Broken Trust

A fundamental problem in the financial markets right now - a problem that's often traced to the failure of Lehman Brothers last month - is the breakdown of trust. Because financial institutions don't "trust" the solvency of other institutions and corporations, they aren't willing to lend money. The end result is a frozen credit market. This is precisely what happened during the Great Depression. After Black Friday, the public lost confidence in the economy, and people began to hastily withdraw their money from banks. The result was a rash of bank failures, and an even larger push to withdraw cash. From 1929 to 1933, over nine thousand banks collapsed, leading to a loss of deposits worth over $6 billion. Because the normal bonds of economic trust were broken, a moderate recession became a devastating and deflationary depression.

But what triggers the breakdown of trust? In recent years, there have been some really interesting experiments that help answer this question. In a recent article, I wrote about some pioneering work performed by Read Montague:

The experiment was born out of Montague's frustration with the limitations of conventional fMRI. "The most unrealistic element [of fMRI experiments] is that we could only study the brain by itself," Montague says. "But when are brains ever by themselves?" And so Montague pioneered a technique known as hyper-scanning, allowing subjects in different fMRI machines to interact in real time. His 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, Montague was 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? It turned out that the caudate worked just like the reward cells in the monkey brain. 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. (Montague is currently repeating this experiment with a collaborating lab in China so that he can detect the influence of culture on social interactions.) The point, he says, is that people were using this TDRL strategy -- a strategy that evolved to help animals find caloric rewards -- to model another mind. Instead of predicting the arrival of juice, the neurons were predicting the behavior of someone else's brain.

The moral is that trust is ultimately about the expectation of rewards. 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. These "rewards" were taken for granted.

But now, in the last few weeks, those rewards have disappeared. The S&P is plummeting, money funds have "broken the buck," and banks are going bankrupt. The point is that these financial losses aren't simply monetary: because of how the brain computes trust, they are also personal. The end result is a collapse in the bonds of trust that all markets depend on.

So what should Bernanke and Paulson do? The problem is that restoring trust is ultimately about rewards, not reassuring statements or congressional plans. 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.

PS. One way to think of the financial markets right now is that instead of being populated by rational agents, they're full of people with borderline personality disorder.