A free-market economy that is as dependent upon credit as the US economy (and as, we are learning, the world economy) is an economy dependent upon the sociological relation of trust. If there is trust, credit has a good chance of flowing. If there is distrust, credit will freeze in place. The best way for an economic actor -- an investor, a businessowner, or an everyday person trying to make sense of his or her economic environment -- to make sense of the credit economy is to see it as a complex product of individual and institutional intepretation meant to figure out whose wealth is legitimate and whose wealth is not. The key is to develop a working theory of legitimate wealth. After the house of cards that has been economic growth in this country the past few years, the men and women who develop notions of wealth that can withstand intense scrutiny will have a leg up on the competition.
Along these lines, James Surowiecki has a nice, short, interesting commentary in the current New Yorker.
In December, 1912, J. P. Morgan testified before Congress in the so-called Money Trust hearings. Asked to explain how he decided whether to make a loan or investment, he replied, “The first thing is character.” His questioner skeptically suggested that factors like collateral might be more important, but Morgan replied, “A man I do not trust could not get money from me on all the bonds in Christendom.” Morgan’s point was simple but essential: systems of credit depend on trust. When trust is present, money flows smoothly from lenders to borrowers, allowing new enterprises to start, existing ones to expand, and daily business to move along without a hitch. When it’s absent, we find ourselves in a world where lenders hoard capital, borrowers are left empty-handed, and the economy’s gears grind to a halt—a world, in other words, like the one we’re now living in.
. . . .
The fear that has overpowered lenders is not just about the current market chaos. It also reflects their lack of faith in the models and systems that they rely on to evaluate risk. For Morgan, that process of evaluation was all about relationships. In the modern financial system, by contrast, risk evaluation involves two things: impersonality and outsourcing. Personal judgments about the reliability of a borrower—the sort of judgment that Morgan, or a small-town banker, would make before issuing a loan—have been replaced by mathematical models. And lenders have delegated much of the responsibility for evaluating borrowers to other players, such as credit-rating agencies. In many cases, an AA rating was all a company needed to get a loan.
There’s no doubt that this system has had huge benefits. It has made it easier for money to connect lenders and borrowers. It has removed the kinds of personal bias that kept capital in the hands of people whom men like J. P. Morgan approved of. And it has vastly expanded the amount of lending as well. But all those benefits have come at an exorbitant price. The problem with an impersonal system is that when the models fail, and when companies’ ratings become suspect, everything is called into question. Lenders can’t fall back on their own judgments of a specific company or individual, because such judgments aren’t part of their typical decision-making process. Instead, they’ve adopted a deep-seated distrust of all borrowers, even financially secure ones. If the Fed is now taking corporate I.O.U.s, it’s because everyone else is acting according to that old motto: In God we trust—all others pay cash.<
Read the whole thing here.