Public Trust has Economic Consequences

Howard Davies says we need to rebuild trust in financial markets: 

Public trust has economic consequences, by Howard Davies, Commentary, Project Syndicate: Public trust in financial institutions, and in the authorities that are supposed to regulate them, was an early casualty of the financial crisis. That is hardly surprising, as previously revered firms revealed that they did not fully understand the very instruments they dealt in or the risks they assumed. … But … if this loss of trust persists, it could be costly for us all.

As Ralph Waldo Emerson remarked, “Our distrust is very expensive.” The Nobel laureate Kenneth Arrow made the point in economic terms almost 40 years ago: “It can be plausibly argued that much of the economic backwardness in the world can be explained by the lack of mutual confidence.”

Indeed, much economic research has demonstrated a powerful relationship between the level of trust in a community and its aggregate economic performance. Without mutual trust, economic activity is severely constrained. …

So if it is true that trust in financial institutions – and in the governments that oversee them – has been damaged by the crisis, we should care a lot, and we should be devising responses which seek to rebuild that trust. …

In the United States,… a … systematic, independent survey promoted by economists at the University of Chicago Booth School of Business … did show a sharp fall in trust in late 2008 and early 2009, following the collapse of Lehman Brothers.

That fall in confidence affected banks, the stock market, and the government and its regulators. Furthermore, the survey showed that … if your trust in the market and in the way it is regulated fell sharply, you were less likely to deposit money in banks or invest in stocks.

So falling trust had real economic consequences. Fortunately, the latest survey, published in July this year, shows that trust in banks and bankers has begun to recover, and quite sharply. This has been positive for the stock market.

There is also a little more confidence in the government’s response and in financial regulation than there was at the end of last year. The latter point, which no doubt reflects the Obama administration’s attempts to reform the dysfunctional system it inherited, is particularly important, as the sharpest declines in investment intentions were among those who had lost confidence in the government’s ability to regulate.

It would seem that rebuilding confidence in the Federal Reserve and the Securities and Exchange Commission is economically more important than rebuilding trust in Citibank or AIG. Continuing disputes in Congress about the precise details of reform could, therefore, have an economic cost if a perception that the system will not be overhauled gains ground. …

Researchers at the European University Institute in Florence and UCLA recently demonstrated that there is a relationship between trust and individuals’ income. …

The data show, intriguingly, that … if you diverge markedly from society’s average level of trust, you are likely to lose out, either because you are so distrustful of others that you miss out on opportunities for investment and mutually beneficial exchange, or because you are so trusting that you leave yourself open to being cheated and abused. …

Maybe we should trust each other more – but not too much.

Deviating from society’s average level of trust is costly only of the average level of trust is correct. Prior to the financial crisis, the level of trust was too high and more distrust than average would have been helpful in avoiding losses. Also, because the level of trust was too high, restoring trust to the blind faith level it was at before the crisis would be unwise. There wasn’t enough fear and mistrust in financial markets as the bubble was inflating, and more skepticism and doubt than is appropriate. We need to rebuild trust, but even with an optimal regulatory response, we shouldn’t go back to the same level of trust in complex financial products, ratings agencies, etc. that we had before.

Originally published at Economist’s View and reproduced here with the author’s permission.
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