Most policy makers still don't understand the urgent need to restore
trust in our financial system, or the need to prosecute Wall Street
executives for fraud and other criminal wrongdoing.
economists have been saying for well over a decade that trust is
necessary for a stable economy, and that prosecuting the criminals Is
necessary to restore trust.
Trust is Necessary for a Stable Economy
In his influential 1993 book Making Democracy Work, Robert Putnam showed
how civic attitudes and trust could account for differences in the
economic and government performance between northern and southern
Political economist Francis Fukiyama wrote a book called Trust in
1995, arguing that the most pervasive cultural characteristic
influencing a nation's prosperity and ability to compete is the level
of trust or cooperative behavior based upon shared norms. He stated
that the United States, like Japan and Germany, has been a high-trust
society historically but that this status has eroded in recent years.
1998, Paul Zak (Professor of Economics and Department Chair, as well as
the founding Director of the Center for Neuroeconomics Studies at
Claremont Graduate University, Professor of Neurology at Loma Linda
University Medical Center, and a senior researcher at UCLA) and Stephen
Knack (a Lead Economist in the World Bank's Research Department and
Public Sector Governance Department) wrote a paper called Trust and Growth, arguing:
Smith (1997 ) observed notable differences across nations in the
'probity' and 'punctuality' of their populations. For example, the Dutch
'are the most faithful to their word.'John Stuart Mill wrote: 'There
are countries in Europe . . . where the most serious impediment to
conducting business concerns on a large scale, is the rarity of persons
who are supposed fit to be trusted with the receipt and expenditure of
large sums of money' (Mill, 1848, p. 132).
Enormous differences across countries in the propensity to trust others survive
Trust is higher in 'fair' societies.
trust societies produce more output than low trust societies. A
fortiori, a sufficient amount of trust may be crucial to successful
development. Douglass North (1990, p. 54) writes,
The inability of societies to develop effective, lowcost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the Third World.
If trust is too low in a society, savings will be insufficient to sustain
positive output growth. Such a poverty trap is more likely when institutions -
both formal and informal - which punish cheaters are weak.
Heap, Tan and Zizzo and others have come to similar conclusions.
In 2001, Zak and Knack showed
that "strengthening the rule of law, reducing inequality, and by
facilitating interpersonal understanding" all increase trust. They
Our analysis shows that trust can be
raised directly by increasing communication and education, and
indirectly by strengthening formal institutions that enforce contracts
and by reducing income inequality. Among the policies that impact these
factors, only education, redistributive transfers, and freedom satisfy
the efficiency criterion which compares the cost of policies with the
benefits citizens receive in terms of higher living standards. Further,
our analysis suggests that good policy initiates a virtuous circle:
policies that raise trust efficiently, improve living standards, raise
civil liberties, enhance institutions, and reduce corruption, further
raising trust. Trust, democracy, and the rule of law are thus the
foundation of abiding prosperity.
"raising civil liberties", and "reducing corruption" and "democracy"
all have to do with the rule of law, which - as discussed below - in
turn, means prosecuting violations
of the law. Likewise, by "enhancing institutions", they mean
regulatory and justice systems which enforce contracts and prosecute
And while Zak and Knack appear to favor redistribution of wealth, fighting inequality does not have to offend conservative values. As I recently pointed out, conservatives are against rampant inequality, and prosecuting fraud is the best way to reduce inequality:
Robert Shiller [one of the top housing economists in the United States] said in 2009:
it's not like we want to level income. I'm not saying spread the
wealth around, which got Obama in trouble. But I think, I would
hope that this would be a time for a national consideration about
policies that would focus on restraining any possible further increases in inequality.
If we stop bailing out the fraudsters and financial gamblers, the big banks would focus more on traditional lending and less on speculative plays
which only make the rich richer and the poor poorer, and which
guarantee future economic crises (which hurt the poor more than the
Moreover, both conservatives and liberals agree that we need to prosecute financial fraud. As I've previously noted,
fraud disproportionally benefits the big players, makes boom-bust
cycles more severe, and otherwise harms the economy - all of which
increase inequality and warp the market.
So once again, we are back to the importance of prosecuting fraud.
A 2005 letter in premier scientific journal Nature reviewed the research on trust and economics:
Trust ... plays a key role in economic exchange and politics. In the absence of trust among trading partners, market transactions break down.
In the absence of trust in a country's institutions and leaders,
political legitimacy breaks down. Much recent evidence indicates that
trust contributes to economic, political and social success.
an article in 2006 entitled "The Economics of Trust". The article
summarizes the importance of trust in creating a healthy economy:
going to the corner store to buy a carton of milk, only to find that
the refrigerator is locked. When you've persuaded the shopkeeper to
retrieve the milk, you then end up arguing over whether you're going to
hand the money over first, or whether he is going to hand over the
milk. Finally you manage to arrange an elaborate simultaneous exchange.
