Social trust, social fragility and the financial crisis

<p><em>Romesh Vaitilingam interviews Paul Seabright for Vox<br />
</em></p>
<p><em>August 2010<br />
</em></p>
<p><em>Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5487]</em></p>
<p><strong>Romesh Vaitilingam: </strong> Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with Paul Seabright from the Toulouse School of Economics. Paul and I met at the European Economic Association&rsquo;s annual meeting in Glasgow in August 2010, where we spoke about his book The Company of Strangers: A Natural History of Economic Life. The book has recently been reissued to take account of the financial crisis. But I started off by asking Paul to explain the basic idea of his book.</p>
<p><strong>Paul Seabright: </strong>You got to the street in the morning and you maybe buy a newspaper from somebody or you buy a cup of coffee. You can sit down with your cup of coffee and you read the newspaper in a cafe. And you're doing something that your prehistoric ancestors would have found suicidal. You're trusting your life to people who have absolutely no reason to want to help you. And as we now know from the studies of hunter gatherers and apes and so on, have every reason to want to kill you.</p>
<p>What the book is about is this small but extraordinary miracle that although in many ways in our brains we have all the inherited psychology of the great apes, and in particular of the hunter and gatherers humans that succeeded them, which should lead us, based on everything we know, to be suspicious of strangers, to be very cautious before we ever get into a situation where they can do us any harm. In fact, we constructed a social life that depends on them to an extent that is so extraordinary that we've forgotten how it happens.</p>
<p>If you took away all of the things that other people do to you, people who you've never met, all of the goods they prepare for you to wear and to use, the food they prepared for you to eat, you'd starve within a few weeks, so would I.</p>
<p>I'd be quite incapable of surviving without the help of all of these unknown individuals; I expect you would be too. The book is about the fact that we've managed to do something which everything in our psychology ought to suggest would be impossible, but which is the foundation of the prosperity of the societies we know today.</p>
<p><strong>Romesh: </strong>So, it's really about how trust evolved, how we got to a position as individuals to treat strangers as &ldquo;honorary friends,&rdquo; in the terms you used in the book.</p>
<p><strong>Paul: </strong>Absolutely. Given that we've evolved to be very good at trusting people we know well and we have somehow managed to use that talent to trust people we don't know at all.</p>
<p><strong>Romesh: </strong>In the new edition of the book, which you've written since the financial crisis and the Great Recession, you've applied this idea. Can you explain how that trust issue relates to the financial crisis?</p>
<p><strong>Paul: </strong>Absolutely, yes. One of the ways we have learned to trust other people is that we trust the institutions within which they work. So, there's a knock on the door in the morning and I go to the door and there's a strange man I've never met before. You might think the natural, sensible thing to do would be to shut the door in his face and not to let him anywhere near my house. But, suppose, he's wearing a uniform, and he's a repair man from the company that sold me my washing machine. Well, I'll let him in. I don't know anything more about him than that, but the uniform acts as the kind of badge that makes me willing to trust him.</p>
<p>Now, almost everything we do in our day to day life is borne up by that kind of badge wearing. The reason I can go up to a stranger and ask him for a cup of coffee is because there's a Starbucks sign discreetly nearby or whatever it might be. So our life is constructed around what you might think of as a series of passports people use to persuade others that they really are trustworthy.</p>
<p>Now, the most sophisticated of those passports come from financial institutions. If somebody comes up to me in the street and asks me to give them many thousands of pounds, or somebody sends me a nice email from Nigeria or whatever, then in general I'll have nothing to do with that.</p>
<p>On the other hand, I might well go into a building and hand over many thousands of pounds to somebody I've never met before, because they come with the authority behind them of a financial institution. And what happened in the financial crisis was that we learned about the uses and the abuses of that kind of trust.</p>
<p>What in particular I want to describe is the fact that the reason why the architecture of our financial system became so fragile was not that the whole system was run by greedy people. We know that most of life is run by greedy people anyway and that doesn't explain why it became fragile at the particular point it did.</p>
