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Crises of Confidence and Social Capital

Written by: Bill Sherman on Thursday, 18 September 2008, 1:14 PM

In the past few weeks, we’ve witnessed the implosion of many massive financial institutions–such as Fannie Mae, Freddie Mac, AIG, Morgan Stanley, Merill Lynch, and Lehman.

I’m not going to look at the financial and accounting issues that have driven these events. Let’s set aside discussions of mark-to-market valuation. However, there’s an interesting social capital element here at play as well. Over the past few days, we’ve heard about a crisis of confidence in the financial markets.

“The economy is not short of money. It is short of confidence,” said Sung Won Sohn, economics professor at California State University.” (in the AP Newswire).

So, how can social capital help us understand the turmoil? Joseph Stiglitz, Nobel laureate in Economics, has written an interesting definition of social capital with a strong economic focus:

“The market value of a firm typically exceeds by a considerable amount the value of its physical assets and the human capital that is attached to the firm. Accountants call this capital “good will,” but it is, I think, closely akin to what many of us think as social capital.”

Stiglitz goes on to say that one key factor within social capital represents an aggregation of reputations and a way to sort out reputations.

As individuals, we tend to do business with those we trust (people who get the job done, do it well, and honor their commitments). Businesses choose the same way. Let’s take a look at an editorial from The Economist written last week prior to the collapse of Lehman.

Lehman has not suffered the client and counterparty defections that spelt doom for Bear. Indeed, other Wall Street firms, dubbed the “friends of Lehman”, seem determined to keep trading with it. This is not out of altruism . . . . rather, there is genuine fear that a second failure would deal markets a terrible blow, hurting everyone. At some firms, instructions to keep trading with Lehman are coming from the top.

The financial system represents a social network–both on the micro-level (individuals) as well as the macro-level (nations and global financial institutions). There’s an interconnectedness of the network where at some point, the health of your neighbors impacts your health as well.

Trust forms the foundation for ongoing business continuity–whether it’s a deal done on a handshake or in a lengthy contract. Healthy degrees of reciprocal trust sustain markets. Overly-high degrees of trust lead to “irrational exuberance”, and low degrees of trust lead to “crises of confidence.”

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