On The Economics of Integrity

by: Rick Newman

It's easy to bash the government. Nobody likes the banks or their fat-cat CEOs. Corporate America is the enemy, laying off millions.

Do we trust anybody anymore? Actually, yes. In her new book, The Economics of Integrity, journalist Anna Bernasek describes how virtually every aspect of the modern economy—from routine transactions to the inner workings of the global monetary system—is based on an intricate web of trust. That might sound scary, but the fact is that a blend of government regulations, societal rules, and enlightened self-interest produces a system that serves consumers remarkably well, compared with the alternative. I spoke recently with Bernasek about the growing distrust in big institutions and the possible consequences. Excerpts:

Americans seem as if they don't trust anybody these days. They don't trust the government, they don't trust banks, and they don't trust institutions. Some of that is for good reason. And it seems to be one reason the tea-party movement has sprung up. Do we have a crisis of trust? Economically, I think it is a crisis of trust. You had President Obama talking about the deficit of trust in Washington. Look what happened with Toyota (NYSE:TM). There's a perception we can't trust automakers. At companies, there's been a lot of destruction of trust, especially with employees. What is a recession but a lack of trust?

In your book, you talk about how all these basic transactions, like buying milk or returning a product or withdrawing money from an ATM, are based on a vast system of trust and integrity. Explain why. Trust is fundamental to the modern economy. It makes things go. Traders are able to go through with a transaction because each trusts the guy at the other end of the phone. Look at the Internet. EBay (NASDAQ:EBAY): It's amazing that we trust somebody on the other side of the world to send us something. Trust is fundamental to almost every transaction in the economy. Buying coffee: The transaction is only successful if there's integrity on one end and trust on the other.

When you buy a gallon of milk, you're trusting the integrity of the storekeeper to give you unadulterated milk. You're also trusting the farmer, the vet, the milk hauler, and a whole chain of other people. And they all trust each other. We have to pay attention to trust. It's vitally important.

Why is the trust there? One, I think it's basic human nature. We want to trust people to do the right thing. Second, there are rules and institutions that add integrity. Milk used to be dangerous. In the 1920s, people decided they needed guidelines for milk. Today, you never even think about it. You just take for granted that milk is safe.

For most of American history, people didn't really trust institutions, right? Especially the banks. Today we don't even think about the security of our bank accounts. We know they're safe. But from the birth of the country, nobody really trusted banks. One hundred years ago, few Americans put money in banks. We've built trust in banks slowly, over time. That probably began around World War I. The United States was producing a lot of goods being sent overseas. People were becoming more prosperous. U.S. industry was supplying much of the machinery for the war. That was the first taste Americans had of putting money in banks. It ended really badly. Even before the Great Crash, small banks started going under. A lot of people lost their savings and were wiped out. Then so many more banks failed after the Great Crash. That led to a whole movement of rebuilding the financial system.

When did Americans start to trust banks again? Not until sometime after World War II. People became prosperous again, but the biggest factor was government policies, especially the creation of the FDIC. For the first time, we were able to stop panics. Up till then, the whole history of banks had been characterized by panics. The FDIC was the single-most genius move the government has made to stop panics.

Where do we stand now? Trust has increased over time. But there are times when you have these big dips, just like the business cycle. We're clearly in one of those dips.

Here's the odd thing. Practically every American benefits from the stability that the government brings to the economy, even now. Yet judging by polls and the tea-party movement and other trends, the beneficiaries of the system hate the system. I know. I find it baffling. I grew up in Australia, where people generally feel good about the government. It's surprising to me that so many people here hate the government. But then I understand why. Look at healthcare reform. The way that was presented was ridiculous. People couldn't understand it. It was so complicated nobody could tell whether it would help them or hurt them.

What happens when trust in institutions falters? I still believe there's enormous trust and integrity in the economy, in the systems that make it work. This is an opportunity for us to focus on what's important. To stand back and look at what works and how important it is.

What are some ways we could enhance trust in American institutions? Financial reform is the first thing. Why are there no changes? The financial industry brought the economy to its knees, and still we don't have any kind of reform at all. We could be poised for a big step backward, maybe a 1970s-style period of malaise. Financial reform wouldn't even increase the deficit. It doesn't cost much, if anything.

So how can we fix that? We should set up the financial system in a way that makes sense for everybody. Make it fair. It needs to be simple and intuitive. Who wants to believe in a system you don't understand? It's like driving. There are a lot of rules that govern driving, but when you get in your car and go, it's all pretty intuitive. When you get to a red light, you stop. Obey speed limits, or risk a penalty.

In finance, they made it so complicated, but if you think about it, what were the issues? One, there was no disclosure. That's why we had all this off-balance-sheet stuff at the banks that blew up. Two, there were no rules. The banks could take any kind of risk they wanted. Three, they were taking these risks with other people's money. They make it all sound so complicated, but it's not so hard to fix all that. We've messed it up with all these details.

The government has the same problem. How can we trust the government when it's so complex? Again, look at healthcare reform. Why can't we do something simpler? Complexity is a way for people to cheat, and people know that.

What else? Reform the tax system. What we have now is the opposite of an integrity-enhancing system. There's no disclosure, and it's so complex. Cheaters don't get caught. Instead of having a system where people say, 'You're crazy if you don't cheat on your taxes,' we should have a system people believe in. Maybe they wouldn't even mind paying taxes if they thought it was fair. But when everybody cheats, it's a disaster. I know, these are all cans of worms and very hard to fix. But it doesn't need to be as complicated as it is.

Are you optimistic? I am. I have to be. At heart, this is still an amazing country.

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Disclosure: No positions