Wary investors could learn a lot from my nephew

Both need incentives to rebuild their shaken trust.

What lies at the heart of the current financial crisis? An important clue: It's similar to a problem I faced this summer with my 6-year-old nephew.

Playing around at the beach one day, I said to him, "Here, let me flip you into the water." "NO!" he said with panic, and from then on, I couldn't get him to play. "I promise not to flip you," I told him. But though we love each other, he would not believe me. What to do? I was face-to-face with the "promise problem."

The promise problem goes like this: "How do I know you will keep your word? How do I know you'll do what you say?" And that, in a nutshell, is what is shaping our economic lives – more than economics or mob psychology.

Like my nephew, investors now look at borrowers' promises and shout, "NO!" For good reason, each seems to wonder, "How do I know borrowers will pay what they promise?"

One basic solution is to use something called a trust support – any mechanism or arrangement that can help boost trust when a mere promise won't cut it. The right trust supports can make a big difference.

To the point: "I promise not to flip you," I told my nephew, "and if I do, I'll give you $10." This instantly changed everything and for the rest of the afternoon we played happily together.

What changed? I gave him a trust support. There were many I might have tried. I might have asked his mother to vouch for me, or let the lifeguard watch me carefully. Here, I offered to penalize myself and compensate him if I broke my word. It worked. I'd made my commitment reliable enough for him to accept it. And then I followed through.

Thankfully, trust supports don't just work with 6-year-old boys. Normally, they are crucial to institutions such as the housing market, preventing bad promises, strengthening others, and managing risks. Alas, by neglect, error, and corruption the housing market's normal trust supports failed. We wound up with bad promises and toxic bank assets.

The test we face today is whether we can solve the promise problem well enough to restore investor confidence in banks and other borrowers. Fortunately, we have solved the problem in many kinds of previous crises.

The US faced the problem in 1787 when states couldn't keep their commitments to put down Shays' Rebellion. Our solution was the Constitution, with its stronger federal government and its array of checks and balances to guard against tyranny. We faced the promise problem in 1933 when banks were failing. Our solution was the FDIC, federal audits, and other checks, incentives, and penalties that saved the banking system.

American mediator George Mitchell faced it in the 1990s in Northern Ireland where the conflict made all sides highly distrustful of one another. His work helped produce the Northern Ireland peace accords, with their many creative mechanisms to strengthen trust. All of these cases – and there are many others like them – relied on a variety of well-chosen trust supports for resolution.

It doesn't always work so well, of course, but we have reason to hope. While there is no single off-the-shelf solution to the promise problem we now face, there are dozens of trust supports to choose from. The task now is to find ones that shore up confidence in the promises of borrowers with toxic assets.

Asking questions such as these can help skilled negotiators find the right one:

1) Who can serve as a credible bridge of trust? The government, for instance, can back borrowers' promises.

2) How can we most effectively watch or test the promisemaker's ability to perform? Helping lenders know what toxic assets borrowers hold might help them test for ability to perform.

3) What incentives and penalties can best encourage performance? My nephew is a case in point.

4) Are there ways to build in mild, moderate, and strong trust supports? A range can help lenders and backers intervene early and late with the least coercion necessary.

5) Does the solution satisfy all parties' key interests?

6) What if the worst-case scenario happens?

The promise problem is as central to the current crisis as it has been to many others. It's the issue lurking behind many of the world's biggest problems. Want to stop global warming? The spread of nuclear weapons? Human rights abuses? Tackling the promise problem is the great and often solvable challenge behind the others. The world my nephew lives in will depend on how we respond to it.

Seth Freeman teaches negotiation and conflict management at New York and Columbia universities. He is working on a book entitled, "Promises: Making Commitments More Reliable in Business and Beyond."

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