Trust: No Economy, Money, Business Without It

Uploaded 3/23/2023, approx. 17 minute read

My name is Sam Vaknin. I served as economic advisor to several governments around the world for almost three decades. I worked with multinationals as financial advisor. I've collaborated with multilateral institutions such as the IMF and the World Bank.

Based on all this experience and the observations I've made, I would like to discuss with you today the issue of trust in economics.

On my other main channel, Sam Vaknin, on YouTube, I just posted a video which deals with trust in interpersonal relationships. In that video, I've analyzed the psychology of trust. So actually the two go together, they're complementary pieces.

But this particular part, this particular video, deals with economics. Economics acquired its dismal reputation by pretending to be an exact science rather than a branch of mass psychology.

Yes, granted, there is behavioral economics. But even behavioral economics is not going far enough.

There's no admitting among economists, even behavioral economists, that economics is 100% a branch of psychology.

In truth, it is a narrative struggling to describe the aggregate behavior of human beings. It seeks to cloak its uncertainties and shifting fashions with mathematical formulae and elaborate econometric computerized models. It's not working too well.

So much is certain, though, that people operate within markets. These markets are free, these markets are regulated, they're patchy, they're organized, they're numerous types of markets.

But people work within markets. People attach numerical and emotional values to their inputs, work, capital. And similarly, they attach values to their possessions, their assets, their natural endowments.

People communicate these values to each other by sending out signals. And these signals are known as prices.

Prices are signals about the value that people attach to various things.

There's a famous saying that the cynic knows the price of everything and the value of nothing.

This distinction is a bit artificial.

Yet, these entire edifice, the market, and its price and signaling mechanisms, they critically depend on a psychological fact.

And this is trust. If people do not trust each other, if people do not trust the economic envelope within which they interact, preemptive mistrust, if there is a lack of trust or pervasive lack of trust, permeating, ambient, economic activity gradually grinds to hold.

There is a strong correlation between the general level of trust and the extent and intensity of economic activity.

Francis Fukuyama, the political scientist, distinguishes between high-trust and prosperous societies and low-trust and therefore impoverished collectives.

Trust underlies economic success, he argued already in 1995.

But there's a problem with that. Like every psychological extensive trait, it's not a monolithic quantity.

There are a few categories of economic trust.

Some forms of trust are akin to a public good and they are closely related to governmental action or inaction. The reputation of the state and its institutions, the pronounced agenda of the government, they all determine, to a large extent, trust.

Because the government has become a huge part of modern economies.

Other types of trust are the outcomes of kinship, tribal, ethnic origin, personal standing, goodwill, reputation, corporate runs and other data generated by individuals, households and firms. They are data-related trust.

Such information creates two types of output, reinforced trust, where behavior matches expectations, and inductive distrust, where behavior frustrates expectations.

Sothere we have kind of two processes.

Sometimes we behave so that our behavior reflects expectations, enhances them and realizes them in many cases.

Sometimes, and this is what I call reinforced trust, and sometimes our behavior frustrates expectations, diminishes them, negates them, challenges them, undermines them or even vitiates them. This is what I call inductive distrust.

Let's start with the various types of trust.

The most basic foundational trust is trust in the playing field.

To transact, people have to maintain faith in a relevant economic horizon and in the immutability of the economic playing field or envelope.

Put less obscurely, a few hidden assumptions underlie the continued economic activity of market players.

Market players, for example, assume, or agents assume, that the market will continue to exist. It's a very simple assumption.

In the foreseeable future, the market will continue to exist in its current form. It will remain inert, unhindered by externalities and external shocks like government intervention, geopolitical upheavals, pandemics, crisis, abrupt changes in accounting policies and tax laws, hyperinflation, institutional and structural reform, and other market deflecting events and processes.

This projection, this extrapolation of the market, is of course counterfactual. Markets are very often subject to external shocks. This would explain the dynamic of bubbles and busts.

Because bubbles are founded, fundamentally, they are extensions of the extrapolation.

Without this extrapolation, there would be no bubbles.

The belief that future market players operating in identical markets would absorb the current supply. Its yields lead to bubbles and busts is when reality testing is restored and there are external shocks, regulation, taxation, pandemics, crisis, wars, etc.

Market players assume that their price signals will not be distorted or thwarted constantly. The market signals will not be interfered with or interrupted. There will be no intervention skewing the efficient and rational allocation of risks and rewards.

So things like insider trading, stock manipulation, monopolies, cartels, trusts, informal economic activities like the black market or the grey market, hoarding, all these tend to consistently but unpredictably distort pricing.