<p>What it explained why it became fragile at the particular point that it did was, paradoxically, that it was working so well that we no longer asked ourselves questions about the foundations of that success. In particular, we treated it as a black box, which could be relied on to go on working all the time. So, it's looking a bit like the autopilot in a plane. If the autopilot works really, really well, then the pilots go to sleep.</p>
<p>You want to have some kind of system in which you can trust the autopilot most of the time, but for the rare occasions when the autopilot might misfunction somebody has got their eye on it and somebody knows what to do. In some sense, too much of our financial architecture was on autopilot, to mix metaphors from architecture and aeronautics.</p>
<p>The result of that was that when the fragility started to become evident, then first of all there's a bit of a scramble because everybody thought it was somebody else's responsibility. And when it became too big to ignore, nobody quite knew how to react.</p>
<p><strong>Romesh: </strong>You also make an analogy to go on from aeronautics and from architecture, you use the analogy of the electricity supply, in a way financial services are a key part of our infrastructure. Can you unpack that analogy a little bit more?</p>
<p><strong>Paul: </strong>Yes. That analogy I borrowed from a financial economist in America called Gary Gorton, who has written some very interesting stuff on the crisis. He makes a very interesting point. I think that when we use financial institutions and financial instruments, we have to know very little about the detail of the way they work. If I write you a check for &pound;50 you know that it's worth the same as a check for &pound;50 written by somebody else written on a different bank. You don't normally have to sit down and think, &quot;This &pound;50 check on Lloyds is worth the same as a &pound;50 check on the Royal Bank of Scotland.&quot; The whole point about the institution of banking and deposit taking is that claims on those deposits have a value that doesn't have to be constantly called into question.</p>
<p>And that will be quite different for example, if we used--as we might well use--our mutual funds to settle our ordinary payments. And if you offered me a one <em>n</em>th share of your mutual fund account, and it was different from somebody else's mutual fund account, then I might have to ask all sorts of questions about whether the one <em>n</em>th share that you offered me as a payment was worth the same as the one <em>n</em>th share that somebody else is offering me.</p>
<p>Now, the great thing about deposit taking institutions, we don't have to ask that question. And Gary Gorton puts his finger on it when he says that a well functioning banking system allows people who know nothing about financial instruments to use the benefits of financial instruments in exactly the same way as an electricity grid that allows a person who's not an electrician to get the benefits of using electricity. And that's great.</p>
<p>You know, I plug in my kettle to the grid without really having to know anything about physics or the electronics of it. And most of the time, I can ignore it. Now, we know that electricity grids sometimes break down. And they sometimes break down for reasons that might have to do with sudden spikes in demand because it's the break in the World Cup final. They could do for more complex reasons as when the electricity grid in California blacked out some years ago. And when that happens, that's usually because people become too complacent about how well it's all working.</p>
<p>In exactly the same way, when everybody becomes too complacent about how well a financial system is working, then you have to worry. And that's particularly true because in finance, as we were discovering, the rate of technological innovation is so much faster than the electricity. And so, the new instruments that are being developed all of the time, some of them have the capacity to undermine the very stability that is making everybody stay complacent about how the system works.</p>
<p>But, in a sense, the point that I think that very nice analogy of Gary Gorton&rsquo;s makes is that if the system were working terribly and were not delivering great benefits, then it would be mysterious why it should have this capacity to catch us so unawares. You know, people who say, &quot;Oh, you know, modern finance is a disaster,&quot; in a sense, haven't grasped the essentials of that point. Modern finance can trap us in this way, precisely because it does deliver such real and such valuable benefits, and is so trustworthy for such a remarkable part of the time.</p>
<p><strong>Romesh: </strong>And over that time, you really date it back to the period where we've really built up this trust since the last time there was a huge collapse, which was back in the 1930s. And, you seem to suggest that we came out of the Depression and learned the wrong lessons in terms of how we think about the financial sector.</p>
<p><strong>Paul: </strong>Yes we did. There's nothing more dangerous than to think that we've learned the lessons of history and, therefore, we can relax. In particular, the lessons that we thought we'd learned from the 1930s, I think, comprise three rather dangerous simplifications.</p>
