The Most Damaging U.S. Deficit: TrustChris Farrell
The tragic reverberations of the Apr. 20 explosion aboard the Deepwater Horizon offshore rig aren't letting up. The Gulf oil spill is an ecological disaster for the affected coastlines of Florida, Louisiana, Alabama, Mississippi, and Texas. The eventual economic damage will be substantial, too. The local fishing and tourism industries face bleak years. The Federal Reserve Bank of Atlanta recently calculated that some 132,000 jobs are at risk in the accommodation and food industries of metropolitan areas along the Gulf.
The financial damage extends far beyond the Gulf and its environs. BP (BP) has lost some 45 percent, or $80 billion, of its market value, suspended its dividend, and agreed to put $20 billion into an escrow fund to compensate victims of the oil spill. Offshore oil rigs and their workers are idle, with the Administration having placed a six-month moratorium on deepwater drilling.
That said, the most worrisome long-term economic impact of the Gulf spill lies elsewhere: The catastrophe is adding to the gradual erosion in trust in U.S. professional elites and major institutions, from government to business. It has hardly inspired confidence to watch the White House scramble to prove that President Barack Obama wasn't as detached from the crisis as he often seemed, or to witness the inability of the world's best oil engineers to stop the underwater gusher.
Confidence in the economy's commanding heights has taken a beating following a long run of scandals and malfeasance. The list includes everything from the Enron and Worldcom failures, Bernie Madoff's massive fraud, the subprime loan mess, the government rescues of Fannie Mae, Freddie Mac, and AIG (AIG), the controversy surrounding Goldman Sachs' (GS) collateralized debt obligations, and so on. The Tea Party movement may grab all the attention with its antigovernment rhetoric, but surveys have repeatedly shown that its sentiment is widely shared. For instance, a series of long-run surveys by the Pew Research Center find that only 22 percent of those surveyed say they can trust government. That's about the lowest measure in half a century. The ratings are similarly abysmal for large corporations and banks and other financial institutions: respectively 25 percent and 22 percent.
Trust isn't as easy to measure as land, labor, and capital. It's more like a recipe or a software protocol that allows for economic exchange and all kinds of innovation. Nobel Prize Laureate Kenneth Arrow famously remarked that "virtually every commercial transaction has within itself an element of trust." Societies with high levels of trust are fertile ground for developing large corporations and innovative enterprises. Low-trust societies feature people who don't like to do business with folks outside their family or community; smaller, family-run companies are the norm.
trust: an economic multiplier
There is compelling evidence that large economic benefits stem from both high levels of trust in institutions and a belief in the general trustworthiness of individuals in society. What's more, trust becomes increasingly vital to commerce as the products or services that are traded grow more sophisticated. It takes a lot more trust to buy a giant printing press—from a belief that it is well-made to confidence that repair services will keep it running—than to buy a simple commodity such as wheat.
"Along these lines sociologists, political scientists, and recently, economists have argued—and showed—that having a higher level of trust can increase trade, promote financial development, and even foster economic growth," says Paolo Guiliano, professor at the Anderson School of Management, UCLA. "Hence the more trust, the better for a country's economy."
There's the rub. Take the stock market. The decision to buy stock partly reflects an analysis of value and risk tolerance. But it's also an act of faith or trust that the underlying data is reliable and that the system is fair. Research by economists Luigi Guiso of the European University Institute, Paola Sapienza of Northwestern University, and Luigi Zingales of the University of Chicago suggests that trusting individuals are significantly more likely to buy stocks and risky assets after adjusting for wealth, legal protection, and a number of other factors. For instance, in studying Dutch investors, they find that trusting others increases the probability of buying stock by 50 percent and raises the share of wealth invested in stocks by 3.4 percentage points.
What then are the implications of a decline in trust in the fairness and functioning of financial markets? A Financial Trust Index created by Sapienza and Zingales in December 2008 shows that in the first quarter of 2010, 23 percent of Americans trusted the nation's financial system, down 2 percent from the previous quarter. Looking at the stock market section of the survey in particular, only 16 percent of respondents said they trusted it. "I think that trust is important in transactions, especially financial transactions," says Zingales. "It's hard to quantify but it's very important to decisionmaking and development."
Perversely, attempts to counter the decline in trust in the aggregate may be exercising a dampening effect on the economy's vitality. Since the collapse of Enron in 2001, the government has imposed an increasing number of checks and balances on business, ranging from the corporate accounting and reporting reforms of Sarbanes-Oxley to the current financial services reform bill currently being hammered out in Congress.
lack of trust stifles innovation
It isn't just government. Businesses have also established internal checks and balances, administrative layers of compliance, and auditing rules and regulations, all geared toward reassuring investors and employees that breaches in trust won't happen. The time clock and the expense report calculated to the penny have been replacing trust and common sense.
Many of these efforts are well-intentioned. Taken together, much of the government and corporate regulatory state is now counterproductive. "When the workplace become less trusting it becomes less innovative," says John Helliwell, professor emeritus of economics at the University of British Columbia. "Successful companies turn the 'I' into a 'we' and the lack of trust converts a lot of 'wes' into an 'I'."
The most dangerous element in the burgeoning trust shortage may be the inability of the nation's political system to put its enormous debt and deficit on a downward trajectory. Right now, global investors are making an enormous bet that Congress, the White House and the Federal Reserve will manage that Herculean feat. The rate on U.S. Treasuries is remarkably low. Even more striking, the U.S. Treasury Inflation Protected Security is predicting that inflation will average slightly less than 2 percent over the next 5 years, and a fraction over 2 percent for 10 years.
This boils down to an additional matter of trust—that prickly political factions can somehow pull together to make difficult fiscal choices. Given the tone and substance of the nation's political discourse, it's almost impossible to imagine Washington getting down to business and enacting over the medium-and long-term the kind of political compromises that will be needed to embrace fiscal conservatism.
If investors in U.S. Treasuries are wrong, the crowd that makes its bets on rampant inflation and financial disarray—i.e., gold investors—may have the last laugh. With the yellow metal closing at $1247.2 on the Comex on June 17—up about 25 percent over the past year—you may already hear them chuckling.