Policy Papers


Trustworthy Economics

Geoffrey Hosking |

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Executive Summary

  • The dominant mode of economics has four main defects: (i) it ignores morality; (ii) it fetishises rationality and self-interest; (iii) it treats individuals as discrete units who relate only through trade and consumption; (iv) it underestimates uncertainty.
  • The current economic crisis has cast fundamental doubt on the orthodoxy that economic policy promotes growth via the markets and ensures efficient allocation of resources. It has shown that markets do not assess risk well, do not allocate resources efficiently and, when unrestrained, tend towards the unstable disequilibrium of booms and bust.
  • Much can be learnt from morality and human psychology about the workings of the market. A key question is the relationship between the self-interest of traders, which Adam Smith argued inadvertently benefited society as a whole, and 'sympathy' with others, a desire to help those in distress.
  • The concept of trust (and distrust) should be at the centre of the study of economics. It explains human behaviour better than the assumption of rationality and self-interest. It offers a way for human beings to take decisions and act together, rather than merely as individuals. It helps us to explain how economic actors take decisions when they have less than perfect information.
  • Using the concept of trust makes it much easier to explain what has given rise to the present crisis. It has been caused by both misplaced trust and abuse of trust. In autumn 2008 what precipitated the near-death experience of the US and British banks was a collapse of mutual trust. They did not know enough about each other's exposure to debt to engage in even routine overnight lending.
  • We need to bolster trust and confidence. The key must be to make financial institutions more trustworthy. Restoring trust involves finding better ways to deal with risk.
  • Banks should be regulated by government and international financial institutions. There should be greater transparency around the operation of hedge funds and trade in derivatives. Large financial companies should have incentive systems which reward genuinely productive activity.
  • We need to rethink and devise methods of financing routine but vital activities such as health services, education, transport, housing and utilities - Britain has a rich history of friendly societies, cooperatives and mutual funds on which to draw in this regard.

The malaise of economics

There is a widespread feeling that the science of economics has lost its way. Its current orthodoxy is a belated child of nineteenth century Utilitarianism. It is trapped in a narrow and misleading view of human nature which regards human beings as individuals motivated by material self-interest and making rational choices with a wide range of good information normally available to them. Most economists seem to believe the aim of economic policy should be to promote growth through the medium of markets - which by nature are self-correcting, tend towards equilibrium, assess risk better than any government agency, and ensure the most efficient allocation of resources.

The current economic crisis has cast fundamental doubt on all of this. It has shown that markets do not assess risk well, do not allocate resources efficiently and, when unrestrained, tend towards the unstable disequilibrium of boom and bust. But where are we to look for more reliable guidelines? George Akerlof and Robert Shiller have accused economists of ignoring the vital input of 'animal spirits', a term they borrow from John Maynard Keynes. Similarly, according to the Financial Times, at a recent gathering of leading economists in Cambridge to discuss the failures of economics, 'One of the central conclusions was that economists and market traders alike need to devote far more time to human psychology, rather than just the raw economic numbers beloved of many policy wonks.'

Some thinkers also urge that we need morality to restrain the market. Robert Skidelsky for example, attacks 'the worship of economic growth for its own sake. ... The main moral compass we now have is a thin and degraded notion of economic welfare, measured in terms of quantity of goods.' Similarly, in his 2009 Reith Lectures Michael Sandel called for a reinjection of moral concepts into our understanding of markets. 'It is time', he said, 'to rethink the role of markets in achieving the public good.' He added 'There's now a widespread sense that markets have become detached from fundamental values, that we need to reconnect markets and values.'

The dominant mode of economics has four main defects: (i) it ignores morality; (ii) it fetishises rationality and self-interest; (iii) it treats individuals as discrete units who relate only through trade and consumption; (iv) it underestimates uncertainty.

Self-regulating markets and the 'invisible hand'

Those who believe morality has no place in efficient, self-regulating markets draw on Adam Smith's concept of the 'invisible hand'. Briefly stated, Smith asserts in The Wealth of Nations that, in making optimal use of his own capital in his own interest, the merchant, without intending to, actually promotes the best interest of society as a whole. 'By directing [his] industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.... By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.'

