Trust and risk

Colin James’s speech at Unisys Technology Forum, Queenstown, 6 May 2008

I start with a quotation on trust from the American political philosopher Francis Fukuyama in his 1995 book on the topic. “Economic activity represents a crucial part of social life and is knit together by a wide variety of norms, rules, moral obligations and other habits that together shape the society. A nation’s wellbeing, as well as its ability to compete [economically], is conditioned by a single, pervasive cultural characteristic: the level of trust inherent in the society.” (1) In short, trust is critical to commerce.

The economic importance of trust is that it helps manage risk. And that is important because, just as trust is vital to commerce, Fukuyama also noted, so is “openness to risk”. (2) Without taking risks, there is no advance. That is the essence of capitalism, which has made us rich beyond anyone’s imagination two centuries ago. Capital is put up — put at risk of loss — in expectation of a dividend. Trading is carried on with others in expectation that those on the other side of the deal will keep their bargain.

The less trust there is the higher the expected return must be for those with capital to risk it. So less is attempted. And less trade is done if traders cannot trust those they trade with. Less activity means we are less rich than we might have been.

So when we talk about risk and trust, we are talking about the health of our economy and our own wealth and general welfare. It therefore matters how we manage risk and the degree to which we can trust the system and those within it.

Fukuyama worried that trust was declining and thought this was evident in “the rise of violent crime and civil litigation; the breakdown of family structure; the decline of a wide range of intermediate social structures like neighbourhoods, churches, unions, clubs and charities; and the general sense … of a lack of shared values and community with those around them.” “Just as its savings rate has been too low to replace physical plant and infrastructure adequately, so its replenishment of social capital has lagged in recent decades.” (3)

In that passage Fukuyama was describing the United States. But most of our sorts of societies, by which I mean what are colloquially known as the Anglo societies — Australia, Britain, Canada, New Zealand, the United States — tell the same story of a decline of trust in each other. We are more fearful. We worry our daughters will be raped or worse. We drive our kids to schools to which we walked safely. We think we live in a much riskier, more dangerous world.

And so we are less open to risk. Instead, we hope we can banish risk from our lives. We look to governments to banish risk for us. We complain when they don’t.

Fukuyama puts it this way: “…people who do not trust one another will end up cooperating only under a system of formal rules and regulations, which have to be negotiated, agreed to, litigated and enforced, sometimes by coercive means.” (4) He argued that if trust is limited to families and personal contacts, commerce will remain small-scale. For large-scale corporations capable of large-scale activities to develop spontaneously (as happened from the nineteenth-century onwards), modern societies have needed a system of rules, habits and practices which govern arm’s-length transactions through, as Fukuyama put it, notions of “reciprocity, moral obligation, duty to community and trust which are based in habit rather than rational calculation”(5).

Apply that to the credit crunch we are now living through. The flow of credit dried up when banks no longer knew what the contracts they were holding really meant and whether those on the other side of the contracts could make good their promises.

This was tough on the banks and required intervention by central banks on an unprecedented scale to stop the system from freezing up. It was tougher on the people who lost their houses and/or their savings. And companies which do real things find it hard to get funds to do those real things, which costs jobs. The banks (a) don’t have the funds or (b) have redefined risk to rule out all but gold-plated activities or (c) are charging prohibitive interest rates. Opportunities for wealth creation are lost.

To a large extent, this is a result of a distorted interpretation of risk.

Until the 1990s, those managing and handling investors’ funds defined risk prudentially — that is, as the probability of losing part or all of the investors’ capital. During the 1990s, however, risk in the financial sector morphed from an assessment of the possibility capital might be lost to a fear of being left behind by not riding the wave of fashionable new investments and thereby losing clients to funds managers who did ride that wave.

In the 1990s the fashion was the dotcom shares which zoomed into the stratosphere — then crashed back to earth. This decade it has been the brilliant new repackaging of debt. Banks created special off-balance-sheet vehicles (that is, evaded the Basel rules) to get into the game. A simpler way to put it is to say they cheated. Fukuyama’s “reciprocity, moral obligation and duty to community” went out the window.

