CHAPTER 27 THE ROLE OF CONFIDENCE IN FINANCE

CHAPTER 27

THE ROLE OF CONFIDENCE IN FINANCE

RICHARD SWEDBERG

It has been understood for a long time by bankers and politicians that confidence plays an important role in finance. Economists, in contrast, have been slow to realize this. As a result a strong tradition in the economics literature that discusses what confidence is and what role it plays does not exist. The main theoretical as well as empirical work in this area, in short, remains to be done. The same is also true for establishing what econo­mists so far have said about the role of confidence in finance. Again, the result is a weak, close to nonexistent, understanding of what confidence is.

One may speculate why this is the case. One factor may be that mainstream econom­ics focuses on a narrow set of factors that drive economic behavior, and confidence is not one of them. It is, for example, possible to argue that one can make good analyses without taking confidence into account. This is an argument that needs to be taken seri­ously, and those who advocate that there is a need for a better understanding of confi­dence in finance must be prepared to show how this will improve the analysis.

Another reason for the neglect of confidence in the analysis of finance has to do with the common conviction among economists that confidence belongs to the field of psy­chology, not economics. To this can be added the fact that mainstream economics has by tradition not been very interested in psychology, including the field of economic psy­chology that was created by George Katona and others in the 1950s (e.g., Katona 1975). A more successful attempt to bring psychology and economics together can be found in behavioral economics, a topic to which I shall return later in this chapter.

Sociology has for natural reasons had even less to say about the role of confidence in finance. Economic sociology has only been around for a few decades and has not pro­duced very many studies of finance. This is true even if we take into account the work by sociologists who are active in the field known as the social studies of finance (but see, e.g., Knorr Cetina and Preda 2005; Pixley 2004).

Given the absence in economics as well as in sociology of a well-developed tradition that studies the role of confidence in finance, I will structure this chapter as follows.

530 RICHARD SWEDBERG

I will first introduce the main attempts so far to deal with this topic, in economics as well as in sociology. The reasons for discussing the contribution by economists in a hand­book of sociology are two. First, the economists have had much more to say about confi­dence in finance than sociologists have. Second, and following Schumpeter’s dictum that economic sociology consists of an area that is situated at the intersection of sociol­ogy and economics, it is natural for the study of confidence in finance to draw on both of these sciences (Schumpeter 1954: 25-7).

Since so little work on this topic exists—and so little consensus on the role of confi­dence in finance—it is also necessary to touch on a few related topics in this chapter. One of these has to do with the relationship between trust and confidence. According to the everyday use of these two terms, for example, they have related and partly over­lapping meanings—but is this also the case for the way they are used in economics and sociology? It is clear as well that the role of confidence is not limited to the area of the economy, and, in the economy, to the area of finance. What lessons can be learned from general discussions of confidence as well as from discussions of confidence in economic life in general? Addressing topics and questions of this type increases the difficulties in dealing with the topic of confidence in finance and takes it in divergent directions.

Part i: Economists on the role

of confidence and trust

In order to give the reader a sense of how economists have looked at confidence, I will start out by presenting the content of one of the few overviews of this topic that exist (and perhaps even the only one). It is a brief article entitled “Confidence," which appeared in The New Palgrave Dictionary of Money and Finance (Walters 1992). It appeared in the early 1990s and is written by Alan Walters, a British expert on money and finance.

Walters makes two major points in his article. The first is that confidence plays a very small role in modern economics: “Confidence . . . is largely ignored by modern theoreti­cal economics” (Walters 1992: 423). The second is that confidence is primarily a psycho­logical phenomenon—and it is this fact that makes it so hard to for economists to deal with confidence. “Economists’ tools and models” Walters says, show a distinct “inabil­ity” to analyze confidence, without resorting to “market psychology” (Walters 1992:

424-5).

But even if a basic incompatibility between economic theory and the psychological phenomenon of confidence exists, economists have for a long time nonetheless dis­cussed various forms of confidence. According to Walters, their interest has taken three forms: they have developed surveys of confidence; they have looked at the role of confi­dence in the business cycle; and they have studied confidence and governmental policy.

Surveys of confidence include the famous surveys of consumer confidence that have been produced since the 1960s by the Conference Board and the Survey Research Center at the University of Michigan. But to Walters these surveys do not really address the issue of confidence, but what people think that the economy will be like in the future. He concludes: “it is doubtful if these surveys of confidence help in understanding the effects that confidence has on economic conditions” (Walters 1992: 423).

