Trust Is the Glue . . .

Most of us view trust as valuable and desirable, something that improves the quality of our personal lives.  We seldom take the next step and view it as indispensable, a vital ingredient in society — and in the economy.  But all credit is based on trust, and the fundamental problem in a credit crisis is not just the lack of “liquidity” but also the absence of trust, the trust that is essential to all financial transactions.

British Historian Geoffrey Hosking noted recently:  “A liberal, free market society needs ‘trust in the trustworthy’ as the core of its values, not just as a Quixotic moral ‘extra’.”  (See, “Trust: Money, Markets and Society.”)  Operating somewhere between hope and certainty, trust is the belief that the other person means what he says.  That is, he could be wrong but he is not trying to deceive.  He is reliable in the same way we feel ourselves to be reliable.

In times past, a handshake was often considered sufficient to seal a deal.  But such a handshake had to be “trustworthy,” offered by someone who knew himself, knew his resources, and was aware, as well, of the dangers in making a promise he couldn’t deliver.

Hosking points out:  “The 2000s were bad years for social trust, at least in the UK and USA. They were the culmination of several decades during which generalized social trust had been declining. Surveys in the UK suggest that, when asked in 1959 ‘Would you say that most people can be trusted?’ 56 per cent replied ‘Yes’; in 1998 the equivalent figure was 30 per cent. In the USA, when asked the same question in 1964, 55 per cent answered ‘Yes’, but in 1995 only 35 per cent.”

And then came the credit crisis with the collapse of investment values.  The exposure of the greed, carelessness and fraud that permeated the financial industry leading up to that crisis eroded even further the public’s trust.  The extraordinary salaries and bonuses subsequently meted out to those responsible for that failure finished the job.

Hosking pointed out that more than financial inefficiency and distress is at stake.  With distrust pervading the population, all the social services that government traditionally provide become more difficult to administer and more expensive:  “As a result, there are today more overworked teachers and demoralized social workers, there is more litigation, greater reluctance to help the police, greater recourse to private health care and the like.”

The essential point is not that people need to be encouraged to trust.  Most of us want to trust and have the basic capacity to trust.  We need institutions that are trustworthy.

Our Need for Fictions

We like to think that all problems have solutions.  The reasons may be complex and difficult to grasp, but our faith is that if we understand the causes, we can cure the effects.

And the simpler answers are better.  The appearances of things are often confusing, yet if we dig deeply enough we will get to the core of truth that will give us more control over events.  But that belief is getting harder and harder to sustain.

Investors, for example, used to try to focus on “the fundamentals” of a stock to determine if it would grow in value.  Was the company well capitalized? well managed? strategically positioned in the market?  Brokerage firms used to employ analysts to study such factors in order to advise their customers.  But, then, economists looked at the data more closely and discovered that no analyst actually out performed the market systematically.  The best an investor could do was to diversify, assemble a large basket of securities that covered the range of possibilities.  That discovery led to the birth of index funds.  They don’t solve the problem for investors, but they make it easier to live with it.

Recently Jonas Lehrer wrote in Wired about how science too is failing us.  He focused on the pharmaceutical industry’s efforts to produce drugs that target specific ills, and he gave the example of an extremely promising drug to treat cholesterol developed by Pfizer.  In the final phase of clinical trials it turned out that the drug did not work.  Indeed, in many cases, it harmed patients.  (See, “Trials and Errors: Why Science Is Failing Us.”)

Lehrer reminded us that the Scottish philosopher David Hume pointed out over 200 hundred years ago that we never really know the causes of anything.  We see correlations between events and we make up stories that connect them, but “causal explanations are oversimplifications.”  According to Lehrer, “they help us grasp the world at a glance.”  On the other hand, “those same shortcuts get us into serious trouble in the modern world when we use our perceptual habits to explain events that we can’t perceive or easily understand.”

