These are unprecedented times for our economy (at least since the Great Depression). No one would have predicted several years ago that we’d see the federal government forced to take over the two largest mortgage holders (Freddie Mac and Fannie Mae), the largest worldwide insurer (AIG), and 3 of the 5 largest investment banks forced either to sell at bargain-basement prices, declare bankruptcy or get government assistance (Merrill Lynch; Lehman Brothers; Bear Stearns, respectively).
Underlying the well-working of the whole economic system both at the micro and macro level is trust. Other scholars have written about this before, most notably James Coleman in his 1988 discussion of Jewish diamond merchants in New York (“Social Capital in the Creation of Human Capital“); the merchants’ interconnecting networks and interpersonal trust allowed them to freely lend diamonds to each other for examination and ensure that the bags were honestly returned. The social networks helped ensure that any short-term gains to be made through dishonesty would be swamped by being shunned in the future when one’s poor reputation spread through these networks.
But at the macro level, our economy also depends on trust: Trust that the banking systems will continue to work. Trust that the U.S. government will be in a position to pay back all the money it borrows for Treasuries. Trust that stocks will go up or are a good place to park retirement assets. Trust that one’s money market fund that has nominally had an unguaranteed $1 per share price will continue to be so valued. Trust that funding will be available in the future at reasonable rates.
When trust starts to dry up, these well-oiled financial systems can become remarkably rusty and liquidity and access to capital can dry up amazingly fast. At the same time on Tuesday that AIG was trying to get billions pumped into their operations, they had a remarkably hard tapping credit; the benchmark inter-bank LIBOR rate (used to peg many variable rate mortgages) literally nearly doubled in one day.
One of the spectacular ways in which one sees trust underlying our economy is in bank failures. While some bank runs are driven by fraudulent activity by the bank that suddenly cause everyone to question whether their assets’ security, normally we live with the fiction that our assets are there for us. In reality of course, our bank deposits aren’t sitting in the bank, but the bank has lent out our money to make more money and to be able to pay us interest, meet their expenses and make a profit. The banks keep some small reserves to cover the expected levels of daily withdrawals, but these are desperately inadequate when we all decide to do this at the same time and the banks can’t get our cash back fast enough from borrowers. As “It’s A Wonderful Life” styled it, ‘Don’t Look Now, but there’s Something Funny Going on at the Bank, George.’
There was an interesting commentary on bank panics by Jane Kamensky (Brandeis) and this one (LA Times Op-Ed) and a talk show where she discusses the importance of trust to banks.
The FDIC tried to help create trust after the Great Depression by insuring our deposits up to $100,000, hoping that this would avoid runs on banks, although we are learning that this too depends on trust. There is some mounting evidence that the amounts FDIC maintains are not really adequate for a big financial meltdown. The FDIC used up one sixth of their total reserves just paying out to IndyMac depositors when that bank went under this summer. While the FDIC can raise premiums that banks pay for this insurance, at some point they run the risk that these higher payments will in turn make more banks unprofitable and force them to liquidate as well.
The economy is becoming like the veritable sausage axiom, don’t pay too much attention examining how it’s produced.
[For good background on what is going on with the economic woes, see "Diamond and Kashyap on the Recent Financial Upheavals", these NY Times posts, or "Worst Crisis Since '30s with No End Yet In Sight" (WSJ), likening crisis to doctors treating a patient in intensive care.]
Note: HybridVigor has an interesting post that concludes from the financial meltdown in 2008 that “Markets depend on trust, but self-interested egoists don’t engender trust.” More specifically, “When it comes to social trust, free markets are freeloaders. Free markets are most efficient when a high degree of social capital exists, but the “flaw” Greenspan alludes to is simply the friction between egotism and trust. It turns out that trust, not egotism, is what keeps a market in check. But markets today encourage risky, self-centric, and flamboyant behavior. The Laws of Relation predict that relationships set up in this way result in everyone being worse off.”
Note also that David Brooks has a related article 4-5 months after this post called “An Economy of Faith and Trust” (1/16/09)