The Economist’s Buttonwood columnist summed up this reinterpretation of risk in an article in March on the death of Tony Dye, a fund manager who in the heady dotcom days continued playing by the rule of prudence at a time when managed funds’ imperative was changing to one of beating the market. “Risk [was] redefined as the danger of falling short of the benchmark rather than the risk of losing the clients’ money. Indeed, the main risk faces the [fund] manager himself — clients may move elsewhere in search of a better-performing fund”. (6) Dye left his fund just before the dotcom crash proved him right. As Buttonwood dryly put it, “those who bought either the London or New York share indices in 1998 earned a real annual return of just over 2% up the end of 2007; safe Treasury bonds earned 3.7% over the same period.”

The problem with the new treatment of risk was that it made investing much riskier: the risk of losing one’s capital climbed as the returns did. The magical derivative securitisation of loans which seemed to de-risk risky ventures actually leveraged the risk into the jetstream. Risk of losing one’s capital was out of sight up there but the risk hadn’t gone away.

You can’t stay in the jetstream forever. Eventually you have to come back to the tarmac and if your plane runs out of fuel before you get down gently it is a long way to fall and the landing is rough. So some bank bosses have lost their jobs and their banks are now part-owned by the Chinese, oil state and Singaporean governments through “sovereign wealth funds”. (New Zealand has one of those, colloquially known as the Cullen fund, a future fund to meet post-2020 pension payments. But it hasn’t got big enough to buy big chunks of American, German and Swiss banks.)

The banks’ erstwhile bosses will live in great physical comfort, beneficiaries of mind-stretchingly huge bonuses and final payouts and, in some cases, highly lucrative new jobs. Ordinary folk lose houses and jobs. Good, feet-on-the-ground businesses find it harder to do business.

Trust in the financial system has weakened. That undermines commerce.

And with diminished trust comes another risk for business: the risk of over-regulation by jittery or scapegoat-hunting parliaments and governments.

As Alan Jury wrote in the Australian Financial Review on 27 March apropos the Australian Stock Exchange’s insistence that it is policing the equity market effectively, “if everybody played nice there wouldn’t be a need for regulators. Unfortunately the real world is full of people who have made their fortunes by working out how far they can push things without crossing a legal line — and they are often celebrated for their success in doing so. Morality doesn’t play a big part in making money. What the regulators have to do, and have to be properly empowered to be able to do, is relentlessly and ruthlessly pursue those whose avarice doesn’t recognise that line.”

Line-pushing is integral to capitalism. Exceptional risk-takers are the ones who make the breakthroughs. But line-crossers, as distinct from line-pushers, damage the system. They undermine trust.

The risk then is that parliaments and governments will go too far, that they will substitute their intervention for trust. And if they do that they will diminish the scope for taking risks and so the potential for creating wealth.

This can be seen as cyclical: risks turn sour and hurt a lot of people and governments regulate to ensure those risks cannot be taken; over time more and more risk-taking is regulated; eventually there is a need and a demand to relax the regulations; risk-taking is encouraged, then overdone (perhaps with a bit of near-fraud or actual fraud) so risks go sour; and there are new demands that governments regulate against the new risk-taking; and so on.

It would be nice if this cycle could be smoothed out, just as it would be nice if the business cycle itself, the ups and downs of the economy, could be smoothed. But attempts to fix the economic cycle have failed. And so far there seems to be no way to fix the regulatory cycle. Both cycles are business-as-usual risks of doing business.

But there are three drivers which might be taking us out of the regulatory cycle into new territory.

One is the diminution of general trust in our sorts of societies. If we are less trustful of fellow citizens, we will be less trustful of corporations. That is Fukuyama’s 1995 thesis and there is something in it.

The second driver which might be taking us out of the cycle is digital technology. The huge improvement the new technologies enable in everyday life — internet banking, for example, and instantaneous connection with distant friends and relatives — also require trust that the systems will not be misused to cause us damage, by, for example stealing our identities or our savings or by making ill use of material we put on Facebook and Bebo as teenagers.

That is a focus of an important part of Unisys’s work and I will not develop it further here except to say that if there is serious and/or widespread grief as a result of misuse of the new technologies, trust will be seriously undermined and it may well have effects beyond the digital sphere.

