Donald C. Clark/HSBC Chair in Consumer Finance, Professor of Finance, and Zell Center Faculty Fellow
Editor’s note: updated findings are available on the Financial Trust Index site.
Consumer spending, home prices, 401(k) values, and employment levels are but a few of the economic vital signs that have plummeted during the upheaval of the past months. While these indicators help to describe today’s crisis, new research by Paola Sapienza (Kellogg) and Luigi Zingales (Booth) suggests that true insight into the root causes of a nation’s financial strength or weakness lies in a different measure: trust. The authors point out that when Lehman Brothers defaulted and AIG had to be rescued by the government in September, the economy was still cruising along—second quarter growth was a comfortable +2.8 percent. And yet, these companies set off an avalanche of corporate devastation ultimately leading to unprecedented bail-out packages and pessimism. How did the default of an investment bank, with very limited lending to the real economy, snowball into the financial crisis we face today? The researchers say it all comes down to trust—an underlying force that frames and influences many of the more traditional economic measures.
The first wave of their newly launched Financial Trust Index shows how trust in U.S. financial institutions and government leadership has eroded and offers possible causes and effects that must be confronted in order to design and implement successful plans to rebuild. The Index will measure public opinion every three months, providing snapshot views and evolution over time of this vital yet intangible asset—an asset so critical that its absence can bring even the richest, most advanced economies to a grinding halt.
Trust and Social Capital
We think government should intervene, but they shouldn’t just give money to Citibank.“Virtually every commercial transaction has within itself an element of trust, certainly any transaction conducted over a period of time,” wrote Nobel laureate economist Kenneth Arrow in 1972. The words ring no less true today. Trust is a critical element of a broader phenomenon, social capital, which has attracted increased attention in recent decades. The concept of social capital is not as historically entrenched or readily defined as physical capital, like concrete and computers, and human capital, like skilled laborers and managerial practices, both traditionally recognized as drivers of any economy. But social capital—the shared habits, values and trusting relationships that span and unite a society—nonetheless imparts very real influence on welfare and development in an economy. Said Sapienza, “In the 1990s, macroeconomists started using the concepts of trust and social capital. They looked across different countries and found that higher social capital and trust led to larger firms, better growth, and more development.”
Political scientist Edward Banfield famously explored the dangers of diminished social capital in his 1958 book The Moral Basis of a Backward Society. He described his time living among a dysfunctional culture of “amoral familism,” where people were concerned solely with the condition of their own immediate family, to the exclusion of outsiders. This undermined any broader cooperation for the common good of the community. Though he referred to this region using a pseudonym, Montegrano, to maintain anonymity for its inhabitants, it is widely accepted that he was describing regions of rural, southern Italy, such as Calabria, the “toe” of the boot-shaped peninsula.
Sapienza experienced firsthand much of what Banfield described. “I come from southern Italy,” she said. “My parents didn’t write many checks. With checks, you have to trust that the other person won’t make counterfeit copies of your check, and that there’s enough money in the account to cover the check.”
Though social capital and trust can have profound impact on human behavior and interaction, they are not inherently economic concepts. So researchers have been seeking mechanisms by which trust can impose real influence upon economic events. Said Sapienza, “One engine of growth is finance. Trust must be really important, especially with incomplete contracts, when you can’t write down every possible detail in fine print. It’s a leap of faith, for example, to give money to a broker to invest in the market. You have to trust that the broker won’t run away with the money, that a manager will run a company in the best interests of the share holders, not for personal gain.”
Trust and Finance
To further explore and formalize relationships between trust and finance, Sapienza and Zingales hired an independent research company to conduct a telephone survey. The twenty minute survey was completed by 1,034 adults, each of whom makes financial decisions for their household. Results from the first wave of the nationally representative survey, which was conducted from December 17, 2008, to December 28, 2008, have a margin of error of 4.39 percent. The survey will be repeated every three months to track changes in attitudes over time.
The Financial Trust Index shows how trust in our nation’s financial institutions and government leadership has eroded, with possible causes and effects that must be confronted in order to design and implement plans to rebuild.Respondents were asked how much they trusted certain types of people or institutions, using a scale from one, “I do not trust at all,” to five, “I trust completely.” Banks were the most trusted institution, although they teetered between trust and mistrust with an average rating squarely in the middle of the scale at 3.0. Government (2.4), large corporations (2.2), and the stock market (2.1), plumbed ever greater depths of mistrust.
Interestingly, institutions were perceived differently than the individuals they employ. But the influence of those institutions on their employees varied. On the positive side, something about banks (3.0), perhaps their incentive structures and regulatory practices, must confer a positive influence on bankers, who were considered slightly less trustworthy as individuals (2.7). On the darker side, however, the perception of the stock market (2.1) suggests that its inner workings must somehow tempt and tarnish stock brokers, who earn slightly greater trust as individuals (2.2).
All of these individuals and the institutions in which they choose to make a living are considered less trustworthy than “other people in general,” whose 3.3 rating was the only one to achieve the better-than-neutral, more-trusted-than-non-trusted half of the scale. So in spite of all that has happened, average Americans appear to still have a modest level of faith in their neighbors.
Trust and Economic Behavior
Sapienza and Zingales then found evidence confirming that trust is not just a quaint ideal, but a powerful motivator of economic behavior. Differing levels of trust in brokers and the market influenced plans to increase or decrease investment over the next few months. Similarly, trust in bankers and banks influenced plans to withdraw deposits.
