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Goldman Sach’s Toxic Asses – Part Deux

April 27, 2010


In the first installment of this series I discussed the fact that Goldman Sachs and similar firms (‘The Golden Boys, or TGB for short) function like conglomerates – that is, they have a group of related businesses which occupy a wide swath of the financial services market. I went on to suggest that since this is an industry structure that creates inevitable conflicts-of-interest, TGB would argue that they’re not to blame for having done what looks like to the rest of us ignoramuses like unsavory double dealing. Although for obvious reasons they won’t come right out and say it, they’ll make the case that, like Aesop’s fable about the scorpion & the frog that most of us remember from ‘The Crying Game’, they’re just doing what they do…their thang …keepin’ it real. Don’t hate the playah…hate the game!

Once they’ve successfully re-directed our attention away from their activities and to the inevitable “big picture” (there’s always a big picture, right?), they’ll immediately pivot to the philosophical question – do we really want to risk our success as capitalists by changing the way that they, the critical linchpin to all success and wealth, operate? Go ahead & hate the game, they’ll tell us. But don’t forget that it’s the only game in town. And if we mess w/the playahs…god help us all!! Do we really want to live in the world of Atlas Shrugged?

This argument will play well to the cheap seats: the only thing worse Americans hate worse than being screwed over by rapacious elites is being abandoned by them. How that plays out eventually is pretty easy to see – TGB will part with their ritual pound of flesh, and there will be some tinkering at the edges that will sound a lot like the noise a barn door makes when it’ s being slammed (after the horses are gone, that is). But it’s pretty clear that they’ll avoid fundamental structural constraints (as formerly represented by ‘Glass Steagall’ , the updated version of which is The Volcker Rule).


OK, now that I’ve had my little audience participation moment with respect to the gamesmanship that we’ll all see in the next few days & weeks, let’s get return to illuminating the structure that led to the mess.

We’ve established that TGB operate in an environment in which conflicts-of-interest abound. We’ve also established why, despite the fact that those conflicts are obvious to all observers, it’s a difficult problem to tackle (because the structure which gives rise to those conflicts is a well-accepted one on American business). But as problematic as that structure is relative to conflicts, it’s made much worse by one particular aspect of the financial services industry.

Unlike firms that make cars or airplanes, or dig fossil fuels out of the ground, or make food or building materials, TGB’s raw materials consist of little more than information and people.  And information and people are two of the more fungible commodities in any value chain – that is, they can be easily swapped around, re-purposed, acquired, dumped, and hidden (in the case of information…people less so, although they can be easily bought-off.) depending on the needs of the firm.

Information is, by its nature, ephemeral and easy to manipulate. And people, as contrasted with things like industrial production facilities, mines, farms, large retail stores, etc., are a current rather than long-term asset.  You can always tell them to do something else, or if you can’t find a good use for them, take their cost to zero (that is, fire them) whenever you want to.

So both people and information – TGB’s core factors of production – represent highly controllable expenses. Of the two, the people are the biggest expense. And here’s where another immensely beneficial dynamic comes into play; unlike so much of what you need to make cars and build actual products, people can be paid on commission. That is to say that for financial services firms a pretty big chunk of their largest single expense is conditional on how well the firm fares in the marketplace.

Everybody talks about how great incentive-based systems are at getting employees to focus on the things that important to the success their company. And they are. But the thing we hear – and think –about much less is the effect that incentive-based systems have on the decision-making processes of management. By tying so much of their largest single cost (labor) to the success of a particular initiative, management is able to substantially limit the downside to the firm of any particular business strategy. That is, if you’re a manager you may screw up – and screwing up certainly isn’t free – but the consequences of that screw-up are nearly so dire if the lion’s share are borne by your employees. When things go south, you offer the employee another shared-risk opportunity, or if they’re really specialized – or it’s clear that the failure was a result of their execution and not your strategy – you just get rid of them and move along.

Now, TGB certainly aren’t playing in the only industry that pays for a critical piece of its value chain on a commission basis. Car dealers, restaurants, retail salespeople, even physicians, all derive some or even most of their paycheck based on how much they produce. But each of those industries have very real and compelling constraints on how much the incentive system affects their behavior – in all cases, if their employees screw-up badly or completely rip off their customer, sooner or later it’ll bite them (both employee and employer) on the ass. Because part of what TGB sell is risk itself, and because they take their cut when the deal is done and have almost no connection to quality of the product they’re selling, taken together with managers’ ability to simply dump bodies rather than being stuck with inconvenient things like idle factories or empty retail stores, means they’re almost completely insulated from the consequences of predatory behavior.

We’ve heard a lot of talk about ‘moral hazard’ relative to playing with other people’s money. This is certainly true, and important.  But the thing we hear less about is the moral hazard of playing with other people’s labor. Yet that’s the world that the management of Wall St. firms live in. To my eye that fact accounts at least as much of their decision-making process – and the damage caused by the decisions themselves – as does the source of their capital.

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