Can people be fooled again and again? (Goldman Sachs edition)

A very interesting article in the NYT today, in which Greg Smith gives his reasons for resigning as an executive director at Goldman Sachs. Apparently, he's tired of his firm's practice of ripping off its clients:

What are...quick ways to become a leader [at Goldman today]? a) Execute on the firm’s “axes,” which is Goldman-speak for persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit. b) “Hunt Elephants.” In English: get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don’t like selling my clients a product that is wrong for them... 

It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail. Even after the S.E.C., Fabulous Fab, Abacus, God’s work, Carl Levin, Vampire Squids? No humility? I mean, come on. Integrity? It is eroding. I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact. 

It astounds me how little senior management gets a basic truth: If clients don’t trust you they will eventually stop doing business with you. It doesn’t matter how smart you are.

If Smith is to be believed, and Goldman makes a large portion of its money by tricking clients into making financial mistakes, then this raises an extremely interesting question: How has Goldman gotten away with this for so long? 

Economists generally believe that you can't fool people for very long. In fact, this idea is the cornerstone of many very important models. George Akerlof's legendary "Lemons" Model, for example, assumes that if people know that they might be getting ripped off, they'll just exit the market (and hence avoid getting ripped off). In macro, Robert Lucas' Rational Expectations Hypothesis rests on the idea that policymakers can't repeatedly trick agents in the economy.

So before we conclude that something is very wrong with basic economic axioms, let's think of some ways that Greg Smith's report might be consistent with our prior beliefs:

Possibility 1: Goldman's clients aren't really getting ripped off that much. In real markets, every transaction involves some "surplus" for both the buyer and the seller. It may be that Goldman's "ripping off" of clients is just the way Goldman takes its share of the surplus - i.e., that getting slightly "ripped off" is an inevitable but bearable cost of doing business with Goldman. It might be that all of Goldman employees' braggodochio ("We took those clients for a ride, hahaha") might just be hot air.

Possibility 2: The government somehow forces people to do business with Goldman. In some markets, the government guarantees a firm a monopoly, through regulation, preferential deal-making, etc. An example is utility companies; another is the notorious ratings agencies. It may be that some combination of government regulation, preferential deal-making, or implicit bailout guarantee may be forcing businesses to do business with Goldman instead of some smaller or less well-known or well-connected (but more honest) investment bank.

Possibility 3: Learning takes a long time. Smith says that "if clients don’t trust you they will eventually stop doing business with you." But how long is "eventually"? Maybe if your firm hires a bunch of the smartest (and least scrupulous) finance people, they can keep tricking people for decades on end. Maybe Goldman will die now that people have caught on.

But suppose these don't fully explain the situation? As scientists - or even just as rational thinkers - shouldn't we entertain the possibility that people can be fooled again and again, and simply never learn that they're being fooled? Last fall, I saw George Akerlof (he of the Lemons Model) give a talk called "Phishing for Phools," in which he raised exactly this possibility. How could that happen? Well, let's think of some ways:

Possibility 4: Behavioral effects are very strong. It may be that some sort of deep-seated psychological processes in human beings are too strong to be overcome by rational learning within any reasonable time scale. In other words, maybe we are built to just keep believing the same lies over and over and over. That may sound improbable, but sometimes when I look at U.S. politicians' campaign promises (How long have Republicans been promising to cut spending?). I wonder. Alternatively, people may un-learn what they learned in the past.

Possibility 5: The influx of trick-able people may be faster than the learning process. If enough suckers are born every minute, it may be that the total number of suckers grows over time, even if some fraction of the suckers are always wising up. Thus, there may always be more clients for Goldman to rip the faces off of, even if no one keeps getting their face ripped off forever.

Possibility 6: Rapid structural change may make learning impossible. As Andrew Lo demonstrates in this paper, if the underlying structure of the economy changes at about the same rate that we learn about it, there may never be a model that allows us to understand the economy. This goes for individuals' rationality as well. If the financial world undergoes continuous structural transformation, it may be possible for a Goldman Sachs to keep ripping people off as new structural changes emerge.

I'm sure there are some possibilities I've left off of this list. But I think that figuring out the relevant importance of these effects is crucial if we want to understand what we should do - if we should do anything at all - about the shenanigans of firms like Goldman Sachs. I don't pretend to have the answer. But simply assuming that people can't be fooled is a luxury that we economists may no longer have.


Update: A bunch of people are putting forth another hypothesis: that Goldman has only been ripping people off for a relatively short time. But in Liar's Poker, Michael Lewis discusses a culture at Salomon Brothers in the 1980s that is almost identical to what Greg Smith describes at Goldman. Furthermore, Lewis says that all the big U.S. investment banks (of which Goldman was one) were doing the same thing, and that Europeans often marveled at the willingness of American investors to keep their money within a small circle of oligopolistic investment banks that were obviously ripping them off. Yes, Michael Lewis' book is just an anecdote, but then again, so is Greg Smith's article. 25 years of face-ripping is a long time.

Update 2: Justin Fox also pooh-poohs the idea that Goldman's face-ripping is a recent phenomenon.