Walters’ discussion of surveys of confidence is very brief, and it does not at any point address the issue of finance. His attitude to what he calls “business confidence” and its role in the business cycle is different. He devotes far more space to this topic, for one thing. He also notes that this topic includes finance, in the form of “financial panics”

Walters centers his discussion of the role of confidence in the business cycle around a work that probably few people are familiar with—The Trade Cycle (1922) by Frederick Lavington. According to Lavington, businessmen make their decisions in a rational manner. At times, however, their decisions are colored by hope; this results in “unduly high confidence or optimism” (Walters 1992: 423). And sometimes their decisions are colored by apprehension, which results in “unduly low confidence or pessimism” (Walters 1992: 423).

Lavington’s analysis makes us realize that the notion of confidence is linked to opti­mism and pessimism, even if it may be hard to pinpoint the exact difference between a strong sense of confidence and optimism, on the one hand, and an absence of confi­dence and pessimism, on the other. Walters, in presenting Lavington to the reader, also introduces a few other concepts that are commonly found in discussions of confidence: uncertainty and animal spirits. If there is uncertainty, he suggests, there will be room for the animal spirits. And, depending on the strength of the animal spirits, there will be lit­tle or no confidence.

The concept of animal spirits comes from Keynes, and Walters refers to the British economist several times in his article. We are, for example, told that one can find a rudi­mentary form of confidence multiplier already in Lavington, and that the idea of surveys of confidence traces its origin to Keynes’ work. And Keynes argued that confidence var­ies directly with the faith we have in our forecasts.

Walters also directs some criticism at Keynes, especially for not working out the effects of confidence on the business cycle. The reason for this omission, he says, is that Keynes felt that confidence “was mainly a matter for business psychology rather than for analytical economics” (Walters 1992: 424).

The third topic that Walters surveys in his article is confidence and government pol­icy. This type of confidence essentially deals with the type of confidence that the general public as well as businesspeople have in the way the government handles the economy. Walters suggests that what is ultimately at issue here is consistency. In order to inspire confidence, government policy in economic affairs has to be credible—and for it to be credible, it has to be consistent.

An economic policy that is internally inconsistent will fail, according to Walters. As an example he mentions a situation in which the budget deficit is not properly aligned with the monetary policy or with the inflation rate. Walters also attacks Keynes’ idea that the government should counter downturns in the business cycle, with the argument that this is very likely to erode confidence. The reason for this is that in the end a deficit always has to be paid off.

While Walters’ article can serve as an introduction to the role of confidence in eco­nomics, it also needs to be complemented. One reason is that it is very short and fails to do justice to, say, the contribution of Keynes. Another reason is that quite a bit has hap­pened with the analysis of confidence during the 20 years or so since Walters’ article was written.

When did economists start looking at confidence? Histories of economics typically begin with The Wealth of Nations (1776), and one may therefore ask if its author had something to say on the topic. The answer is that the closest Adam Smith comes to a dis­cussion of confidence is in his remarks on the role of a merchant’s reputation. According to Smith, there is variation in the “character” displayed by merchants from different countries. The Dutch are “more faithful to their word” and better at “performing agree­ments” than say the English. And the English, in their turn, are more faithful and so on than the Scots. Adam Smith also notes that the more frequently people interact with one another, the more important it is for the actors to have “character.” The reason for this, he suggests, has to do with “self-interest,” which “leads men to act in a certain manner from views of advantage” (Smith [1766] 1997: 17).

These remarks on reputation and character are not to be found in The Wealth of Nations but in Lectures of Jurisprudence, something that again alerts us to the fact that confidence is a topic that tends to lie outside the normal domain of the economist. And again we find a new topic—this time, reputation—that is close to, and overlaps with, confidence, without being identical to it. It should also be noted that by linking interest so closely to confidence, Adam Smith can be seen as an early proponent of the calcula- tive view of confidence.

While an expert on the history of nineteenth-century economics might continue in this vein and point to some minor statements on confidence in the works of Ricardo, Mill, and so on, I shall limit myself to a discussion of a single work from this century. It is, however, a work that has much to say about the role of confidence in finance: Lombard Street (1873) by Walter Bagehot.

Keynes has called this book “one of the classics in Political Economy” (Keynes 1915: 369). The main reason for singling it out for discussion in this chapter is that it is proba­bly the most influential work ever written on the role of confidence in finance. It is in this work, more precisely, that the classical strategy for how a central bank can restore confi­dence in a financial crisis was first outlined. During the recent financial crisis, for exam­ple, Bernanke repeatedly referred to what Bagehot says in Lombard Street (e.g., Bernanke 2008, 2009).

Bagehot’s purpose in writing Lombard Street was first and foremost to make the finan­cial community in England realize that the Bank of England, which was a private bank at the time, must resume the kind of responsibilities that we today associate with a central bank. England was at the time the banker of the world; and the concentration of capital that could be found in the financial district of London well surpassed that of any other

financial power. Banking was, however, also very vulnerable to crises—and unless cer­tain measures were taken, Bagehot argued, one of them could destroy the English banks.

