Tuesday, March 10, 2009

Trust and bank policy 

Several weeks ago I noted that one thing the stimulus package (or any of the proposals that so far have come from the Obama Administration) would generate is trust.
I think that key determinant in this [recession] is the degree to which Americans generally trust each other. That level has been sufficient to support democracy in the English-speaking world or Anglosphere. I'm more optimistic that our culture and moral fiber maintains trust even when confidence is shaken as it surely has been the last 18 months. To the extent it does, this recession shall pass, and like Shiller I'm not inclined to think stimulus does anything to shake that.
Craig Newmark notes that the topic of trust has taken off lately. Since I wrote, Sapienza and Zingales have started to research the amount of trust in financial systems. Showing that it has declined, they conclude:
For financial markets to play their vital role once again, we must restore people�s faith in them. The most effective way to do so is to eradicate the perception that the government is run in Wall Street�s interest. The ethics rules issued by President Obama are a good but insufficient first step. More important is to redesign the bank rescue plan so that it clearly acts in the interest of the country (having well-capitalized banks), not the interest of Wall Street (having taxpayers bail out current investors).
Newmark also links this paper by Bruce Yandle, which I've skimmed so far and think needs a full read. Trust is built through market transactions over time; formal rules help reduce that time. Describing Hayek's work he says:
Simply put, in the absence of market-generated trust-forming devices transacting parties could never afford enough police and regulators to induce honest behavior among ordinary people. Trust and trust-forming mechanisms can be a low-cost substitute for police, regulators and court actions.
So what arises instead are, Yandle states, common codes and customs and certification, like audited balance sheets. Moody's and Standard and Poor's replaces a handshake. Willem Buiter goes further, saying "for every good, service or financial instrument that plays a role in your �model of the world�, you should explain why a market for it exists," since without some kind of trust only a "pre-Friday Robinson Crusoe autarky" exists.

Nothing said by the Obama Administration so far proposes to repair that. If anything, its silence on the banking system indicates it too has lost trust. (See this by Simon Johnson, e.g.) It is stuck having itself instead lampooned. (h/t: Greg Mankiw.)

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