<p>The first idea was that in the 1930s we thought banks had failed because people panicked. And as I say in the book, this is sort of the little bit like the theory that it's running away from the lions that causes the lions to eat you. You know, there is some truth in that. But, if you go to a game reserve, it's not a truth on which you really want to rely. </p>
<p>And, similarly, we've been discovering since then that I think as a result of careful historical work by economic historians that although there was quite a lot of panic, and although many banks failed, in most cases, the panic was well founded. It wasn't the panic that caused the failure. The failure was caused by incompetence and dishonesty in exactly the same way as it's been caused recently by incompetence and dishonesty.</p>
<p>Now, how did that feed into the other bad lessons we learned? Well, the second lesson we thought we'd learned was that the people you had to worry about were the small depositors the households, the individuals, the small firms, and so on. They didn't really know very much about finance. They couldn't be expected to worry their little heads about it. And so, naturally, they had to be reassured. And they had to be reassured by deposit insurance, and everything had to be done to make them avoid panicking.</p>
<p>The grown ups, the people who are the professional investors, they don't need reassurance. They understand about finance. They're not going to panic. So, essentially, it's going to be possible, providing we protect the small depositors, to let the big depositors take care of themselves.<br />
And that turned out to be a big mistake, because what happened, for example, when Lehman Brothers went belly up, was not that there'd been a panic of the small depositors, it was that the professionals panicked. And, in some sense, it was the banks that stopped trusting each other before we, the rest of the public, could realize it was time to stop trusting the banks.</p>
<p>Now, many people think of the Northern Rock episode, when there was a run --the first run on British banks since the 19th century--has been emblematic of the crisis. But it wasn't. It was a radical exception to everything else that happened in the crisis. And it happened for completely different reasons because the deposit insurance coverage in the UK was somewhat incomplete, which is a problem that's since been fixed.</p>
<p>But the panic of the small depositors, the kind of people who lined up outside Northern Rock, posed no real threat to the banking system at all. It was the panic of the big people, of the financial investors. It was when nobody who had money on overnight deposit was willing to trust institutions in which they were trying to put that money. In other words, it's when the corporate treasurers and when the treasurers of the banks themselves were not trusting other banks that we really had a seizure in the financial system.</p>
<p>So, the idea was that we didn't have to worry about professional investors. We realize now that professional investors are precisely the people we have to worry about most of all. That kind of lesson, we now, I think, understand much better. But, we still have to find ways of making those professional investors behave in ways that are more consistent with the long term health of the financial system.</p>
<p>And, if I can just say, the final lesson the we thought we'd learned was because we thought it was the small investors who were prone to panic, and we didn't have to worry about the big ones, the general message was that confidence had to be sustained in the financial system even if the underlying reasons why we might have to be confident are not always very sound.</p>
<p>So, the importance of maintaining confidence led policymakers right across the world to welcome things that looked as though they were confidence restoring, like the increase in house prices which made everybody more confident. Those things were in fact making people feel more confident, but at the same time, simultaneously undermining the objective basis that they had to be confident. And we now realize that what's important is not making people feel confident, but making sure that the system in which their confidence rests is actually deserving of that confidence.</p>
<p><strong>Romesh: </strong>Your book draws on evolutionary ideas as well as material from economic analysis and from history, and some other disciplines: Is there some kind of evolutionary flaw in humankind that makes us prone to not learn the lessons of history, or learn the wrong lessons from history?</p>
<p><strong>Paul: </strong>Well, I think that's being a bit tough to us and where we've come from. You know, there's a whole discipline called behavioral economics within which I work, and which obviously I think is full of rich and interesting insights, but which has a tendency to see human beings as rather imperfect, rational calculating machines.<br />
I don't think we're imperfect, rational calculating machines, I think we're extremely sophisticated apes. And it's much more interesting and perceptive, I think, to see us as sophisticated apes than as imperfect computers.</p>
