Sunday, December 21, 2008

The Dark Side of Social Networks: Trust and Bernie Madoff

Dora Costa and I have a new book recently published by Princeton Press . The book focuses on the causes and consequences of social networks during the U.S Civil War. In the final chapter we discuss what is known about the "dark side" of social capital. Bernie Madoff represents an example of what we didn't talk about. In our chapter, we discuss examples such as the Ku Klux Klan and terrorist groups. Both groups are aided by the close social ties between their members.

What is my point about Bernie Madoff? The New York Times is running long articles making the point that because Bernie was jewish, lived in a nice part of New York City and attended the right social events and looked avuncular that rich jewish households trusted him and didn't ask any questions.

Trust crowds out investor effort as households didn't bother to ask the tough questions and do the basic "due diligence" before investing their $.

To repeat my point, suppose that New Yorkers don't like Republicans from Alaska --- based on Gary Becker's work on the economics of discrimination --- a Republican from Alaska would only be able to attract New Yorkers to invest in her funds if she did a fantastic job explaining every bit of her business plan; the burden of proof would be on her and she would need to be 150% above the bar for New Yorkers to invest in her.

In a world where effort is costly and people are lazy, we need less trust --- both trust in government bailouts (due to ex-post moral hazard) and ex-ante trust in the Madoffs in the world. In a dog eat dog world, each decision maker would need to do his own research before investing.