January 2008 Archives

Making capitalism really work - not just supply and demand, but the rich level of investment that really powers the system forward - requires a sophisticated finance system.

The human fuel that drives capital, epitomized in Gordon Gekko's classic phrase "Greed is Good," is good at building up that financial system. People would generally prefer to have their money making money for them than to be laboring directly for a wage. It's easier.

Unfortunately, that same fuel that drives people to create such systems also erodes the systems they build.

Why?

Because sophisticated financial systems - even just a bank - require a massive amount of trust in their operation. Financial systems aren't perfectly transparent, and thrive in large part because people don't wonder why their deposits aren't sitting in the bank vault at all times.

In the very long term, of course it makes sense for a self-interested financial operator to build and maintain trust. The returns will be more reliable because the many systems connected by the operation will have a much smoother and more predictable set of opportunities.

However, humans don't tend to live in the very long run. That same greed that drives the creation of financial institutions can undermine them severely when short-term profits are readily available, and when ethical or outside regulatory frameworks aren't strong enough to keep operators focused on the very long term.

To make matters much much worse, human trust doesn't go up and down smoothly. Trust tends to accumulate slowly, but collapse suddenly. The discovery of one lapse leads to suspicions of other lapses, especially in a sphere where transparency isn't always possible.

Right now, it seems very clear that a large part of the recent American economy was driven by fraudulent operators seeking short-term profits. Those operations were then sold to a much larger group of investors thanks to creative repackaging that freed those operators from the risks they had incurred and paid them well. The hard question is just how poisonous that breakdown of trust will be to the larger system - not simply in the numbers on the balance sheets, but also in the trust that lubricates markets overall.