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.  

But 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.

Many years ago, I was driving through downtown Minneapolis with several younger cousins from Dallas, Texas.  As we pulled up to a major intersection, we noticed a homeless man standing on the side of the road. He looked sad and desperate, wearing filthy clothes and holding a sign soliciting money from the passing vehicles.

As we passed the man, one of my cousins, who was perhaps six or seven years old at the time, leaned out the window and yelled, "Get a job!" Undoubtedly, the United States is a "pick-yourself-up-by-your-bootstraps" society.  We honor back-breaking work and private enterprise.  When in trouble, we prefer to look to friends and neighbors, rather than ask the government for handouts and support. We tend to have a love-hate relationship with this fact as a society. On the one hand, we hold dearly these values, which have been lauded by social thinkers like Max Weber and Alexis de Tocqueville as reason for America's rich civil society and strong culture of entrepreneurship.  At the same time, our "bootstrapping" belief system and the associated American Dream often engender selfish behavior and harmful prejudices that none of us should be proud of.  We evade taxes to protect our hard-earned money.  We accept the inadequacy of our social safety net.  And, like my cousin once did, we categorically blame the poor and homeless for their plight. The random confluence of two interesting stories got me thinking about this topic last week, and how it has shaped our attitudes toward development. One story was the outrage over Kiva's decision to begin offering micro-financing to entrepreneurs in the United States.  (More on that here, here, and here.) The second was a report I caught on Minnesota Public Radio on the 27 year old Loaves and Fishes program.  The program was established as a temporary measure to feed the homeless and the poor after the Reagan administration cut back on welfare programs in the early eighties. The Loaves and Fishes story represents how we have traditionally approached development within our own country.  Development is all about job creation and entrepreneurship.  It's about creating policies and institutions that stimulate private investment and create sustainable private sector employment.  The role of aid and charity then (which are also largely private in the U.S.) has been to temporarily prop up those who are transitionally poor or  provide longer-term support to those perfectly incapable of supporting themselves.  It's a "tough love" approach to development that places emphasis on individual motivation, capacity, and dignity. The Kiva story, on the other hand, places the "tough love" approach to development that we have applied within the U.S. in stark contrast to how we've approached development in the rest of the world.  The American international aid establishment and American attitudes toward aid abroad have traditionally revolved around charity first, enterprise second.  I don't know why this is.  It's an utterly mind-boggling contradiction.  But it was readily apparent in the Kiva story, where individuals who were staunch supporters of "interest-free" loans to entrepreneurs in other countries lashed out against the idea of providing the same kind of  "charity" to poorer individuals at home.  It's as though we believe people in the U.S. can and should be able to make it on their own, just like we did, while families abroad need our help and charity to get ahead.  It's American Exceptionalism at it's finest. This double-standard has failed us for too long. Which makes it that much more exciting to see how our attitudes toward development both at home and abroad are evolving.  The role of poverty-focused non-profits in the U.S. can't simply be to plug holes in the social safety net.  We're learning this.  And the emphasis placed on entrepreneurship in international development efforts needs to be significantly greater.  Every day, we're seeing more and more of this. It's an exciting time to be in this field.  I don't know about you, but (in typical American fashion) I'm optimistic for the future.