A Crisis of Trust

LONDON – 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.

It is difficult not to take some private pleasure in this comeuppance for the Masters of the Universe. But, unfortunately, 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.

Even within Europe, there is powerful evidence that countries where mutual trust is higher achieve higher levels of investment, particularly through venture capital investment, and are prepared to use more flexible contracts, which are also beneficial for growth and investment. 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.