Confidence and trust (and Bagehot used the two terms interchangeably) stand at the very center of his analysis of the fragile nature of the banking system. “Credit means that a certain confidence is given, and a certain trust reposed” he writes (Bagehot [1873] 1922: 22). “‘Is the trust justified and is that confidence wise’? These are the cardinal questions”

What Bagehot refers to in this quote is the kind of confidence that a banker must have in the person to whom money is lent. But this is only side of the equation. The other side has to do with the confidence that the depositor has to have in the bank, in order to part with the money. In France, for example, Bagehot notes, many people do not trust the banks and therefore keep their money at home.

At both ends of the banking business, in other words, confidence is crucial. Or in Bagehot’s words: “The peculiar essence of our banking system is an unprecedented trust between man and man” (Bagehot [1873] 1922: 151). This “unprecedented trust” also means that the banker has to do anything he can to keep people calm and not to endan­ger confidence. One classical line in Lombard Street reads: “Adventure is the life of com­merce, but caution, I had almost said timidity, is the life of banking” (Bagehot [1873] 1922: 220-1). Another related quote reads: “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone” (Bagehot [1873] 1922: 68).

Panics, however, or sudden losses of confidence, do occur; and Bagehot devotes many pages to analyze how these can be triggered, and what can be done to stop them and restore confidence. Losses in the loan portfolio of banks are extra dangerous for pre­cisely this reason. And, especially in cases when the losses are hidden and suddenly dis­closed, the crisis can bring down the whole financial system.

The best way to stop a crisis and restore confidence, Bagehot famously says, is to “lend freely” (e.g., Bagehot [1873] 1922: 48, 64; emphasis added). When a panic is on, the natu­ral instinct for a banker is to hold tight to the money. In this situation, Bagehot argues, the central bank—the Bank of England—must behave differently. It must lend freely and, by giving the impression that it has confidence in the system, it will restore confidence.

It was earlier mentioned that Keynes regarded Lombard Street as a classic in econom­ics. He especially praised Bagehot’s gift for observing what was going on in real life. He had less appreciation, however, for Bagehot’s analytical skills and basically felt that Bagehot was more of a psychologist than an economist. “Lombard Street” Keynes sums up, “is the Psychology of Finance, not the theory of it” (Keynes 1915: 373). This is another instance, in short, of the view that confidence is important in real life—but that econom­ics unfortunately cannot deal with it.

Next to Bagehot, Keynes is the economist who has made the most important contri­bution to the analysis of confidence. While Bagehot concentrated on the role of confi­dence in the banking system and how to handle its sudden disappearance in a crisis, Keynes was more interested in the role that confidence plays in the regular working of the economy and especially how it influenced investments. Keynes touches on confi­dence in many of his writings, but most importantly in General Theory (Keynes 1936; see also Keynes 1937).

The main question that Keynes raises in General Theory is how full employment and steady economic growth can be ensured in a society with a capitalist economy. His well- known answer is that the state has to intervene in order to increase demand and to steer investments in a productive direction. This is also the general picture into which Keynes fits confidence. The role of confidence, he argues, is crucial; and that is to help offset the uncertainty that is inevitably part the decision to make an investment. Investments cannot exclusively be made based on rational considerations; they also involve confidence.

Keynes’ analysis of confidence can be found in the famous chapter 12 in General Theory, which contains his most important contribution to the sociological analysis of the economy (Keynes 1936: 147-64). Besides its analysis of confidence, this remarkable chapter (which deserves to be known as a classic in economic sociology) also introduces such well-known Keynesian notions as animal spirits and the stock market as a beauty contest. These two latter concepts are usually presented and discussed in their own right, but as we soon shall see they are closely linked to the phenomenon of confidence.

Keynes starts out from the idea that investment represents the key to production and economic growth. Investments, however, also depend on an evaluation of distant events and these are impossible to know. On this point Keynes refers to his own work on statis­tics and argues that probabilities simply do not apply to future events. Rational calcula­tions cannot present a solution; the only way you can proceed is with the help of confidence. Confidence, from this perspective, is defined as “how highly we rate the likelihood of our best forecast to be wrong” (Keynes 1936: 148).

At this point of the argument in chapter 12 Keynes stops and presents the reader with the fullest statement that can be found in his work on the role of confidence in economic life:

The state of confidence, as they term it, is a matter to which practical men always pay the closest and most anxious attention. But economists have not analyzed it care­fully and have been content, as a rule, to discuss it in general terms. In particular it has not been made clear that its relevance to economic problems comes in through its important influence on the schedule of the marginal efficiency of capital. There are not two separate factors affecting the rate of investment, namely the schedule of the marginal efficiency of capital and the state of confidence. The state of confidence is relevant because it is one of the major factors determining the former, which is the same thing as the investment demand-schedule.