A little taste of life in a world without trust--now imagine trying
to arrange a mortgage.
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.
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.
Above all, trust enables people to do business with each other. Doing business is what creates wealth.
distinguish between the personal, informal trust that comes from
being friendly with your neighbors and the impersonal,
institutionalized trust that lets you give your credit card number out
over the Internet.
In 2007, Yann Algan (Professor of
Economics at Paris School of Economics and University Paris East) and
Pierre Cahuc (Professor of Economics at the Ecole Polytechnique (Paris))
We find a significant impact of trust on income per capita for 30 countries over the period 1949-2003.
Similarly, market psychologists Richard L. Peterson M.D. and Frank Murtha, PhD noted in 2008
Trust is the oil in the engine of capitalism, without it, the engine seizes up.
Confidence is like the gasoline, without it the machine won't move.
is gone: there is no longer trust between counterparties in the
financial system. Furthermore, confidence is at a low. Investors have
lost their confidence in the ability of shares to provide decent returns
(since they haven't).
In 2009, Paola Sapienza (associate
professor of finance and the Zell Center Faculty Fellow at Northwestern
University) and Luigi Zingales (Robert C. McCormack Professor of
Entrepreneurship and Finance at the University of Chicago Booth School
of Business) pointed out:
drop in trust, we believe, is a major factor behind the deteriorating
economic conditions. To demonstrate its importance, we launched the
Chicago Booth/Kellogg School Financial Trust Index. Our first set of
data—based on interviews conducted at the end of December 2008—shows
that between September and December, 52 percent of Americans lost trust
in the banks. Similarly, 65 percent lost trust in the stock market. A
BBB/Gallup poll that surveyed a similar sample of Americans last April
confirms this dramatic drop. At that time, 42 percent of Americans
trusted financial institutions, versus 34 percent in our survey today,
while 53 percent said they trusted U.S. companies, versus just 12
As trust declines, so does Americans’ willingness
to invest their money in the financial system. Our data show that
trust in the stock market affects people’s intention to buy stocks,
even after accounting for expectations of future stock-market
performance. Similarly, a person’s trust in banks predicts the
likelihood that he will make a run on his bank in a moment of crisis:
25 percent of those who don’t trust banks withdrew their deposits and
stored them as cash last fall, compared with only 3 percent of those
who said they still trusted the banks. Thus, trust in financial
institutions is a key factor for the smooth functioning of capital
markets and, by extension, the economy. Changes in trust matter.
They quote a Nobel laureate economist on the subject:
every commercial transaction has within itself an element of trust,”
writes economist Kenneth Arrow, a Nobel laureate. When we deposit
money in a bank, we trust that it’s safe. When a company orders goods,
it trusts its counterpart to deliver them in good faith. Trust
facilitates transactions because it saves the costs of monitoring and
screening; it is an essential lubricant that greases the wheels of the
In 2009, Time Magazine pointed out:
Traditionally, gold has been a store of value when citizens do not trust their government politically or economically.
In other words, the government's political actions affect investments, such as gold, and thus the broader economy.
2010, a distinguished international group of economists (Giancarlo
Corsetti, Michael P. Devereux, Luigi Guiso, John Hassler, Gilles
Saint-Paul, Hans-Werner Sinn, Jan-Egbert Sturm and Xavier Vives) wrote:
Public distrust of bankers and financial markets has risen dramatically with the financial crisis. This column argues that this loss
of trust in the financial system played a critical role in the
collapse of economic activity that followed. To undo the damage,
financial regulation needs to focus on restoring that trust.
is crucial in many transactions and certainly in those involving
financial exchanges. The massive drop in trust associated with this
crisis will therefore have important implications for the future of
financial markets. Data show that in the late 1970s, the percentage of
people who reported having full trust in banks, brokers, mutual funds
or the stock market was around 40%; it had sunk to around 30% just
before the crisis hit, and collapsed to barely 5% afterwards. It is
now even lower than the trust people have in other people (randomly
selected of course).
Prosecuting the Criminals Is Necessary to Restore Trust
Nobel prize winning economist Joseph Stiglitz says that we have to prosecute fraud or else the economy won't recover:
legal system is supposed to be the codification of our norms and
beliefs, things that we need to make our system work. If the legal
system is seen as exploitative, then confidence in our whole system
starts eroding. And that's really the problem that's going on.
think we ought to go do what we did in the S&L [crisis] and
actually put many of these guys in prison. Absolutely. These are not
just white-collar crimes or little accidents. There were victims.
That's the point. There were victims all over the world.
Economists focus on the whole notion of incentives.
People have an incentive sometimes to behave badly, because they
can make more money if they can cheat. If our economic system is
going to work then we have to make sure that what they gain when they
cheat is offset by a system of penalties.
