Trust is the prime victim of the current global financialmeltdown. Much is made about greed as a motivator of market behaviour, a laGordon Gekko’s "Greed is Good" speech in the film Wall Street. However, whatmakes modern market economies so successful is not that financial markets are a"free for all" but that they have to operate within clearly definedrestrictions. Ultimately it is the rules and protections that promote economicperformance in the world’s rich economies.
Even profoundly poor societies typically have thriving town marketswhere goods and services are exchanged and haggled for. At heart behaviour inthese town markets is little different to that found in sophisticated financialmarkets. The products are different. So are the venue, clothes, and perhapslanguage 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 anexchange 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 andservices. 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 theother party will deliver their promise and, equally important, that thirdparties 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 thepayment I am going to make will genuinely provide me with these shares, thatothers will accept my right of ownership (and thus also my future right tosell these shares), and that the information provided about the company istrustworthy. Any doubts I might have about any of these factors will reduce mywillingness to proceed with the transaction.
Of course there will always be a degree of doubt associatedwith any transaction that is associated with the future. Even when deals aremade in good faith, this does not stop a change in circumstances leading peopleto regret deals made. As a result the more certainty I have about futureprospects, the higher will be my willingness to pay a higher price and, as aresult, the greater likelihood that a deal and exchange will be made.
This is where market regulations and rules come in tofacilitate the operations of financial markets. Regulations and rules ensurethat promises and agreements are adhered to, and they limit the extent thatinformation provided misrepresents the true situation. Regulations will notalter variations in price as circumstances change, but they should protect, orat 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 marketflexibility and the need to protect the rights of participants. As in allwalks of life, the profit motivation has encouraged a steady flow of innovationin financial markets. Also, as in other activities, such innovations come withrisks. Pharmaceutical innovations have produced many health enhancingmedications. There has also been the odd disaster, like thalidomide. As withpharmaceuticals, financial regulations face the natural tension betweenproviding protection to participants and allowing the market freedom to developnew 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 wasthe motivator and regulation had not kept up to protect the innocent.
Ultimately, new regulations will be put in place to preventa repeat, but for now the damage is done. The fall in stock prices seen inrecent months not only reflects their previous over-inflated values, but alsothe impact of a collapse in trust. Market participants no longer have muchcertainty in the credit worthiness of other participants. The complexity ofthe subprime financial arrangements mean that no one is sure about thefinancial soundness of any organisation. Although government actions havemoved into provide some market assurance, there is little they can do to stopthe downward spiral in trust.
Unfortunately trust and confidence are probably the mostvaluable commodities in a modern economy. Without them, few of us are willingto part with our hard earned money. As a result fewer investment projects willproceed and this will have direct impacts on employment, on the prices that wewill receive for our exports, thus on spending by farmers, and so on. Ultimatelythe 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 notsomething that typically recovers in a great hurry. As when a friendprofoundly hurts you, it will take them a long time and many good deeds torecover your confidence.
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