There is, however, not much to be said about the state of confidence a priori. Our conclusions must mainly depend upon the actual observation of markets and busi­ness psychology. This is the reason why the ensuing digression is on a different level of abstraction from most of this book. (Keynes 1936: 148-9)

Note that so far Keynes has argued that confidence is indispensable to the key problem of economics, namely production and economic growth. He has also stated that econo-

THE ROLE OF CONFIDENCE IN FINANCE 535

mists have ignored confidence and that it must be introduced into economic theory. But how does Keynes want to proceed from this point onward? His answer, to repeat, is as follows: “Our conclusions must mainly depend upon the actual observation of markets and business psychology. This is the reason why the ensuing digression is on a different level of abstraction from most of this book.”

Keynes, in other words, says that he will rely on precisely the two qualities that made it possible for Bagehot to deal with confidence: observation and psychology. But even if he attempted to go beyond Bagehot and introduce confidence into economic theory, he also says that he will be unable to proceed in the same way as he does elsewhere in General Theory.

Keynes’ answer to the question of how confidence helps actors to handle faraway events or to form long-term expectations is as follows. In the stock market actors not only make forecasts as best as they can, they also depend on “conventions,” and this pro­vides them with the confidence they need for their forecasts. In starting up and in run­ning firms, businessmen have to make forecasts. And what gives them confidence is something else: animal spirits.

On the stock market the private investor draws on a convention for how to evaluate the stocks; to the extent that this is done, he or she is able to proceed with confidence. This type of confidence, however, is brittle in nature, since these conventions are based on superficial knowledge and are easily influenced by what other actors think. Since confidence on the stock market is structured in this particular way, it is inherently unstable.

Adding to the problem, from Keynes’ perspective, is that professional investors do not have long-term productivity as their goal. What they try to do is essentially to figure out how the private investors view the market. This is where Keynes’ famous theory of the stock market as a beauty contest comes into the picture. Professional investors try “to anticipate what average opinion expects the average opinion to be” (Keynes 1936: 156). What happens on the stock market, according to Keynes, consequently depends on “the state of confidence of the speculator,” and the problem is that this type of confidence is based on conventions that have little to do with production (Keynes 1936: 158).

Keynes also discusses the confidence of another key actor in the modern economy, namely the businessman; this type of confidence differs in many ways from that of the speculator on the stock market. Instead of being based on inherently unstable conven­tions, it draws on animal spirits or the spontaneous urge that human beings have to act. These types of emotions particularly dominated economic life before the separation of ownership and management of the firm, according to Keynes, but are still operative in the modern economy.

The tendency is nonetheless for the activities on the stock market (“speculation”) to be more important for the economy than those of individual businessmen (“enterprise”). This means that investments will be handled in a poor way and that the state has to inter­vene and assume some responsibility for investments. What consequences this will have for confidence, Keynes does not say. It would seem to entail a third type of confidence, however, namely confidence in the state as an economic actor.

After Keynes very little attention was paid to confidence in the economics literature till the 1970s. From this time onward modern economics has become more pluralistic, and it has opened up to many new types of analyses such as game theory, behavioral economics, neuroeconomics, and so on. In several of these new approaches one can find studies that deal with confidence. It is hard to generalize, but there seems to be a tendency to either use the term “confidence” and cast it as a psychological and nonra- tional phenomenon, or to use the term “trust” and see it in more structural and rational terms.

Behavioral economics draws on psychology to recast economic analysis and tends to use the term confidence. The most important stream of research in this type of approach is centered around the idea of overconfidence and has its origin in a pioneering study from 1992 by Dale Griffin and Amos Tversky (see also Pech and Milan 2009). Overconfidence is here interpreted to mean that “people are more confident in their judgments than is warranted by the facts” (Griffin and Tversky 1992: 411). The article by Griffin and Tversky mainly uses examples that have nothing to do with finance, but the authors also note that overconfidence can lead to “regrettable financial investments” (Griffin and Tversky 1992: 432).

Today’s behavioral economics is very broad in scope and also has a macroeconomic branch, as exemplified most importantly by the work of Robert Shiller. Among Shiller’s many attempts to take confidence into account, there is, for example, his work on inves­tor confidence, including his Index of Investor Confidence (e.g., Shiller 1999, 2000: 44-68). His most important attempt to outline a theory of confidence for macroeco­nomic analysis is, however, to be found in a recent book coauthored with George Akerlof, Animal Spirits.

