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My recent SocialEarth post on investing in waste discussed the chapter by Bergstrom, Kerr and Lachmann in the book, “Moral Markets.”  The chapter, which spans all of 10 pages, is so thought-provoking that I wanted to dig into it a bit more here.

How Wasting Time Changes Incentives

The basic idea, demonstrated in a game-theoretical manner by the authors, is that selfishness and “cheating” are only logical in a world where business partners are cheap and easy to come by.

Think, for example, of how easy it would be to cheat or abuse customers if they were a dime-a-dozen and virtually costless to acquire.

Lucky for us, this isn’t the case; new businesses owners quickly discover that customer acquisition is often hugely expensive.

It is this very fact – that building relationships requires an investment of time and resources – that enables most transactions between business “partners” to occur.  The sunk investment in the relationship makes exploiting a partner a costly decision. Not only would exploitation destroy the relationship and the investment of time it represents, but it would mean having to make a similar investment in a new relationship with a new partner. Social practices that require wasting time, then, create incentives that favor cooperation and build trust.

On the other hand, without this wasted time, the incentives would be such that it would make more sense for one partner to take the money and run, and then go find another partner and do the same to him.

Financial Crises and Overly-Efficient Markets

The irony here is that the authors lead us to the conclusion that making markets too efficient can actually be detrimental over the long-term.

How can that be?  Isn’t the goal to lower transaction costs?  Isn’t that one of the keys to economic growth? Not if the authors are correct and too-efficient markets skew incentives in favor of exploitative relationships that destroy trust and, ultimately, greatly increase transaction costs.

Is this starting to sound familiar? It probably should, as it could be argued that overly efficient markets were part of the cause of the recent financial crisis.

As Niall Ferguson discusses in his book, “The Ascent of Money,” the secondary market for mortgages and mortgage-backed securities (and their associated CDOs) were innovations that allowed the risks and liabilities associated with these loans to be effectively hedged and distributed throughout financial markets.

On the positive side, this meant that your local WellsFargo branch could hand out a virtually unlimited number of mortgages, since they would provide you with yours and sell it off almost immediately in the secondary market.  The fees collected on the transaction would bring nice profits, while selling off your mortgage would free up capital to provide yet another mortgage to someone else.

Throughout the early 2000s, mortgage lenders indeed repeated this process in an almost never-ending cycle that pushed rates of homeownership up to their highest levels in US history.

On the negative side, however, the fact that your local WellsFargo branch wouldn’t be bearing the risk of giving you a mortgage meant that they had little stake in the transaction. Lending relationships used to be established based on the kind of trust-building and “time wasting” discussed above, in order to protect lenders from risk of default. This new arrangement, however, allowed the old courting process to be tossed aside. After all, the person (or people) who would ultimately own your loan and collect your interest were likely to live hundreds if not thousands of miles away. So all WellsFargo had to do was collect your information and make sure you met the requirements on paper.

In fact, the distance between the actual borrowers and lenders made it easy for naive, risk-seeking “lenders” to extend credit to even the flakiest of borrowers. As we now know, the eventual result was to push even the most “sub-prime” of borrowers into homes and mortgages that they wouldn’t be able to afford. Once these individuals began to default on their loans en masse, the house of cards would come tumbling down.

Where To From Here

Bergstrom, Kerr, and Lachmann remind us that the social and cultural institutions, like courtship and time-wasting, that we have created over the centuries often play an integral role in making our societies and economies work. Yet, we also recognize that courtship is costly and inefficient, and we want to find ways to lessen these transaction costs so that our economies can continue to grow.  So what to do?

It’s tempting to simply say that we must make the courtship process more efficient.  That is, find ways to build trust while wasting less time, perhaps through more scientific and efficient vetting processes.  However, more efficient courtship, no matter how it’s done, still means fewer “sunk costs” in the relationship and therefore greater incentive to exploit.

However, what if courtship could be paired with reputational currency systems in such a way as to make the efficiency of the courtship process proportional to the strength of one’s reputation? We already approximate this in places like eBay and the job market.  On eBay, you might be willing to buy from a lower-ranked seller, but perhaps only after having the opportunity to communicate with him directly over the phone. In the job market, candidates who are referred by competent and reliable employees are likely to move through the hiring process faster than those who submit applications online.

So what if we could make our reputations more digital, portable, and universally accessible as well as acceptable/reliable?  Could we then eliminate some of the “sunk costs” associated with courtship for highly trustworthy partners while increasing the investment in “waste” required from less trustworthy peers?

It’s hard to say.  But the fact remains – until we can create new social institutions that allow us to reduce transaction costs without increasing the incentives for cheating, we must be wary of making our markets too impersonal and efficient.

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Marketplace is fantastic.  If you don’t already listen, please start.

Here is some nice commentary and analysis on the stress tests and how banks are reacting.

APM Marketplace: Stress Tests

WordPress’s Tag Surfer feature I’m finding very handy.  This morning it served up an interesting post from The Guru Investor on the myth that it took it took investors 25 years to recoup their investment after the great crash of 1929.

Here’s a snippit, but do check it out:

“While many have cited the fact that the Dow Jones Industrial Average took 25 years to get back to its pre-Great-Depression highs as reason to worry that the coming market recovery could take a upwards of 10 or even 20 years, Hulbert says the 25-year Depression recovery figure is misleading for a number of reasons. In reality, he says, it took only four-and-a-half years after the Depression bottom for investors to recapture their losses.”

This is a bit of an old reference in internet time (from > month ago), but this is a new blog, so who cares.

Below is a link to one of the better bits I’ve heard on the reality and dangers of deratives trading, how the trade was allowed to grow and thrive over the years, and how the lack of transparency leant itself to the eventual collapse.

“Frank Partnoy directs the University of San Diego’s new Center for Corporate and Securities Law.”  He’s also a former derivatives trader.

Enjoy!

Frank Partnoy on NPR’s Fresh Air

Whether you are an avid follower and interpreter of the financial crisis or just trying to figure out why you lost your job, look no further. 

Lots of good analysis from Simon Johnson, former IMF chief economist and MIT professor, and his co-authors, James Kwak and Peter Boone.

The Baseline Scenario.

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