Tuesday, October 25, 2011

Trust and mistrust

Many economists agree that today the U.S. economy is caught in what Keynes called a “liquidity trap.” While the Federal Reserve Bank is engaged in what is called “quantitative easing,” essentially increasing the money in circulation, banks and companies are awash in cash. One result is that the Fed is trying to “push on a string.” No amount of easing can convince financial and non-financial institutions to lend or invest the money they already have.

The preference for liquidity means that decision makers are unwilling to take the risk of investing dollars in their own projects or the projects of borrowers. One question is why there is so little tolerance for risk, or conversely so much desire for safety. There are two kinds of risks to consider, market risk and counter-party risk. The former is familiar. We can never be certain that a project will pay off. The future is unknown. But the latter risk is less common. It is based on a suspicion that appearances are deceiving. Just because a company or banks says that its earnings, cash flow, book value, are “X,” does not mean that this is so. At the height of the financial crisis, counterparty risk was pronounced, because decision-makers did not how to value the mortgage backed securities that formed such a large part of commercial and investment banks’ portfolios. The “books” could not be trusted. As a result, financial institutions stopped lending to each other in the “repo” or repurchase market. They could not trust that the collateral for such loans was properly valued. One argument suggests that counterparty risk is one reason the Federal Reserve Bank has failed to stimulate economic growth. All the money in the world cannot reduce mistrust.

Perhaps this is a reminder of how much our markets depend on trust. We trust that the U.S. government will never default on its bonds, and that it can, if it wishes, lend “its full faith and credit” to other entities who want to borrow our money.  It is also why inflation is an emotional as well as a economic issue. Should inflation devalue the dollar we would interpret this as the government’s violation of our trust in its currency. One-reason investors trusted the faulty assessment of the bond-rating agencies, such as Fitch and Moody’s, is that they are a part of a quasi-monopoly sanctioned by the government.

But there is another kind of trust that is not trust in others, but trust in oneself. From a psychodynamic point of view, a person can trust himself because he has an internalized image of his parents and siblings as loving and beneficent. The psychological equation goes something like this, “If the most important people in my life loved me, then surely I can trust my own impulses.” People fortunate enough to have had such an experience can make decisions with emotional conviction.

Such people naturally gain the confidence and trust of others, as they should. The dilemma is that sometimes people can project what we might call a “pseudo-conviction.” This is based on an internal experience of feeling defective, of being unlovable, but the resulting despair can lend an urgency to the wish that one’s needs be met. Here the psychological equation goes like this, “Only by being admired and loved will I be able paper over my defects.” We call such people narcissistic, and if they have a modicum of talent, they too can win the trust of others by virtue of their drive and sense of urgency.

The problem is that such people are more likely to play fast and loose with data that purport to measure economic value. The desire for admiration undermines their integrity.  Beginning in 2001, several years before the financial crisis, Lehman Brothers recorded a temporary loan of securities, as the sale of securities, so that at the end of each quarter it looked like they had more cash than was the case. News reports also suggest that during the financial crisis itself, Richard Fuld, the CEO of Lehman Brothers, could not tolerate the idea that the firm was worth far less than he imagined, and that this stubbornness contributed to the firm’s demise. His refusal may have reflected his own narcissistic investment in the glory of the firm, the same emotional investment that enabled misleading accounting practices. One compelling issue worthy of exploration is what role narcissism played in the run up to, and the unfolding of, the financial crisis.


  1. Larry,
    I don't think it is possible to get a full understanding of the breakdown of trust in our society without a consideration of politics. Such considerations tend to generate acrimony, but there is no good reason why that cannot be avoided. With that as a wish, I suggest that in complex society, large scale economic transactions will not be undertaken unless it is believed that the laws that guarantee the fulfillment of contracts will be faithfully and disinterestedly executed. The conservative view is that the present administration has subordinated the disinterested execution of contracts to the advancement of the interests of favorites. This began almost immediately with the auto industry bailouts when the interests of shareholders, secured creditors, were illegally subordinated to the claims of the unions, who were unsecured creditors. This sort of thing has continued apace, with the most recent case being Solyndra , where the claims of taxpayers were illegally subordinated to those of certain private investors. This situation is not helped when the President cannot seem to open his mouth without echoing Proudhon's proposition that "Property is theft." According to this view, the Federal Reserve can pump as much money into the economy as it likes, and it will serve only to fatten companies' balance sheets without leading to investment. Who would invest if they thought the profits would be confiscated?

  2. With the auto companies going bust the shareholders had no claim- their claim is residual. The bond holders did have a claim but it is very common for bond holders to take a haircut in order to sustain the enterprise. This is what is being discussed right now in Europe. It seems to me that without government intervention the companies would have been sold at book value --essentially for scrap and net accounts receivable. Union workers received no extra pay as a result of the transactions- that is happened only now with the successful negotiation of new projects.

    As far as I know tax payers have no legal standing to claim a share of profits that accrues to companies that sell to the government or get subsidies from the government.

    The fed reserve pumps money into the economy by buying bonds from bondholders. It is a market exchange- I don't see the theft here.

    I think your comment reflects an exaggeration.