s a radical idea: How about regulating the perpetrators of the crisis, rather than the profiteers? Or maybe the Fed should require all the top-ranking officers of every company that receives a bailout to resign? Or how about one upper-level resignation for every $1 billion a Wall Street investment bank borrows from the Fed’s discount window.

This isn’t complex stuff, folks. If the Treasury Secretary sincerely wished to clean up and re-regulate the banking system, his new regulations would only require about 50 words:

1. No officer of any publicly traded financial institution may receive more than $10 million per year in total compensation.
2. No financial institution may borrow more than $10 for every one dollar of readily marketable assets (i.e. “Level I” assets) on its balance sheet.
3. No financial institution may incur any liabilities “off-balance sheet.”
4. No exceptions.

Implement these regulations and you would have forever eradicated the DNA of financial catastrophe from the American financial system.

But what would critics say about such “draconian” new regulations? (We’ll call these regulations the “Level Playing Field Act of 2008.”) After choking on their foie gras, they would probably protest, “That’s not nearly enough compensation for top officers! You’d lose the top talent!” Then they would protest: “What! No off-balance sheet financing? Are you crazy? That’s where all the juice is! You would lose the ability to ramp up return on equity!”

To which we would reply: “Hallelujah!” and “Amen!”… Finally, we could purge the financial system of all the “talent” that has delivered America’s most severe credit crisis since the Great Depression. Finally we could purge the system of the “creative” leverage that the “talent” has amassed over the last several years. Finally, we’d have a banking system that would operate like one – a banking system that would provide capital to entrepreneurial endeavors, rather than to catastrophic speculations.

The American financial system does not need “talent” and “creativity.” It needs prudence and perspicacity. It does not need creative bankers. It needs dull bankers.

Why? Because the American financial system needs to safeguard its capacity to finance creative and talented entrepreneurs. It needs to safeguard its capacity to preserve the purchasing power of our currency and to safeguard the legendary America capacity to create wealth from the bottom-up, not to destroy wealth from the top-down.

But the American financial system still possesses too much talent and creativity to operate prudently. In fact, Ben Bernanke and Hank Paulson may be the most creative finance officials in American history.

Consider yourselves forewarned!

Eric J. Fry
for The Daily Reckoning

Eric Fry

Eric J. Fry, Agora Financial’s Editorial Director, has been a specialist in international equities for nearly two decades. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short-selling.  Following his successes in professional money management, Mr. Fry joined the Wall Street-based publishing operations of James Grant, editor of the prestigious Grant's Interest Rate Observer. Working alongside Grant, Mr. Fry produced Grant's International and Apogee Research —  institutional research products dedicated to international investment opportunities and short selling. 

Mr. Fry subsequently joined Agora Inc., as Editorial Director. In this role, Mr. Fry  supervises the editorial and research processes of numerous investment letters and services. Mr. Fry also publishes investment insights and commentary under his own byline as Editor of The Daily Reckoning. Mr. Fry authored the first comprehensive guide to investing internationally with American Depository Receipts.  His views and investment insights have appeared in numerous publications including Time, Barron's, Wall Street Journal, International Herald Tribune, Business Week, USA Today, Los Angeles Times and Money.

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