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Wednesday, July 15, 2009

How Should We Interpret Goldman Sach's Unexpectedly Large Earnings?

The NY Times Room for Debate is discussing how we should interpret Goldman Sach's compensation pool, which will be an $11.36 billion set aside for the first half of 2009. Here's the unedited version of my entry (you may like the shorter, edited version better):  

Returning to High-Risk Strategies, Room for Debate, NY Times, by Mark Thoma: What does the size of Goldman's compensation pool tell us? It signals several things. First, it gives some indication that the financial sector is improving, and that is good news. There's no guarantee, however, that the overall economy will follow anytime soon. Even with improvements in the financial sector, the recovery of the broader economy is likely to be a slow process.

One of the reasons I expect the recovery to be slow despite improvements in the financial sector is that the economy cannot go back to where it was before the crisis hit. The financial and housing sectors need to shrink, too many economic resources were used unproductively in support of these activities, and the automobile sector is also in transition.

And it's not just that the financial sector needs to get smaller so that resources can be used productively elsewhere, the financial sector also needs to change its ways so that risk accumulations do not threaten the financial system and the broader economy. As Robert Reich notes today, Goldman's chief financial officer tells Bloomberg News that "Our model really never changed, we’ve said very consistently that our business model remained the same." Thus, a second signal from Goldman's unexpectedly large earnings is that firms such as Goldman Sachs are returning to the same high-risk strategies backed by too big to fail government guarantees that got us into trouble in the first place, and that aspect of Goldman's success is worrisome. It's a signal that the excesses that led to the high incomes of financial executives have not ended.

Why aren't the profits and the bonuses paid to executives justifiable? Don't they signal the superior talents of Goldman employees, and don't those talents deserve to be rewarded by the marketplace? I think we can legitimately question whether this is a reward for superior talent. Goldman was helped by bailout funds -- there's some debate about whether it actually needed a direct infusion of funds -- but it's certainly true that Goldman benefitted when its counterparties such as AIG were bailed out. Goldman is also benefitting from its early escape from government constraints that still inhibit the ability of other firms to compete on equal - though perhaps overly slippery and risky - footing.

 So Goldman's earnings are not simply the product of the superior talent of Goldman's executives, there is more to the story. In addition, the bad incentives that executive compensation structures provide was one of the factors that caused the crisis, and the size of the compensation pool tells us there is work yet to be done to fix this problem.

Other entries from William K. Black, Yves Smith, Charles Geisst, David Merkel, and Jeffrey Miron.

    Posted by on Wednesday, July 15, 2009 at 12:18 AM in Economics, Financial System, Media | Permalink  Comments (64)

          


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