Given the weight nowadays placed on this concept, one would expect Smith to have explained it thoroughly. Actually he uses it only as a handy metaphor, designed to illuminate a particular assertion, about choosing between domestic and foreign markets. In itself it has limited application, and cannot be deployed to sustain a broad argument about markets. Emma Rothschild even asserts that the 'invisible hand' was 'un-Smithian', and in any case an 'unimportant' part of his theory; neither did economists use the concept much until well into the twentieth century and, when they did, made assumptions Smith would mostly have rejected.

If The Wealth of Nations does not fully explain the 'invisible hand', perhaps Smith's other work can give throw light on the moral dimension of markets. He was after all Professor of Moral Philosophy at Glasgow University. His Theory of Moral Sentiments offers us an account of a society in which human beings interact peacefully without being coerced by a Hobbesian autocrat. They do so because they each have an inherent moral sense, a faculty of 'sympathy' with others, a desire to help those they see in distress. We also, according to Smith, all carry latent within us an 'impartial spectator' which restrains our inborn egocentrism by rendering us sensitive to the ways others react to us and the judgements they make about us.

At first sight, this soothing vision seems to have little in common with the often ferociously competitive world of The Wealth of Nations. After all, notoriously, 'It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest.' How do we jump from 'interest' to 'sympathy'?

One way, perhaps, is to note Smith's emphasis on human beings' mutual interdependence. In his view, no individual can produce everything he/she needs even for subsistence, let alone a tolerable life. Hence the division of labour, which grows ever more complex, and hence also what Smith called 'the propensity to truck, barter and exchange one thing for another.' In mutual commerce two individuals motivated by self-interest meet, and the outcome is mutually beneficial. 'Whoever offers to another a bargain of any kind proposes to do this: "Give me that which I want and you shall have that which you want."' But does such reciprocal self-interest actually generate sympathy?

The importance of money

In a limited sense, perhaps it does. To engage in such a deal at all, a minimal amount of trust is necessary. A purchaser will be reluctant to accept a deal from a character whom he regards as untrustworthy. After all, the purchaser often lacks the expertise to assess the quality of a commodity; or its reliability cannot be verified till well into the future, when it will be too late to rectify the deal. That is why, if there is bargaining over the price of a commodity, the seller will usually conduct his side of the negotiations in a friendly manner which at least appears open and honest. The ultimate guarantor of trade, though, is money, because that is a unit of value recognised by society and usually guaranteed by some kind of impartial authority. Without money one is driven back on barter or gift, which are by comparison clumsy expedients.

Money is complex, and it is not always obvious why it is trusted. The Ashmolean Museum in Oxford has a permanent exhibition of the different types of money which have been used over the centuries. It includes shells, bangles, stones, rolls of cloth, various metals, and paper - objects which appear to have nothing in common except that, as the exhibition leaflet states, 'they all work as money because people place trust in them when they are used in transactions'.

Money is a repository of trust, then, but it is a multi-storey structure. Nowadays most of us hold it in the form of an entry in electronic account records. That is the uppermost storey. One storey below that is paper money, and one lower still is gold or one of the objects displayed in the Ashmolean. None of them are real 'goods' which we can eat, or with which we can clothe or warm ourselves; they are just symbols of entitlement to a good. So there are at least four storeys. In uncertain times we feel safer climbing down a storey or two, as the current brisk demand for gold illustrates.

Actually, though, why is money trusted at all? This is a question which preoccupied the sociologist Georg Simmel. He came to the conclusion that money embodies a generalised social trust whose justification is not demonstrable, but without which social and economic life is inconceivable. 'Without the general trust that people have in each other, society itself would disintegrate, for very few relationships are based entirely upon what is known with certainty about another person, and very few relationships would endure if trust were not as strong as, or stronger than, rational proof or personal observation.' Money does not, then, automatically create trust. Its function is rather to fix a human predisposition to trust and make it economically effective.

