Goldman Sachs: Failure of Innovation

How Peter Drucker virtually predicted the mortgage-related securities scandal

By Rick Wartzman

Whether Goldman Sachs Group (GS) broke the law remains to be seen. But one thing is for sure: The firm violated one of Peter Drucker's core principles of innovation.

"Innovation is an effect in economy and society, a change in the behavior of customers … of people in general," Drucker wrote. "Or it is a change in a process—that is, in how people work and produce something. Innovation therefore always has to be close to the market, focused on the market, indeed market-driven."

By sharp contrast, so-called innovations exploited by Goldman—mortgage-related securities the firm was betting would decline in value—weren't geared to the broader market at all; they were inwardly focused and traded by Goldman for its own profit.

As Carl Levin, the Michigan Democrat who chairs the Senate Permanent Subcommittee on Investigations, has observed: "The nature of Wall Street's function has changed. They still argue that they're providing capital and stimulating innovation, and to some extent they are. But there's been a significant shift here to the model where they're out for themselves. Their client is themselves."

Serving the In-house Trader

Drucker saw this mess coming a long time ago. In a piece he penned in 1999, "Financial Services: Innovate or Die," he frowned on the kind of transactions that have done such terrible damage to Goldman's reputation and, more important, to the world economy. Since the 1970s, he wrote, "the only innovations" among banks "have been any number of allegedly 'scientific' derivatives.

"But these financial instruments are not designed to provide a service to customers," Drucker continued. "They are designed to make the trader's speculations more profitable and at the same time less risky—surely a violation of the basic laws of risk and unlikely to work. In fact, they are unlikely to work better than the inveterate gambler's equally scientific system for beating the odds at Monte Carlo or Las Vegas."

The tendency to inflate one's bottom line without actually creating anything of real value (a good, a service, a job, a gain in productivity) hasn't infected only Wall Street, of course. Across countless industries, many executives now spend more time and energy on financial engineering than they do on product engineering.

Drucker, for his part, was hardly naïve about high finance. He understood full well that businesses must engage in hedging and option trading to deal with volatile fuel prices or fluctuating currencies. "Foreign exchange risks," Drucker noted, "make speculators out of the most conservative managements."

True Innovation: ATMs

But that is not the same as a bank actively trading for its own account, a practice that can quickly turn those who traditionally have been the institution's primary customers into secondary considerations. "I believe banks should be banks serving clients," Citigroup (C) Chief Executive Vikram Pandit recently wrote to President Obama, in a statement that, in a different day and age, would have seemed as laughably obvious as the color of George Washington's white horse.

Former Federal Reserve Chairman Paul Volcker, who has been trying to erect a wall between banks that stick to taking deposits and those that want to make risky wagers for their own advantage, commented not long ago that only one financial innovation has been worth much of anything in the past 20 years. And it isn't the collateralized debt obligations (CDOs) at the center of the Goldman scandal. Rather, it's the automated teller machine. "That really helps people … and is a real convenience," Volcker said.

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