Friday, 18 September 2009

The next 100 days: thinking about risk, trust and ethics

Slí Eile: “the citizens of this country are understandably angry about the state of the banks. They are bitterly disappointed by the failure of our regulatory system. They are appalled by the details of the reprehensible behaviour of some in the financial system and in the property sector in whom they placed their trust and they are also angry with the Government. Many ask why we are putting money into the banks while they endure the brunt of the difficult budgetary decisions which we must take. There is now unfortunately a breakdown of trust in the entire system.” (Minister for Finance, Dáil Eireann, 16 September 2009).

…. a ‘breakdown of trust’ …. ‘in the entire system’

Lets mull over that especially as it is said by the elected representative with responsibility for spending close to one half of GDP, overseeing the banks, NAMA, macro-economic policy and all those major choices and ‘hard decisions’ pending in the next 100 days.

How did we arrive at this point? Why? If trust is like a pane of glass shattered in an instant or over many instants – how can it ever be rebuilt again? We are all only too familiar with the story of betrayed trust from residential institutions for children to banks to politicians and many other organs of respectable society.

A surprising feature of any economic system is trust. Trust is to the operation of markets as oxygen is to life. A collapse in market ‘sentiment’ – read ‘feeling’, ‘mood’, ‘instinct’, ‘perception’, ‘belief’ – can be dramatic, sudden and stampede-like.
That soft, touchy-feely, hard to quantify, hard to legislate for thing is known as trust. At its core, trust is what people expect others to do or not do. It is an expectation founded on experience or something else related to human evolution and experience over many generations.

Trust is predicated on the basis of perceived or acknowledged risk – where I risk some good or resource on the assumed or perceived good will of others to act honourably. I trust you to reciprocate a favour or service at some future date; you trust another to reciprocate a favour done to you; I trust that person and that person trusts me on the basis of his/her trust in you. Generalised inter-personal trust is the result of a countless number of exchanges over time.

But ….. trust among various social groups and between various political, legal and corporate institutions is the agent which sustains economic progress. For all its warts and limitations, social partnership between 1987 and 2008 helped us to emerge from where we were to a position of relative economic strength. It was built – to some degree on cooperation and trust – the idea that give and take can yield gains for everyone in the medium-term that are would not be possible if each economic interest seeks to maximise its interests without regards to others.

Clearly, trust has been shattered ‘in the entire system’ and this is as serious as it gets. Rebuilding it will require radically different policy responses and joined up thinking. If some form of social and economic partnership is to emerge from this current impasses it will have to take a very different form to what went before. It may even have to take a much more emphatic cross-border and transnational dimension where, increasingly, the only way to deal with global issues such as the race-to-the-bottom, climate change and market instability is through combined global cooperation allied to local initiative.

NAMA, Post-Lisbon, Sovereign debt defaults, Social Cohesion, Global Warming, future pension liabilities, terrorism, poverty….. or loss of employment and income, break-up of relationships, ill-health – the list is endless. Risk – like power – is everywhere. But, is it such a bad thing?
Have we too much of the wrong type like cholesterol? How do we manage risk – personally, corporately, at the level of society?

If we as parents, community, society do not invest in our young children what are the risks for them and everyone else? Everything has consequences and sometimes we have to make difficult choices with different types of risks. If only we could calculate the risk mathematically and feed it into a risk model to give us the optimum response strategy! But, life is of course not that simple.

In strictly market terms, ‘risk’ denotes that which is associated with effort or capital (any type including physical, human, community, ethical) where the ‘return’ or the outcomes are uncertain. The uncertainty of return provides a justification for a premium ‘payment’ to the one who undertake the risk. Underlying any risky venture whether in terms of economic production, medical intervention or venture sport … there is a time element. One decides to chose one option or course of action over another on the basis of rational, moral or instinctive grounds. The result of such a choice may not be apparent for a long time. The ‘payback’ or secondary impacts (on others as well as oneself) takes time to yield.

How does risk apply to trade in goods, services and finance capital? Since the world is far from the deterministic machine image used by some 19th century social engineers and theorists, the impact of any investment or consumption strategy is unknown. All we have to go on is (i) past experience and data (of which we have more than ever), (ii) some theory or set of theories about the way people, markets, institutions work and (iii) preferences with regard to which things matter most in life.

In many ways the financial swinger market party of the last two decades gave a huge outlet for indulgence in ‘risky’ behaviour. Ironically, a lot of the party goers got infected and now very few will party anymore for fear of contracting more bad assets. Put another way, banks stop lending to each other and nobody trusts anyone else or what the value of anything will be in a year’s time. Short-termism which drove us to where we are now becomes even more dominant. And so we have an extraordinarily short-termist approach to correcting the fiscal deficit while people just assume that one or both of the following will happen: property values will recover by a sufficient amount as to pay for NAMA in the coming decade and international recovery will, eventually, lift us out of the slump in demand and consumer/investor confidence.

Greed has been cited as a key ingredient in the current crash. We had a relentless, ego-driven, empire-building, look at my stash mentality. Compete, grow, conquer, excel …. It gave full vent to primitive instincts. That amazing book ‘Lord of the Flies’ by William Golding tells a story about school boys stranded on an isolated island where chaos breaks out as they divide into competing groups. I often wonder how thin a veneer civilisation is over an underground of very destructive forces…..check out Dick Fuld who drove Lehman to collapse. But, we would be very wrong to think that the sum of greed on the part of many individuals was the only factor that brought us to where we are. The very institutions, cultural norms, societal structures and assumptions that underpinned our ‘entire system’ were based on a view of how things worked and how things should work.

Just when many in Government, economics and finance thought that a bit regulation and fiscal smoothening would see off any repetition of the Great Depression we got the Great Recession. If people just looked at the recent experiences of Japan, Sweden, Finland and many other places and thought through the possible sequence of triggers set off by one big banking collapse in the US economy they would have realised that a massive and systemic collapse in confidence, trust and coordinated market response is possible. People can act like rational beings in a way that wrecks the larger polity and market. It is a type of Prisoners’ dilemma so beloved by game theorists.

The next 100 days will tell a lot. A courageous Government in Ireland would:

* acknowledge the full truth of how we got to where we are now
* give example and take the lead by applying its own medicine to itself
* engage all those charged with economic recovery in an open dialogue based on facts and values leading to practical solutions and policy adjustments painful as they will inevitably be
* take charge of the seriously ill banking system in a way that is just, workable and effective from the point of view of restoring economic confidence in the medium-term (none of which I think NAMA meets)
* afflict the comfortable and comfort the afflicted.

I am afraid that on this very last point, we are witnessing more the exact converse.

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