I have been quiet recently because events are so terrible that I wanted to be ready to offer some thoughts that might really help. Here is the first of a series that will, I hope, help you see why we are in such a jam now and why social software may offer us a a healthy and sustainable way out.

Am I qualified to speak about such things. I think so. I was an investment banker for 23 years and was responsible for a major banks strategy for some time. In a way I was partly to blame for the mess that we find ourselves in. I also walked away from that life and rebuilt a new life largely based on the principles that I will offer in the hope that they may give us hope.

Part 1 is a description about what is credit. The core idea is that the natural reality of sound credit is that it is not transactional but social. If sound credit is indeed as I say social in nature, then there will be a way to deploy social software to create a better alternative.

There are two credit ratings that we have - both offer us the opportunity of having resources that we don’t have right now. One leads to serfdom and slavery and the other leads to freedom.

Hugh’s cartoon above gives us a hint here as to what choice leads to freedom.

Man is born free; and everywhere he is in chains. One thinks himself the master of others, and still remains a greater slave than they. How did this change come about? I do not know. What can make it legitimate? That question I think I can answer. (J J Rousseau - The Social Contract)

In the world that is dying around us, a credit rating was a statistical score that enabled a transactional system to lend us money. In the world to come - which is also the world that was before the modern credit system, credit was the product of how much you contributed to your community. Your credit rating was your reputation, based on your actions, as understood by your peers in the context of your bounded community. In this older system, credit was not transactional but social. Wealth was not money but the health and extent of your relationships.

So what does this mean in practice? What is wrong with a transactional credit system? What is a a social system?

We are suffering the normal bust/boom today of a reliance on a transactional system. The system that lent us the money made money on the transaction, so the system was skewed to lend us a much as possible. So, at its extreme, students were lent $20 - 50K, people with no real cash flow were given mortgages that they could not repay or even service, investors bought securities such as CBO’s taking the rating as a given and not thinking about the underlying issues that might prejudice their investment.

Our problems today are all rooted in the fact that credit became transactional and so masked the risk both the the lenders and to the borrowers.

The underlying issue about lending money has always been universal. The most important parts of lending money are these:

The crucial “Credit” decision is not whether the borrower can repay you - it is do you have a high expectation that he WILL REPAY you. The key to credit is a knowledge not of cash flows but of character.

In 1933, my two great aunts both went to their husbands and demanded that they lend a pool of working capital to their brother, my grandfather. Their husbands, who were both in construction, and so had funds, did so. But they lent the money as much because they knew that Alec would rather die than not repay them under these circumstances. They also had the power of their wives to ensure that Alec would protect their decision. At the time of lending the money, Alec had no way of repaying it. Only his real credit rating, his honor, stood assurance. The social capital of his sisters was the guarantee. This is how the Grameen Bank works or how Social Credit (Micro Credit) works.

The lenders and investors of today all missed this. They relied not on the character of the borrower and a profound understanding of what was going on - but on a score. They relied on a formula based on statistics based on transactions that left out the heart of credit - relationships and emotion.

The whole idea of a pool of mortgages breaks this key rule. Derivatives and swaps break this key rule. The direct relationship between the borrower and the lender had been dissolved.  Imagine that you have a sweater with some good and some bad threads in it. How do you get at the good threads? It can’t be done. You can’t extract the good from the bad if they are co-mingled like this. All that is left is the letter of the law. And the law is not enough. There has to be the will to repay and in a transaction, there can be no such will. In Canada a mortgage  rests upon the person of the borrower with the house as collateral. In the US it is the house alone. So the central  relationship is weakened by design.

Because credit really relies of deep personal knowledge and personal commitment. It can’t easily be scaled. So sound credit cannot be naturally abundant.

But in a transactional universe, scale is everything. So an economy based on easy to get credit which is based on a transactional context, must fail. Now that we have introduced pooled securities and derivatives, failure is not only guaranteed but will have a huge impact because we have leverage on leverage.

You don’t believe me? In the US the banking system has failed in 1857, 1907, 1933, 1986 and 2008.Stop and think about this for a minute.

The US banking system has failed in 1857, 1907, 1933, 1986 and now in 2008. What does that tell us? That we keep repeating the same design flaw. Each time the impact of the failure has been greater. We keep the assumption that we can scale credit based on a score and not on a real relationship. The product of the 2008 failure is what? Huge mega banks that can only take a transactional view. What is the inevitable result going to be? Sooner rather than later we will have a Krakatoa type of failure, if we don’t have one now.

So, please - please do not fool yourself that things are going to be OK soon.

The second aspect of being a creditor is the issue of power. Why is it always a bad thing to lend to a friend or a family member? Because it affects the relationship. Being such a borrower broke my granny’s  spirit and my grandfather’s. After he had repaid the loan, he killed himself. You can see now why my own family story has so informed my own view of credit. For as a creditor, you are in the power of the lender. The more you borrow, the less freedom you have. At some point you become a serf.

You graduate with a BA and $30,000 in debt - what choices do you have in a career? You have to choose the money. You have to accept work that may not fit you. The promise was that if you get into debt to get a degree that you will earn more. In reality you have become a serf.

