This Wall Street fairy tale doesn't have a happy ending

Morgan Stanley's base in New York. It and Goldman Sachs became bank holding companies last year regulated by the Federal Reserve.
Morgan Stanley's base in New York. It and Goldman Sachs became bank holding companies last year regulated by the Federal Reserve. (Daniel Acker/bloomberg News)
By Steven Pearlstein
Friday, October 30, 2009

Once upon a time, there was a magical kingdom whose capital markets were ruled by two firms known as Goldman and Morgan. Each firm earned $1 billion a year in trading profits. By custom, 25 percent of these profits were shared with the employees, according to their needs and talents. The markets worked remarkably well in allocating capital to the realm's most productive enterprises, and the kingdom prospered.

Goldman had a clever trader named Peter, who in one year produced $50 million in trading profits, which earned him $10 million in salary and bonus. Eyeing those profits, Morgan offered Peter $15 million to switch firms. He quickly accepted. Not to be outdone, Goldman responded by luring Paul, Morgan's top trader, for something more than $15 million. A general bidding war for talent ensued.

After several years of this competition, neither Morgan nor Goldman was able to gain a competitive advantage. The industry was still earning the same $1 billion in trading profits, but now nearly half of those profits were distributed to employees. Although every employee benefited, most of the gains went to Peter, Paul and a handful of other top performers.

Before long, the students at the kingdom's universities noticed that they could make much more money going into finance and began to alter their career choices. Some professions, such as law and management consulting, were able to continue attracting top students by matching the starting pay at Goldman and Morgan. Many others were forced to settle for less-talented graduates or to try to attract graduates from other kingdoms.

Meanwhile, the owners of Goldman and Morgan began looking for new sources of revenue and profit to finance this never-ending bidding war for talent. The firms gathered all their financial wizards -- mathematicians, engineers and economists -- and set them to inventing whole new categories of securities that could be traded, in addition to sophisticated new trading strategies that would increase the number of times each security changed hands.

These innovations did little to improve the efficiency or output of the rest of the kingdom's economy, but over time, they allowed Goldman, Morgan and their employees to capture a greater share of the realm's income and wealth.

The people of the kingdom rushed to embrace these new securities and trading strategies, even if most did not understand them. Because of them, just about any commoner could get loans for any purpose, with no questions asked and no money down.

Businesses discovered that they could make more money buying and selling other businesses than doing the hard work of inventing new products or better ways to make them. And investors calculated that they could earn outsized returns by placing their bets with large amounts of money borrowed from each other or residents of other kingdoms.

There were some at the castle who warned that all this borrowing and trading of financial assets was too good to be true and needed to be restrained. But the king's ministers would not listen. They were blinded by the glitter of all the gold pouring in from tax collectors, along with the silver generously sent their way by the Morgan and Goldman traders. They professed shock when it was finally revealed that few of the new securities were worth anything close to what people thought.

Today, the people of the kingdom are angry. Their income and wealth are lower than when our story began. Most of the gains of the era of riches have long since been siphoned off by the Goldman and Morgan traders.

Businesses are saddled with capacity they cannot use and debt they cannot repay. A generation of top talent has been squandered, and the gap between rich and poor has widened.

If there is a moral to this tale, it is that finance alone cannot make a kingdom thrive and prosper. Trading assets is largely a zero-sum game: The buyers' gains are the sellers' losses, or vice versa. Economies benefit to the degree that financial markets efficiently allocate capital from those who have it to those who can make the most of it.

Surely, one measure of that efficiency is how little is skimmed off by the financial middlemen. So the next time someone tells you that it's no concern of yours if Wall Street traders are earning a king's ransom, remind him of the story of Goldman and Morgan and the financial wizards who thought they could spin capital out of straw.

© 2009 The Washington Post Company