Why economists should use the concept of trust

I suggest therefore that we should put the concept of trust (and distrust) at the centre of the study of economics. It fills all the four lacunae I pointed out in current economic theory. It is a moral concept. It explains human behaviour better than the assumption of rationality and self-interest. It offers a way for human beings to take decisions and act together, rather than merely as individuals. And it helps us to explain how economic actors take decisions when they have less than perfect information - which is almost always. As Niklas Luhmann has pointed out, trust enables us to take decisions when not all relevant facts can be ascertained. Trust enables one to keep the process of decision-making within manageable bounds by taking some factors for granted, relying on persons to act in one's favour or on events to turn out favourably, on sufficient but not exhaustive grounds. 'The complexity of the future world is reduced by the act of trust. In trusting, one engages in action as though there were only certain possibilities in the future.'

Along with its opposite, distrust, trust explains market behaviour better than the assumption of rationality. It is, moreover, absolutely crucial to markets. As Joseph Stiglitz has pointed out, 'What makes economic systems work, by and large, is trust:... savers have to turn over their hard-earned money to others, and to do so there must be an expectation that at least they will not be swindled.'

Using the concept of trust makes it much easier to explain what has given rise to the present crisis. It has been caused by both misplaced trust and abuse of trust. In recent decades many of us in advanced economies have used money and its credit-based derivatives both to increase our consumption and to provide ourselves with security. We are able to face the future with confidence thanks to our deposits in savings banks, pension funds and insurance policies, all of which depend on economic growth to flourish. So economic growth has become the great trust-sustaining myth of our era, to which we all subscribe. It largely replaces reliance on family, friends or religious communities to face risks and see us through hard times.

Many of us have also endeavoured to secure our futures by borrowing money to purchase real estate, which offers both a home and (so far) a safe and high-yielding investment. As Financial Times commentator Martin Wolf has observed, though, it has also turned most of us into 'highly leveraged speculators in a fixed asset that dominates most portfolios and impairs personal mobility.'

The cumulative deregulation of financial institutions starting in the 1980s has freed banks and building societies to offer clients ever more credit (the financial term for trust) to buy homes, cars, holidays and consumer durables. They created a new 'subprime mortgage' market. They did not want to look over-committed, though, so they moved the loans off their accounts by repackaging them and offering them to other banks as securities. Splitting up debts in this way was supposed to spread risk, but unfortunately the resulting 'collateralised debt obligations' (CDOs) were so complex that most dealers apparently did not understand them. They took them on trust. The CDO market soared upwards off like a jump-jet. In 2001-6, for example, the value of CDOs underwritten by the investment bank Merrill Lynch rose from $2 billion to $52 billion.

Nearly all of us took on more debt, more or less well supported. Those who could not take out even subprime mortgages were left ever further behind, so that a world of socially divisive make-believe - in effect weakly based trust - was created.

The funds in which we placed our trust sought profitable investment all round the world. Bankers and fund managers willingly expedited the process, since that was how they earned their skyscraper salaries and bonuses. Those individuals who made a lot of money in this way joined hedge funds, which betted large sums on future price movements and thus intensified rises and falls in the market. Credit rating agencies, paid for their services by financial institutions, gave high marks to nearly everyone involved, either unaware of underlying risks or preferring not to disparage their paymasters. Between 1980 and 1995 investments from mutual funds, insurance funds, pension funds and such like grew tenfold, and much of this was foreign investment, which often offered especially favourable returns.

There is one area, however, where money has no power: the afterlife. In the Groeninge Museum in Bruges, two paintings by Jan Provoost hang side by side. One of them shows a miserly merchant on his deathbed pointing to the healthy positive balance in his ledger and desperately trying to pass a promissory note across to the next painting, where a grinning skeleton refuses to accept it and preaches a little sermon on the limitations of finance. His sentiments are confirmed by a reverend-looking gentleman in the background.

