(This guest post previously appeared at the author’s blog)
It has been reported that Federal prosecutors are considering the possibility of a criminal indictment of Goldman Sachs. It is early yet, but it’s worthwhile to contemplate what the consequences of this action would be.
In 1988, Drexel Burnham Lambert faced the prospect of RICO charges arising from the Milken issues that would have effectively destroyed the firm. The company plead nolo to avoid that death sentence, but it was mortally wounded and imploded months later, with moderately unpleasant consequences for the financial markets (including the derivatives markets). The mere prospect of a Treasury Department ban on its participation in Treasury auctions due to one of its traders having squeezed the T-note markets (arguably a less severe sanction than anything associated with criminal charges) caused a run on Salomon Brothers that almost destroyed the firm; only Buffett’s frantic efforts saved the firm. (That article is an interesting read. I smiled at the part where Buffett was talking on a payphone. Was it that long ago?)
Goldman’s stock was down hard on the news, and its CDS spread widened.
Criminal charges against the firm raises a significant risk of a run (specifically, a withdrawal of short term credit) that could threaten the firm. Goldman is well-capitalised, and in a decent liquidity situation, but not so soundly financed that it is inconceivable that it could fail. Similarly, Buffett’s connection to the firm provides an economic cushion, and perhaps just as importantly, a political one.
It must be remembered that these situations are highly non-linear, due to the substantial feedback and the existence of multiple equilibria. Runs can be self-fulling. If enough creditors believe the rest will run, they will run, which will cause others to run, etc. That is, ironically given that firms like Goldman have been accused of commencing speculative attacks against whole countries, such firms are actually acutely vulnerable themselves to such attacks.
Again, Buffet’s presence here may be crucial: if lenders believe that he will inject additional capital into the firm, they will be less likely to run.
Bottom line: even a criminal charge against the firm is unlikely to be fatal, but the risk of a non-linear, unstable, destructive response is not out of the question.
And given the centrality of Goldman to the financial system, it going non-linear could cause a destabilizing, non-linear response in the broader markets. If Goldman defaults on derivatives, the scramble to replace the positions would have large price, volatility, and correlation effects that can set off their own non-linear feedbacks. Similarly, the effects on the credit markets would not be pretty to watch. The world financial system is still very fragile. It is not recovered from the 2008 cataclysm, and it is under considerable stress from the European mess. In this environment, feedbacks can be particularly destabilizing and destructive.
Which raises interesting political issues. Are the Treasury and the Fed engaged in contingency planning to deal with the potential for Goldman distress arising from criminal charges? I am sure this is a particularly delicate issue: is Justice in contact with Treasury and the Fed about these issues, either to keep the financial authorities aware so they are not caught by surprise, or for consultations about the substance of the charges? If they are in contact, is it two way, or is it just a matter of Justice briefing Treasury or the Fed?
This is particularly delicate given the political toxicity of banks in general, and Goldman in particular. Anything that smacks of giving Goldman a pass will cause a non-linear political effect. But actions (or lack of actions) that contribute to or do not mitigate a shock to the financial system could be devastating both economically and politically.
These are not palatable choices, and that makes it very difficult to assess what course will be followed. This uncertainty is exacerbated because “the government” is not a unitary thing. Multiple independent decision makers have the power to take actions that would have serious effects. Even a mis-statement by a press spokesman can have cataclysmic consequences. (Remember the incautious statement by a spokesman for the East German government that set off the train of events that caused that government to collapse?) All of this uncertainty contributes to the risk of destabilizing responses.
On a more philosophical level, this issue creates some interesting dilemmas. Recall the intense reaction to the Supreme Court’s decision in the Citizens United case? Many commentators, especially on the left, were outraged at the Court’s treatment of corporations as “persons” for certain purposes. My intuition here is that the same folks would likely be outraged if the government did not pursue criminal charges against Goldman. Would they experience any cognitive dissonance at their denial of the personhood of corporations as a matter of principle, and their insistence that the corporation be prosecuted as a criminal–criminality a behaviour undertaken by individual persons?
Of course, you might ask whether I would feel any cognitive dissonance about not prosecuting Goldman. To which I reply: legal personhood encompasses a bundle of characteristics, rights, and obligations. Considerations of efficiency and justice suggest that is desirable to endow corporations with some of the individual pieces of this bundle, but not others. There are trade-offs involved, and its is wise to eschew categorical, all-or-nothing choices, and instead make a pragmatic judgment about the legal rights and protections of corporations. Yes, corporations are like persons in some respect, but not necessarily in all respects. The problem is that lawyers tend to think in categories, not trade-offs, and this leads to difficulties.
Insofar as the specifics are concerned, the key issue is the incentive effects that charging the firm criminally would have. The prospect of the large losses that could result from criminal charges would certainly provide a greater incentive for upper management to monitor and discipline the actions of their subordinates; that’s the whole idea behind vicarious liability. But this effect could also be achieved by prosecuting the individual managers responsible for oversight of underlings that engage in criminal acts.
Moreover, the prospect of a non-linear response to the charges (let alone a conviction) means that the cost of the criminal sanction is likely hugely disproportionate to the harm, and hence have an excessive deterrent effect.
Furthermore, many innocent individuals would be harmed by a crippling or destruction of Goldman–its innocent employees in the first instance, but myriad other individuals as well.
Finally, given that (a) these crimes, if they occurred, are economic in nature, (b) the cost of the harm can be approximated with some accuracy, and (c) Goldman is sufficiently wealthy as not to be judgment proof from the economic harm that resulted from its actions or lack of action, a strong case can be made that civil action, including third party actions by those injured, is more efficient than criminal prosecution.