These findings echo others recently reported by Sapienza and colleagues, suggesting that they are touching upon some very real, very influential phenomena. “We surveyed people in the Netherlands and found that their level of trust was one of the biggest influences on their investment in the stock market,” said Sapienza. She added, with thick irony, that this study was released in December 2008, just a few days before former NASDAQ chairman Bernard Madoff was publicly accused of defrauding billions of dollars from investors in his private investment firm, Madoff Investment Securities LLC.
When asked how their trust had changed over the past three months, people indicated a decrease across all categories, with perceptions of the stock market most soured. Pinpointing the root cause of something as complex and shapeless as a loss of trust can prove difficult if not downright impossible. Yet some prime suspects emerged from the data. People whose trust in markets plummeted the most over the past three months were those whose personal wealth eroded the most, in percentage terms, over the past year. In addition to this raw, personal financial pain, Sapienza and Zingales suspected that some high-level policies and (in)actions may have also undermined trust. They asked respondents to identify the main cause of the 2008 financial crisis, providing them with six options from which to choose.
Those who blamed excessive government intervention (11 percent of respondents) or global imbalances (6.7 percent) retained the greatest trust in the market (trust levels 2.4 and 2.6, respectively). The respondents with the least trust in the market blamed the government, citing lax oversight (16 percent; 1.9) or regulation (15 percent; 2.0) as chief causes of the crisis. Similarly low were levels of trust among those who heaped blame upon companies, citing poor corporate governance (15 percent; 2.2) or managerial greed (36 percent; 2.0).
These findings are of particular interest to Sapienza and Zingales, because they take small but significant steps toward suggesting how to most effectively combat the nation’s current trust crisis—and, by extension, financial crisis. Said Sapienza, “We hope to be able to understand which policies are working, which ones aren’t. For example, when there’s a huge, negative shock to trust, like when bond rating agencies were mislabeling AAA bonds, what should government do?”
When contemplating possible interventions for a patient, every medical student learns to “first, do no harm.” The same principle does not seem to be foremost in the minds of Washington’s purse holders and policy makers, at least in the eyes of the public. The majority of respondents (80 percent) indicated that government intervention made them less confident in the market. So even though a combined 32 percent of people blame the government for not doing enough to avert the crisis via regulation or oversight, 80 percent then lost confidence when the government ultimately took action.
In other words, intervention alone is not enough—the intervention must actually accomplish something. Even among the subsegment of respondents who felt that federal intervention in the financial sector should increase (a 55 percent majority of the total group), 75 percent still lost confidence as a result of recent federal intervention.
This presents an enormous problem, suggests Sapienza. “The government’s reaction when people started walking away from the market wasn’t to intervene to increase transparency. They just pumped money,” she said. “But people now are saying, ‘We think government should intervene, but they shouldn’t just give money to Citibank.’” Citibank is a division of Citigroup, which is to receive an estimated $50 billion from the government under its Troubled Asset Relief Program (TARP).
To dig even deeper, to understand specific features of the unfolding intervention drama and their unique influence on trust, Sapienza and Zingales had respondents read Hank Paulson’s mind. Respondents were asked to choose what motivated then-Treasury Secretary Paulson as he engineered and executed the government response. While 20 percent of respondents had no opinion, the remaining 80 percent were evenly split. Half the group, 40 percent of the overall respondents, believed Paulson acted in the interest of the country. The other 40 percent, however, believed that Paulson’s plan was meant to benefit Goldman Sachs, the investment bank at which he served as chairman and CEO prior to being appointed Secretary. Goldman Sachs is to receive an estimated $10 billion in Federal funds as part of the TARP. Of those 40 percent who harbor conspiratorial notions of cronyism and self-enrichment on the part of Paulson, 90 percent were made less confident in the market when the government intervened. Coziness between government and the financial industry, whether real or not, is clearly a problem in the eyes of many Americans.
The Housing Market
While this first wave of Financial Trust Index analysis focused on trust in banks, brokers and the federal bureaucracy, Sapienza and Zingales are eager to investigate another key aspect of the ongoing crisis: the housing market. Said Sapienza, “We’re looking at dissonance between perceived and actual home value, asking, ‘How much have home values dropped in your area?’ We’re comparing these beliefs to real home values, zip code by zip code. Most people think that their home is doing better than the rest.”
Another related, painfully real issue is mortgage default. The Internet is abuzz with advice from sites such as youwalkaway.com, which outline do’s and don’ts for those planning to intentionally default on their mortgage. Said Sapienza, “What’s the moral basis of strategic default? How many people would walk away from their house, default on their mortgage, once the home value was less than the amount still owed? The standard economic view, not concerned with moral incentives, would simply project home values and defaults. But we asked &lsqulsquo;If your house was worth $50 thousand less than what you owed, would you walk?’”
“Only 14 percent said ‘yes,’” she said. “The others felt that they were making a moral choice.”
Arrow, Kenneth (1972) “Gifts and Exchanges,” Philosophy and Public Affairs, 1(4): 343-362.
Banfield, Edward (1958) “The Moral Basis of a Backward Society,” The Free Press, Glencoe, IL.
Guiso, Luigi, Paola Sapienza, and Luigi Zingales, (2008) “Trusting the Stock Market,” Journal of Finance, 63(6), 2557-2600.
Brad Wible is with the Office of Research, Kellogg School of Management
Sapienza, Paola and Luigi Zingales (2009). “A Trust Crisis.” http://www.financialtrustindex.org/results.htm
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