Studying trust enables us to understand markets better than the assumption of rationality. Human beings tend to trust beyond the point at which evidence would suggest they should begin to distrust. But trust is not infinite, and when eventually it does turn to distrust, it does so precipitately and cumulatively. This is precisely the way financial markets operate. Typically a bubble begins to form when a new and apparently lucrative opportunity presents itself: it may be a new invention, the opening of a new market, the discovery of hitherto unknown resources such as minerals, or the end of a war. In response investors find ways to mobilise existing funds or raise credit to take advantage of the possibilities. Bankers, brokers and other intermediaries will usually help them, for that is how they earn their livelihood. The price of a commodity or the shares of a company rise sharply in response to ballooning demand, and an extra impulse is imparted by speculators hoping to profit by the upswing. Trust is highly contagious. A fever or 'mania' results, in which investors pile aboard, not wanting to be left out or outdone by rivals. Eventually, some event or even just a rumour casts doubt on the long-term prospects. One or two major investors calculate that the commodity or share price no longer matches the risk, and begin to sell. News spreads that something is wrong. Distrust is equally contagious. Panic sets in and feeds on itself; the price plunges. Investors sell out hastily, without even pausing to make fuller inquiry, lest delay lose them even more money. Overstretched investors, those who borrowed heavily to buy on the upswing, are ruined; firms go bankrupt; and even banks may collapse. Exaggerated trust turns to equally exaggerated and destructive distrust. Both the upswing and the collapse exemplify what Akerlof and Shiller call the 'confidence multiplier'.

I suggest, then, that we need to place trust at the centre of the study of economics. Not just trust alone, since misplaced trust can be pernicious, but trust in the trustworthy. It is a tricky concept to handle, admittedly. There is almost no way it can be quantified, so we would have to reduce our reliance on mathematical models. But then those models have proved pretty misleading anyway.

There can be no doubt of the paramount importance of 'trust in the trustworthy' to prosperity and financial stability. The 'masters of the universe' easily forget that the resource through which they wield their power - money in all its various configurations - depends ultimately on trust. If they routinely and grossly abuse it, they undermine their own power. The 'invisible hand', if it exists at all, is trust.

Policy implications

How can we apply the concept of trust in the trustworthy to grappling with our current economic problems? It is obviously relevant, since in autumn 2008 what precipitated the near-death experience of the US and British banks was a collapse of mutual trust. They simply did not know enough about each other's exposure to debt to engage in even routine overnight lending. What we should be looking for, then, are ways to bolster trust and confidence. The key must be to make financial institutions more trustworthy. This is both a moral imperative and an economic one.

After the hair-raising experience of the 1930s depression, banks were tightly regulated. As a result, from the 1930s to the 1980s they were relatively stable and there were no major financial crises. But after deregulation in the 1980s, there followed a long series of crises. Since most of them inflicted their toll of human suffering outside the advanced west, we did not take them seriously enough, and assumed that we ourselves were immune. At the moment, incredibly, it seems we are continuing to make this assumption. We are acting as if 2008-9 was an aberration, and we are returning to business as before. This insouciant behaviour will sooner or later unleash another crisis, probably even more serious.

Restoring trust involves finding better ways to deal with risk. This in turn entails having enough information about counterparties to conclude transactions with confidence. Banks are inherently risky, since they borrow short and lend long. It is obvious that our current financial institutions have a spectacularly poor record at dealing with that risk, even though it is supposed to be their speciality. They need therefore to be regulated by governments and international financial institutions in the interests of the public, which otherwise has to bail them out when they fail.

Here are some suggestions about how restoring trust might be done.