Robert Shiller said recently that failing to address the legal issues will cause Americans to lose faith in business and the government:
said the danger of foreclosuregate -- the scandal in which it has
come to light that the biggest banks have routinely mishandled
homeownership documents, putting the legality of foreclosures and
related sales in doubt -- is a replay of the 1930s, when Americans lost faith that institutions such as business and government were dealing fairly.
will have to be full-scale investigation and cleaning up of the
residue of that, before you can have, I think, a return of confidence in
the financial sector. And that's a process which needs to get
Galbraith also says that economists should move into the background, and "criminologists to the forefront".
regulators know this - or at least pay lip service to it - as well.
For example, as the Director of the Securities and Exchange
Commission's enforcement division told Congress:
from the fallout of the financial crisis requires important efforts
on various fronts, and vigorous enforcement is an essential component,
as aggressive and even-handed enforcement will meet the public's fair
expectation that those whose violations of the law caused severe loss
and hardship will be held accountable. And vigorous law enforcement
efforts will help vindicate the principles that are fundamental to the
fair and proper functioning of our markets: that no one should have an
unjust advantage in our markets; that investors have a right to
disclosure that complies with the federal securities laws; and that
there is a level playing field for all investors.
Nobel prize winning economist George Akerlof has demonstrated
that failure to punish white collar criminals - and instead bailing
them out- creates incentives for more economic crimes and further
destruction of the economy in the future. Indeed, William Black notes that we've known of this dynamic for "hundreds of years". And see this, this, this and this.
Of course, it's not just economists saying this.
One of the leading business schools in America - the Wharton School of Business - published
an essay by a psychologist on the causes and solutions to the
economic crisis. Wharton points out that restoring trust is the key
to recovery, and that trust cannot be restored until wrongdoers are
According to David M. Sachs, a training and supervision analyst at the Psychoanalytic Center of Philadelphia, the
crisis today is not one of confidence, but one of trust. "Abusive
financial practices were unchecked by personal moral controls that
prohibit individual criminal behavior, as in the case of [Bernard]
Madoff, and by complex financial manipulations, as in the case of AIG."
The public, expecting to be protected from such abuse, has suffered a
trauma of loss similar to that after 9/11.
"Normal expectations of what is safe and dependable were abruptly
shattered," Sachs noted. "As is typical of post-traumatic states,
planning for the future could not be based on old assumptions about
what is safe and what is dangerous. A radical reversal of how to be
now feel more gratified saving money than spending it, Sachs suggested.
They have trouble trusting promises from the government because they
feel the government has let them down.
He framed his argument
with a fictional patient named Betty Q. Public, a librarian with two
teenage children and a husband, John, who had recently lost his job.
"She felt betrayed because she and her husband had invested
conservatively and were double-crossed by dishonest, greedy businessmen,
and now she distrusted the government that had failed to protect them
from corporate dishonesty. Not only that, but she had little trust in
things turning around soon enough to enable her and her husband to
accomplish their previous goals.
"By no means a sophisticated
economist, she knew ... that some people had become fantastically
wealthy by misusing other people's money -- hers included," Sachs said.
"In short, John and Betty had done everything right and were being
punished, while the dishonest people were going unpunished."
an individual recover from a traumatic experience provides a useful
analogy for understanding how to help the economy recover from its own
traumatic experience, Sachs pointed out. The public will need to "hold the perpetrators of the economic disaster responsible and take what actions they can to prevent them from harming the economy again." In addition, the public will have to see proof that government and business leaders can behave responsibly before they will trust them again, he argued.
Note that Sachs urges "hold[ing] the perpetrators of the economic disaster responsible." In other words, just "looking forward" and promising to do things differently isn't enough.
As Wall Street insider and New York Times columnist Andrew Ross Sorkin writes:
will pick on minor misdemeanors by individual market participants,”
said David Einhorn, the hedge fund manager who was among the
Cassandras before the financial crisis. To Mr. Einhorn, the government
is “not willing to take on significant misbehavior by sizable”
firms. “But since
there have been almost no big prosecutions, there’s very little
evidence that it has stopped bad actors from behaving badly.”
at big corporations surely dwarfs by orders of magnitude the
shareholders’ losses of $8 billion that Mr. Holder highlighted. If
the government spent half the time trying to ferret out fraud at
major companies that it does tracking pump-and-dump schemes, we might
have been able to stop the financial crisis, or at least we’d have a
fighting chance at stopping the next one.
And as a former congressional aide recently said in some of the most colorful language to date:
put Lloyd Blankfein in pound-me-in-the-ass prison for one six-month
term, and all this bullshit would stop, all over Wall Street," says a
former congressional aide. "That's all it would take. Just once."