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Essay: TRUST IN EXCHANGE: Adam Smith’s Presupposition

For completely different reasons, 1776 was a momentous year for Americans and for the British. Americans commonly mark the year as the beginning of the American Revolution; the British tend not to mark the year at all except as it relates to Adam Smith’s 1776 publication of The Wealth of Nations. Among the many things that Americans have done to annoy the British in the ensuing years is to appropriate Smith’s concepts in erecting an economic system that has grown well beyond the wealth-generating scale of the British economy.

The non-intuitive conclusion of Smith’s “invisible hand” cautions us to think twice about altruism. According to Adam Smith, the pursuit of self interest, in the aggregate and assuming an appropriate institutional infrastructure, produces social good more efficiently and more widely distributed than alternative systems one might imagine constructing. Over the past two centuries Smith’s concepts have been refined in both practice and theory by a legion of economists, moral philosophers, financiers, business executives, and governments, partly in response to the challenge of other bold experiments such as communism. The American model, anchored in the two fundamental constructs of business enterprise and organized markets, has been a major U.S. export during the remarkable expansion of the world economy especially during the past twenty years.

Reports of recent spectacular business failings (e.g. Enron, Global Crossing, WorldCom) and institutional lapses (e.g. Andersen, Merrill Lynch) reveal a gulf between practice and theory that one would find hard to applaud. We read of emerging American expressions of self-doubt (the New York Times headline: “Will Capitalists Dismantle Capitalism?”) and condemnations from foreign observers (including such British voices as the respected Economist magazine: “The American Economy Singed”).

To interpret what is happening in the contemporary American application of the Smithian thesis, we should focus our attention on a fundamental element that makes our system work: trust. The role of trust in business may be viewed as naïve (a common European view of Americans) or, alternatively, as I shall try to argue, it may be viewed as a pragmatic feature of a system with an impressive — albeit imperfect — track record.

Let’s consider the basic building blocks of the American system: property rights, money, and market exchange.

Property

The modern economic interpretation of property, as ownership, is another concept that the British gave us. We know that the concept is neither natural nor subject to universal agreement as demonstrated by disputes over the causes of the Indian Wars or of the taking of Hispanic California in the 19th century. Each of us appropriates certain rights over our property — that is, over our own labor and the goods and services that we possess. How we accomplish such appropriation depends on the institutional infrastructure that governs how we interact with each other.

Subject to pressure, institutions do change. Institutions may be formal (e.g. laws) or informal (e.g. generally accepted business practices). The practice of how we reward CEOs is an institution that has evolved rather significantly over the past 20 years. The common practice of giving a credit card to a waiter for processing payment for a meal has become an institution. The arrival of e-commerce occasioned transactions utilizing credit card numbers that pressured us to adapt the payment institution, which we appear to have done with some reluctance. The potential for regulatory reform of financial reports for public companies signals an imminent institutional evolution.

Property rights are multifaceted and institutions influence how we exercise them. They include: the right to possess, the right to use, the right to transform, the right to earn income from, and the right to dispose of or restrict another’s access to. Because property rights are so various, it is costly both to exercise them and to protect them. The point of the interaction between property rights and institutions is that property rights are never perfectly delineated. Something is always left, effectively, in the public domain. This simple fact is central to understanding how exchange works and how an exchange system can be sustained. For any two parties to engage in an efficient exchange, the value that each party foregoes must be worth the value each party receives. We know that this condition is not satisfied in every instance of exchange in our market system, but it happens often enough to produce some momentum.

Value & Exchange

We have made great strides in figuring out how to represent value, so that values – or their representations – may be traded again and again. In our market exchange system, value is represented by money. Money has many features, but ultimately it, too, is a claim. The claim to pay is either one that the state makes (legal tender) or one that a member of a closed system makes (scrip).

Rights are difficult to measure in every circumstance, and circumstances that call for measurement may arise before, during, or after an exchange. Parties may participate in an exercise to specify the claims each is willing to trade. This can be simple (e.g. you purchase an airline ticket that specifies a flight at a time departing from one location proceeding to another) or complex (e.g. you produce a service level agreement to govern how you will deliver work). Parties may be inspired to invoke their claims during a moment of consumption (e.g. when you see the large fellow stuffing his carry-on baggage in the compartment over your head and then announcing that he will be occupying the middle seat next to yours). Parties may be required to engage in measurement after exchange takes place (e.g. the work that defines the activities of the entire audit industry). Even when they can be measured, it is costly to enforce rights. Sometimes, even when a right can be measured, one chooses not to protect it because the cost of enforcement would be too high. Thus, property rights are susceptible to ‘capture’.

Most shareholders of Adelphia, Tyco, Enron, and Worldcom would have found it prohibitively costly to acquire sufficient information to inform themselves of relevant behavior of the top executives that would have caused them either to sell their shares or initiate remedial action. Remedial action (enforcement), as executed through the courts, would also have been costly for the common shareholder. So, it is not surprising that nothing happened…at least for a while.

Guile or Trust?

One occasionally hears of brilliant moves on the part of a clever executive or political figure. The moves often are judged brilliant because the sponsor took advantage of a behavioral assumption that the figure was not bound to abide. In general, if guile supplants trust as the institution supporting economic exchange, then the unfortunate chain reaction this would produce is potentially very far-reaching. To represent value, money requires trust that the government will not rescind its guarantee to pay. Similarly, to assure the repeated exchange that their enterprises require for survival and growth, the captains of industry must trust each other to portray the enterprises that they represent with some degree of accuracy. We have a system that presumes no endgame because the system is built on trust.

Speaking of Games:

Is it not extraordinary that the vendor at the ballpark can throw a bag of peanuts across rows of fans to a customer, who passes payment to the vendor through the hands of a multitude of complete strangers having no formal association with the transaction, who return change from the vendor in the same manner? Typically, there is no cheating, no chaos. The glue that holds this system together is trust. It is a system that appears to be significantly more resilient than the system of exchange that associates the ballplayer and the club management. From time to time, as strikes, lockouts, and the rescission of government protection are threatened, even they awake to the pragmatic value of trust.

David Gautschi is a firm director with Deloitte and Touche, co-author of the recent book Netmarkets: Driving Success in the B2B Networked Economy, and a former professor in the School of Business at the University of Washington.

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