The Fabric of Economic Trust

By: Sam Vaknin, Ph.D.

Also published by United Press International (UPI)

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Economics acquired its dismal reputation by pretending to be an exact science rather than a branch of mass psychology. In truth it is a narrative struggling to describe the aggregate behavior of humans. It seeks to cloak its uncertainties and shifting fashions with mathematical formulae and elaborate econometric computerized models.

So much is certain, though - that people operate within markets, free or regulated, patchy or organized. They attach numerical (and emotional) values to their inputs (work, capital) and to their possessions (assets, natural endowments). They communicate these values to each other by sending out signals known as prices.

Yet, this entire edifice - the market and its price mechanism - critically depends on trust. If people do not trust each other, or the economic "envelope" within which they interact (“preemptive mistrust”), economic activity gradually grinds to a halt. 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 in a 1995 tome.

Trust is not a monolithic quantity. There are a few categories of economic trust. Some forms of trust are akin to a public good and are closely related to governmental action or inaction, the reputation of the state and its institutions, and its pronounced agenda. Other types of trust are the outcomes of kinship, ethnic origin, personal standing and goodwill, corporate brands and other data generated by individuals, households, and firms. Such information creates two types of output: reinforced trust (where behaviour matches expectations) and “inductive distrust” (where behaviour frustrates expectations).

I. 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.

They assume, for instance, that the market will continue to exist for the foreseeable future in its current form. That it will remain inert - unhindered by externalities like government intervention, geopolitical upheavals, crises, abrupt changes in accounting policies and tax laws, hyperinflation, institutional and structural reform and other market-deflecting events and processes.

They further assume that their price signals will not be distorted or thwarted constantly, thus skewing the efficient and rational allocation of risks and rewards. Insider trading, stock manipulation, monopolies, cartels, informal economic activities (“black market”), and hoarding all tend to consistently but unpredictably distort price signals and, thus, deter market participation.

Market players take for granted the existence and continuous operation of institutions: financial intermediaries, law enforcement agencies, courts, the civil service, educational institutions, and so on. It is important to note that market players prefer continuity and certainty to evolution, however gradual and ultimately beneficial. A venal bureaucrat is a known quantity and can be tackled effectively. A period of transition to good and equitable governance can be more stifling than any level of corruption and malfeasance. This is why economic activity drops sharply whenever institutions are reformed.

II. Trust in other players

Market players assume that other players are (generally) rational, that they have intentions, that they intend to maximize their benefits and that they are likely to act on their intentions in a legal (or rule-based), rational manner.

III. Trust in market liquidity

Market players assume that other players possess or have access to the liquid means 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 it is to transact with others, directly or through intermediaries, such as banks.

IV. Trust in others' knowledge and ability

Market players assume that other players possess or have access to the intellectual property, technology, and knowledge 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 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. Market participants are presumed to harbor realistic expectations, commensurate with their skills and accomplishments. Allowance is made for exaggeration, disinformation, even outright deception - but these are supposed to be marginal phenomena.

When trust breaks down - often the result of an external or internal systemic shock - people react expectedly. 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, not knowing how long will the system survive. Criminal activity increases.

People compensate with fantasies and grandiose delusions for their growing sense of uncertainty, helplessness, and fears.  This is a self-reinforcing mechanism, a vicious cycle which results in under-confidence and a fluctuating self esteem. They develop psychological defence mechanisms.

Cognitive dissonance ("I really choose to be poor rather than heartless"), pathological envy (seeks to deprive others and thus gain emotional reward), rigidity ("I am like that, my family or ethnic group has been like that for generations, there is nothing I can do"), passive-aggressive behavior (obstructing the work flow, absenteeism, stealing from the employer, adhering strictly to arcane regulations) - are all reactions to a breakdown in one or more of the four aforementioned types of trust. Furthermore, people in a trust crisis are unable to postpone gratification. They often become frustrated, aggressive, and deceitful if denied. They resort to reckless behavior and stopgap economic activities.

In economic environments with compromised and impaired trust, loyalty decreases and mobility increases. People switch jobs, renege on obligations, fail to repay debts, relocate often. Concepts like exclusivity, the sanctity of contracts, workplace loyalty, or a career path - all get eroded. As a result, little is invested in the future, in the acquisition of skills, in long term savings. Short-termism and bottom line mentality rule.

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 extra-legal activities rise, society is polarized between haves and haves-not, interethnic and inter-racial tensions increase. To rebuild trust in such circumstances is a daunting task. The loss of trust is contagious and, finally, it infects every institution and profession in the land. It is the stuff revolutions are made of.

V. Trust and Distrust Indices

I suggest a simple index of economic trust with the following variables, all of which are scored on a scale of 1 to 10:

T (i) = P+L+C+I+S+M+V+F+R+W

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

1 divided by the index (1/T(i)) would be the index of economic mistrust.

Population size (P): the bigger the population, the easier it is to cheat and deceive because information is disseminated more slowly and peer pressure is limited;

Law enforcement (L): efficient law enforcement and a functional judiciary enhance trust;

Corruption (C), surprisingly, has 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 (I): the more connected individuals are and the faster the dissemination of accurate, transparent information, the higher the level of trust. Technologies such as the Internet serve to enhance economic trust;

Stability and Predictability (S) are the cornerstones of economic trust: government intervention, geopolitical upheavals, crises, abrupt changes in accounting policies and tax laws, hyperinflation, institutional and structural reform and other market-deflecting events and processes all tend to reduce the average level of trust;

Available and reliable price signals (M), not distorted by insider trading, stock manipulation, hoarding, informal economic activities (“black market”), monopolies, and cartels;

Reliable store of value (V): currency or goods and services can as means of exchange and generate trust only when they represent real long-term value;

Functioning institutions (F) are crucial to the establishment and maintenance of trust: financial intermediaries, law enforcement agencies, courts, the civil service, educational institutions, and so on;

Cultural-social rationality (R): in all cultures and societies there are times when the optimization of profits and benefits, the ethics of contracting, and otherwise rational economic behaviour are subordinated to often self-defeating and self-destructive irrational beliefs, prejudices, stereotypes, and biases, spurred on by capricious and arbitrary leaders, ethos, and mores. Such surrealism is not conducive to economic trust;

Wherewithal (W): when all the economic actors and agents possess the liquidity and knowledge necessary to complete their transactions and honour their obligations, this creates and sustains an atmosphere of trust.

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