Infometrics
Infometrics
PUBLIC ACCESS:
What price trust?
Fri 24 Oct 2008 by David Grimmond.

Trust is the prime victim of the current global financial meltdown.   Much is made about greed as a motivator of market behaviour, a la Gordon Gekko’s "Greed is Good" speech in the film Wall Street.   However, what makes modern market economies so successful is not that financial markets are a "free for all" but that they have to operate within clearly defined restrictions.   Ultimately it is the rules and protections that promote economic performance in the world’s rich economies.

Even profoundly poor societies typically have thriving town markets where goods and services are exchanged and haggled for.   At heart behaviour in these town markets is little different to that found in sophisticated financial markets.   The products are different.   So are the venue, clothes, and perhaps language of the participants.   But the motivations are more or less the same, obtaining a price that is agreeable to both buyers and sellers so that an exchange can take place.

The key difference is the time element in the products traded.  In town markets there is typically an immediate exchange of money for goods and services.   In financial markets the exchange is typically of promissory notes; the entitlement to an asset or a service at some time in the future.

Underpinning such deals is a high level of trust that the other party will deliver their promise and, equally important, that third parties will acknowledge and honour the change in circumstance.   For example, for me to purchase some shares in a company I would need to be assured that the payment I am going to make will genuinely provide me with these shares, that others will accept my right of ownership (and thus also my future right to sell these shares), and that the information provided about the company is trustworthy.   Any doubts I might have about any of these factors will reduce my willingness to proceed with the transaction.

Of course there will always be a degree of doubt associated with any transaction that is associated with the future.   Even when deals are made in good faith, this does not stop a change in circumstances leading people to regret deals made.   As a result the more certainty I have about future prospects, the higher will be my willingness to pay a higher price and, as a result, the greater likelihood that a deal and exchange will be made.

This is where market regulations and rules come in to facilitate the operations of financial markets.   Regulations and rules ensure that promises and agreements are adhered to, and they limit the extent that information provided misrepresents the true situation.   Regulations will not alter variations in price as circumstances change, but they should protect, or at least limit, participants’ exposure to unscrupulous behaviour by others.

Financial market regulations and rules have evolved overtime, reflecting the natural tension between the benefits accruing from market flexibility and the need to protect the rights of participants.   As in all walks of life, the profit motivation has encouraged a steady flow of innovation in financial markets.   Also, as in other activities, such innovations come with risks.   Pharmaceutical innovations have produced many health enhancing medications.   There has also been the odd disaster, like thalidomide.   As with pharmaceuticals, financial regulations face the natural tension between providing protection to participants and allowing the market freedom to develop new innovative products.

Subprime mortgages are the financial markets’ current "thalidomide".   For a while they provided opportunities for many in the United States to buy houses and offered easy money to financial institutions.   Greed was the motivator and regulation had not kept up to protect the innocent.

Ultimately, new regulations will be put in place to prevent a repeat, but for now the damage is done.   The fall in stock prices seen in recent months not only reflects their previous over-inflated values, but also the impact of a collapse in trust.   Market participants no longer have much certainty in the credit worthiness of other participants.   The complexity of the subprime financial arrangements mean that no one is sure about the financial soundness of any organisation.   Although government actions have moved into provide some market assurance, there is little they can do to stop the downward spiral in trust.

Unfortunately trust and confidence are probably the most valuable commodities in a modern economy.   Without them, few of us are willing to part with our hard earned money.   As a result fewer investment projects will proceed and this will have direct impacts on employment, on the prices that we will receive for our exports, thus on spending by farmers, and so on.   Ultimately the world economy, and New Zealand will recover, but there are no quick fixes.  The prerequisite is a recovery in trust and confidence, and this is not something that typically recovers in a great hurry.   As when a friend profoundly hurts you, it will take them a long time and many good deeds to recover your confidence.

Related Articles