Trust, where trust is due
When my love swears that she is made of truth,
I do believe her though I know she lies,
That she might think me some untutored youth,
Unlearned in the world’s false subtleties.
Thus vainly thinking that she thinks me young,
Although she knows my days are past the best,
Simply I credit her false-speaking tongue:
On both sides thus is simple truth suppressed:
But wherefore says she not she is unjust?
And wherefore say not I that I am old?
O! love’s best habit is in seeming trust,
And age in love, loves not to have years told:
Therefore I lie with her, and she with me,
And in our faults by lies we flattered be.
Shakespeare, Sonnet 138
The crisis mantra has been — and continues to be — of restoring trust, of rekindling those animal spirits that are at the heart of the aggregate of human behaviour that is the economy. But perhaps the boom that we are now yearning to return back to by brute policy force already carried the seed of self-destruction? A long-term investor, we are acutely aware of the wild gyrations of mood swings, yet we advocate the policy makers keep their cool and stay away from trying, and inevitably failing, to micro-manage actors, whereas economic actors should regain modesty in the face of uncertainty. Capitalism is resilient, States are not.
What can I know?
The first question at the core of German philosopher Immanuel Kant’s Critique of Pure Reason helps us to understand why trust is deemed important for economic cycles, but it also leads us to question the validity of trust as a driver for action.
Ever since Roosevelt’s ominous 1933 nothing to fear but fear itself, the loss of trust is considered to be at the heart of economic crises. Yet, like pregnancy, trust is a binary variable only in individuals. In the marketplace, it lies at one end of a measurable continuum of outcomes of the cognitive process. What is, then, the opposite of trust?
In the real world of limited resources, limited knowledge and fundamental uncertainty about the future, making decisions based on trust is inevitable. In economic terms, relying on trust reduces transaction cost in an economy and thus encourages activity. But what activity?
Indeed, the build-up to the financial crisis may be read as a story of overabundance of trust, of overconfidence. When trust began to revert to its mean — as it always does, the house of cards collapsed. What follows is a brief summary of that narrative.
Ground Zero of the crisis was the US real estate market. Everybody was confident that the only way this market could go was up steadily. With that assumption firmly in place, everybody wanted a piece of the action, even if they could not afford it, and banks were happy to oblige, assuming that the rising tide would lift all boats. The subprime market was born.
The wealth effect was an important driver of consumption growth: Owners were able to draw cash from their real estate by increasing the mortgage to the higher value of their homes, hence the notion of the ATM at home. They trusted that rising prices would invariably help them build their home equity, given a year or two.
Next in line of leverage were banks. Thanks to the confidence in the Great Moderation with its promise of permanently low interest rates and low volatility, they had no qualms to operate their balance sheets with very low equity ratios. Their confidence was boosted by a regulatory framework (Basel II) that relied on risk-weighting: Irish banks for instance were obliged to hold zero capital for Irish government debt. These low capital ratios generated outsize profitability. Profitability was enhanced even further by the securitisation of loan portfolios which were packaged and sold off under the originate to distribute model to other investors. Instrumental in that sale were top grade ratings equivalent to risk-free investments from rating agencies.
Rating Agencies trusted their models, which promised very low probabilities of default even for portfolios of subprime loans, if only the portfolio was diversified enough. This would be the objective presumption, without taking into account the conflict of interest built into the Rating Agencies’ business model by the fact that the issuer pays for his own rating.
Investors of course put faith in both Rating Agencies and analysts, expecting that they could save on onerous due diligence for their investment activity by delegating the task to others. It is a known fact, though, that analysts tend to herd around the consensus opinion because the single biggest career risk for an analyst is to be wrong and alone. If the analyst is right and alone, then that’s considered a lucky outlier, but if she’s wrong in a crowd, then everybody else was equally wrong as well. That explains the reluctance of analysts to stray too far from the consensus mark and leads to group think.
When the edifice of trust started crumbling and threatened to take the banking systems of several countries down with it, nations took up the gauntlet and saved banks, even though many countries’ balance sheets were already stretched with debt. This was deemed necessary as the fractional banking system itself is built on the notion of trust: banks go down if their liabilities are all called at the same time in a bank run. This is where Bagehot’s[1]lender of last resort (the central bank) steps in. However, Bagehot would have groaned at the extent and indiscriminate nature of bank rescues performed recently: His precept only covers rescuing illiquid banks, insolventones should be left to default. But obviously, default was not an option politically — hence the second part is often conveniently forgotten in the case of large institutions.
