Or, why human beings are bad investors.
Free Exchange has Anthony Gottlieb’s recollections of interviewing Bernie Madoff about financial regulation:
at the time he came across merely as calm, strikingly rational, devoid of ego, and the last person you would expect to make your wealth vanish. I certainly would have trusted him with my money. I cannot say the same of other financial superstars I interviewed. . . . Perhaps it is the most confidence-inspiring ones that you have to look out for.
I couldn’t agree more. We human beings have this completely misplaced confidence in our ability to judge people by “looking them in the eye.” I recall reading about one study (sorry, I don’t remember anything else about it) which showed that hiring managers were more likely to make good hires by selecting solely on the basis of resumes than by interviewing people – because using resumes is completely objective, while interviews allow you to interject your own erroneous beliefs. (I do believe that if you use interviews well – that is, to obtain factual information, like how well someone can actually write a computer program – you can do better than just using resumes; but maybe I’m just fooling myself.)
There are a couple of ways to look at this phenomenon. One is to think about motivations. There are people who are trying to rip you off and people who aren’t. The latter have no motivation to try to seem trustworthy, so they don’t bother. The former do have that motivation, so they try. Some are bad at it; some, however, are very good at it.
More broadly, what does it mean to appear trustworthy? “Trustworthiness” is just a set of signifiers that are generated by one person and that enter the brain of another person, like a firm handshake or a steady gaze. It’s like those luxury car manufacturers who expend effort and cost engineering the sound of the car door closing, because that sound is a signifier for quality. There is some evolutionary process whereby these signifiers got attached to the concept of trustworthiness in our brain over the history of the species, and maybe the connection was valid at some point. But now that people can reverse-engineer the connection and replicate the signifiers whether or not they are actually trustworthy, our instincts aren’t much use anymore.
The only way not to be fooled by your instincts is to rely solely on objective facts. Now, in the Bernie Madoff case, one can object that the only visible “facts” were themselves cooked, and that is true. But that just means we need better policing of things that are presented as facts. And I think the overall point still holds.
The Baseline Scenario 
The issue of what is true and what is false in human nature, and how you tell the difference, has been a major topic (if not the major topic) of popular discourse for millennia, from the greatest works of religion and philosophy down to the gutter-press dissections of latest Hollywood marital breakdowns. Therefore, it is mildly amusing that now even economists have noticed it is of some importance.
The short answer on trust is “the deeper you see the more you trust”.
As the UK TV series “Hustle” points out, “you cannot con an honest man”. Gamblers need to believe in a system that can beat the odds, and people wanted to believe Madoff was doing something slightly extraordinary to explain his exceptional returns. As long as they were beneficiaries, his investors preferred not to ask hard questions.
Madoff is surely only very small fry, just a cheap crook “caught swimming naked as the tide goes out”, as Warren Buffett puts it so delightfully. The scale of deliberate deception is much greater than this and our culpability, or lack of “collective mindfulness”, is far more profound.
For instance, Fareed Zakaria’s GPS programme on CNN (December 28, 2008 – English slightly edited) hosted this frank discussion between pundits:
Hernando De Soto, President, Institute for Liberty and Democracy:
From a Third World point of view, the interesting thing is that, as trust breaks down in Western societies, like the United States, banks have stopped lending to each other because nobody really knows who owns what assets and what liabilities. You are starting to find out that the real economy has a lot more to do with trust than with the so-called fundamentals.
We have lost track. And we’ve lost track, because instead of having universal documentation as to who owns what — which is what international cooperation would give us — today, most of the paper in the world is untraceable.
Jagdish Bhagwati, Professor of Economics, Columbia University:
In each of these financial crises, the new instruments and changes have usually gone way beyond comprehension, and that is really at the heart of financial innovation.
Hernando De Soto:
It is about transparency.
Jagdish Bhagwati:
The downside is really important. When we say we must regulate, the regulators must first understand what has to be regulated.
Joseph Stiglitz, Nobel Prize-Winning Economist, Columbia University:
I think the point that Jagdish made is exactly right, that much of the innovation that we have had in the financial sector in the last two decades has been of negative value. It has been creating complexity. It is not a question of disclosure. You could disclose these documents, but nobody — the buyer, the seller, the regulators — can understand them. And it was done deliberately. It was done deliberately so people could not understand what was going on.
Hernando De Soto:
The reason you are in paralysis, the reason you are collapsing, is because you no longer know who’s got whose hand in whose pockets. You have to make a distinction. And remember that financing is there at the service of production, in combination, and is not center stage.
***
Sadly, because we did not challenge things we did not understand, we have become collectively liable for the consequences of the deception. We have failed in our responsibility to be truthful to ourselves and to demand the same standards of honesty in others.
The short answer on trust is “the deeper you see the more you trust”.
As the UK TV series “Hustle” points out, “you cannot con an honest man”. Gamblers need to believe in a system that can beat the odds, and people wanted to believe Madoff was doing something slightly extraordinary to explain his exceptional returns. As long as they were beneficiaries, his investors preferred not to ask hard questions.
Madoff is surely only very small fry, just a cheap crook “caught swimming naked as the tide goes out”, as Warren Buffett puts it so delightfully. I can’t see why so many commentators treat him with a sort of grudging respect. The scale of deliberate deception is much greater than this and our culpability, or lack of “collective mindfulness”, is far more profound.
For instance, Fareed Zakaria’s GPS programme on CNN (December 28, 2008 – English slightly edited) hosted this frank discussion between pundits:
Hernando De Soto, President, Institute for Liberty and Democracy:
From a Third World point of view, the interesting thing is that, as trust breaks down in Western societies, like the United States, banks have stopped lending to each other because nobody really knows who owns what assets and what liabilities. You are starting to find out that the real economy has a lot more to do with trust than with the so-called fundamentals.
We have lost track. And we’ve lost track, because instead of having universal documentation as to who owns what — which is what international cooperation would give us — today, most of the paper in the world is untraceable.
Jagdish Bhagwati, Professor of Economics, Columbia University:
In each of these financial crises, the new instruments and changes have usually gone way beyond comprehension, and that is really at the heart of financial innovation.
Hernando De Soto:
It is about transparency.
Jagdish Bhagwati:
The downside is really important. When we say we must regulate, the regulators must first understand what has to be regulated.
Joseph Stiglitz, Nobel Prize-Winning Economist, Columbia University:
I think the point that Jagdish made is exactly right, that much of the innovation that we have had in the financial sector in the last two decades has been of negative value. It has been creating complexity. It is not a question of disclosure. You could disclose these documents, but nobody — the buyer, the seller, the regulators — can understand them. And it was done deliberately. It was done deliberately so people could not understand what was going on.
Hernando De Soto:
The reason you are in paralysis, the reason you are collapsing, is because you no longer know who’s got whose hand in whose pockets. You have to make a distinction. And remember that financing is there at the service of production, in combination, and is not center stage.
***
Sadly, because we did not challenge things we did not understand, we have become collectively liable for the consequences of the deception. We have failed in our responsibility to be truthful to ourselves and to demand the same standards of honesty in others.