Tuesday, December 07, 2010

Declining Trust in the U.S. Financial Markets

Friedrich Nietzsche

Below I've posted a chart of the levels of trust expressed by investors chatting in online financial social media since 1998.  As you can see, the level of trust has dropped 33% since 1998 in a series of steps.  It has not made a real attempt at recovery.

Economic studies have found that levels of interpersonal trust in a society are related to rates of economic growth.  (Others are less confirmatory).  In any case, it's fairly intuitive that we are less likely to take business risk if we don't think we can trust the person we are entrusting to grow, manage, or invest our money.  So the decline in trust we've measured is problematic for the future prosperity of the U.S. 

So the next question is, how can we restore trust in the financial system? 
1.  First of all, we've got to stop the bleeding.  We need fewer Madoff's, Jeff Skilling's, et al through better oversight and regulation of the financial system.  The Dodd-Frank bill addresses some of the relevant areas. 
2.  We've got to change incentives for economic players to violate trust.  For now, most financial firms use an annual bonus system.  This system incentivizes taking high short term risks with OPM (other people's money) in order to get a higher annual bonus for the individual risk taker.  This incentive system should morph into a longer term, stake-driven protocal.  Otherwise we'll bubbles rising again and again fueled by individual incentives.  Consider how many people have been punished for making bad bets during the financial crisis?  (None as far as I'm aware, and they've all kept their nice bonuses from pre-2008).
3.  We've got to punish breaches of trust (legal enforcement).  When the legal system enforces arbitrary, irrelevant, or outdated laws, or when it hands out punishments that don't do justice to the actual suffering caused, it loses credibility.  Recall that Madoff remained free for many months before his trial while the case was prepared.  To most victims, that appeared as a failure of justice. 
4.  A shared social mission.  Seeing others selflessly work towards a goal that benefits others restores trust.  Historically major wars and religious revivals served this function, but it's also possible through leadership (Roosevelt with the WPA and Reagan's "morning in America" were able to create such a sense in much of the population).  Perhaps shared sacrifice towards cutting the budget, educational reform, or healthcare overhaul could do it?  I don't know - once distrust is used as a political tool, then we're in a different stage of the game.

Certainly, there is a social devaluation of trust that is seen in recent politics.  This may be a by-product of new forms of communication and media.  When Elliot Spitzer becomes the host his own show on CNN after prosecuting many financial leaders as attorney general of NY (allegedly unfairly) and then being caught breaking the law systematically himself while Governor of NY, what does that say about our assessment of character versus desire for entertainment? 

Whatever the solution, I imagine we'll know the harbingers of returning trust when we feel them.  For now, the erosion will likely continue as more and more municipalities, states, and sovereigns come looking for debt relief, and mistrustful investors balk at bailing them out.

Richard Peterson M.D.
rpeterson "at' marketpsych.com

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