Friday, October 22, 2010

In Goldman, Sachs We Trust

John Kenneth Galbraith (1908–2006)
From John Kenneth Galbraith: The Affluent Society and Other Writings 1952–1967

This week (October 24–29) marks the anniversary of the Great Crash, a cataclysm pushed to the foreground by events of recent years—although for many Americans, the cause of the 1929 calamity is at best an incomprehensible, nebulous “house of cards” or “Ponzi scheme” (which, to great extent, it was). In his enduringly popular account,The Great Crash, 1929, the economist John Kenneth Galbraith explains, in very clear terms, exactly what happened. In one now-famous chapter, he describes how, during the late 1920s, it seemed everybody in the nation was buying stocks to get rich quick. Rather than wondering if the run-up was fueled by little more than unbridled imagination and misguided optimism, some Wall Street experts sincerely worried “that the country might be running out of common stock,” a problem they believed was a major cause of stocks’ high prices. So various ways to increase investment opportunities were invented and offered to the public.

One method of increasing the number of stocks, relatively new in the U.S., was the creation of the investment trust. Such companies did not really produce anything or foster new enterprises; instead, they “merely arranged that people could own stock in old companies through the medium of new ones”; that is, the trust’s sole purpose was to invest its funds in the stocks of other companies. The problem, however, was that there was often no relation to the amount of money invested in the trust to the amount of money the trust invested, in turn, in stocks. “The difference,” Galbraith writes, “went into the call market, real estate, or the pockets of the promoters.”

The investment trusts succeeded largely because the “product” they sold to the average trader was expertise: “One might make money investing directly in Radio, J. I. Case, or Montgomery Ward, but how much safer and wiser to let it be accomplished by the men of peculiar knowledge, and wisdom.” And the trusts were not really new companies; instead, most of them were sponsored by existing companies—for example, J. P. Morgan was behind the investment trust United Corporation. Furthermore, it almost goes without saying, investment trusts would sponsor investment trusts that would, in turn sponsor investment trusts; each of these companies issuing stocks that they would often sell to each other or to other investment trusts. Many of these companies learned quickly that through the “the miracle of leverage” (the degree to which borrowed money is used), they could “swing a second and larger [trust] which enhanced the gains and made possible a third and still bigger trust.”

Which brings us to Goldman, Sachs and Company. In the final section of his chapter on investment trusts, Galbraith describes the unique and outsized role the company had in the inevitable debacle, with total losses that, in today’s dollars, would equal about $475 billion.

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Goldman, Sachs and Company, an investment banking and brokerage partnership, came rather late to the investment trust business. . . . If you don't see the full story below, click here (PDF) or click here (Google Docs) to read it—free!

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