Clean water seems to improve public health dramatically.  When surgeons wash their hands, fewer patients die.  These are robust correlations.  But when we try to account for the complexities of biological compounds interacting with the body or to predict the behavior of financial markets, we get enmeshed in our own fictions.  “The details always change, but the story remains the same: We think we understand how something works, how all those shards of fact fit together. But we don’t.”

Lehrer concludes: “we live in a world in which everything is knotted together, an impregnable tangle of causes and effects. Even when a system is dissected into its basic parts, those parts are still influenced by a whirligig of forces we can’t understand or haven’t considered or don’t think matter.”

We need our common sense explanations of things, but we also need to be wary of them.  This is particularly true as our world gets more complex and interrelated.  And it won’t get easier.

The Categories We Live By

In the eyes of the law, a corporation is a person, but when a real person, that is, a person of flesh and blood, declares bankruptcy or defaults on his or her debt it is usually considered a moral failure — at the very least a source of embarrassment.  American Airlines’s recent declaration of bankruptcy, on the other hand, was greeted by many commentators in the press as a smart “business decision,” a way of reducing debt and regrouping for growth.

James Surowiecki pointed this out in The New Yorker, contrasting the plight of the Airline with tens of thousands of mortgage owners who are “underwater,” i.e. owing more than their property is worth.  Our conventional moral standards prevent most of us from taking advantage of the “smart” way out of such predicaments.

To be sure, there are penalties for individuals who declare bankruptcy or default on their loans, usually in the form of restrictions on the debts they can subsequently undertake with credit cards and loans.  But the greatest obstacles are fear and shame.  Surowieki notes that one study suggests that eighty-one per cent of Americans think it’s immoral not to pay your mortgage when you can.”  (See, “Living By Default.”)  And, he adds, the banking industry has been seeking to reinforce that belief:  “the head of the Mortgage Bankers Association, argued that defaulters were sending the wrong message ‘to their family and their kids and their friends.’”

In what sense, then, are corporations “persons?”  This is a question of increasing urgency as the U.S. Supreme Court has ruled that corporations, as persons, are entitled to freedom of speech and can make unlimited contributions to political campaigns.  On the other hand, can they fall in love and dream?  Can they get sick and die?

The creation of fictitious corporate persons has proven very beneficial to modern economies.  Their legal rights have been instrumental to the growth we have sustained in the modern era.  But it is a fiction, nonetheless, often a useful fiction — but sometimes not.

The mind makes sense of the complex world through the categories it creates.  A large part of thinking is finding the right categories, the ones that help us to be more productive, more successful, and more human.

Let’s try the thought experiment of shifting our categories in the other direction, towards creating more profitable, more corporate-like people rather than more people-like corporations.  Families might consider divesting themselves of obsolete members, like grandparents, or selling off underperforming assets, like children who don’t do their chores.  What about cutting back on food when times are tight as a matter of policy, or selling off surplus body parts?  We might consider routinely right-sizing our extended families, selling information on our friends, or even diversifying by selling off parts of ourselves.

How restrictive and inhibiting it can seem to be a non-corporate person.

BETA WEALTH

Now You Have it – Now You Don’t

Preoccupied as we are with the 1% at the top, we lose sight of how volatile all wealth today has become – and “beta” is the measure of change, relative to the market.  Technology and gambling stocks can have betas of 1.5 or more, since they tend to overshoot the market in cyclical ups and downs, while utilities hardly move at all.  The problem, of course, is that high “beta’s” don’t last.

As The Wall Street Journal put it recently:  “The new rich have become the high-betas of our economy. With their dependence on financial markets, their leverage and their hyperspending, the top 1% have income swings that now are more than twice as high as those of the rest of the population.” (See, “The Truth About Wealth.”)

A November Federal Reserve study found that “a third of the people in the top 1% in 2007 . . . were no longer in the top 1% in 2009.”  A report commissioned by J.P. Morgan Private Bank, found that only 15% of the Forbes 400 stayed on the list over a 21-year period.