The third driver is that in our sorts of societies we have generally become much more risk-averse.

We used to learn about risk as kids by doing things that occasionally brought us minor grief — and, for the unlucky ones, major grief. Now we seem to wrap kids in cotton wool, most of us. Playgrounds must be super-safe; male teachers must be super-careful not to touch, even to plaster a cut; food must be super-clean, even though eating a bit of dirt helps build immunity.

This super-averseness to risk may in part have developed because we have fewer kids, often only one in a family, and to lose that one is to lose all. It may also be in part because medical science has conditioned us to expect long lives so the risk of having it shortened is magnified: consequently, we want guarantees of absolute safety, for example, before we will eat genetically modified foods and we expect to be plucked off a mountain by helicopter if our irresponsibly underprepared afternoon hike goes wrong; and we are encouraged to believe life can be made risk-free by technological improvements in, for example, cars (which actually may be counterproductive by giving teenagers, and underdeveloped middle-aged males, a false sense of invulnerability). The super-averseness to risk may also in part be because the news media, which is now predominantly entertainment driven, has understood that the best entertainment is a daily diet of horror and mayhem: we like to be frightened and scandalised but over time it is corrosive of trust in others.

To make our lives risk-free we look to parliaments and governments to provide the cotton wool. If there are still risks in life, “they” should remove them. “They” should regulate risk out of existence. One school of thought defines government as risk management; it is not far from that notion to demanding the government manages risk out of existence.

Listen to the demands for the government somehow to have protected you from investing in finance companies that turned out to be houses of cards. Look at the demeaning sillinesses we endure at airports because we fear some nutter or demon will storm the cockpit — sometimes I think I should face Mecca and bang my head on the floor in deference to the winners in this sad game. Inquire into our reverence for abundance that has made us spew more carbon into the atmosphere, so then we demand governments do something about climate change but at no cost to ourselves. We have an “epidemic” of crime which requires harsh sentences and many more prisons — though only in someone else’s backyard. (My solution: the Auckland islands.)

Parliaments and governments in fickle democracies have no choice, if they want to be re-elected, but to listen to those demands and to give the appearance of having some idea of what to do about them.

There is a cost: first, higher taxes; second, a higher cost of doing business or barriers to doing business.

Businesses live with the business cycle — if a business gets caught in the wrong place at the wrong time in a cycle, it can be curtains. Businesses live with the possibility that a project will go wrong or that a competitor gets the jump with a new product or marketing technique or just better luck. Prudent businesses make contingency plans for shocks that occur outside the business cycle, like the present credit crunch. Prudent companies avoided excessive debt during the recent scramble (which came courtesy Alan Greenspan’s misreading of inflation in the late 1990s and in this decade). Those companies are now well placed. Prudent farmers price in the likelihood of dry years and floods.

This is managing downside risk. Upside risk is opportunity and the secret of capitalism. Downside risk is threat, which must be managed for survival. Downside risk requires a defensive response; upside risk invites an expansive response. The two are linked, of course: if we become too worried about downside risks we will be less likely to take upside risks.

The next decades hold some large downside risks.

There is an immediate problem with the prices for staple foods as grain stocks have collapsed because of weather shocks, rich Europe and United States converting food-producing land to fuel production, speculators looking for ways to make money and hoarding by some food exporting economies. There are riots right now and governments in food-hit countries will struggle to contain the pressures — even in rich democracies, rocketing food prices are counting against governments, as Gordon Brown has found in Britain this past week. Down the track there is potentially another source of international — or intercultural — tension as the supplanting of traditional foods in poor countries with western-style fatty and sugary foods (in part the result of rich countries’ protectionism and subsidies) is generating poor health outcomes.

Beyond that, serious water shortages loom as a result of over-exploitation of aquifers in India, northern China and elsewhere, which threaten industrial and food production. And as China sets out to assure itself of water by controlling and diverting headwaters, that threatens disruptions to water supplies in surrounding countries. Water wars are not unimaginable.

Then there is the scramble for oil, coal and minerals. China is very active in Africa, Australia and even in this country (for coal) and there is now tension over its attempts to buy into suppliers. Prices have gone through the roof. The cost to consumers is high. Resentment will grow against China. Resentment within China at the west — the rest of the world — is growing. Resource wars are not unimaginable.