In this study, the authors state that while most of economic life can be understood with the help of the concept of interest, along the lines first outlined by Adam Smith, there is also another part of economics that can only be explained by referring to man’s “noneconomic motivations” or animal spirits (Akerlof and Shiller 2009: 3). These ani­mal spirits account in particular for two very important aspects of economic life: its var­iation and its sharp fluctuations.

While animal spirits is a term that comes from Keynes, Akerlof and Shiller have reinterpreted it for their own purposes. It no longer means man’s spontaneous urge to action, but instead covers the following five phenomena: confidence, temptations, envy, resentment, and illusions.

Akerlof and Shiller state that confidence represents “the corner stone of our theory” and that it should be used in a way that differs from that in which most economists cur­rently use it (Akerlof and Shiller 2009: 5). When economists have discussed confidence, they have mainly seen it in terms of a multiple equilibria analysis and/or as a bleak atti­tude to the future. The argument has been that without confidence, you may get stuck in an undesirable equilibrium; and with the help of confidence, you can move to a better economic future.

To Akerlof and Shiller this view of confidence is wrong since it “suggests that confi­dence is rational,” while “the very meaning of trust is that we go beyond the rational”

(Akerlof and Shiller 2009: 12). As an example of how confidence (or rather its disappear­ance) can affect finance, they mention the collapse of Lehman Brothers in September 2008.

The main suggestion of Akerlof and Shiller on how to introduce confidence into eco­nomic theory has to do with something they call the “confidence multiplier.” Drawing on Keynes’ idea of the multiplier, they suggest that a confidence multiplier indicates “the change in income that results from a one-unit change in confidence—however it might be conceived or measured” (Akerlof and Shiller 2009: 16).

If we now turn to the approaches in modern economics that prefer to use the term trust, and not confidence, we find that the emphasis is more on stability, rationality, and the broadly social qualities of trust, than on irrationality and individual psychology. The tone of this line of research can be illustrated by a famous statement on the role of trust by Kenneth Arrow. In The Limits of Organization, he describes trust as “an important lubricant of a social system” (Arrow 1974: 23; cf. Arrow 2009). The full quote reads as follows:

Now trust has a very important pragmatic value, if nothing else. Trust is an impor­tant lubricant of a social system. It is extremely efficient; it saves a lot of trouble to have a fair reliance on other people’s word. (Arrow 1974: 23)

From the characterization of trust as something efficient and stable, there is only a small step to what Oliver Williamson has called “calculative trust” (Williamson 1993: 463-4). This approach is also often used in game theoretical analyses of trust. It similarly informs the increasing number of empirical studies of trusts that have been carried out by econ­omists. Rafael La Porta and his coauthors show, for example, that there exists a relation­ship between the number of trusting people in a country and its level of inflation and GDP growth rate (La Porta et al. 1997).

Neuroeconomists also seem to identify more with the view that is implicit in the con­cept of trust, than with the focus on uncertainty that can be found in the research on confidence (e.g., Fehr 2008). The main insight in neuroeconomics is that trust is linked to a hormone called oxytocin, which is related to the tendency of human beings to be social. Oxytocin has its origin in the brain and affects the organs through the blood­stream. In one of his experiments Ernst Fehr administered oxytocin to a number of stu­dents through a nasal spray and then told them to play a so-called trust game, which involved investing a sum of money. Students who received a dose of oxytocin were more willing to trust their financial partners than those who did not receive the hormone (Angier 2009).

While economists who do work in finance have not shown much interest in trust, there does exist today a small body of work in this highly technical field (Sapienza 2009). What view of trust one can find in this type of economics can be gleaned from an article that was published in 2008 in the Journal of Finance, “Trust in the Stock Market” (Guiso, Sapienza, and Zingales 2008). Its key argument is that trust can help to explain the puz­zle of why so few people invest in stocks. The more trust there is in a country, the more its citizens will invest in the stock market.

The authors define trust as “the subjective probability individuals attribute to the pos­sibility of being cheated” (Guiso, Sapienza, and Zingales 2008: 2557). There exist “outer factors” that influence individuals to buy stocks (such as the quality of investor protec­tion) as well as “interior factors” (such as their education and religion). The authors also refer to cross-country data. The conclusion of the study is that less trusting individuals are less likely to buy stocks—and if they do buy stocks, they buy less.

I earlier referred to Schumpeter’s statement that economic sociology is situated some­where in the gray area between economics and sociology, and the sociological flavor of the study of trust and participation in the stock market is incontestable. This is also true for much of the other research on confidence and trust that has been discussed. Bagehot’s ideas on why confidence is especially important in the banking business are, for exam­ple, easily cast in sociological terms. And even if Keynes always referred to psychology and never to sociology when he discussed confidence, there is a clear sociological dimension to his analysis.