You are told that home ownership is a good thing. But if the bank has 100% of the equity of your home, who owns the home? You are a serf. You think that if you have a lot of stuff that you look successful. But if you have a lot of consumer debt to pay for all this stuff, you are only a serf. So now with all this debt, you have to work for “The Man”. You think you are free but you dare not question your employer. You are a serf. You are indentured.

This is not just about the low income folks. Many who have had huge incomes are just as much slaves as the rest. Worse. Their identity is tied to their image of success as my granny’s was. Their fall will be even more terrible because they thought they were free when in fact they too were slaves. Rousseau was right then and now. Many think themselves free but are in reality slaves.

Rubbish you say. I am not a serf. So let’s take a test. Are you free or are you a serf?

In the Middle Ages, Serfs were tied to the estate of the Lord. They could not move. They had an income but had to pay taxes to the Lord. Who himself did not pay much tax. They had housing, but the houses really belonged to the Lord. Their children were born serfs. They had no social mobility. In fact, as the system grew, what few middle class yeomen got pulled down into serfdom. The full power of the law was behind the system. If you tried to escape, the full force of the law enforced serfdom back upon you.

So how are you doing? Is your life any more free as a major borrower today? The full power of the law is also on the side of the lender. How are your kids doing too?

So what to do? Is there a healthier system than our transactional credit system? For I am not saying we should not use credit. I am saying that credit positioned in a transactional context is guaranteed to give us this boom and collapse cycle and in the end make most people not only poor but slaves.

First of all we need a better context for credit. “Better” being a context based on the observable reality of nature rather than a fantasy based on beliefs of men. We have to have a credit system based on observable truth if we are to have any chance of avoiding this boom/bust serfdom system repeating.

In the Middle Ages, the overarching belief was that the Earth was the centre of the universe. But observers such as Galileo proved that the observed reality was different. he was able to prove that the Sun was the centre. I bring this up because what I am going to say will sound as heretical as Galileo did at the time.

Our great belief is that Money is wealth. Being itself neutral, this belief has enabled us to accept and then to believe that the end in life to get as much money as possible is to be wealthy and free. Worse, because money in itself is neutral, a means of exchange, it has lead us to believe that all exchanges in life are, and should be, transactional. In so doing, we have set up our credit system to fail.

For all of time credit has been in reality social.

Credit is based in a relationship and it drives a relationship. Credit can only be a transaction when it is based on a fantasy. As we have seen, all the brilliant risk management models of Wall Street failed. Credit is not a commodity. It is a social object. Credit is not based on models but on emotion.

So what does a social credit system look like?

Imagine that you are a tin trader. It is 100 BC. Your home is in what is now Acre. You sail to Britain with object of buying Tin. How are you going to do the deal? Just turn up and give the tribal leader a check? Think about this for a minute. You are going to have to spend maybe a year in building trust. You may have to do a small deal and return in a year to establish more trust. Over time, you may marry the Chief’s daughter or leave a son behind as surety. Both sides work hard to establish a relationship that facilitates a healthy trade. Both profit mutually. Neither is subservient to the other. But it is not an easy process. It is not a transaction.

This type of credit is not lost in the mysts of history.

You are of Italian descent. You daughter is getting married next week. What happens at the wedding? The guests know that one of their jobs is to pitch in to ensure that the couple can buy a house with either a very small mortgage or none at all. Each guest gives a meaningful sum. Why? Because when when it is your turn, you know that your community will help your daughter do the same. The point is to give the couple a real home. A home that they own and not the bank!

The Italian community in St Louis does not restrict itself to weddings. All of its members know that the more that they give into the system, the more free and self reliant they all become. All pay attention to the impact of their social actions. Over time, the flywheel effect picks up and more and more resources become available to the members. The entire system is governed not by law but by social custom.

At the heart of the natural credit system are two things. Your personal reputation and your community.

On PEI, until recently, there was a code in your file that if you had it opened the doors. There would be a comment on your file that said this “Known to the bank”. This was the equivalent of a AAA rating. Island Bankers could do this safely because, it was a product of the community that we have here.

On PEI, we are small enough for your full character and hence reputation would be known to many. This did not mean that mistakes were not made. But on the whole, a lender could have a judgment on whether you passed the first test of real credit - would you pay the loan back. PEI also had a strong position in the second test. Being a small place where there are no secrets, the community itself, like my great aunts, could play a role in the borrowers good behaviour.

This has been too long a post already. In the next post I will offer some thoughts about what we can do now to return to a more healthy relationship with what wealth is and what a better credit system might be.

But as a teaser, here are a few thoughts.

• Wealth is not your bank balance or your portfolio - as we may all find out soon as these may disappear. Wealth is the health of our social network. My son James is “broke but not poor”.

• When we give into our social network, we are making deposits into a real credit system

• In a social credit system - it is a system of peers - there is less risk of there being a power imbalance

• In a social credit system there is much less risk of a default

This system has existed for all human time and has its modern examples that we can build on.In my next post I intend to expand on what we can do ourselves to get outside the transactional system. For the powers that be will do their best to restore it. Only we can elect to live outside it.