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.
Congratulations on having your post selected for the July Carnival of Trust, hosted this month by Adrian Dayton at http://adriandayton.com/2009/07/carnivaloftrust/ .
Personally, I could not disagree more with the idea that trust boils down simply to rational calculations of self-interest. But your article regardless raises important issues in a thoughtful manner, hence Adrian's selection, I'm sure.
The Carnival of Trust is a monthly compendium of the best posts loosely related to the subject of trust. Hosted on a rotating basis by thoughtful and critical hosts like Adrian, the limited (10 or so) selections each month are intended to bring good ideas to the Carnivalâs readers, and respect (and readership) to the blogs selected. (A history of past Carnivals can be seen at http://trustedadvisor.com/trustmatters.carnivalofTrust ).
Again, congratulations on your selection for the July Carnival of Trust.
Charles H. Green
Trusted Advisor Associates
This fits well with the tit-for-tat strategy that was described in Axelrod's "Evolution of Cooperation".
There has been some interesting macro-level research on the matter as well. This looks at levels of trust in African societies, which apparently correlate fairly strongly with how affected they were by the slave trade.(Which suggests the very unfortunate punchline that trust isn't something a society rebuilds quickly.)
It might also serve to demonstrate how we make the false assumption that predicting the future will be stable once we perceive the relationship of patterns involved. But Hume so correctly pointed out that this is not the case with in his work known as the Problem of Induction. I think there may also be an important factor in the degree of perceived betrayal. But when the full range of economic incomes that are involved in the market are considered it is probably not wise to use an average of income capital as the base line. The percent of one's risk to asset ratio might be a much better indicator but even then people value assets variably as well. Nevertheless studies have shown that there is a fairly strong ratio that bounds people's risk aversion. It is an extremely messy problem. Retribution might also figure in. I am uncertain of any specific studies but it seems that once some retributive action is rewarded the betrayed party the playing field levels more quickly. The problem with the current economic meltdown is that there is no perceived -or perhaps even actual - means to dole out some kind of placating retribution to all the injured parties to the correct complicit parties.
The world economy in general, and American capitalism in particular, have always essentially been one giant Ponzi scheme, relying on an increasing base of consumers for smooth functioning. For the time being that supply of consumers ran out, not simply because of 'trust' but because of 'fear' which is paralyzing to the financial system. Like all Ponzi schemes it will re-appear in a slightly altered, new-and-improved form for another run, in the endless boom-and-bust cycle.
I'm not sure if it was planned, subconscious, or coincidental, but cooperation is a common root in both this latest blog as well as Jonah's previous blog, "Population Density." In short, cooperation was likely instrumental in the birth of human civilization (âPopulation Densityâ) and without it our civilization breaks down (âTrustâ).
Our global economy is a mess partly because people have taken advantage of cooperative situations, resulting in a loss of trust as well as other things. (Greed is the likely driving force for this behavior.) To hold our global economy together, weâve analogically placed rubber bands around it, but our actions (fueled by our increasing wants and desires) continue to stretch out these new bands to their snapping point. Adding more rubber bands is a temporary fix that isnât going to work forever. We need to create a better system
Being less greedy is a potential starting point towards creating a new system. For example, to control my wants and desires, I indulge, and sometimes allow myself an added 10% luxury, but only in the few things I truly love. So to reference another blog of Jonahâs, I wouldnât spend $170 on a pair of jeans, because I donât really love jeans. If I bought them, I would consider it excessive, and my action would contribute to further strain on the rubber bands on our global economy.
Another potential starting point is to seek out and invest in cooperative situations, but focus on giving whenever possible and taking only when necessary.
Cooperation fundamentally relies on trust as well as win-win outcomes. Cheating is a constant threat within any cooperative framework because it relies on win-lose outcomes. This is why humans are generally very adept at cheater detection and retribution. However, as the scale of human activity gets global, complex and impersonal, the evolutionary faculties lose their relevance. A regulatory framework with checks on cheating and a compensation scheme with couplings to win-win outcomes have to be a necessary part of financial systems and productive economies.