And so they deter market participation.

The market, the liquidity dries up. Market players take for granted the existence and continuous operation of institutions, financial intermediaries like banks, insurance companies, law enforcement agencies, courts, civil service, educational institutions and so on and so forth.

It is important to note that market players prefer continuity and certainty to evolution, however gradual, however ultimately beneficial.

A vinyl bureaucrat, a corrupt politician, is a known quantity, can be tackled effectively. The cost is known, the transaction cost. A period of transition to good and equitable governance can be more stifling, more damaging than any level of corruption and malfeasance.

And this is why economic activity drops sharply whenever institutions are being reformed.

Witness the transition from communism to capitalism in Eastern Europe and in the former republics of the USSR.

The second type of trust is trust in other players.

Market players assume that other players are generally benign, rational, that they have intentions, they're intentional, that they intend to maximize their benefits, that they're likely to act on their intentions in a legal, rule-based, rational manner.

This has been challenged by the School of Behavioral Economics, Kahneman, etc.

I'm not going to eat right now, but this is an underlying sort of assumption.

You can trust others.

Then there's trust in market liquidity.

By the way, the second type of trust, it leads to phenomena like and Bernie Madoff and so on. These con artists leverage this type of trust.

And I encourage you to watch the video about the psychology of trust in my other channel.

Then there's trust in market liquidity.

When players assume that other players possess or have access to, the liquid means that they need in order to act on their intentions and obligations.

They know, from personal experience, that idle capital tends to dwindle and that the only way to perhaps maintain or increase the capital is to transact with others directly or through intermediaries, such as banks.

So they trust that liquidity will never remain hidden, obscured, under the mattress, but we're always exit, we're always out in order to participate in market activities so as to grow.

Then there is trust in other people's knowledge and ability. Market players assume that other players possess or have access to the intellectual property, the technology and the knowledge that they need in order to realize their intentions and obligations.

This implicitly presupposes that all other market players are physically, mentally, legally and financially able, competent and willing to act their parts as stipulated, for instance, in contracts they sign.

The emotional dimensions of contracting are often neglected in economics.

Players assume that their counterparts maintain a realistic and stable sense of self-worth based on intimate knowledge of their own strengths and weaknesses.

Self-awareness is critical. Market participants are presumed to harbor realistic expectations, commensurate with their skills and accomplishments.

Fake it till you make it is a very bad foundation for any market.

Allowance is made for exaggeration, of course. We all know that there is disinformation, even outright deception, but these are supposed to be fringe phenomena, very rare.

They can't become the founding principle.

And gradually, in today's modern economies, we are, we regrettablyare moving in that direction.

Fake it till you make it, have become an operating and organizing principle.

When trust breaks down, often the result of an external or internal systemic shock, people react as expected.

The number of voluntary interactions and transactions decreases sharply.

With a collapsed investment horizon, individuals and firms become corrupt in an effort to shortcut their way into economic benefits because they don't know how long will the system survive.

The short horizon, criminal activity increases. People compensate with this market failure. People compensate with fantasies and grandiose delusions for their growing sense of helplessness and certainty, fears.

This is a self-reinforcing mechanism. It's a vicious cycle which results in underconfidence and fluctuating self-esteem.

I mean, people develop psychological defenses, pronounced psychological defenses. They act out very often.

Cognitive dissonance begins to rain. People say, "I really choose to be poor," rather than, for example, heartless or ruthless.

There's pathological envy. People seek to deprive other people of their possessions and achievements and assets, and this way gain emotional reward.

Relative positioning becomes paramount and predominant. You can see this in social media, where people compare their popularity with others.

There's rigidity that sets you. "I'm like that. My family or ethnic group has been like that for generations. There's nothing I can or am willing to do."

Then there's passive-aggressive behavior, obstructing the workflow, absenteeism, stealing from the employer, and besting, adhering strictly to arcane regulations.

These are all reactions. These are all dysfunctional reactions to a breakdown in one or more of the four aforementioned types of trust.

When trust breaks down, there is something called anomie. M.L. Dokheim described it in his work.

Anomic societies, anonomic institutions, anonomic economies, they create dysfunctional, counterproductiveand antisocial behavior.

In a trust crisis, people are unable to postpone gratification. They often become frustrated, aggressive, deceitful if they're denied.

They resort to reckless behavior and to stop-gap economic activities. In economic environments with compromised and impaired trust, loyalty decreases and mobility increases.