Part 2: Sociologists on the role of confidence and trust

While economists to some extent have theorized both the concept of trust and that of confidence, this is not the case with sociologists. Why sociologists have looked at trust but not at confidence is not clear. One clue, however, can be found in the one and only major sociological study devoted to the phenomenon of confidence, namely Rosabeth Moss Kanter’s (2006) Confidence. What Kanter means by confidence, it turns out, is a belief in oneself. Confidence, in other words, has probably been viewed by sociologists as a psychological phenomenon, just as in economics. And since Durkheim, sociolo­gists have tended to stay away from truly psychological phenomena and mainly focus on what takes place outside the individual, as opposed to what happens inside the mind of the individual actor.

But if sociologists do not use confidence as a distinct concept in its own right, this does not mean that they have a unitary concept of trust. As it turns out, modern sociolo­gists have produced a bewildering number of theories of trust. Before addressing this issue and discussing what it entails for the analysis of confidence in finance, however, it is useful to look at some earlier contributions by sociologists to the understanding of trust.

Of the classics, it is especially Simmel and Weber who have written on trust. Weber did not develop a special concept of trust but used a variety of related and overlapping terms. His most successful analysis of trust is probably to be found in his analysis of political legitimation. Coercion is not enough to dominate a population in the long run, Weber argued; something else is needed to inspire trust in the ruler. The three types of legitimation were his answer.

Weber also made some interesting contributions to the understanding of trust in eco­nomic life. One of these can be found in “The Protestant Sects and the Spirit of Capitalism” in which he notes that people in the United States tended to trust individu­als who were members of certain religious sects (Weber [1920] 1946). During his trip to the United States, Weber also says in this article, he ran into a person who wanted to become a banker and who therefore became a Baptist. He knew, Weber says, that if he joined a sect, people would have no difficulty in trusting him with their money (Weber [1920] 1946: 304-5).

It can also be argued that Weber’s concept of rational capitalism has an important component of trust. What makes rational capitalism so superior to other forms of capi­talism, according to Weber, is precisely its predictable nature. Merchants and other eco­nomic actors can trust that courts, the state and so on will act in a certain manner. Without this predictability or trust, Weber notes, it would not be possible to mobilize the huge sums of capital that are necessary in the modern economy.

Simmel discusses trust in Philosophy of Money as well as in his general sociology (Simmel [1907] 1978: 178-9, 480; 1950: 318-20, 345-8). In the former work he cites the inscription of a Corsican coin: non aes sedfides (“Not money, but trust”). Trust, Simmel explains, is crucial to the existence of money in two ways. First, you have to trust that a certain coin is worth a certain amount. And second, you have to trust that other people will accept the coin at its value.

Simmel discusses money and trust in Philosophy of Money, but he also touches on credit and trust. What he has in mind with credit, however, is personal credit and not the kind of credit on which the banking system is based. In general, it seems that Simmel knew very little about banking and the stock market.

Simmel was, however, very interested in trust as a general phenomenon, in society as well as in the economy, and also in different types of trust. On the one hand, he sug­gested, there exists a kind of trust that is based primarily on knowledge. If you know something completely, Simmel says, you do not need to trust. But if you do trust, there is always a chance that you may be wrong; “any trust always entails a risk” (Simmel [1907] 1978: 480). A farmer, for example, typically trusts that there will be a harvest next year, and he bases this on empirical grounds.

Translators of Simmel’s work into English often render the word Vertrauen in this type of context as “confidence” But Simmel also used this term for another type of trust; here the translators use “trust.” In the latter case there is something else involved besides knowledge. This something else, Simmel said, is “hard to define” but has its clearest expression in religious faith (Simmel [1907] 1978: 178). His most precise attempt to define this element can be found in his description of it as an “element of social-psycho­logical quasi-religious faith” (Simmel [1907] 1978: 179). Simmel was clearly looking for a word to describe trust that had some elements in common with religious faith, but which also differed from it. Perhaps secular faith is close to what he had in mind with “quasi­religious faith”

Before leaving Simmel, it is important to note that he emphasizes the interactional dimension of trust and confidence more than its psychological and individual dimension. Trust and confidence, he says, are something that “people have in each other” (Simmel [1907] 1978: 178). But the interaction involved is not the same for these two concepts. While confidence tends to be something you give, trust is something you tend to accept (Simmel 1950: 348).

Just as the economists reacted to, and received important inspiration from, the events of the Great Depression in the 1930s, so did the sociologists. One particular analysis of the events during this period has become a sociological classic. This is Robert K. Merton’s analysis of a run on a bank in his essay “The Self-Fulfilling Prophecy” (Merton [1948] 1968).

