FedUpUSA

Archive for the ‘Trust’ Category

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.

But top 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 Italy.

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.

In 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:

Adam Smith … 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
today.

***

Trust is higher in ‘fair’ societies.

***

High 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 conclude:

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, … 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.

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.

Forbes wrote an article in 2006 entitled “The Economics of Trust”. The article summarizes the importance of trust in creating a healthy economy:

Imagine 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.

“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.

***

Above all, trust enables people to do business with each other. Doing business is what creates wealth.

***

Economists 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)) reported:

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.

Trust 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:

The 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 percent today.

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:

“Virtually 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 economic system.

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.

In 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.

They noted:

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:

The 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.

***

I 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:

Shiller 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.

Economists such as William Black and James Galbraith agree. Galbraith says:

There 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 underway.

Galbraith also says that economists should move into the background, and “criminologists to the forefront”.

Government 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:

Recovery 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.

And when Zak and Knack – quoted above – discuss “enforcing contracts”, “raising civil liberties”, and “reducing corruption”, they are talking about enforcing the rule of law, which means prosecuting violations of the law. Likewise, when they refer to “enhancing institutions”, they mean regulatory and justice systems which enforce contracts and prosecute cheaters.

And when Zak and Knack promote reduction of inequality, that means prosecuting fraud as well. Specifically, as I recently pointed out, prosecuting fraud is the best way to reduce inequality:

Robert Shiller [one of the top housing economists in the United States] said in 2009:

And 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 rich).

***

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.

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 held accountable:

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 gratified occurred.”

People 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.”

Helping 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:

“They 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.”***

Fraud 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:

“You 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.”

Washington’s Blog

I was disappointed with the Christmas Eve ditties from Treasury and
FHFA re: the Agencies. To be honest, I was appalled. The two releases
contained significant information. The timing was obviously an attempt
to slip in some bad news while everyone is drinking eggnog.

Of course that backfired. The blogs, and yes, the MSM disintegrated
those that sent the emails out on Christmas Eve. The smell that these
announcements have created is not likely to go away anytime soon.

If you are reading this you know the story. Treasury ponied up for
another $200b for Fannie and Freddie and the management of these
entities are getting serious paychecks.

The former clearly establishes that Fannie and Freddie have been
nationalized. I don’t care what they say any longer. The numbers speak
for themselves. The $400 billion the taxpayers have signed up for far
exceeds any theoretical value for these two important institutions.
Sadly, ‘the people’ own these things at this point.

The notion that the Agencies are private sector companies with
influential shareholders is over. These entities are no longer big shot
players on Wall Street. There is no earnings prospect for these
behemoths. There is no upside. There is no justification for
multimillion dollar salary packages.

The Agencies fund themselves with lines of credit from Fed and
Treasury. The Fed is buying 1.45 Trillion of their dodgy paper. Why in
the world do we need to pay someone $6mm per year to run that mess?

A question for Mr. Geithner; What are the salaries and bonuses being
paid to the people who run FHA? These are government salaries. FHA is a
part of HUD. Compensation for Fannie and Freddie Exec’s should conform
to those guidelines. Not the other way around. We need to end the myth
that F/F are private sector entities. They are not.

We are not stupid Mr. Geithner. We watch what you are doing very
closely. There are a significant number of us who flat out do not trust
you. You have given us good reason in the past and you have proven
again that you are not trustworthy. You tried to ‘Sneaky Pete’ some
important information past us. In my view you owe us an apology and
explanation, or better still, a letter of resignation. This
Administration has promised a much higher standard than you have
delivered.

? Washington’s Blog.

A 2005 letter in premier scientific journal Nature reviews 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.

Forbes wrote an article in 2006 entitled “The Economics of Trust”. The article summarizes the importance of trust in creating a healthy economy:

Imagine
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.

 

“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. ***

 

Above all, trust enables people to do business with each other. Doing business is what creates wealth. ***

 

Economists 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.

Similarly, market psychologists Richard L. Peterson M.D. and Frank Murtha, Ph.D. wrote in October:

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.

Trust 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).

And two professors of finance write:

The
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
percent today.

 

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:

“Virtually
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 economic
system.

Americans clearly don’t trust the big banks and financial companies.

Indeed, as leading economists have pointed out, the big financial institutions don’t even trust each other,
because they know that all of the other companies might have hidden
toxic assets in SIVs, overvalued their assets, gamed their books, or
otherwise tried to bury their problems.

