Failing Trust Has Led to Failing Markets

Trust has taken a leap to the foreground given the implosion of financial markets. And rightly so.

Irish economist and market researcher Gerard O’Neill writes:

"…the essence of the present financial crisis is a collapse in trust: including trust between banks and other banks; between banks and their customers; and indeed between banks and governments."

O’Neill cites a BBC program that asks the question, “Is trust evaporating in contemporary society? Does more monitoring of people and politicians increase trust, or encourage paranoia?”

Robert Reich, former US Labor Secretary turned academic, has also been waxing eloquent on the subject, on TV Talk Shows and on the radio:

…why are the free marketeers in the Bush Administration rushing to Wall Street’s aid? The answer goes deeper than the subprime mess. The Street has suffered a serious decline in trust…Yet trust is its most important asset. Financial markets trade in promises — that assets have a certain value, that numbers on a balance sheet are accurate, that a loan carries a limited risk. If investors stop trusting those promises, Wall Street can’t function.

…It worked great as long as everyone kept trusting and the market kept roaring. But all it took was a few broken promises for the whole system to break down.

There are two debates going on now. One is political, built on pent up resentment and schadenfreude—the Main Street vs. Wall Street argument. The other is ideological—free markets vs. regulation. Both are somewhat bogus, but I’ll stick to the second.

Pure free markets exist only in economists’ imaginations—thank god. Competition is inherently instable. The goal of every competitor is not to maintain a state of competiton, but to obliterate that state—often by colluding, sometimes by winning. Imagine a football game without referees. Every functioning market needs some regulation to avoid imploding into a black hole of monopoly.

But neither is “more” regulation the right answer. Regulation by bureaucrats, cronies, incompetents or the venal is not much better than anarchy.

“Who” and “how” are critical regulatory questions. And there are some basic principles. You’d think they’d be obvious, but they are frighteningly easy to lose track of.

One is transparency. Nothing cuts out envy, suspicion, and temptation better than sunlight. Yet the SEC and Congress allowed an entire set of financial products and markets to be invented—out of sight. Opponents of mark-to-market accounting—please explain to me how politicians can make valuations more transparent than accountants plus a market can do?

Another is time. The more fragmented and transactional the business model, the more is needed some timeframe over which society can see relationships and consequences between those transactions. If the industry manages itself solely through zero-sum one-off deals, then regulators must provide that longer-than-a-nanosecond view.

A third is the connection of the parts to the whole. The mortgage industry is a perfect example: it used to be that mortgage agents, lenders, home-owners and mortgage-holders interests’ were all aligned. A year ago I wrote about a 1995 economists’ view of the industry as it looked then, vs. the disaster-in-the-making it had become. The difference was all disconnected parts with no one minding the holistic store—no one in industry, no one in regulation.

I usually write about personal trust; that’s the “pure” version of the stuff. But make no mistake, trust is critical socially. Some industries can self-regulate, based on the three principles above. Though just now, offhand, I can’t think of any examples.