But even the little guys suffer huge swings in the value of their assets, as mortgaged homes sink underwater and stock prices gyrate wildly.  The total amounts may be less, but the volatility can be the same. The rich may be more prone to these dangers than the rest of us.  Not used to worrying about paying the bills, they can more easily neglect the bottom line.  But the dangers apply to everyone.

The Journal went on to list the underlying causes of this volatility, none of them surprising to any who have given more than a moment’s thought to guarding their investments against excessive risk.

Overconcentration in one asset or class of assets.

Leveraging debt to support speculation or lavish lifestyles.

Spending based on false assumptions or paper profits.

These dangers boil down to matters of common sense and self-delusion, psychological factors that could be corrected if we paid more conscious attention to our behavior.  Most of us tend to put too high a valuation on our assets in order to give ourselves an emotional boost.  Extra money not only feeds our fantasies about what we can buy, but it also makes us feel more important and successful.  On the other hand, we are reluctant to accept lower valuations and the lesser status they entail.

Behavioral economists have been familiar for sometime with the fact that we all tend to be “loss averse.”  That is, we put off accepting that our investments have declined in value, often to the point that profits turn into losses.  Or we succumb to the “money illusion,” the belief that the price tag accurately reflects the value of what we own, neglecting to correct for inflation, for taxes, for fees.

Rich or poor, we all struggle to hold on to a realistic and reliable grasp of what we have.  Our minds continually flirt with “beta” values — and frequently succumb to unnecessary loss.

Less Than They Think

What justifies the bloated expenses of the finance industry, the exorbitant salaries, percentages taken off the top, the finder’s fees, the bonuses?  We have to wonder what do bankers do that justifies the added cost of their services?

The cynical view is that they “take money from one pot, skim some off the top, and put it into another pot.”  But that can be actually useful, argues Thomas Philippon, professor at N.Y.U.’s Stern School, as that money is often needed to finance start-ups or expand existing enterprises.  And since there is a real service performed and some risk in performing it, they should be compensated.

Moreover, there has been genuine innovation in designing ways to measure risk and leverage resources.  As a result, less money can stretch further and do more, and that is an increase in productivity that deserves to be rewarded.

On the other hand, of course, is the fact that all too frequently those innovations led to a reckless denial of risk.  It wasn’t so much that assets were leveraged to an alarming degree, which they were during the credit bubble.  The more serious problem was that the original assets were over-valued to begin with and repackaged to conceal the real risk they held.  Driven by frenzied competition for investors, banks failed to question their decisions and, in many cases, the risk-management procedures they put in place were circumvented or just ignored.

As Kim Stephenson has pointed out on Mindful Money, new rules are not likely to work.  “Apart from anything else, you simply start an ‘arms race’ to see who can subvert the rules most effectively.”  But just as legitimate innovation can and should be rewarded, failures and lapses can and should be punished. (See, “Tough on Pay, Tough on the Causes of Pay.”)  And the banks that are too big to fail can be broken up.

Investors who were hurt by the catastrophic collapse of financial markets and the continuing weakness of the economy are rightfully upset that the punishment never happened.  The banks, in fact, are bigger than before.  The public is upset as well.  Enormous amounts of tax money were used to bail out the industry.  That amounts to a subsidy of failure, or what has been called “moral hazard.”  There has been no lesson to learn.

So it is time to look at our underlying assumptions about the finance industry, and that is what Philoppon has done in research reported in The Wall Street Journal.  Last year, finance accounted for 8.4% of our GDP in the U.S. – compared to 2.8% in 1950.  That’s a huge increase, but Philippon argues that the value finance adds to our GDP today is 2% below its current share.  In other words, it should be a bit over 6%.  That would be a reduction of almost 300 trillion dollars for the U.S., 45 trillion for the UK, using World Bank estimates.  (See, “Number of the Week: Finance’s Share of Economy Continues to Grow.”)

Those are sobering figures.  And they provide a hint about how much of a correction would be warranted if we could think rationally about what we were getting from bankers for the money they are getting from us.