Goldman Sachs Takeaway: Fix Our Financial System or Get Ready for the Next Horrific Collapse

Only an overhaul in our broken banking and financial system will prevent the next collapse. Goldman Sachs' misdeeds are merely a symptom of a much bigger problem.

Greg Smith's mea culpa about Goldman should not come as a surprise to anybody who has a remote connection with the financial services industry. But to suggest that the allegations made by Mr. Smith are unique to Goldman's culture is ludicrous. They are symptomatic of a much broader problem embedded in Wall Street culture as a whole. Goldman's major sin was being more astute at exploiting this system than most of its competitors.

The toxic derivatives sold to what employees of Goldman derisively referred to as "muppet" clients (since when was being a "muppet" such a bad thing?) were certainly neither a trend unique to GS, nor was it a recent phenomenon. The truth is that this activity has been embedded in Goldman's culture since the days when Robert Rubin was co-CEO of the company and advocated GS taking proprietary positions (trading for its own account), even if it meant betting against their clients.

Goldman was a successful company and success tends to breed imitation. Eventually, everybody on Wall Street was doing the same shitty business. Goldman, for example, wasn't the only one selling these toxic mortgage products, which helped to blow up the world's global economy in 2008, but they were smart enough to hedge them.

Why is all this so dangerous? Think of the recently deceased James Q. Wilson's "Broken Windows" thesis, which he largely used as his model for "blue collar" crime. Wilson thought that it was necessary to tackle even small signs of crime and decay in a community in order to prevent larger, more system criminal activity from emerging. You see a broken window, you go after the culprit. In the elite white collar crime context we have been following the opposite strategy of that recommended under the theory.

As the economist/criminologist Bill Black recently noted in a piece discussing Wilson's theory, the whole story of the past two decades has been that we have persistently excused those in finance who persistently break the windows. Indeed, we have praised them and their misconduct.

But as Black has noted, "The problem with allowing broken windows is far greater in the elite white collar crime context than the blue collar crime context. The squeegee guys make tiny amounts of money and are hated and politically powerless. The mediocre financial CEO who engages in accountingcontrol fraudbecause it is a 'sure thing' causes the bank to report record (albeit fictional) profits and becomes wealthy and politically powerful. He uses his wealth to make charitable and political contributions that make him far harder to sanction. He claims that any crackdown on him is 'class warfare' by 'neo-Bolsheviks'."

Incredibly, the Department of Justice, the press, and the economic profession persistently ignore those who become wealthy by breaking windows, communities, and economies. In fact, they are lionised by no less than our President, who once termedboth Lloyd Blankfein and Jamie Dimon "pretty savvy businessmen." Yes, and Al Capone was a pretty savvy businessman -- who just happened to be sloppy on his tax returns.

Realistically, what is required is a wholesale shift in our banking culture. In the old days, a banker “hedged” his credit risk by doing (shock!) CREDIT ANALYSIS. If the customer was deemed to be a poor credit risk, no loan was made. But if the loan was made, and turned out to be profitable, both lender and borrower made money, which is how banking should work.

It goes back to a point I have made many times: Creditworthiness precedes credit. You need policies designed to promote job growth, higher incomes and a corresponding ability to service debt before you can expect a borrower take on a loan or a banker to extend one. And, as the economist Hyman Minsky used to point out, in the old days, banking was a fundamentally optimistic activity, because the success of the lender was tied up with the success of the borrower; in other words, we didn’t have the spectacle of vampire-like squids betting against the success of their clients via instruments such as credit default swaps.

The main problem is that “finance” simply became too big. At the peak it captured 40 percent of all corporate profits (it recovered that share by the beginning of 2010 thanks to the bail-out and “creative” or even fraudulent accounting), and about a fifth of value-added to GDP. Interestingly, we find the same phenomenon in 1929, when finance received 40 percent of the nation’s profits. Apparently that represents a practical maximum and thus a turning point at which the economy collapses.

Perhaps of equal importance, finance virtually captured government, with Wall Street alumni grabbing an unprecedented proportion of federal government positions that have anything to do with the financial sector—including Treasury—under three consecutive presidents (from Clinton through Obama). It is not surprising that Wall Street gets deregulation when it wants, and that in spite of the scale of the current financial crisis—which has wiped out an estimated $50 trillion in global wealth—there has been no significant reform to date.

Real reform will likely have to wait for another collapse. When it comes, it will wipe out even more wealth, and will bring on even more intolerable suffering. Looking at today's situation that context, Greg Smith's letter is interesting, but ultimately it will be a sideshow unless it wakes us up to the bigger picture. The entire system demands overhaul.

Marshall Auerback is a market analyst and commentator.
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