I r’ber attending a presentation at college where I was told markets are not about demand, supply or prices. It was completely about trust. You may have all the other three but if no trust markets are not going to be effective. Trust is more crucial in a market for financial products where benefits are going to exist after sometime in future.
It is very interesting to note that two economists – Luigi Zingales of Chicago and Paola Sapienza of Kelloggs are doing tons of research on the subject. They have even developed a index Financial Trust Index:
The mission of the Financial Trust Index is to monitor the level of trust Americans have in banks, the stock market, mutual funds, and large corporations, and to regularly assess how current events, policy and government intervention might affect this trust.
The duo has written numerous papers as well on the subject. Check Professor’s websites for papers.
I just read this paper from the duo which says that trust in financial markets is very low and has slipped sharply in recent months.
If a modern Rip Van Winkle had fallen asleep two years ago and woken up now, he would wonder what had happened to the U.S. economy. Two years ago, we were in the middle of an economic boom. Banks were eager to lend even at the cost of forgoing important covenants, and corporate America (and the entire world) was producing at full steam, so much so that commodities prices were rising in anticipation of a future scarcity. Today we are quickly sliding into a deep recession. Banks are not lending and commodity prices are plummeting in expectation of a dramatic slowdown of production throughout the world. Neoclassical economic models cannot explain this dramatic change. There was no apparent shock to productivity nor a clear slowdown in innovation. The government has kept taxes low. The Federal Reserve has kept interest rates low and cut them even further. What happened?
Something important was destroyed in the last few months. It is an asset crucial to production, even if it is not made of bricks and mortar. While this asset does not enter standard national account statistics or standard economic models, it is so crucial to development that its absence — according to Nobel laureate Kenneth Arrow — is the cause of much of the economic backwardness in the world. This asset is TRUST. As stressed by Arrow: “Virtually every commercial transaction has within itself an element of trust, certainly any transaction conducted over a period of time.” Without trust, cooperation breaks down, financing breaks down and investment stops.
They then present results of their latest survey. Here are the broad findings:
We find that trust in the financial sector is indeed very low and is reported as having declined sharply in the last few months. This lack of trust is correlated with people’s willingness to invest in the stock market and their tendency to withdraw deposits. While the heavy losses suffered can in part explain this reduced trust, a crucial factor seems to be the way in which the government has intervened. While the majority of respondents favor government intervention in financial markets, 80 percent of the pro-intervention majority think that the way in which the government has intervened in the last few months has made them less, and not more, confident in the market. A big factor in this lack of trust is the perception — shared by 40 percent of the respondents — that the main purpose behind Treasury Secretary Paulson’s act was the interest of Goldman Sachs and not the interest of the country.
Fairly interesting stuff. It looks pretty simple and obvious if we think of it. Trust is going to be broken in times of crisis. A trust crisis simply deepens the crisis. However, to put it all empirically is really the challenge. The paper was written when Paulson was the Treasury Secretary. It will be interesting to see where the index is headed now. I think it would have slipped even lower since then. The policies have only gone worse and moreover it is Paulson’s earlier policies which are making a comeback.
It is interesting to note that economists are now researching in areas which were assumed as given. Behavioral economics has made leaps of progress to show humans are anything but rational. Then there is ongoing research on neural economics. And now this research on trust.
The way economics concepts and theories are being questioned now (by really big names like Greenspan, Acemoglu, Willem Buiter etc) it will be interesting to see which other areas would field of economics move into? It is surely an exciting time for economics research. Thinking differently may not have been appreciated earlier, but looks set to be rewarding now.