Budget Cuts = Highway to Hell?

A couple of weeks ago, a report¹ was released predicting that austerity measures being sought by Republicans in the House would “derail the recovery.” This report was created by the venerable investment banking giant Goldman Sachs. This alone should suffice for the legitimacy of the argument.

Except it doesn’t.

You see, in this case, Goldman isn’t the epitomized success story in a dog eat dog world, perched up top as the unbiased observer of the economy. While there are many reasons Goldman's report has reached this conclusion, a case built on economic facts and realities unfortunately isn’t one of them.

The main reason Goldman is all up in arms over budget cuts is self-interest. If the cuts go far enough this year for the US Federal Government to not need deficit spending, the Treasury does not need to raise money via bonds. A decline or even complete non-issuance of US bonds (Treasuries) means that brokers and market makers (primary dealers²) in the Treasuries market (POMO³) stand to lose business. For Goldman, combined with their internal trading (PPT⁴ / HFT⁵),  that is one of their most profitable sectors post-2008 recession (along with Investment Management for mutual funds and pensions).⁶

So guess who’s a primary dealer at POMO?⁷

But of course, one report is an aberration. Certainly two reports reaching the same conclusion must be substantive enough to prove the conclusion? If only.

The second report was issued by Moody’s, one of the big three credit rating agencies (CRA). Finally, someone experienced in determining risk and grading sovereign debt (and therefore the economy). Surely, they must know what they're doing! Except that Moody’s (along with Fitch and Standard & Poor’s), was responsible for inflating the ratings for toxic assets^8,9 that in part led to the financial meltdown. One case cannot be logically extended to suppose guilt for all ratings, can it? As the old statistics teacher used to day, correlation does not mean causation. However, the way CRA’s operate, with their revenue coming from the clients(ie Goldman Sachs) who request ratings,  this can and has led to a confirmation bias in their evaluations, as evidenced in the aforementioned case.¹⁰

Can we sincerely expect Goldman Sachs and Moody’s to bite the hand that feeds? If not, can we really be confident in their analysis?

1.      http://politicalwire.com/archives/2011/02/28/gop_budget_cuts_could_derail_recovery.html

2.      http://en.wikipedia.org/wiki/Open_market_operations

3.      http://www.newyorkfed.org/markets/pridealers_current.html

4.      http://en.wikipedia.org/wiki/Proprietary_trading

5.      http://www.thedailyshow.com/watch/wed-september-30-2009/cash-cow---high-frequency-trading

6.      http://www2.goldmansachs.com/our-firm/investors/financials/current/annual-reports/2009-complete-annual.pdf (Note: Page 2, 32,55 for revenues and page 34 for definitions )

7.      http://www.newyorkfed.org/markets/pridealers_current.html

8.      http://www.huffingtonpost.com/2009/09/23/eric-kolchinsky-moodys-wh_n_295789.html

9.      http://blogs.reuters.com/commentaries/2009/09/21/what-did-rating-agencies-know-about-aig/

10.  http://www.ft.com/cms/s/0/606af4d2-52f8-11df-813e-00144feab49a.html#axzz1FOO3iBiI