Brad DeLong Gives An Economics Lesson

This posting on Brad DeLong's web site is an excellent explanation of the basis for the SEC suit against Goldman Sachs. It also takes a step back and explains some economic theory which is very useful:

The economist's presumption is that freely-chosen acts of market exchange are good things: win-win. This presumption can be overturned:

• Perhaps those buying do not understand what they are really buying.
• Perhaps the seller is misleading the buyers.
• Perhaps the active exchange itself the motive for other bad actions outside the narrowly economic sphere (when the existence of British demand for tobacco, sugar, and cotton triggers the growth of plantations in and around the Caribbean and makes it worth people's while to wage war in Africa to steal slaves, then that market for cotton, sugar and tobacco is a bad thing, even though both the sellers and the buyers of cotton, sugar and tobacco like it).

But in general acts of market exchange are win-win, for people trade off things they don't value very much for the things they value a great deal. I give the barista behind the coffee machine money--generalized purchasing power. She gives me coffee. Beforehand, she had too much coffee and not enough money. Beforehand, I had too much money and not enough coffee. Afterwards we are both happier and both better off.

Now let's move to finance. The problem with finance is that we are not treating coffee for food, or CD players for clothes, but that we are instead trading money for money. The win-win benefits from exchanges of goods for goods are obviously there. The win-win benefits of trading money for money--where are they? It turns out that they are there. There are, actually, four:

1. Trading money now for money later: people who want to save now and spend later can make win-win trades with people who want to spend now and save later.
2. Risk: people who are unusually averse to risk in general can make win-win trades by trading off some of the risks that they are bearing to people who are unusually tolerant of risk in general.
3. Insurance: people who are holding a lot of one big risk can reduce the risk of catastrophic loss by paying a great many others to each take a small piece of that risk.
4. Information: people who have information that prices are going to rise can make win-win deals with people who have information that prices are going to fall--although here the win-win is not for the participants in the trade: for them it is zero-sum, and the winners are those others who observe the market price at which the trades occur.

And here we come to the crux of the SEC's Goldman Sachs case. The SEC alleges that Goldman Sachs claimed to the buyers of the ABACUS 2007-AC1: $2 Billion Synthetic CDO Referencing a static RMBS Portfolio security that it was a deal of type (3) constructed primarily by ACA Management, LLC when it was in fact a deal of type (4) constructed primarily by investor John Paulson, and that this claim by Goldman Sachs was a misstatement of a material fact--an active attempt by sellers to mislead buyers, and thus to erase the win-win character of the deal.

As one correspondent writes:

People... writing CDS protection thought that they were writing insurance... that the overall price of insurance on US mortgages were too high and they wanted to write some, pushing the price down... writing risk on a "generic mortgage exposure", similar to an index of mortgages... pretty normal insurance business.... They would think that on the other side was a load of little investors not unlike themselves, picked by a CDO manager with roughly the same incentives as they had. If you had told them that they were taking the other side of a proprietary bet they would have run a mile--just like anyone in the insurance business does when they pick up a whiff of potential moral hazard...

I am sure that the Goldman-Sachs investment bankers convinced themselves that the origin of the security was not "material information"--it did not bear on the characteristics of the cash flows from the security, after all: they were what they were, and they were fully disclosed. What the origin of the security carried information about was about the character of the market--that it had people like John Paulson in it actively trading. But it wasn't "material information" about that particular security, the Goldman-Sachs investment bankers must have told themselves. Hence there was no duty to disclose Paulson's role. And disclosing the role would muddy the waters and make the CDO harder to sell...

Whether the SEC or Goldman-Sachs is correct will be for the jury to decide. But why file the case in New York? Surely a jury somewhere else would be more likely to find for the SEC...

The above is very interesting and informative. As I was reading the bit about trading money for money I thought "this is excellent". This is a nice summary of the things that Karl Marx ignored. He thought capitalism was a parasite on workers because he had a "labour theory of value" i.e. value is only created by the sweat of some guy's brow. Marx completely ignored financial transactions because he didn't understand them. He didn't understand the value of the 4 types of money-for-money transactions listed by DeLong.

Because Marx didn't understand this, something like 80 million people died in the 20th century under Communist regimes. This is the very point that John Maynard Keynes was trying to make when he said "even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist". The ideological wars of the 20th century were fought because Marx didn't understand the utility of financial transactions. Instead, he convinced radicals to destroy capitalism "for the benefit of workers". In fact, his descendants created slave labour camps the size of countries and their secret police killed millions to protect "the Idea", the very wrong idea, of Marx.

And we have just had a $10 trillion economic meltdown cause by ideologues on the right who don't understand the purpose of government. They convinced themselves that all government is onerous and the only "proper" social relationship is a contract freely entered into by both parties. But this is a myth. Where is the contract signed by people downstream from a mill that dumps mercury in the water and blinds the children and causes many to go mad? There is a value to government. The financial crisis has re-established that financial regulation is needed to keep banks for going bust and Wall Street from selling junk bonds as AAA "investments".

Ideas count. Bad ideas can kill tens of millions. Bad ideas can cause a ten trillion dollar meltdown.