In the meantime, we have arrived at the stage where most of the excess financial sector leverage has been transferred to nations’ balance sheets (private sector excess leverage has come down only marginally so far). Consequently, sovereign debt once deemed risk-free is now under scrutiny for default risk, and the first dominoes are already falling. The issuer of the world’s reserve currency gets away with high debt levels at very low rates for now because investors still trust in the USD’s status, for lack of a better alternative. And still, default is not an option politically …
The boom was therefore resting on clay feet of abundant trust and overconfidence. Trying to rebuild it might be possible, but judging from the experience of increasingly violent past crises, the next one would be even worse. Should we really strive to go back there? Can we sustainably go back there?
Economic decisions are made in the realm of uncertainty. It is useful to gauge its extent by reference to a taxonomy of uncertainty[2].
Complete certainty is only available in the domain of classical physics and may therefore be disregarded in our context.
Most models of financial markets work with the definition of risk that is used at the second level of risk without uncertainty: all statistical properties of risk are fully known. This is the risk level appropriate to describe an honest casino.
Only now are we beginning to approach economic reality. Under fully reducible uncertainty, we assume that all possible outcomes are known, but not their statistical distribution. That can be estimated by empirical means, though. However, there needs to be a single, homogeneous model that causes the phenomena which we can observe in the world of fully reducible uncertainty.
“Under partially reducible uncertainty, we are in a casino that may or may not be honest, and the rules tend to change from time to time without notice.” This is where the monsters of reality live. Observed phenomena may well be generated and explained by multiple models. Sometimes, markets are liquid and efficient; sometimes they freeze up without warning. Analysis is valuable and has explanatory power, but only to the extent that it can reduce uncertainty.
The top two levels of uncertainty (irreducible uncertainty and “Zen uncertainty”) are characterized by model ignorance beyond the reach of any meaningful quantification. Therefore, they do not suit the requirements of practical life.
The taxonomy of uncertainty thus reveals two crucial facts:
- Risk and uncertainty are two altogether different animals, even though the terms are often used synonymously: Risk can be captured, described and forecast fully by statistical means, whereas uncertainty cannot. In an uncertain reality, there always remains an unknowable likelihood of the unexpected.
- Many, if not most economic decisions are made under conditions of uncertainty rather than merely risk. Weighted by impact, uncertainty decisions are almost certainly more important than risk decisions. The crisis has demonstrated beyond doubt the inability of risk-based models to cope with uncertainty issues. Effective practical consequences are yet to be drawn.
What ought I to do?
That brings us to the second question from Kant’s Critique. Given that trust is not an unadulterated, stable good, and that economic decisions have to be made under uncertainty, what is a responsible course of action for political, regulatory and corporate leaders and investors?
Today’s leaders know trust — they live and breathe it. That’s why they responded forcefully to a perceived loss of trust in the system as the symptom of a liquidity crisis. But that response may well have been the wrong course from a systemic perspective. It was assuming that the crisis was just a transient crisis of confidence (as in Bagehot’s bank runs), whereas in fact, it becomes increasingly evident that we are dealing with a systemic solvency crisis.
Leadership in a liquidity crisis is much less demanding than in a solvency crisis, because liquidity crises tend to be of shorter duration and often do not require painful measures. Usually they can be resolved by taking a swaggering stance on the part of the lender of last resort, deploying shock & awe and wait until the crisis blows over. In a solvency crisis however, painful & therefore unpopular cuts are inevitable. Deferred cuts are usually even more painful. It is in this context that Mervyn King, the Governor of the Bank of England, is quoted as having said that whoever wins the 2010 UK elections will be unelectable for a generation. Definitely not an encouraging outlook for the incoming team.
Many of the shock & awe measures taken during the crisis and in its wake proved to be of a hitherto unknown quality: Treasuries and Central Banks became directly involved in negotiations with threatened actors in order to find ways to stabilise them, rather than taking the traditional path of authoritative action. Negotiations by definition take place among equals, therefore, by choosing a negotiated approach, the authorities accepted to be placed at the same level as their counterparts.
Subsequently, governments took over or guaranteed liabilities from the financial sector without losses to holders of such liabilities, thereby taking the place of a regular actor in the financial markets with its own particular agenda, rather than the traditional role of the watchdog on one hand and the boringly conservative and predictable seller of government debt on the other (let’s forget the tax authority for now). With rescue operations and — even more so — with unprecedented monetary and fiscal policy action, authorities entered the business of issuing promises they could not be sure they would be able to honour.
By doing so, authorities introduced systemic uncertainty at a level that was not built to handle it: the State. Citizens expect the State to be forever, whereas actors in the capitalist system may succeed or fail — they come and go. Failure is a necessary, indispensable part of the system. Capitalism has built in redundancy to cope with uncertainty whereas States do not. Their failure to honour a promise is a major event.
