Incentives matter: Goldman Sachs file (updated)

Peter Klein over that the Organizations and Markets blog writes on the $3.4 billion second-quarter earnings of Goldman Sachs and explains that they shouldn't surprise anyone. But I'm sure they have. Klein writes

The business of political capitalism, that is. Like Enron, Goldman operates primarily in the nebulous world of public-private interaction. It is the US’s most politically powerful financial firm, skilled at navigating the byzantine regulations governing the virtually nationalized US financial sector. Goldman’s eye-popping $3.4 billion second-quarter earnings shouldn’t surprise anyone; as Craig Pirrong notes, these earnings reflect good old-fashioned moral hazard, with Goldman exploiting its too-big-to-fail status by taking on huge amounts of risk.

Craig Pirrong at the Streetwise Professor blog explains,

Goldman knows it is too big to fail. How does it know this? Well, the government bailed out AIG not so much for AIG’s sake, but for the sake of big AIG counterparties–most notably Goldman. Moreover, given the conventional wisdom that the government’s primary error in the financial crisis was its failure to bail out Lehman–a piker compared to Goldman–it doesn’t take a rocket scientist to figure out that it won’t repeat that mistake in the future, and let Goldman go down. So Goldman knows it can get bigger, and take more risk. It is the classic heads Goldman wins, tails the sucker taxpayer eats the loss gambit. If nobody steps in to rein in the firm, it will continue to add risk, thereby enhancing the value of the Treasury put hiding in the equity entry on its balance sheet.

Somebody should be stepping in–but nobody is. Why not? Partly, no doubt, it is Goldman’s political heft. It is likely too that important policy makers don’t want to crack down on a major source of risk capital to the markets in the fear that this would impede a recovery. Even though in reality, that risk capital is your money and mine, with the exception that we have no chance of capturing the upside, and are left with a good chunk of the downside. This is a piece with the hair-of-the-dog strategy being pursued by Treasury and the Fed.

The moral hazard problem here should be obvious to anyone. Goldman Sachs takes huge risks, which if they come off makes them huge profits. If they don't come off them they know they are Too-Big-To-Fail, so the taxpayer gets to pick up the bill. A win-win for Goldman Sach, if not the taxpayer. But this should point out the reason why we want to keep politics and business apart.

Update: In the comments section Peter Salmon points us to this Goldman Sachs Internal Memo.