Join our community of smart investors
OPINION

The cost of the Barclays' scandal

The cost of the Barclays' scandal
July 2, 2012
The cost of the Barclays' scandal

This temptation should be resisted. The scandal could have long-term costs vastly in excess of one or two basis points on interest rates.

The issue here is one of trust. Trust is central to most economic transactions. We trust that Amazon and Ocado will deliver the goods we ordered; we trust that shops will sell us products of acceptable quality or replace them; we trust that our employers will pay us at the end of the month; and so on. As Deirdre McCloskey wrote in The Bourgeois Virtues, "business normally depends on a state of trust not on explicit contracts".

There's a reason for this - asymmetric information. In most transactions, one party knows more than the other. Sellers of goods know more about their quality than buyers; job applicants know more about their industry and honesty than interviewers; companies know more about their prospects than outside investors; buyers of insurance know more about their riskiness than sellers. Faced with such inequalities of knowledge and therefore power, people would not enter into transactions without trust - ideally in their counterparty not to abuse their greater knowledge, but failing that in the legal system to give them redress. There's a reason why old-style bankers had the motto 'my word is by bond'; they knew that business could not be well done on any other basis.

It's no surprise, therefore, that researchers have found that economies grow faster if people trust each other more. Eric Uslaner and Oguzhan Dincer, two US economists, have found that US states where trust is high subsequently enjoy faster growth in GDP and employment than states where trust is low. And Roman Horvath of Charles University in Prague concludes from a study of 46 countries that "trust is one of the top determinants of long-term economic growth".

Herein lies the real potential cost of Barclays' Libor fiddle - and perhaps more importantly, banks mis-selling of interest rate swaps to small businesses. Such behaviour threatens to reduce the general level of trust, which in turn will depress long-run growth.

Imagine trust in banks were even lower than it is. People would then deposit less with them, which would make it even harder for banks to lend. And potential borrowers would be loath to borrow anyway, if they did not trust banks to keep credit lines open or to charge them less than exorbitant fees. The economy would suffer. And if this distrust leaches into society more generally, the basis for other economic transactions would also be weakened, impoverishing us even further.

You might think that the solution to this is tougher regulation of banks; if they cannot behave honourably freely, such behaviour must be imposed upon them. However, a paper by Philippe Aghion and Andrei Schleifer of Harvard University shows that this has a cost. Regulation, they say, can actually lead to further distrust, partly because if businesses are tightly regulated, they have less to gain from investing in getting a good reputation. This, they say, raises the danger of economies falling into a bad equilibrium in which there is distrust and heavy regulation which in turn reduces trust, entrepreneurship and economic activity.

Trustworthiness, then, is not just a moral virtue. It is an economic one. A society in which people trust each other will have more active markets, lighter regulation, more entrepreneurship and greater prosperity. A society of Arthur Daleys would be poor.

In this context, Sir Mervyn King's call for a change in banking culture is not mere moralising - it recognises a threat to our long-term growth. Sadly, though, such cultural change might be achievable only by unpalatably radical methods.