How To Solve the Economic Crisis

The Economics of Trust

A 2005 letter in premier scientific journal Nature reviews the research on trust and economics:

Trust … plays a key role in economic exchange and politics. In the absence of trust among trading partners, market transactions break down. In the absence of trust in a country’s institutions and leaders, political legitimacy breaks down. Much recent evidence indicates that trust contributes to economic, political and social success.

Forbes wrote an article in 2006 entitled “The Economics of Trust”. The article summarizes the importance of trust in creating a healthy economy:

Imagine going to the corner store to buy a carton of milk, only to find that the refrigerator is locked. When you’ve persuaded the shopkeeper to retrieve the milk, you then end up arguing over whether you’re going to hand the money over first, or whether he is going to hand over the milk. Finally you manage to arrange an elaborate simultaneous exchange. A little taste of life in a world without trust–now imagine trying to arrange a mortgage.

Being able to trust people might seem like a pleasant luxury, but economists are starting to believe that it’s rather more important than that. Trust is about more than whether you can leave your house unlocked; it is responsible for the difference between the richest countries and the poorest.

“If you take a broad enough definition of trust, then it would explain basically all the difference between the per capita income of the United States and Somalia,” ventures Steve Knack, a senior economist at the World Bank who has been studying the economics of trust for over a decade. That suggests that trust is worth $12.4 trillion dollars a year to the U.S., which, in case you are wondering, is 99.5% of this country’s income. ***

Above all, trust enables people to do business with each other. Doing business is what creates wealth. ***

Economists distinguish between the personal, informal trust that comes from being friendly with your neighbors and the impersonal, institutionalized trust that lets you give your credit card number out over the Internet.

Similarly, market psychologists Richard L. Peterson M.D. and Frank Murtha, Ph.D. wrote in October:

Trust is the oil in the engine of capitalism, without it, the engine seizes up.

Confidence is like the gasoline, without it the machine won’t move.

Trust is gone: there is no longer trust between counterparties in the financial system. Furthermore, confidence is at a low. Investors have lost their confidence in the ability of shares to provide decent returns (since they haven’t).

And two professors of finance write:

The drop in trust, we believe, is a major factor behind the deteriorating economic conditions. To demonstrate its importance, we launched the Chicago Booth/Kellogg School Financial Trust Index. Our first set of data—based on interviews conducted at the end of December 2008—shows that between September and December, 52 percent of Americans lost trust in the banks. Similarly, 65 percent lost trust in the stock market. A BBB/Gallup poll that surveyed a similar sample of Americans last April confirms this dramatic drop. At that time, 42 percent of Americans trusted financial institutions, versus 34 percent in our survey today, while 53 percent said they trusted U.S. companies, versus just 12 percent today.

As trust declines, so does Americans’ willingness to invest their money in the financial system. Our data show that trust in the stock market affects people’s intention to buy stocks, even after accounting for expectations of future stock-market performance. Similarly, a person’s trust in banks predicts the likelihood that he will make a run on his bank in a moment of crisis: 25 percent of those who don’t trust banks withdrew their deposits and stored them as cash last fall, compared with only 3 percent of those who said they still trusted the banks. Thus, trust in financial institutions is a key factor for the smooth functioning of capital markets and, by extension, the economy. Changes in trust matter.

They quote a Nobel laureate economist on the subject:

“Virtually every commercial transaction has within itself an element of trust,” writes economist Kenneth Arrow, a Nobel laureate. When we deposit money in a bank, we trust that it’s safe. When a company orders goods, it trusts its counterpart to deliver them in good faith. Trust facilitates transactions because it saves the costs of monitoring and screening; it is an essential lubricant that greases the wheels of the economic system.

Americans clearly don’t trust the bankers and the financial bigwigs.

Indeed, as leading economists have pointed out, the big financial institutions don’t trust each other, because they know that all of the other companies might have hidden their problems or gamed their books (see this, for example). See also this.

There’s Nothing We Can Do!

The main problem we are facing is that our leaders are pretending that there is not much they can do to fix the economic crisis.

But the truth is that the powers-that-be are getting too many perks from the current system to really fix it.

Let’s look at an analogy. A gang member keeps on getting thrown into jail for selling cocaine. The court-appointed psychiatrist says “why don’t you stop?”. The gangbanger says “I don’t know how to stop”. In reality, the gentleman is making money dealing cocaine, and maybe getting a sense of safety and community in belonging to a gang.

Or here’s an analogy closer to home for me. My very young daughter frequently throw tantrums. When my wife and I tell her to stop screaming, she says “I don’t know how to stop.” We tell her she just has to decide to stop screaming, and then the screaming will stop. She repeats “No, I don’t know how to stop!” and keeps on screaming. Obviously, the pay-off of getting our attention (and getting our goat) makes it worthwhile for her to keep on screaming.

Similarly, Bernanke, Geithner, Summers, Barney Frank, Chris Dodd, Obama and the rest of the gang pretend they don’t know how to fix the economy, because, in reality, their corporate funders don’t want it to be fixed.

How Can We Fix the Economy?

Given that there is a total breakdown in trust, our leaders can only help to turn the economy around if they admit that they’ve blown it.

They have to admit that:

  • The entire modern financial system has been built on a house of cards (see this and this)
  • Our economy cannot prosper without a strong manufacturing base, and without services which actually help people (instead of doing othing but shuffling money around from one financial desk to another)
  • They allowed far too much leverage in the system and far too much fractional reserve banking
  • Throwing more money at the too-big-to-fail companies will not help anything, and that it is the American people who need relief
  • The Fed can’t simply blow one bubble after another to rescue the economy
  • Things have been shrouded in too much secrecy, and that we need radical openness of the financial system

If our leaders admitted these things, trust would be restored, and we could get back to work and restore our economy.

Can’t be done! Not politically realistic!

Sure, the cocaine dealer and my little girl say the same thing.

What it means is that they don’t want to change because they would lose their perks.

Note 1: Americans no longer trust the politicians, the justice system, their ability to obtain liberty, or the media. Americans know that the boys lied us into war in Iraq (which has bankrupted us to the tune of $3-5 trillion dollars), imported communist Soviet Union torture techniques and then said “we don’t torture”, spied on Americans (even before 9/11 … confirmed here and here) while saying “we don’t spy”, and covered up the facts about 9/11 (even the 9/11 Commission thinks there was a coverup … see also this).

Therefore, I passionately believe that a new honesty has to take place among our government and corporate institutions, and that the truth about these crimes has to be fully revealed before our economy will fully recover.

Unrealistic? Idealistic? Not feasible? Okay, but then trust will not be restored and the depression might last decades, with widespread violence the possible result.

Note 2: It’s obvious that many politicians think they have to do something about the economic crisis. And so they throw trillions of dollars into bailouts, “loans” and other schemes which are actually making the problem worse.

This is the flip side to the problem of pretending you can’t do anything. Doing something just to be doing something isn’t very smart – especially when restoring trust would cost trillions less and would be much more effective.

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