NB: I am not a macroeconomist (IANAM)

A few years ago, Francis Fukuyama put out a book called Trust, a summary of some arguments are presented at: Social Capital and Civil Society – Prepared for delivery at the IMF Conference on Second Generation Reforms

He argued that social capital was a positive externality that produces trust, and civil society only succeeds if people have trust in the words of others, i.e. they believe others will do what they say, and of course that only emerges if people do if fact do what they say.

The recent economic meltdown in the world economy has resulted apparently in banks being unwilling to lend to other banks for fear they won’t be paid back. That fear arises because, in fact, some banks now defunct, did not pay back loans. They lack trust. One (or in this case a few) bad players shattered the system of trust that had a positive externality in encouraging lending.

The economy only works because of beliefs that a small piece of paper (a dollar bill) will be redeemable by complete strangers for something far more valuable than a piece of paper. Through this belief, we can replace barter with a money economy, we can lend money we don’t have (a la banks) and create wealth by investing in wealth-creating instruments now rather than waiting until sufficient resources are acquired.

It is hard to say how many years advanced economically we are because of borrowing, but one imagines it is probably decades. If the ability to borrow collapses, not only can we not grow faster, we will grow slower as old debts still need to be repaid out of current income leaving little available out of current fund for investment.

Positive externalities operate in two ways, as virtuous circles (more of ‘a’ begets more of ‘b’ which begets more of ‘a’) or in reverse as a vicious circle (less of ‘a’ begets less of ‘b’ which begets less of ‘a’). Changing direction requires an external shock (a collapse of trust for instance, or a major infusion of trust through a government intervention).

The classic examples of virtuous and vicious circles in transportation and public transport ridership and service, which grew as virtuous circle from the 1880s until the 1920s, and where after the past 60 years of vicious circle operation, most of the US has very little service and ridership left (despite 30 years of very expensive investments). In the US, transport is “pay as you go” at the federal level, which may very well be a source of for our under-investment, as there is an unwillingness to capitalize now our benefits from investments due to the positive gains they will provide in the future. If we don’t want the entire economy to follow the path of public transport in the US, something must be done.

As suggested above, the collapse of trust is warranted if the players are not trust-worthy. Even if there is an external insertion of funding, if the behaviors of the players reveal their true preferred actions, and these are not regulated in a transparent way, the system cannot necessarily be restarted without new rules to establish trust. As Ronald Reagan was fond of saying “Trust but Verify” (doveryai, no proveryai”).

The same I am sure will hold true of bankers, who not only seemingly distrust each other, but also should distrust the previous failed systems of verification (bond rating agencies) that were insufficient in providing advance warning of emerging problems.

Verification only works with transparency, where the actions of players are observable by all. This occurs on open regulated markets, rather than over-the-counter trades.