The frog, the scorpion and Goldman Sachs

James Rickards Contributor
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Americans are quite familiar with customer data mining by large corporations even if they are unaware of the network science behind it. No sooner do clerks scan bar codes at the check-out counter, then e-coupons turn up in our in boxes with just the right timing to get us thinking, “yeah, good idea; let’s buy some ink cartridges while they’re on sale today.” My favorite is Google which posts relevant ads on Gmail before you’re done typing the key words; although they often miss the mark like when you’re writing about the shoe bomber and they offer you a deal on Italian loafers.

These techniques are the benign side of data mining. They are, at worst, mildly annoying and, at best, extremely helpful, allowing us to save money when we were in the market for the suggested goods anyway. This is what economists call value added, that is, taking some raw material, in this case data, and processing it to improve the finished product or lower costs.

Now consider another example of data mining, not done by retail firms, but by giant investment banks such as Goldman Sachs. These banks have thousands of customers transacting in trillions of dollars in stocks, bonds, commodities and foreign exchange daily. By using systems with anodyne names like SecDB, Goldman not only sees the transaction flows but some of the outright positions and whether they are bullish or bearish. Data mining techniques are just as effective for this market information as they are for Google, Amazon, Wal-Mart and others. It’s not necessary to access individual accounts to be useful. The data can be aggregated so that the bank can look at positions on a portfolio basis without knowing the name of each customer.

One need not be a market expert to imagine the power of this information. You can see which way the winds are blowing before the storm hits. You get a sense of when momentum is draining out of a trade so you can get out of it before the market turns. You can see when bullish or bearish sentiment reaches extremes, suggesting it may soon turn the other way. This use of information is the ultimate type of insider trading because it does not break the law; you are not stealing the information, you own it.

So what do Goldman and others do with this mountain of market information? Do they send coupons to customers or text them with great trading ideas? A few lucky customers, usually giant hedge funds, may get a call on some insights, but this mountain of immensely valuable market information is used mainly to power their giant proprietary trading desks allowing them to rack up consistent excess returns. Economists have a name for this also. It’s called “rent seeking,” which means taking value from others without any contribution to productivity. The difference between value-added behavior and rent seeking is like the difference between Amazon trying to sell me a book or planning to steal my library. In nature, the name for a rent seeker is parasite.

The ideal existence for a parasite is symbiosis, or balance, where it offers some minimal service to the host, (some parasites devour insects which annoy the host), while extracting as much sustenance from the host as possible without killing it. But sometimes the symbiosis is disturbed and the parasite takes too much and actually destroys the host, which can end up destroying the parasite as well. This recalls the fable of the scorpion and the frog. Both are on the edge of a river looking for a way to cross. The scorpion cannot swim and asks the frog for a ride on its back. The frog at first says, “no,” for fear of being stung. But the scorpion assures the frog it will not sting him because they would both drown. The frog agrees to carry the scorpion. Once they reach the middle of the river, the scorpion stings the frog and they begin to drown. The frog cries, “why did you do that?” and the scorpion replies, “it’s my nature.”

And that is the nature of Goldman. Gather up as many customers as possible, aggregate the available information to achieve a superior market view and then relentlessly extract rents from the marketplace. Better yet, tell yourself you’re smarter than everyone else and you’ve earned the rents from the symbiosis.

We actually wouldn’t care about this if we weren’t subsidizing it. If Goldman wants to Hoover up information and their customers are willing to be used, that’s their business. We should mind that the taxpayers are supporting it. We should mind that Goldman has the ability to take government guaranteed deposits. We should mind that Goldman was bailed out in the AIG rescue and never even said thank you to working Americans who paid the bill.

Worse yet, the parasite is now killing the host. The United States is drowning in debt, much of it incurred to bail out Goldman, AIG, GMAC, Fannie Mae and all of the other rent seekers. The U.S. is like the frog; well meaning but blind to nature of scorpions.

Wall Street likes to say, “what’s good for Wall Street is good for Main Street.” That’s the scorpion talking. What’s good for Wall Street is good for Wall Street. Never forget it.

James G. Rickards is a writer, lawyer and economist and the former General Counsel of Long-Term Capital Management. Mr. Rickards holds an LL.M. (Taxation) from the New York University School of Law; a J.D. from the University of Pennsylvania Law School; an M.A. in international economics from the School of Advanced International Studies, Washington DC; and a B.A. degree with honors from the School of Arts & Sciences of The Johns Hopkins University. He can be contacted at james.rickards@gmail.com, and on Twitter at @JamesGRickards.