The point for business is that supply chains will potentially be threatened if there is not peaceful resolution of these tensions. History suggests the odds of such peaceful, cooperative resolution are less than 50-50.

And on top of those downside risks is climate change. Climate change is a threat in itself longer-term, if the United Nations’ panel of scientists is to be believed (though the most recent research suggests a 10-year cooling lies ahead first for countries bordering the North Atlantic). More immediately for business the downside risk is parliaments’ and governments’ reactions to the scientists’ measurements and forecasts: some are imposing targets and taxes or cap-and-trade regimes. This has generated large new uncertainties in those countries for big emitters of greenhouse gas and higher costs for small business and consumers. Different governments are responding differently and attempts at international agreement so far show little promise: trust between nations and between cultures is slowly built and quickly lost; action on climate change requires high trust because it is a classical prisoner’s dilemma — all countries would do best if all nations cooperated but each nation will lose if it acts alone.

Climate change illustrates the downside risk for business in sudden changes in government policy. Some examples:

* Japanese farmers dependent on large subsidies and trade protection may find that the government gets nervous about China’s pursuit of bilateral free trade agreements and dumps them to get into the bilateral FTAs itself and not be left isolated on the fringes. Farmers in this country who can remember back to the 1980s know the pain of a withdrawal of subsidies.

* Insurance companies spent heavily to get into the accident insurance market that was opened up in New Zealand in 1999, only to be just as suddenly shut in 2000 by a different government.

* Employers who embraced John Howard’s Work Choices in Australia now have to go into reverse after a change of government.

* European steel producers, among others, have had to adjust to a greenhouse gas emissions trading regime which threatens their viability. Airlines round the world have three years to work out how to respond to Europe’s decision to bring them into the trading regime. Exporters to Europe may find themselves taxed if their governments don’t match Europe’s climate change measures.

You can easily build your own list. And you might want to make an additional list for China, where the rule of law does not apply, where edicts in Beijing are routinely flouted at the provincial or local level, where corruption is rife and where it is difficult to ensure subcontractors of subcontractors are on the level.

But if we expend our energies on downside risks we risk missing the opportunities in upside risks.

The next decades are likely to generate some big upside risks. Right now, for example, climate change offers opportunities such as trading carbon credits, selling carbon offsets and developing carbon profiling of supermarket products.

Looking out over the next few decades, the marriage of nanoscience and bioscience has huge potential in information and health management. Solar energy technology looks set to liberate us from oil and coal. The blazing technological advances of the late twentieth century may well look like a dull glow in the rear view mirror of the mid-twenty-first.

All that needs is for parliaments and governments not to get in the way — that is, not to overreact to angry or fearful or mistrustful populations, even when that anger or fear or mistrust is temporarily justified, as it is now by the financial shenanigans of rich bankers and dangerous gaming of food markets. Trigger-happy governments are downside risks for business and, as a result, for all of us. The role of governments is to protect trust, not reduce it. Over-regulation reduces it.

But for governments to strike that balance requires trust: trust within borders and across borders; trust within cultures and between cultures. In the past 10 years, even since Fukuyama wrote his dispiriting analysis, trust has diminished, both within borders and cultures and across borders and cultures.

Can that be reversed? Can we as populations focus less on downside risk and more on upside risk and so on opportunity and its companion, improved welfare? I shall not risk offering an answer. I don’t have enough trust in my judgment.


1. Francis Fukuyama, Trust. The Social Virtues and the Creation of Prosperity (Penguin, 1996, first published Free Press, 1995), p7

2. Fukuyama, Trust, p46; see also p36: “People form attitudes toward risk — for example, which is more dangerous, nuclear power or exposure to people with AIDS? — not from any rational analysis of the real risks involved in either case but based on whether they are broadly liberal or broadly conservative.” And, p359: “Where formerly princes sought to vanquish each other by risking their lives in bloody battles, they now risk their capital through the building of industrial empires.”

3. Fukuyama, Trust, p11

4. Fukuyama, Trust, p27

5. Fukuyama, Trust, p11

6. The Economist 27 March 2008