For example, Anna Schwartz – co-author with Milton Friedman of the leading monetarist book on the Great Depression – told the Wall Street Journal:

We
now hear almost every day that banks will not lend to each other, or
will do so only at punitive interest rates…This is not due to a lack
of money available to lend, Ms. Schwartz says, but to a lack of faith
in the ability of borrowers to repay their debts. “The Fed,” she
argues, “has gone about as if the problem is a shortage of liquidity.
That is not the basic problem. The basic problem for the markets is
that [uncertainty] that the balance sheets of financial firms are
credible.” 

So even though the Fed has flooded the credit markets with cash,
spreads haven’t budged because banks don’t know who is still solvent
and who is not. This uncertainty, says Ms. Schwartz, is “the basic
problem in the credit market. Lending freezes up when lenders are
uncertain that would-be borrowers have the resources to repay them. So
to assume that the whole problem is inadequate liquidity bypasses the
real issue”…

 

In the 1930s, as Ms. Schwartz and Mr. Friedman argued in “A Monetary History,” the country and the Federal Reserve were faced with a liquidity crisis in the banking sector…

 

But “that’s not what’s going on in the market now,” Ms. Schwartz
says. Today, the banks have a problem on the asset side of their
ledgers — “all these exotic securities that the market does not know
how to value.”

 

“Why are they ‘toxic’?” Ms. Schwartz asks. “They’re toxic because
you cannot sell them, you don’t know what they’re worth, your balance
sheet is not credible and the whole market freezes up. We don’t know
whom to lend to because we don’t know who is sound.”

As financial writer Will Hutton says:

“Such
was the break down in trust and sense of panic that some of the most
familiar names in British high street banking would not lend to each
other at all or, at best, just overnight. Instead, the Bank of England
had to supply tens of billions to banks who found the normal sources of
funds blocked.

***

Unless there is a radical and government-led change in ownership,
structure, regulation and incentives so that the principles of fairness
are put at the heart of the Anglo American financial system -
proportionality of reward and fair distribution of risk – there is no
chance of the return of trust and integrity upon which long-term
recovery depends.”

Economist and former Secretary of Labor Robert Reich agrees that Wall Street’s biggest problem right now is the collapse of trust:

The
problem is, government bailouts, subsidies, and insurance aren’t really
helping Wall Street. The Street’s fundamental problem isn’t lack of
capital. It’s lack of trust. And without trust, Wall Street might as
well fold up its fancy tents.

Reich also writes:

Despite
all the money going directly to the big banks, despite all the
government guarantees and loans and special tax breaks, despite the
shot-gun weddings and bank mergers, despite the willingness of the
Treasury and the Fed to do almost whatever the banks have asked, the
reality is that credit is not flowing.

 

Why? Because the underlying problem isn’t a liquidity problem. As I’ve noted elsewhere, the
problem is that lenders and investors don’t trust they’ll get their
money back because no one trusts that the numbers that purport to value
securities are anything but wishful thinking. The trouble, in a nutshell, is that the financial entrepreneurship of recent years — the derivatives, credit default swaps, collateralized debt instruments, and so on — has undermined all notion of true value.

 

Many of these fancy instruments became popular over recent years
precisely because they circumvented financial regulations, especially
rules on banks’ capital adequacy. Big banks created all these
off-balance-sheet vehicles because they allowed the big banks to carry
less capital.

In other words, I would argue that our economy is not
fundamentally stabilizing (notwithstanding a couple of temporary “green
shoots”) because the government and the financial giants are taking
actions and releasing data which encourage more distortion and less trust.

The
crisis will deepen unless honest and transparent accounting is used,
investments become transparent and understandable again, and the
government stops gaming the system for the benefit of the big boys.

As structured finance and derivatives expert Janet Tavakoli says, lack
of transparency, lying and fraud which “we’ve seen massively in the
financial system” has undermined trust, so no one wants to buy our
financial products.

As John Carney writes:

“We’re probably making things worse. Allowing insolvent
institutions to fail and requiring worthless and worth less assets to
be fully written down would provide transparency to the market.
Instead, we’re dedicated to the post-Lehman proposition of “Never
Again.” The various programs of our government continue to obscure
asset pricing and conceal insolvency. This means that you can’t trust
the market to tell you which firms are failing.

 

Twisting the arms of bankers to lend to institutions that may be
insolvent is a recipe for deepening the crisis. We’ve just been through
a period of malinvestment–we spent too much borrowed money on junk.
Borrowing more to spend on junk only digs us in deeper.

 

Bank lending won’t get going again until trust in the markets can
be restored. Fighting a Great Depression era problem probably won’t
help. More transparency, which means more write-downs and failures, is
probably necessary if we’re going to get through this. Unfortunately,
we’re still sailing in the opposite direction.”

