Goldman, Fraud and Adam Smith

April 22, 2010

As the Securities and Exchange Commission’s investigation into Goldman Sach’s Abacus transaction moves forward, Goldman is striking back hard attempting to discredit the motives of the SEC, suggesting it is just a pawn in the hands of nasty Democrats. Apparently, it’s all just a political game.

Meanwhile as this scenario plays out publically, the rumor mill is working overtime in respect to a much larger fraud what was allegedly perpetrated by hedge fund Magnetar. Magnetar during 2006 and 2007 was a major player in the sub-prime mortgage CDO (collateralized debt obligations) market. Apparently, as an equity stakeholder in key funds Magnetar was stuffing CDO’s with incendiary mortgages knowing full well they would fail. Indeed it seems that Magnetar shorted the sub-prime mortgage market at the perfect moment and made an extremely large fortune. It could be luck or simply good timing but insiders are calling this the greatest fraud of the financial crisis era.

It is well known in the trade that the big investment banks play loose and fast with the market, and that they treat their customers and clients according to ‘jungle rules’. In other words anything goes. You may think a bank that is partnering with an up and coming technology firm, organizing their IPO (initial public offering) for instance, would have an interest in the success of that company going forward. If you thought that, you would be wrong. Banks regularly ‘Pump and Dump’ newly minted public companies gaining fortunes for themselves and their favorite clients while leaving their ex clients in ‘penny stock jail’.

Unfortunately this so called ‘hard’ reality of capitalism is anything but. Although tolerating an enormous range of behavior, capitalism depends critically upon trust and trustworthiness. As we are discovering today to our shame, the erosion of trust and confidence in capitalism is like having a heart attack; it seizes capitalism’s circulatory system – slowing or seriously impeding the free flow of capital. And as history has demonstrated many times over… trust, hard won, is easily lost. It must not be taken for granted.

Proponents of hard ball capitalism, when faced with this kind of logic, fall back on Adam Smith and his ‘invisible hand’ or Milton Friedman who claimed that “…there is one and only one social responsibility of business – to increase its profits….”. The idea that bad behavior actually threatens the capital base of society is greeted with laughter, ‘you got to be kidding me’ – well no actually I’m not. Adam Smith, in particular, knew this well.

To fully understand Smith’s ‘invisible hand’ it is necessary to look beyond economics and investigate Smith’s assumptions concerning moral responsibility. In ‘The Theory of Moral Sentiments’ Smith identified three virtues (or factors), Prudence, Justice and Benevolence that he felt govern an individual’s economic motivations. Prudence for Smith is relatively straightforward; it’s simply self-interest by another name. Everyone, he realized, whether prince or peasant has this sort of motivation. A ‘sense of justice’ is more complex, for Smith it implies that rational individuals obey the law, and more importantly can be depended upon to obey the law most of the time. Benevolence is where Smith gets more controversial. For in Smith benevolence implies some sort of interest in people to do the ‘right’ thing even in the absence of specific law.

It is clear that Smith’s ‘invisible hand’ rests on his belief that individuals would strike some kind of balance between the three competing virtues: “The man who acts according to the rules of perfect prudence, of strict justice, and of proper benevolence, may be said to be perfectly virtuous”.

Adam Smith loved free markets, but he would not have approved of modern investment banking behaviour. For Smith virtue and self-command were crucial ingredients in the effective operation of a free market system: “But the most perfect knowledge of these rules (prudence, justice and benevolence) will not alone enable him to act in this manner; his own passions are very apt to mislead him- sometimes to drive him, and sometimes to seduce him, to violate all the rules which he himself, in all his sober and cool hours, approves of. The most perfect knowledge, if it is not supported by the most perfect self-command, will not always enable him to do his duty”.

Hey, that sounds familiar.

Things to Think About

1. Abacus and Magnetar are not aberrations, in many ways they are the norm. Practices of this sort are essential to the investment banking business model, bankers’ profitability and personal bonuses. They’re not going to change these practices without a fight.

2. This situation is unsustainable, predatory behaviour undermines trust in the capitalist system and has a negative impact on the economy at large.

3. This situation will not end without pain. Therefore, like a Boy Scout, Be Prepared!


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