Failure in the global relational economy

Yesterday, news broke that the SEC is accusing Goldman-Sachs of exploiting its middleman position for fraudulent purposes. This case is a striking example of what failures the relational or network structure of the global economy can cause without proper regulation and governance. In fact, this case has several important implications for our understanding of the global economy.

First, by now it should be very clear that we do not live at all in a “market economy”, but rather in a network or relational economy. So, lets just burn those silly principles of economics textbook that are used in introductory economics courses and write some new texts that actually center on this insight. Over the past decades the banking sector has (again) become an all-powerful middleman industry. It is even more profound than that: banking has actually replaced the monetary system itself. Instead of using government or bank issued money, we now use credit and debit cards and, as such, the banking system is mediating nearly all transactions that we make.  (It also collects a nice fee for every transaction that we make with these monetary instruments; a guaranteed income stream therefore results for the banking sector.) As such, there is no “money” as a commodity anymore; instead we rely on a completely virtual system. The implications are profound for our understanding of for the 21st century global economy. Namely, any financial crisis would result in a much larger, even unprecedented trust crisis, exactly as is the case for the financial panic of 2008.

Goldman-Sachs is one of the main middlemen in the financial network that governs our global economy; it is very good at exploiting this position. Profits over 2009 and even 2008 show that middlemen as Goldman-Sachs usually do not have to fear any crisis; they make money hand over fist regardless of what happens around them in the rest of the economy. Only stupidity, such as shown in the behavior by Lehmann Brothers in the run-up to the financial panic and now in the alleged behavior of Goldman-Sachs, would actually result in substantial financial losses.

Second, middleman power is fundamentally corrupting. It leads to more and more exploitation, which in turn undermines the network. And as a result these networks will collapse on a regular basis, following the rhythm of an economic cycle. A well-functioning network results in large gains from positional power for the middleman, which triggers over-extended greed and a collapse follows. After a period of rebuilding, a new cycle begins. The greed cycle in the financial networks was very clear throughout the 19th century. This was a period of complete deregulation; only self-governance and self-regulation actually supported the functioning of these networks. The 19th century financial cycle resulted in an average of one collapse per decade. Over time these crises became worse, ultimately resulting in the Long Depression of the 1890s and the Great Depression of the 1930s. After that, government intervention through regulation, stabilized the financial networks considerably; the worst excesses were prevented until the financial panic of 2008. This occurred after a decade of considerable deregulation.

The only forces that counter such a middleman exploitation cycle are those of positional contestability of middleman positions and the proper regulation of such networks. Contestability works very well in the regular commodity networks in our economy. Shops are great examples of well-contested middlemen that cause very little disruption in the economy. (In the misplaced and confusing language of regular neo-classical economics, this phenomenon is called “market competition”, although these shops operate primarily in network environments rather than markets.) Banking is much less subject to contestability and as such should be regulated much more forcefully. Self-regulation is clearly insufficient, as shown in the economic history of the 19th century and currently the Goldman-Sachs case.

Third, the Goldman-Sachs case shows moreover that the functioning of these networks is closely founded on very high levels of trust. Goldman-Sachs was trusted blindly by its client-investors, who followed its advice; even its institutional clients invested in these fraudulent products that Goldman-Sachs peddled. This trust was completely exploited through the alleged behavior in the case brought by the SEC. This case has major repercussions for the financial sector in general; they now have to purge themselves to rebuild this trust. This ideally implies the re-regulation of these networks and the punishment of certain parties. But this re-regulation has to be done with care; we do not want to have another major financial panic emanating from greedy behavior by financial middlemen in the next decade.

Trust in networks

Recently there has been a small surge in the economics literature addressing the role of trust in the economy. Experiments have shown that trust is extremely important for understanding economic processes. Trust does not fit very well with the traditional concept of “homo economicus”: Rational behavior is not trusting. The building and confirmation of trust usually requires sacrifices of resources, contradicting the utility and profit maximizing hypotheses of the homo economicus.

The Scientific American recently posted an article that looks at the evidence for trusting behavior from behavioral economics, in particular trust experiments and brain scan evidence from neuro-economic experiments.

I want to add my own two cents worth to this. First, trust building is directly related to the functioning of socio-economic networks. The better the functioning of these networks and the denser these networks, the better the development and building of trust. This in turn forms the foundation for a better functioning economy. (A neglected aspect in traditional neo-classical economics.)

On the other hand, network building is firmly founded on the presence of trust and behavioral norms of trusting behavior. The higher the level of trust in the society, the better one is able to build and maintain social networks.

This two-way street between trust building and network building lies at the foundation of my research on networks. It now seems that more and more evidence confirms the justification of these and similar theories of network formation. Here I also refer to the recent work of Markus Mobius and his co-authors.