Happy Talk: Then and Now

It
is true that consumers and small investors drive a large portion of the
economy. And it is true that consumers and small investors, in turn,
are largely driven by their perception of what is happening.

But
I would also argue that all of the happy talk in the world won’t turn
the economy around when the fundamentals of the economy are lousy, or
there has been a giant bubble and vast overleveraging, or there has
been massive fraud, or the government has gone so far into debt that it
has formed a black hole.

Happy talk did not work during the first couple of years of the Great Depression, once the speculative bubble and leverage of the Roaring 20′s burst, leading to the inevitable crash.

As economist Irving Fisher pointed out (as recounted by economist Steve Keen):

Hobbled
by this naive belief in equilibrium, the economics profession was as
unprepared for today’s crisis as it had been for the Great Depression.
Now that the crisis is well and truly with us, all
conventional “neoclassical” economists can offer is the hope that the
crisis can be overcome by a good, strong dose of confidence.

From [Irving] Fisher’s point of
view, such a belief is futile. In an economy with an excessive level of
debt and low inflation, he argued that confidence was irrelevant–and in
fact dangerously misleading, as he knew from painful personal experience.

University of Maryland professor economics professor and former Chief
Economist at the U.S. International Trade Commission Peter Morici wrote in 2006:

The
speculative frenzy of recent years is causing a major adjustment, and
the happy talk of realtors is prolonging the process. The absence of
realistic analysis about the extent of overvaluation is characteristic
in an industry that sees nothing but an upward progression for values,
but houses like any other asset can be overpriced.

Things are likely to get worse before they get better.

Morici was pointing out that there was a bubble in housing, and happy talk would not keep the bubble from bursting.

As Washington Post business writer Steven Pearlstein predicted in August 2007:

Despite
the happy talk from Washington and Wall Street investment houses –
eerily reminiscent, by the way, of the early days of the
savings-and-loan crisis of the late ’80s — these shocks [the subprime
and credit crises] will have serious consequences …

And economist James Galbraith is saying now (just as his father economist John Kenneth Galbraith said 50 years ago) – that “happy talk” won’t solve the crisis.

Indeed, the chair of the congressional oversight committee of the bailouts (Elizabeth Warren) and the senior regulator
during the S & L crisis (William Black) both say that hiding the
true state of affairs and trying to put a happy face on an economic
crisis just prolongs the length and severity of the crash

Donald
W. Riegle Jr. – former chair of the Senate Banking Committee from 1989
to 1994 – wrote (along with the former CEO of AT&T Broadband and
the international president of the United Steelworkers union) wrote recently:

It’s
almost as if the [Obama] administration is opting for a
rose-colored-glasses PR strategy rather than taking a hard-nose look at
actual consumer and employment figures and their trends, and modifying
its economic policies accordingly.

In short, happy talk and fake confidence-building exercises (like the stress tests, which Time Magazine called a con game) don’t work.

Indeed, I believe that trying to instill false confidence will actually backfire on Summers, Geithner, Bernanke and the boys and make the crisis worse.

Why?

Well, initially, as Yves Smith points out:

Team Obama has made it clear that it sees restoring confidence as paramount, when anyone
with consumer marketing experience will tell you that advertising
campaigns that make exaggerated claims about the product often don’t
simply fail (as in customers see through the hype) but often backfire
(buyers discount future ad messages about the product). The
press has had a manipulated feel, with readers on sending news stories
that have misleadingly positive stories with Panglossian headlines and
upbeat initial paragraphs that are often undercut by other material in
the same article.

So in our new branding, “the economy is no longer in a freefall” has
become “recovery.” The self-congratulatory tone among US financial
regulators (who should instead be engaging in serious
self-recrimination for failing to foresee and prevent this crisis) is
premature.

In addition, psychologists say that – until
government and business leaders prove they can behave responsibly, and
until the perpetrators of financial fraud are held accountable – real
trust will not be restored and the economy will not recover

For example, one of the leading business schools in America – the Wharton School of Business – has written an essay
on the psychological 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 held accountable:

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 gratified occurred.”

 

People 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.”

 

Helping 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.

Are the “perpetrators of the economic disaster” being held accountable?

So
far, Obama, Summers, Geithner, Bernanke and the crew have tried to
paper over the cause and severity of the financial crisis, instead of
honestly addressing them. They haven’t lifted a finger to hold anyone
accountable (other than a Madoff or two), but have actually thrown
billions of dollars at the perpetrators (or else appointed them to
government posts).

