The Goldman Sachs Bonuses

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Goldman - Chris Hondros.jpgI have been terribly neglectful of my blogging duties! I haven't blogged for almost a month. Judicial work, some travel, and work on a new book -- a follow-up to A Failure of Capitalism -- has distracted me. I will try to make amends.

Goldman Sachs, we learned earlier this month, may end up paying more than $20 billion in bonuses to its employees in 2009. The controversial bonuses that American Insurance Group (AIG) had wanted to pay had been intended to reward performance before the company collapsed, and most of the recipients appear to have had no involvement in the decisions that precipitated the collapse.

The Goldman bonuses, in contrast, were intended to reward Goldman's employees for their outstanding performance during the economic crisis. The performance was made possible by the government's having bailed out Goldman in September 2008, when it is believed that, upon Lehman's declaring bankruptcy, Morgan Stanley was 24 hours away from following suit--and Goldman Sachs 72 hours. It was saved by receipt of bailout money and, more important, by being permitted to convert from a broker-dealer to a bank holding company. That entitled it to borrow from the Federal Reserve -- unlike Lehman Brothers, which was denied a Fed loan because it was a non-bank. That was not a sound basis for denying it a loan, but Goldman would have been in the same boat, had it not converted.

So the argument goes: Without government aid then, no $20 billion-plus in bonuses for Goldman Sachs's employees in 2009? Maybe zero in bonuses, maybe indeed, no Goldman Sachs at all. Against that background, the bonuses seem egregious. It seems that the government drove a bad bargain when it bailed out Goldman, that it should have demanded a big chunk of Goldman's future profits.

Against this, it can also be argued that a generous bailout was justified by the need to strengthen the banks so that they would lend. And I agree. It is true that the banks have not increased their lending by the amount of money that they received from the government, but had they not received it, they would be lending even less than they are.

Goldman's 2009 profits -- the source of the bonuses -- are not from lending, however, but from proprietary trading. That is, it has been using its own capital for speculation: buying stocks and bonds, and selling stocks and bonds short, and engaging in other speculative maneuvers.

There is nothing wrong with speculation, but its social value is not as great as the profits of successful speculators. The social value of speculation is its contribution to a more accurate valuation of assets, in this case of stocks and bonds. The contribution by an individual speculator, even one as large and expert as Goldman Sachs, must certainly be a great deal smaller than its profits. If Goldman Sachs makes $10 billion trading stocks and bonds, the individuals or firms on the other side of its transactions are $10 billion poorer. It is because the profits from successful trading so greatly exceed the social value of that trading that there is suspicion that too much IQ is being sucked into finance.

In theory, stock prices discount expected corporate profits, and bond prices discount expectations regarding inflation, default risk, and other determinants of interest rates. But the swings, especially in stock prices, greatly exceed the swings in corporate profits. A great deal of the profits made and losses incurred in speculation in stocks do little or nothing to align stock prices more closely with the actual value of the assets of the companies whose stocks are traded. This is another reason to doubt that the profits of successful stock speculators are closely related to the information value of speculation.

So the traders working for Goldman probably are "overpaid" in the sense that their incomes send a bad signal from an economic standpoint to the labor market. PhDs in physics are lured to Wall Street but would probably contribute more to economic welfare by using their scientific skills in business, government, or academia.

The worst consequence of the Goldman bonuses, however, lies in the realm of politics rather than of economics narrowly construed. The degree of economic equality/inequality in a society is bounded: if incomes are made too equal, say by heavily redistributive tax and spending policies, incentives for innovation, enterprise, and hard work will dwindle and the wealth of the society decline, and these effects will put pressure on government to relax its egalitarian policies.

But if incomes are allowed to become too unequal, because an absence of redistributive measures gives differences in skill and luck full rein to determine how poor or wealthy a person shall be, the resentments of the have-nots will create debilitating social tensions and political antagonisms that will exert pressure for redistributive measures. Neither extreme, therefore, is an equilibrium.

The Goldman bonuses (if in fact they are paid) could become a symbol of excessive inequality in American society and a spur to equalizing measures. Their revelation has coincided with high and growing unemployment, underemployment and economic misery and anxiety in general. It looked as if the government had gratuitously enabled a handful of wealthy traders to become still wealthier at a time when much of the population had just become poorer and when the actual contribution of the traders to the welfare of the society was obscure, and perhaps slight in relation to the increment in their wealth. The news that Goldman planned to give $200 million to charity -- one percent of the bonuses -- recalls John D. Rockefeller handing out nickels and quarters to passersby.

(Photo: Chris Hondros/Getty Images)

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.
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