Garbage and Goldman
Goldman Sachs has become the whipping boy for politicians eager to look as if they care about the public. Goldman is Darth Vadar and Wall Street is the Evil Empire. Blaming the economic collapse on the greed of Wall Street expunges all responsibility from politicians and everyone else.
I am not an apologist for Goldman or Wall Street. They do not need me. I have been critical of the derivatives casino created on Wall Street, and have argued for a Tobin tax on all financial transactions, and a move back to Glass-Steagall. But the attack on Goldman and Wall Street has become shrill demagoguery, and I fear demagogues much more than I do greedy bankers.
Representative Marcy Kaptur, a Democrat from Ohio, said today: “The American people deserve justice in the matter of Wall Street banks. Federal authorities should leave no rock unturned as they root out any potential fraud that triggered the crisis and caused thousands of families to lose their savings and their homes.”
Hopefully, the “authorities” do this, for what they find will surely not please the likes of Marcy and other demagogues.
Everyone was greedy and irresponsible. Someone had to be willing to buy the garbage produced and peddled by Wall Street. As I teach my students in economics, there is both demand and supply, and without demand, we would not have had CDOs squared. Yet, politicians have not taken a close look at the idiots on the demand side. They should, and then they should focus their “sincere disgust” at the real villains in this piece.
At the same time, the politicians should take a close look at their roles. But this would not help their chances of being re-elected, and isn’t this what politics is all about, at least for the professional politicians?
Why were so- called “sophisticated” investors lining up to buy what Wall Street was pumping out? They all were looking for extra yield, for the magical few extra basis points without any additional risk – money for nothing.
Why were they looking for extra yield? Yields on low risk investments, U.S. Government Treasury bills and bonds, were in the 4% to 5% range for most of 2006 and 2007. These yields were much lower than the interest rate assumptions built into pension plans, and these types of returns could not have justified the increasing compensation packages paid to the sophisticated investors who manage such plans.
I have selected six groups (Ford, Boeing, AMR, JP Morgan, CalPers and Bombardier) and looked at the actuarial assumptions embedded in the valuations of their employee retirement benefits. The assumptions for 2009, when interest rates were much lower than they were in 2006-07, for the discount rates for estimating the present value of future obligations ranged between 5.80% and 6.60%. The expected returns on assets ranged between 7.22% and 8.50%. (I suspect that if I had selected any other sample of companies, I would have found similar results.) All far exceeded the yields on U.S. Government bills and bonds.
Simple arithmetic should tell us that the average returns on investments cannot exceed the average rates of nominal growth for the global economy over any long period of time. Otherwise, investment income (the income of rentiers) will make up an ever increasing share of total income, and start approaching 100%. This will not happen!
The long-term expected nominal rate of growth of global GDP probably is somewhere in the 5% to 7% range, as long as the rate of inflation does not blow up. This implies that the expected average returns also should run in this range. Obviously, the actuaries and the people responsible for managing the large pension funds have not been taught simple arithmetic. I would like to believe that they did learn complex math, but their willingness to buy exotic financial assets that they largely did not understand suggests to me that they weren’t taught this either.
The demand side needs souped-up returns because of the ridiculous assumptions built into pension plans and underlying their compensation packages. But why did they simply accept the garbage from Wall Street without doing any of their own homework? Because running with the herd and dealing with brand name banks are the best defense when things go wrong. Why work, when the pretense of work suffices for your board of directors?
The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.