Goldman: It's About What's Legal

After 10 hours and 43 minutes of testimony before the Senate's Permanent Subcommittee on Investigations on Tuesday, the hapless Goldman Sachs employees and the angry senators interrogating them were still talking past each other. "I firmly believe that my conduct was correct," said a tired-looking Fabrice Tourre, the Goldman employee who structured the Abacus trade that led to the SEC's lawsuit against Goldman. Meanwhile, Sen. Carl Levin had used the word "s--tty" 12 times and Sen. Tom Coburn had reminded the witnesses that "we're not that stupid."

The problem for Tourre—and for Wall Street more broadly—is that they're so intent on proving that what they did was legal that they can't see that what they did was wrong. These are men (and they usually are men) of the market, and they played by the market's rules. And the market's rules are these: you make as much money as you can without actually going to jail. This is a world in which people are applauded for "blowing up the customer"—that is to say, offloading a crap product on a dim investor.

But it's not the world the rest of us live in. And if Wall Street doesn't realize that quick, financial regulation might turn out very badly for them.

During the 1980s and 1990s, economists in a variety of countries conducted a series of experiments that shocked their profession. The experiments were called "ultimatum bargaining games," and they were very simple: one person was given a pot of money to dole out. The other person got to accept or reject the deal. But here was the catch: if the second person rejected the deal, neither party got any money at all.

Market man—and his bible, textbook economics—would've thought this easy. The second person should take any deal that's offered. After all, even a bit of money is better than no money. But that's not how it worked out. When the second person was offered less than 30 percent, they generally rejected the deal. This was true across countries, age groups, and even dollar amounts. "Apparently, responders do not behave in a self-interest-maximizing manner," commented Ernst Fehr and Simon Gächter in a review of these experiments. Apparently not.

This brings us to a word that's very important to most people but not very important to Wall Street: fairness. As the ultimatum experiments show, fairness is very important to the way most people make their economic decisions. But that particular quality is not very important to how Wall Street makes its decisions. Banks mislead customers, make money from betting against housing bubbles they help fuel, get bailed out with taxpayer dollars, and then pay out massive bonuses to their executives while the rest of the country is mired in a recession they caused. This might not be illegal, and the bailout might have been necessary to save our economy,but all of it is deeply unfair.

Americans were punished for Wall Street's sins and they want reform that will bring this industry more into line with their values. That's why the real divide on "Wall Street reform" (which polls better than "financial regulation," and so has been adopted by the Democrats) is not between Republicans and Democrats so much as between those who believe that Wall Street's business model needs to change and those who believe that we can get by with giving regulators more information and power so they can better police Wall Street.

At this point, the proposals that both the Republicans and the Democrats have released are closer to the second model than the first. But in a dynamic that's very rare for a legislative battle, they're being dragged toward stronger, rather than weaker, reforms. Sen. Chris Dodd's bill started with a "placeholder" on derivatives reform that was supposed to be replaced by a weaker compromise. Instead, Sen. Blanche Lincoln, who's up for reelection in 2010, shocked everyone by muscling in with something much stronger that actually bars banks that get cheap government funds from trading in derivative swaps.

Similarly, the Consumer Financial Protection Agency, an independent watchdog meant to ensure financial firms don't rip off consumers, initially seemed like it'd be the public option of this debate: a popular, liberal priority that Republicans oppose and ultimately kill. Instead, early Republican opposition quickly gave way to total capitulation, and now Republicans have included it in their bill as well.

Just as we saw the financial crisis become a broader economic crisis, we're watching financial-regulation reform become Wall Street reform. And there's an easy explanation for that: in 2008, America was forced to purchase a pretty large ownership stake in the financial system because the place had gotten so out of control and now, as partial owners and continual backstoppers, they want to remake the business into something they feel comfortable insuring. Fair's fair.