People switch jobs. People renege on obligations. They fail to repay debts. They relocate often.

Concepts like exclusivity, sanctity of contracts, workplace loyalty, career path, all these get eroded and become meaningless.

As a result, little is invested in the future, in the acquisitions of skills, in long-term savings.

Short-termism, bottom-of-line mentality rule the day, and you have many get-rich-quick schemes.

The outcomes of a crisis of trust are usually catastrophic. Economic activity is much reduced.

Human capital is corroded and wasted. Brain drain increases. Illegal and extralegal activities rise.

Society is polarized between halves and halves not. Inter-ethnic and interracial tensions increase. To rebuild trust in such circumstances is a daunting task.

The loss of trust is contagious. Finally, it infects every institution, every profession in the land. It is the stuff that revolutions are made of.

I've designed a very simple index of trust and distrust. It has the following variables.

Each of these variables is scored on a scale of 1 to 10. So the formula is T, I, equals P plus L plus C plus I plus S plus M plus V plus F plus R plus W.

And I will explain each one of these shortly.

The index can range, of course, from 0 to 100, with 100 signifying total absolute, unreserved, or pervasive and enduring economic trust. 0 represents a complete absence of any form of trust between and among economic agents and actors.

1 divided by the index, 1 divided by T, I, would be the index of economic mistrust, of course.

So what is P?

The first variable. P is population size. The bigger the population, the easier it is to cheat and to deceive.

Because information is disseminated more slowly, peer pressure is limited, and reputational capital remains localized.

L, the next variable, law enforcement. Efficient law enforcement and a functioning judiciary enhance trust. The rule of law is critical.

C is corruption. Surprisingly, in the formula calculating the coefficient, corruption is a neutral effect.

On the one hand, it encourages preemptive mistrust by upsetting the level playing field.

On the other hand, corruption and venality increase certainty in otherwise uncertain economic environments by providing a tried and true price list for services.

Connectivity is the next variable. I, the most connected individuals are, the more connected individuals are.

And the faster the dissemination of accurate, transparent information, the higher the level of trust.

Technology such as the Internet serves to enhance economic trust. The less information friction there is, the higher the trust.

The next variable is S, stability and predictability. They are the cornerstones of economic trust.

Government intervention, geopolitical upheavals, crises, abrupt changes in accounting policies and tax laws, hyperinflation, institutional structural reform and other market deflecting events and processes all tend to reduce the average level of trust.

M is available in reliable price signals, not distorted by insider trading, stock manipulation, hoarding, informal economic activities, like market, gray market, monopolies, cartels, etc. This is M.

The next variable is V, a reliable store of value, a currency or goods and services that can serve as means of exchange and generate trust only when they represent real, long-term value.

So a value store is critical.

F, functioning institutions, they're crucial to the establishment and maintenance of trust. Financial intermediaries, banks, insurance companies, law enforcement agencies, courts, civil service, education institutions, their functioning predicates trust, creates trust.

R, cultural and social rationality. In all cultures and societies there are times when the optimization of profits and benefits, the ethics of contracting and otherwise rational economic behavior, they are all subordinated to often self-defeating, self-destructive, irrational beliefs, biases, prejudices and stereotypes.

Societies lapse into these irrational states, just look at Nazi Germany. And this is spurred on usually by capricious, ignorant, narcissistic, psychopathic or arbitrary leaders, by some malignancy of the ethos, by some change in mores.

And such surrealism is not conducive to economic trust.

In a nightmare environment one can hardly rely on a dream.

And wherewithal, the next variable is W, when all the economic actors and agents possess the liquidity and the knowledge necessary to complete their transactions and to honor their obligations.

And this creates and sustains an atmosphere of trust. It is impossible to exaggerate or overemphasize the critical role of trust.

And trust being a psychological trait, dimension, belief, value. It's not an economic thing. It's in the mind. It reflects expectations. It's volatile. It's lay- by. It's sometimes dysregulate. It reacts to external shocks, many of which, if not all of which, are not economic.

So there is trust mediates shocks. Trust brings shocks into the economic system, introduces shocks into the economic system.

Trust is the transmission mechanism of shocks. When an external shock happens, like a pandemic, the first thing to react is trust. Trust fluctuates or goes down.

It is through trust that changes in the behavior of economic agents and economic players take place. And these changes in behavior, in turn, have economic consequences.

So the economic consequences are the very last and not necessarily the most important link in a much longer chain, the bulk of which is actually psychological.

[ Pause ].

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