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The Cost of Freedom, the Savings of Trust

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We don’t usually think of trust and freedom as existing in a trade-off relationship. But in an important sense, they do. Thinking about the two factors this way allows us to view trust from an unusual perspective.

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Kathy Sierra has a great post on the degree to which software designers should design in user freedom – there are limits.

On the face of it, freedom is good. More freedom is better. In fact, if it doesn’t threaten us bodily harm, then more freedom is way better. Isn’t it?

Not so. Sierra offers a 2×2 matrix relating payoff to effort. The payoff is good for things like Amazon. But digital home thermostats and new stereo systems give us too much freedom for the payoff. They’re just a pain.

There is a limit beyond which freedom of choice generates shutdown. Barry Schwartz’s The Paradox of Choice explores it well. After a while, complexity overwhelms the desirability of choice.

Sierra and Schwartz happen to illustrate the economic relationship between freedom and trust. In a nutshell, we give up freedom of choice in return for more efficient use of our time. We do it with trust.

Branding is the corporate version of trust. Rather than analyze every brand of bottled water, every version of jeans, or every make and model of HD-TV, we abdicate our freedom to do so in return for the security of a brand name. We trust Sony, or Coke, or Amazon, to make acceptably acceptable selections for us—so are freed to make other decisions.

But trust is about more than branding.

The last two centuries of global economic development have been driven by the search for division of labor. Adam Smith’s pin-makers organized around 19 specialized operations; it was far cheaper to assign individuals to distinct operations than to have each operator do all operations.

The transaction cost of coordination was well below the benefits of specialization.

At a corporate level, transaction costs remained high at the turn of the 20th century; early US auto companies made their own tires rather than incur the cost and risk of buying tires from others.

As transaction costs declined, it became more feasible to contract work out – the history of the auto industry is one of moving from integrated manufacturers to contract assemblers.

In recent years, we’ve seen diverging trends: lower unit transaction costs, and higher volumes of transaction costs. The net effect has been driven more by volume than by unit cost. Transaction costs as a percent of GDP have been going up. By one estimate, they now exceed 50% in the US.

We are reminded constantly of the internet’s effect on lowering unit transaction costs; but we don’t notice that the total of such costs is rising.

Here’s what it means: for further economic efficiency, the ability to reduce transaction costs is going to become more critical than further division of labor.

The more technically and globally integrated we get, the more freedom of choice we get. But at some point, freedom of choice becomes overwhelming.

If I want to make and sell jeans, I probably have dozens (hundreds? thousands?) of ways to contract the work out. Past some point, I don’t want more options—I want someone I can trust to make that decision for me.

In other words, I’ll give up freedom in return for lower transaction costs. The currency of that exchange is trust.

In an economy where half the costs are transaction costs, the currency of trust is massively valuable. Think of the transaction costs between auto producers and their suppliers: lawyers, agreements, contracts, specifications, bonus systems, QC, compliance, etc. Suppose they were 100% obliterated by trust. What kind of marketplace cost reduction would that provide?

Trust is not soft stuff. In a world that is getting massively more connected, greater trust has a very real economic role to play.

Giving up freedom for trust can be, paradoxically, a very freeing thing.

Trust and Regulation

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Regulation is a social substitute for trust.

That’s not a moral statement, just a factual one.

Sometimes the relationship between trust and regulation is obvious We submit to the regulation of traffic laws because we can’t trust everyone will simultaneously interpret the rules of the road similarly. And, when stoplights fail, we trust the regulation of traffic cops, whose very jobs are the result of a citizenry’s decision to be regulated.

Another regulatory no-brainer would seem to be the “commons,” i.e. a situation where, at the margin, it’s in everyone’s personal best interest to behave selfishly. Except that, when everyone does so, everyone turns out the loser. (In game theory, the “prisoner’s dilemma” spells this out). We can’t trust everyone (or even most people) to do what’s socially good, so we submit to regulation.

So it is we end up with regulated airspace and water tablesthough there are still crazies who insist they should be able to fly anything anywhere anytime, and drill any water drillable beneath their half acre of Arizona; plus, we still over-fish.

Closely related are natural monopolies, e.g. utilities (except, bafflingly to me, water companies in the UK). These businesses left unregulated will drift, often quickly, to monopolies. Much of regulatory debate is how to balance society’s interest vs. the normal trappings of markets. (Can we trust Microsoft to innovate? Airlines to share route rights? Telecom companies to share scale economies?)

The right degree of regulation for natural monopolies would be an easy matter for industrial economists, if only political ideologues nattering about free markets vs. socialism would leave them alone.

Much less is clear when it comes to naturally competitive markets in which people and companies behave in an untrustworthy manner toward customers, shareholders, employees and society. Here the issues become more clearly trust-related.

Can we trust the stockbroker’s motives when he recommends a stock? The food company’s label of ‘organic?’ Can we trust that the insurance company will be there when it’s claim time? Can we trust that a corporate email sent in confidence will be treated as such? That a doctor’s prescription is not unduly influenced by a pharmaceutical company?

Here are a few social policy rules of thumb for thinking about the relationship between trust and regulation.

1. Trust—where possible—is preferable to regulation. It avoids moral hazard; it is cheaper; and it is specific to the situation at hand.

2. Industry associations have a potentially powerful role to play. Too often they see their role as defenders of their constituents against regulation, rather than the far more constructive and long-term perspective of evolving powerful self-regulation. (I have blogged on this topic before; for mortgage banking, see my blogpost here; ; for financial planning, see here. Or, simply look at the regulatory nightmare the pharmaceutical industry has become, largely by failure to self-regulate.)

3. Certain industrial economics criteria cry out for regulation. If no one—investor, regulator, customer—has an integrated interest across a sector of business, then the situation is rife for abuse. The securitized mortgage industry had no one with an integrated perspective.  Regulation becomes by default attractive in such cases.

