It is now abundantly clear that the global economy remains mired in a dismal slump. Consumer confidence is still hurting; the unemployment is still rising; home prices are still falling. Despite the best efforts of Congress and the Treasury Department, nobody knows where the bottom is, or when it will arrive.
Obviously, there are no easy solutions. But it’s worth considering how we got here if only to better understand how we might get out. One way to look at the current mess is as a collective breakdown of trust, which led (after the failure of Lehman Brothers, etc.) to frozen credit markets: because financial institutions didn’t “trust” the solvency of other institutions and corporations, they weren’t willing to lend money. Without trust, nobody will take risks.
In recent years, economists have devoted plenty of thought to the importance of trust in the modern economy. Tim Harford had an excellent column on the subject in Forbes:
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. If you make $40,000 a year, then $200 is down to hard work and $39,800 is down to trust.
How could that be? Trust operates in all sorts of ways, from saving money that would have to be spent on security to improving the functioning of the political system. But above all, trust enables people to do business with each other. Doing business is what creates wealth.
Here is where the brain comes in handy. Looking at how trust unfolds in the cortex won’t solve the economic crisis, or even lead to new proposed solutions. The mind is way too mysterious for that. But I think there’s some experimental evidence that can help clarify our thinking about what economic trust is and why it breaks down.
Consider this elegant investigation of trust, led by Brooks King-Casas, Colin Camerer, Read Montague, et. al. The research was born out of a serious limitation of conventional fMRI, which looks at the brain by itself. (An individual is put in a claustrophobic scanner and told to perform a task.) Humans, of course, are a social species, so the scientists (led by Montague) pioneered a technique known as hyper-scanning, which allows subjects in different fMRI machines to interact in real time.
The experiment revolved around a simple economic game in which getting the maximum reward required the strangers to trust one another. However, if one of the players grew especially selfish, he or she could always steal from the pot and erase the tenuous bond of trust. By monitoring the players’ brains, the scientists were able to predict whether or not someone would steal money several seconds before the theft actually occurred. The secret was a cortical area known as the caudate nucleus, which closely tracked the payouts from the other player. (The caudate is usually discussed in the context of addiction, since it plays a central role in modulating our expectation of pleasure.) Montague noticed that whenever the caudate exhibited reduced activity, trust tended to break down.
But what exactly is the caudate computing? How do we decide whom to trust with our money? And why do we sometimes decide to stop trusting those people? At first the caudate didn’t get excited until the subjects actually trusted one another and garnered their separate rewards. But over time this brain area started to expect trust, so that it fired long before the reward actually arrived. Of course, if the bond was broken – if someone cheated and stole money – then the neurons stopped firing; social assumptions were proven wrong.
The moral is that trust is ultimately about the expectation of rewards. Trust may be an admirable social trait, but it’s ultimately rooted in a greedy calculation, emanating from our primal dopamine reward circuitry:
Taken together, these results suggest that the head of the caudate nucleus receives or computes information about (i) the fairness of a social partner’s decision and (ii) the intention to repay that decision with trust. In early rounds of the game, the ”intention to trust” is evident only after an investment is revealed. With experience, this signal shifts to a time preceding the revelation of the investment.
What does this have to do with the economy? Over the last few decades, investors have grown accustomed to predictable rewards coming from the financial markets. We were used to our 7 percent return in the stock market, that 4.5 percent return from a money fund, and that 2 percent return from our bank account. We assumed our homes would always increase in value. In other words, these “rewards” were taken for granted. (It hasn’t helped that the last severe recession arrived in the early 1980′s, more than 25 years ago. People forgot that these financial rewards were contingent, just like the players in the trust game who were shocked that someone would abscond with their cash.)
When those rewards disappear – when home prices fall, and borrowers default, and the markets flatline – the end result is a collapse in the bonds of trust that all markets depend on. The problem, of course, is that restoring trust is ultimately about rewards, not reassuring statements or grand plans from Congress. Until those financial rewards start to feel predictable again – and that may take a long, long time – investors will continue to be wary of each other, just like people who got burned in the brain scanner.