Merton mentions that in the early 1920s some 600 banks went silently bankrupt every year in the United States, and that this figure nearly quadrupled during the years before and after the crash of 1929. The way that even a good bank could go bankrupt during these years inspired Merton to an ideal-typical account of what happens during a run on a bank. He cast his analysis as a story about the fictional Last National Bank, set in the year of 1932. A rumor that this perfectly healthy bank was insolvent made depositors withdraw their money—and this pushed the bank into bankruptcy.

Merton explains what happened in the following way:

The stable financial structure of the bank had depended upon one set of definitions of the situation: belief in the validity of the interlocking system of economic prom­ises men live by. Once depositors had defined the situation otherwise, once they questioned the possibility of having these promises fulfilled, the consequences of this unreal definition were real enough. (Merton [1948] 1968: 476)

While Merton speaks of changes in “beliefs” and “the fulfillment of promises” as the key mechanism involved, it is clear that these terms are very close to confidence or trust. And what Merton describes in terms of the Thomas theorem and a self-fulfilling prophecy can equally well be presented as a classical run on a bank caused by its depos­itors losing confidence. Merton also points out that this type of run on banks can be blocked through “enacted institutional change” (Merton [1948] 1968: 489). As we know, this came about through the creation of the Federal Deposit Insurance Corporation in 1933.

Since the 1980s two developments have occurred that are of importance to the discus­sion of how sociologists view the role of confidence in finance. One of these is the reemergence of economic sociology and the related social studies of finance. The other is the huge amount of attention that has been devoted to the concept of trust. The latter development has involved not only sociologists but social scientists in general.

As earlier mentioned, contemporary economic sociologists have had little to say about confidence and trust. While it is often pointed out that credit implies trust and that the term credit comes from the Latin credere, which means to trust, this is usually also where the analysis stops. One major exception to this tendency does, however, exist, and this is the attempt to portray trust (and confidence) as an emotion.

The two proponents of this view are Jocelyn Pixley and Jack Barbalet, both of whom are influenced by Keynes’ ideas about uncertainty and animal spirits. Barbalet is a pio­neer in the sociology of emotions (as well as active in economic sociology); his work is primarily relevant in this context for the interest that he has shown in the concept of confidence (Barbalet 1998: 82-102; for a critique of Barbalet, see Dequech 2001). According to Barbalet, confidence as an emotion consists of two elements, one that is cognitive and another that is dispositional in nature. “The cognitive element of confi­dence involves images of projections of self and beliefs concerning the future. The dis­positional aspect concerns inclinations to act on those images, projections, and beliefs” (Barbalet 1998: 85).

Jocelyn Pixley’s main contribution can be found in her monograph Emotions in Finance (2004), which is based on interviews with some 40 people in finance, from cen­tral bankers to finance journalists. Her main thesis, inspired by Keynes, is that the future is unknowable and that the only way to proceed is to go beyond rational calculations.

Pixley argues that trust, confidence, credibility, and similar phenomena are all emo­tions that must complement rational calculations in order for forecasts or actions directed toward the future to be possible. The type of emotions involved, she says (and here she leaves Keynes), are social in nature and often carefully managed by central banks, private banks, and some other actors. The main problem, from Pixley’s perspec­tive, is that the modern financial system is based on making short-term profits, and this means that the type of trust it produces is volatile in nature. The tendency in finance is also to deny the very existence of emotions and only to speak in terms of risk, something that adds to this volatility. The solution to the instability of modern finance, the author suggests, is caution and democracy.

Pixley primarily talks in terms of trust; it is now time to take a brief look at the social science discussion of this concept that was begun in the 1980s and has become very vig­orous. The first and perhaps also the most important fact about this discussion is that it has led to no consensus whatsoever about what is meant by trust (see, e.g., Hardin 2001). Some scholars focus on its rational element, while others cast trust in terms of probabil­ity. There also exist a number of studies that portray trust as a very broad phenomenon that is closely related to the notion of social capital. One example of this is Trust by Francis Fukuyama, in which economic prosperity is closely linked to what the author defines as trust (“the expectation that arises within a community of regular, honest, and cooperative behavior, based on commonly shared norms, on the part of other members of that community” (Fukuyama 1995: 26)).

In most of the literature on trust, no particular attention is paid to the concept of con­fidence and the two terms are used interchangeably. There do exist a few exceptions, however, and one of these evokes the ideas of Simmel on trust as quasi-religious faith (see also, e.g., Luhman 1988: 97, Seligman 1997: 25-6). This is in an essay by economic anthropologist Keith Hart (1988), which can be found in the influential anthology on trust edited by Diego Gambetta. Drawing on evidence in dictionaries, he points to the link that exists between religious faith and trust. “Faith,” he writes, “is an emotionally charged unquestioning acceptance” (Hart 1988: 187). “Trust implies depth and assurance of such feeling, with inconclusive evidence or proof. Confidence involves less intensity of feeling, being based often on good evidence for being sure.”