The modern State has evolved to reduce uncertainty for its citizens. In the terminology of uncertainty, its mechanism — the rule of law — is almost entirely located within the third layer of fully reducible uncertainty. The only gateway to uncertainty (apart from foreign policy) is the state of emergency and emergency law. It is hardly surprising, then, that much of the crisis rescue action had to be based on emergency law.
Authorities ought never to have left their relative comfort zone of fully reducible uncertainty. By entering the twilight zone of partially irreducible uncertainty, by making promises they could not be certain they can honour, they gave up their claim to permanence. Demanding trust is very well if you can be sure that it will be deserved by honouring the promises you make, but if it is obvious from the onset that you are wagering on an outcome that is beyond your control (“Yes, we can”), then the demand is foolhardy at best or disingenuous at worst. Electorates around the world intuitively comprehend that and are deeply dissatisfied.
What may I hope?
But such is the state of play. The authorities’ choice of action has turned out to be relatively beneficial for now, and we must hope it remains that way in the interest of everybody. Nevertheless, the crisis is far from over. Indeed, the fundamental odds of an unfavourable outcome are mounting steadily:
- Government debt is unsustainably high and rising, even at low interest rates;
- deleveraging is a long-term process that will take years to bring private leverage down to its historic means, thereby reducing demand and potential growth;
- relatively feeble cyclical growth in mature markets is a result of unprecedented and unsustainable monetary and fiscal policy action;
- demographic dynamics of ageing populations are not helping;
- inflationary signals in the BRIC growth engines may put a break on their fast expansion;
- the political debate around austerity or fiscal stimulus is heating up everywhere.
Add to that mix an unstable currency union, “managed” currencies and potential regional armed conflicts. The resulting picture is complex and not very pretty. Hence, the answer to Kant’s third question What may I hope? is “not much”.
In the scenario that is currently central, we will have kicked the can down another couple of years. Global growth resumes shakily, driven by the growth engines India and China, standing in for the deleveraging USA. However, that scenario indeed carries the seed of self-destruction in an even bigger crisis because leaders will conclude that now, they really know how to manage the system. Overconfidence and trust will know no bounds — for a while.
The second scenario is less pretty in the near term, but more favourable longer term: Authorities take resolute steps to restructure their respective consolidated balance sheets as well as the financial services industry, putting a credible end to Too Big to Fail. This will likely cause some short-term market disruption, but it will put the nexus between the political domain and the financial industry at a healthy arm’s length again.
The long-term investor always need to be prepared for all imaginable scenarios — and some unforeseeable ones, too. That means that our preference lies with a course of action which would (re)create a predictable and robust, or, in Nassim Taleb’s word: anti-fragile environment as quickly as possible. To address the agency issues and conflicts of interest that are everywhere, this framework needs to encompass a high degree of transparency so that economic reality is faithfully represented in business reporting. One of the worst disservices to the cause of building trust in a trustworthy framework was perpetrated when accounting standard setters were forced to defuse some of their more powerful transparency provisions for the alleged benefit of stability. But there can be no stability built on opacity.
Until such time, prudent investors everywhere move to preserving wealth rather than growing it. That may well run counter to the interest and intentions of ill-advised authorities and leaders. But it is plausible in the face of some literature on crises and collapse such as Tainter[3] and Reinhart / Rogoff[4]. Let me quote the Global Guerrillas Blogger John Robb:
“The need for evolutionary advances at the local level will always outstrip the pace of evolutionary change at the center. When the mismatch grows too large, the entire system collapses.”[5]
Some think that the crisis has dealt capitalism a fatal blow from which it will never recover. I beg to differ: Capitalism as a mode of resource allocation is extremely resilient and will survive the collapse of a host society that has become too complex. Let us hope against hope, therefore, that rather than make them more complex, we will be able to reduce the complexity of our governance structures in order to make them more robust. That way, we might be able to trust in Trust again.
Note: The above appeared in Trust Meltdown II, published in 2011.
[1] Walter Bagehot: Lombard Street, A description of the Money Market, London 1873
[2] Andrew Low, Mark Mueller: WARNING: Physics envy may be hazardous to your wealth; 2010 http://arxiv.org/abs/1003.2688v3
[3] Joseph Tainter: The Collapse of Complex Societies, Cambridge 1990
[4] Carmen Reinhart, Kenneth Rogoff: This Time is Different — Eight Centuries of Financial Folly; Princeton 2009