<p>Now, as sophisticated apes, we do quite a lot of things that other apes also do. For example, we care intensely about status.</p>
<p>So, for example, when we do things like manage portfolios for financial institutions, we care enormously about big bonuses, and we manage our investment strategies in order to get those big bonuses, not necessarily because we desperately need to spend large amounts of money, but because those bonuses are signals of our relative status in a peer group. And everything in our primate history tells us that caring about relative status in our peer group is one of the most dominating concerns and passions that anybody can have.</p>
<p>Similarly, one of the things that apes do and do very successfully is try to out strategize each other, and they do so pretty successfully to what I think of as a remarkable degree of sophistication. That's to say, chimpanzees can perhaps anticipate one degree of strategic complexity. Human beings can perhaps manage three degrees of strategic complexity.</p>
<p>In order to be able to solve a dynamic stochastic general equilibrium model and apply it to the real world, you have to be able to solve an infinite number of degrees of strategic complexity, and I don't think it's reasonable to expect us to do that.</p>
<p><strong>Romesh: </strong>[laughs] Final question, Paul. You end the book by talking about fragility, which I think really comes across as a very powerful message. The fact that, you think that it's an extraordinary achievement, the evolution of human beings into this position where we benefit hugely from the company of strangers. But, it does feel, perhaps particularly in the early years of the 21st century, that we are in a very fragile position.</p>
<p>We've had the financial crash, which is another once in a generation event, but there's also all sorts of other challenges like climate change, terrorism, war. Can you just describe a little more how you think about the fragility of this achievement?</p>
<p><strong>Paul: </strong>Well, it's always difficult to know whether you see the glass half full or the glass half empty. I think an interesting analogy between economics and other disciplines comes from medicine where, even if you study disease and you're aware of the terrible ways in which the human body can break down, you can only begin to see how those things happen if you've gone through the process of being extraordinarily impressed by how well the human body functions in the first place. Nobody can be a good doctor if they're not essentially a good physiologist first.</p>
<p>And I think similarly, understanding the crisis, it's not enough to say, we know that capitalism is dysfunctional. You have to understand, in some sense, dare I say, the beauty of capitalism in order to have understood why it can be so terribly flawed. And the flaws are not just that there are breakdowns and crises, but that even when capitalism is working well, it can leave some people terribly out of the prosperity enjoyed by others. And there are parts of the world where, in some sense, capitalism has never properly taken root, and that's a tragedy.</p>
<p>Now, the sense of fragility, I think, is, therefore, engendered by an awareness that because it's so remarkable how far we've come, it's also possible that some of those achievements might be destroyed, either by inadvertence or by conscious malice on the part of some people who want the sophisticated web of human interaction to breakdown.</p>
<p>Clearly, the more imaginative and ingenious terrorists in the modern world try to strike at both symbolic and actual hubs of modern society for precisely that reason. The reason you take out the Twin Towers is not because intrinsically, you think that that particular chunk of US GDP is going to matter. It's because you think the symbolism is going to help to unravel people's ways of feeling trust and confidence in each other in a particularly damaging way and you see it, I mean, the current US controversy over whether to build an Islamic center in the neighborhood of Ground Zero is a terrible testimony to how effective the Bin Laden assault has been. I can't think of any greater tribute to Bin Laden's objectives than to say all Muslims in America should be presumed to have been a party to his plan.</p>
<p>Now, that suggests, therefore, that if we're looking, we need to take a different approach to inadvertent threats to the stability of modern society from malicious threats. And clearly, malicious threats tend to pick the more vulnerable hubs much more than random chance would do. And so clearly, we need to treat those kinds of threats in a different way.</p>
<p>But, the general point is absolutely right. The more sophisticated are the interactions that modern society allows, encourages and develops, the greater the risk that certain kinds of keystones in the architecture might turn out to have much more damaging effects when removed than anybody had previously imagined, and that's a threat we're going to be living with for decades.</p>
<p><strong>Romesh: </strong>Paul Seabright. Thanks very much.</p>
<p><strong>Paul: </strong>Thank you. </p>