  • Large financial companies should have incentive systems which reward genuinely productive activity. If large bonuses are justified, they should be placed in escrow accounts and only paid out after a period of years, when the returns on their activity can be properly assessed.
  • Capital ratios should be increased. Before 2008 some shadow banks were borrowing up to 50-100 times their basic capital, exposing them to enormous risk if things went wrong.
  • The risk has been greatly augmented by the sheer size of the largest banks, which means that their failures endanger the entire economy. They should be trimmed down, and the best way to do this would be by placing their routine retail activities and their investment activities in two separate institutions, so that losses in the latter do not threaten the deposits of ordinary customers in the former. This would have the further desirable consequence that those who engage in risky behaviour bear the losses as well as the gains from their activity.
  • Hedge funds amplify risk and increase financial instability. They need to be brought into the open, where they can be regulated like banks, and their accounts should be available for inspection.
  • Trade in derivatives (CDOs etc.), which amplifies price movements in similar ways, needs to be conducted in an open clearing house, where regulators, the media and the public can keep an eye on it.
  • Credit rating agencies should become publicly financed institutions, so that they are not in hock to special interests, and we can have more confidence in their assessments.

Even if we do introduce much tighter financial regulation, however, it remains likely that bankers will always be several jumps ahead of the regulators. We badly need to rethink the way we finance many of our activities. We have become too dependent on finance coming either from the state or the big banks. For enterprises which are innovative and taking high risks we obviously need joint-stock companies drawing their funds from the stock-exchange and international financial markets. But much economic activity is not like that. Health centres, public utilities, public transport, educational institutions and housing do not need such heroic innovation and seldom incur serious risks, so they do not need to be run as profit-maximising, share-value-driven companies. Rather they need to be steady, reliable performers.

We need to devise methods of financing such routine but vital activities. Britain has a rich history of friendly societies, cooperatives and mutual funds. Two of Britain's most successful firms, the John Lewis Partnership and the Cooperative Group, are cooperatives practising employee share ownership. (So, as it happens, are many of Europe's most thriving football clubs - for example Bayern Munich and Real Madrid, whose fans own most of their shares, whereas Britain's top football clubs are notoriously run in a much more financially volatile manner.) Cooperatives and mutuals are much more likely to generate loyalty to the firm and dedication to the job - motives which no longer appear on the pages of economics textbooks, but which are vital to productivity, not to mention human well-being.

The mutual building society model can serve as an example. Although it offers lower returns than the public limited company model, those returns are more secure and trustworthy. In 2008 all the building societies which had abandoned the mutual model failed and had to be rescued; those which had stuck to the old model survived. At the moment the government is urging reforms which would probably drag many health centres into dependence on financial markets. The lesson from history is that the recent crisis was caused by over-reliance on financial institutions which have forgotten the importance of building trustworthiness into their structure and functioning. Unless we now return to relying more on institutions designed to be trustworthy, we are merely perpetuating the conditions for the next catastrophic breakdown in trust.


Further Reading


George A. Akerlof & Robert J. Shiller (2009) Animal Spirits: how human psychology drives the economy and why it matters for global capitalism. Princeton, New Jersey: Princeton University Press.

Gavin Kennedy (2008) Adam Smith: a moral philosopher and his political economy. Basingstoke: Palgrave Macmillan.

Charles P. Kindleberger (1978) Manias, Panics and Crashes: a history of financial crises. London: Macmillan.

Niklas Luhmann (1979) Trust and Power. Chichester: John Wiley & Sons.

Emma Rothschild (2001) Economic Sentiments: Adam Smith, Condorcet, and the Enlightenment. Cambridge, MA: Harvard University Press.

Georg Simmel (1990) The Philosophy of Money (edited by David Frisby and translated by Tom Bottomore), 2nd, enlarged edition. London: Routledge.

Robert Skidelsky (2009) Keynes: the return of the master. London: Allen Lane.

Adam Smith (1776/1976) An Enquiry into the Nature and Causes of the Wealth of Nations, Vol 1, 456 (edited by R.H. Campbell, A.S. Skinner & W.B. Todd). Oxford: Clarendon Press.

Joseph E. Stiglitz (2003) The Roaring Nineties: seeds of destruction. London: Allen Lane.

Gillian Tett (2010) Fools' Gold: how unrestrained greed corrupted a dream, shattered global markets and unleashed a catastrophe, London: Abacus.

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