4. All else equal, short-term perspectives destroy trust and invite regulation.

5. Transparency may be the least costly form of regulation. It works best when obvious  It works best when obvious: e.g., "smoking causes cancer," or "these assets were marked to market."  Transparency as "the fine print" loses its power quickly. 

6. If an industry is fond of saying things like “caveat emptor,” or “hey it’s not illegal,” or “we’re only giving the consumer what they want,” look out. This is defensive language, typically used against stakeholder complaints—Big Tobacco, Big Food, and, I suspect, melamine producers in China.

7. Personally, I think business-school faculty have a huge responsibility. In an increasingly hyper-linked world, the competition-centric ideology taught as “strategy” is increasingly dysfunctional. It destroys trust by teaching that the natural state of business is to compete against our suppliers and customers, rather than to collaborate with and serve them.

By destroying trust, it invites regulation. Which, as stated in point one above, is the less preferable of the two.

Business, heal thyself; it’s better for all.

Trust-based Selling in the Real World: Case Study #24

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“Alex” (not his real name) is a friend and ex-client.

Alex leads a Private Client practice for a private wealth management firm in a country whose name I will not reveal, but which lies somewhere to the north of the United States.

We talked about his approach to managing his clients’ money. First thing he notes—it’s not just about managing their money.

“They need help from time to time in various aspects of their lives,” Alex says. “I get to know about these issues because they have financial impacts. Marriage, Children, College, Divorce, Insurance, Disease, I hear about them all. It is important to weave all aspects of the client’s life through their financial affairs, nothing personal happens in isolation.

“I cultivate a network of people I know, respect, and trust. Exceptional people who understand the power of relationships; people in real estate; divorce mediation specialists; psychologists; medical specialist; and educators who can help my clients. Whatever it is that they need—I make it my business to help them.

What do your colleagues think of this, I ask?

“They don’t get it. They say there’s no money in those things. I say that’s not the point… I’m in this profession to help people. But in the long term, they are dead wrong—in fact, there is money in this.

“For example, I spent an hour talking with the19-year-old daughter of a client about how to manage her $3,000. I took flak from colleagues for that too. But what they forget is how delighted her father was that his daughter was getting sound financial advice at age 19.

"And he has considerably more than $3,000… as will his daughter, sooner or later. My relationship is with their family.”

“What my colleagues forget is that this is a relationship business. Clients are referred by their parents, their children, friends, colleagues, accountants, lawyers etc. This only happens if you play for the long run.

“But it works; it works beautifully. Some people in my business focus on their transactional income, or look for ways to go seeking more clients through seminars or mailings. I focus on the relationships with my clients and appreciate when they invest in my business through referrals… my cost of marketing is nil.

“But perhaps most importantly, I spend my working days helping people, people I like. My practice is built on relationships where I enjoy working with the clients and they enjoy working with us. How much better can work get?”

How Does Wealth Inequality Affect Trust?

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An old Frank Zappa lyric went, “What’s the ugliest part of your body? I think it’s your mind.”

Similarly, we might ask, “What’s the lowest-trust place in (corporate) America? I think it’s Wall Street.”

Which brings us to the latest issue of Harvard Business School Working Knowledge.

I find HBSWK a pleasure to read—they identify the coolest topics for study. The treatment of those topics—well, that can be quirky.

One fascinating current item is “The Dynamic Interplay of Inequality and Trust: An Experimental Study,” by Ben Greiner, Axel Ockenfels, and Peter Werner.

Here’s the (partial) synopsis:

We study the interplay of inequality and trust in a dynamic game, where trust increases efficiency and thus allows higher growth of the experimental economy in the future. We find that trust is initially high in a treatment starting with equal endowments, but decreases over time. In a treatment with unequal endowments, trust is initially lower yet remains relatively stable.

Cool! An egalitarian society shows a greater decay of trust than one with initially disparate endowments? The implications for political theory, economic policy and social dynamics are juicy, to say the least.

The “dynamic game” the authors use to add some empirical juice to theoretical discussions involves a trustor and a trustee. In a series of interactions, the trustor offers a sum of money to the trustee, which sum is then multiplied by the game; the trustee then returns a certain amount to the trustor.

As the authors say, “The amount sent can be interpreted as a measure of trust, while the amount returned measures the degree of trustworthiness.”

Then ensues 20 pages of analytical bludgeoning. Did you know about the Wilcoxon Matched Pairs Signed Ranks (WMPSR) test? Me neither. Did you know the lowest Gini factor ever measured was in Bulgaria in 1968?

I am numbed and humbled; you could say I’m numbled.

And sure enough, the graphs show a decrease in trust if all players start equally, vs. a low-trust start with sustained low trust if players begin with inequality.

But wait a minute! What happened to Frank Zappa?

The appendix lists the instructions given to the players in this game. Here they are:

Welcome! You can earn money in this experiment. How much money you earn depends on your decisions and the decisions of the other participants…it is guaranteed that you do not ineract with the same participant in two subsequent rounds…The identity of the participant you are interacting with is secret, and no other participant will be informed about your identity.

OK, so I want to measure the role of trust and inequality in an economy. Where should I go?

Los Angeles? Omaha? Detroit?

Nah. Let’s go somewhere people aren’t distracted by entertainment, or meat-packing, or cars.

Let’s go where people interact solely around money. Anonymously. And never with the same person twice. (Blindfolds and knives might make it even more interesting).

And let’s call that a trust experiment.

If this game had a geographical correlate, it would have to be the Land of Gekko, where Fear and Greed are baseline hiring criteria—Wall Street.

Not exactly where I would have suggested one go searching for insights about trust.

What’s the ugliest part of that trust? I think it’s the game.