Indeed, William Black says that “the [government's] entire strategy is to keep people from getting the facts”.

Economist Dean Baker made a similar point, lambasting
the Federal Reserve for blowing the bubble, and pointing out that those
who caused the disaster are trying to shift the focus as fast as they
can:

The current craze in DC policy circles
is to create a “systematic risk regulator” to make sure that the
country never experiences another economic crisis like the current one.
This push is part of a cover-up of what really went wrong and does
absolutely nothing to address the underlying problem that led to this
financial and economic collapse.

 

The key fact that everyone must always remember is that the story
of the collapse was not complex. We did not need great minds sifting
through endless reams of data and running incredibly complex computer
simulations to discover the underlying problem in the economy. We just
needed some people who understood the sort of arithmetic that most of
us learned in 3rd grade.

 

If the people at the Fed, the Treasury, and in other key positions
had mastered arithmetic, and were prepared to act on their knowledge,
they would have taken steps to stem the growth of the housing bubble.
They would have prevented the bubble from growing to the point where
its inevitable collapse would bring down both the U.S. economy and the
world economy…

 

We didn’t need some super-genius to solve the mystery. We just
needed an economist who could breath and do arithmetic. But the DC
policy crowd tells us that if only we had a systematic risk regulator
this disaster could have been prevented.

 

Okay, let’s do a thought experiment. Suppose we had our systematic
risk regulator in 2002. Would this person have stood up to Alan
Greenspan and said that the country is facing a huge housing bubble the
collapse of which will sink the economy?…

 

Alan Greenspan said that there was no housing bubble; everything
was just fine. Would our systematic risk regulator have said that
Greenspan was nuts and that the whole economy was a house of cards
waiting to collapse?

 

Anyone who believes that a risk regulator would have challenged
the great Greenspan knows nothing about the way Washington works. The
government is run by people who first and foremost want to advance
their careers.

 

And, the best way to advance your career in Washington is to go
along with what everyone else is saying. If that was not completely
obvious before the collapse of the housing bubble, it certainly should
be obvious now.

 

How many people in government have lost their jobs because they
failed to see the bubble? How many people even missed a promotion? In
fact, the top financial officials in the Obama administration, without
exception, completely missed the housing bubble. One might think it was
a job requirement.

This lack of accountability among economists and economic analysts is the core problem that must be tackled.
Unless these people are held accountable for their failures in the same
way as custodians and dishwashers, there will never be any incentive to
buck the crowd and point out looming disasters like the housing bubble.

The reality is that we have a systematic risk regulator. It is called the Federal Reserve Board. They blew it completely. We
will do far more to prevent the next crisis by holding our current risk
regulator accountable for its failure (fire people) than by pretending
that we somehow had a gap in our regulatory structure and creating
another worthless bureaucracy.

Remember also that the Wharton study pointed out that
“the public, expecting to be protected from such abuse, has suffered a
trauma of loss similar to that after 9/11.”

Trying to put a happy
face on a grim situation, continuing to do things which are transparent
attempts to instill false confidence, and leaving in power the people
who caused the crisis reinforces the market’s convictions that (1)
government and business leaders are behaving irresponsibly instead of
addressing the fundamental problems and (2) there is no accountability.

Keeping
quiet about how bad things are won’t help. As numerous leading
independent economists and financial experts agree, the three things
that will help are:

1. Honestly addressing the causes of the crisis;
2. Honestly addressing the necessary – if bitter – medicine needed to get out of the crisis; and
3. Holding responsible those who caused the crisis.

Postscript: Time Magazine notes:

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.

It is interesting to note that Americans no longer trust their politicians, the justice system, their ability to obtain liberty, or the media. Americans know that the boys launched the war in Iraq (which will end up costing $3-5 trillion dollars) based upon justifications which turned out to be untrue. Many Americans have read that the government imported communist Soviet Union torture techniques and then said “we don’t torture”. Many Americans also know that the government spied on American citizen (even before 9/11 … confirmed here and here) while saying “we don’t spy”, and that the government apparently planned both the Afghanistan war (see this and this) and the Iraq war before 9/11.

This
is an economic, not a political, essay. But I think the lack of trust
in government concerning political issues poses an interesting
question. Specifically, is it possible that the American people’s
distrust of the government concerning the above-described issues also
bleeds over into a lack of trust in the government’s economic actions
and statements? In other words, if people discover that a government is
lying about political issues, do people trust the government’s
pronouncements about economic issues less?

I
don’t know the answer, but analyzing the possibility could provide a
researcher with an interesting project (or a PhD candidate with a
potential doctoral thesis).