When the nation's most prestigious investment banks found themselves on the verge of total annihilation in the fall of 2008, the most radical and effective government response was not the infamous $700 billion Troubled Asset Relief Program. The wildest salvation scheme for Goldman Sachs, Morgan Stanley and the securities system at large was a plan from the Federal Reserve to give these speculative institutions access to cheap loans from the central bank. It worked. With access to unlimited cheap funding from the Fed, the Wall Street titans survived. Hurrah.
Here's the catch. Cheap Fed funding is a subsidy during good times, and a bailout during bad times. These subsidies are supposed to spur productive activity. We want Fed money to be fueling business and consumer lending -- we don't want it to be encouraging gambling in the securities and derivatives casinos. Those businesses are risky, they create big horrible asset bubbles and then put taxpayers on the hook for losses when the Fed backs them. That's why securities houses like Goldman and Morgan were never, ever granted Fed funding until the fall of 2008.
And Goldman has leveraged that Fed funding for all it's worth. Goldman had to create a commercial bank unit in order to borrow from the Fed, and Goldman chose to house its riskiest businesses in that unit in order to make sure that they would benefit from both cheap Fed funding and the better credit ratings that funding creates. Goldman has about $40 trillion in derivatives operations functioning under its commercial bank unit, which does nothing else but accept money from the Fed. The Fed is funding Goldman's casino, and the economy is getting nothing of value in return.
So what should we do now that Goldman and Morgan are getting access to all of the perks of being a commercial bank without any of the regulatory hurdles? According to William Cohan's latest, disastrous column for the New York Times, Goldman should cut its ties with the Fed and just be a securities firm again. When it inevitably gets into trouble at some point in the future, nobody should bail it out.
That all sounds very nice. Who could oppose ending bailouts?
The trouble is, it has absolutely no teeth. Once the Fed steps in to bail you out, everybody in the market knows it will step in again, regardless of how your business is structured. Every aspect of Goldman's business currently benefits from taxpayer perks, and the greatest perk of all is the fact that Goldman still has businesses. They would be totally and completely gone without massive government aid, and their destruction would be of their own making -- they ran a business that operated with massive and unnecessary counter-party risks which was completely dependent on capital markets confidence for its functionality.
There can be no un-ringing of the bailout bell. Goldman absolutely must be aggressively regulated as a commercial bank to make sure that its subsidies are not destructive. That's the minimum reform. Still better would be to cut off the subsidies, claw-back the bonuses earned over the past two years, and break the bank up into smaller institutions that the Fed would not feel compelled to step in and save. But to pretend the bailout never happened and promise not to do it again is simply not credible.
Even if we could make the entire world forget that the bailouts happened, do we really want companies like Goldman to go back to the same business that got them into big trouble? If Goldman can put the entire financial system in jeopardy -- or at least convince policymakers that its failure would do so--why do we want them to return to business as usual? We'd want them to be more rigorously regulated and structurally reformatted to prevent future disasters.
Cohan's argument is actually a bit worse than what I've presented above. There's always a tension in Cohan's writings between the broad public interest and the narrow interests of whatever firm he's writing about. He can never quite sort out whether he thinks a bunch of rapacious bastards are praiseworthy for enriching their shareholders by juicing the public, or whether the public has a right to be upset with the rapacious bastards who juiced them. But it appears that Cohan doesn't want to see Goldman to cut its ties with the Fed because those ties create problems for the broader economy. Instead, he wants them to spurn Fed money because he's worried that new regulations will make Goldman less profitable.
As it happens, I think Cohan has this profitability issue completely wrong. The two serious rules cracking down on banks with access to Fed funding were basically gutted at the final stage of the reform negotiations. Banks that deal derivatives will have to put up more capital for a small fraction of their derivatives businesses, and banks will only be able to gamble three percent of their capital in proprietary hedge funds. There's quite a bit of controversy as to how much of Goldman's business is straight prop trading disguised as client business, but the new rules do not seem likely to seriously curb those operations. But that cheap funding will always be there, and they'd be fools to give it up for such a paltry set of restrictions.
The important question about the Wall Street reform legislation is not whether the new rules will be good for Goldman profits and bonuses. The important question is whether Wall Street profits and bonuses are derived from activities that benefit the public good. Very little in the legislation that Congress is likely to soon approve will actually address that latter issue. And as a result, there's very little reason to believe that companies like Goldman Sachs will change their ways and stop screwing over the public for money. That doesn't mean the reform bill is a failure. It means it's a first step, and we need another, better bill after this one is approved.