Similar to Simmel, Hart views confidence as being more or less the same as trust, minus most of the quasi-religious element. Hart rejects the idea of a simple continuum, from faith over trust to confidence. While some kind of continuum is involved, the con­cept of trust contains elements of faith as well as evidence. Hart does not say if this is also true for confidence, but possibly this is the case even if the element of faith would be less than in trust.

Concluding remarks: On adding signs to THE THEORY OF CONFIDENCE IN FINANCE

So far in this chapter I have presented and commented on contributions by economists and sociologists that in one way or another deal with confidence in general and confi­dence in finance. It is clear that there exists no consensus either in economics or in soci­ology when it comes to what confidence is and what role it plays in finance.

My own impression is also that such a consensus is not likely to emerge. And since this is the case for trust, it is even more so for confidence. What needs to be done is therefore to try to push ahead theoretically, to advance beyond the current discussion by putting forth new ideas on this topic.

This is what I have attempted to do in an analysis of the role of confidence in the cur­rent financial crises (Swedberg 2010). I here suggest that confidence has a double struc­ture, in the sense that we typically have confidence in something because there is something else we want to know but cannot know. We do not have full knowledge of this something else and therefore have to rely on some kind of substitute, in which we place our confidence. I may, for example, have confidence that some bank will respond in some manner, because it has done so several times before. I may also have confidence in how a rating agency evaluates a bond issue, because I know that this agency has a good reputation.

Confidence, and here I think that Barbalet and Hart are correct, does not only have a cognitive dimension but also an emotional and more holistic one, involving the whole person and not just his or her calculative capacity (what Simmel attempts to capture through his expression “quasi-religious faith”). The reason for this has not only to do with the fact, I would argue, that one draws on confidence in situations where one lacks full knowledge; there also exists another and more important reason. This is that confi­dence is only fully manifested when some action is based on it, since this forces the actor to go beyond whatever knowledge he or she has and, so to speak, take a jump into the unknown.

Trust, I agree with Simmel and Hart, belongs to the same family of phenomena as confidence, but its element of quasi-religious faith is stronger. Confidence, I would argue, is more common in the area of the modern economy, where actors have to be very alert, than in such areas of life as religion, politics, and family. In these latter areas, faith and loyalty are common as well as important.

A solid theory of confidence must also be capable of handling different types of actors. In discussions of confidence and trust, the actor is typically assumed to be an individual. The reason for this is probably that trust and confidence are seen as psychological in nature, and psychology deals with the individual. In the modern economy, however, the main actors are institutions; trust and confidence have consequently to be theorized in such a way that they cover institutions as well as individuals.

What existing theories of trust and confidence do not take into account, I also would argue, is the existence of signs and their role more generally in society (for signaling and trust, see Bacharach and Gambetta 2001). In both trust and confidence, to repeat, you have to rely on something else than full knowledge; this something else, I suggest, can be conceptualized as a sign.

The actor has to find a sign that he or she can rely on, which indicates that something really exists or will happen. If friends vouch for someone being honest, this is a sign; if some person repeatedly has proven reliable, that is another sign. One may call this type of sign a proxy sign, since it stands in for something else that we want to know but lack full knowledge of. In my own work on the economy, I draw especially on the work of American philosopher Charles Peirce, for the understanding of what a sign is and how it operates (e.g., Peirce 1991; Swedberg 2011). Signs, according to Peirce, include words but cover a much wider range.

By introducing an intermediary layer of signs into the analysis between the actor and whatever he or she has confidence in, one also increases that layer’s accessibility to socio­logical analysis. There are actors who create signs as well as actors who interpret them, and both of these processes can easily be analyzed sociologically. There also exist different kinds of signs, all of which have a history that can be illuminated with the help of sociology.

The idea of signs may open up the analysis of confidence in finance to new conceptu­alizations. In Merton’s run on the bank, for example, depositors read signs (rumors) and act on these. And, according to Bagehot, bankers have to be extra vigilant in managing signs because of the peculiar role that confidence plays in deposit banking. Or, to take a recent example from the financial crisis, the rating agencies were much too lax in assign­ing evaluations to stocks and bonds, and the same was true for the investors who relied on these evaluations.

It would probably take another chapter to properly outline what role signs play in the different types of confidence that are part of finance. There is investor confidence, confi­dence in the banks, confidence in the state, and so on. Still, by introducing the concept of signs into the analysis, it is my belief that it can be substantially improved—and also that it can start moving in new and exciting directions.

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