Tuesday, April 27, 2010

Eliot Spitzer and Adam Smith

I have commented on Eliot Spitzer before here. Today, he has a piece on the Goldman Sachs case in Slate. The beginning of the piece is quite useful, as it makes clear that past behavior like Goldman's would more likely have a resulted in a more private reprimand by the SEC. It seems clear, particularly given the timing, that the SEC case against Goldman is aimed at lending political support to financial reform. Nothing wrong with that, of course. The rest of the piece is interesting, as it points out some of the dangers of the culture of too-big-to-fail, and misguided attempts to correct it. Spitzer thinks that Goldman should make a case for its social usefulness, and he poses seven questions, which are
1. What percentage of Goldman's capital is dedicated to proprietary trading, as opposed to capital formation for client companies?

2. What percentage of Goldman's profits derives from proprietary trading, asset management, and prime brokerage activities; and what percentage comes from capital formation for client companies?

3. What percentage of Goldman's profits derives from marketing and trading derivatives, specifically the synthetic CDOs that are at the heart of the SEC investigation?

4. What percentage of Goldman's capital has been invested in U.S. government securities over the last year, essentially taking advantage of an interest arbitrage between Goldman's cost of capital and the rate being paid on Treasury bills?

5. How much income did Goldman derive from bets against products it marketed?

6. How much capital—debt and equity—have Goldman and the other major investment houses raised for their clients over each of the past five years?

7. How much capital have they invested overseas in foreign-based companies—especially through private equity funds?
Here's the problem. Once we start thinking of large financial institutions as too-big-to-fail institutions with oversight by a systemic regulator, it is tempting to start thinking of these institutions as public rather than private. Spitzer needs to be reminded about this quote from Adam Smith's Wealth of Nations, where he states that a private business
by directing that industry in such a manner as its produce
may be of the greatest value, … intends only his
own gain, and he is in this, as in many other cases,
led by an invisible hand to promote an end which was
no part of his intention. Nor is it always the worse for
the society that it was no part of it. By pursuing his
own interest he frequently promotes that of the society
more effectually than when he really intends to
promote it. I have never known much good done by
those who affected to trade for the public good. It is
an affectation, indeed, not very common among merchants,
and very few words need be employed in dissuading
them from it.
People sometimes forget the whole idea behind the "invisible hand." What Smith is saying is that the greedy person pursuing his or her own interests (i.e. Goldman Sachs) can do more for the social good, than someone who is certain of his or her altruism. Further, the greedy person may have a hard time making the case that his or her actions are actually socially useful, even though they are. What's the lesson? Financial regulation needs to be hands-on and hands-off. We need to regulate financial risk-taking, and do it in a systemic way, but we need to be mindful of letting the financial sector do its job.


  1. Sure Spitzer is trying to elicit a reaction, he's trying to find a new platform. The overall question he asks however is interesting: What is the "Economic Value" generated by GS and friends? Or are they just a "leach" in the middle, is GS the mafia or a productive member of our society? There is no reason that GS should have special treatment -- such as access to the discount window if it provides no value to society.

    That's the question

  2. Economic analysis teaches us that leaches can in fact exist. These are thieves. A thief contributes nothing to economic welfare, and in fact reduces it as he or she is just sucking up resources. I think it's impossible to make the case that GS is pure thievery. However, we also know that market failures exist, and it is easy to make the case that part of what GS does involves market failures, and we want to understand how to correct these. It's more subtle, I think, than a question of "being nice" to GS or not.