Why a crisis of trust hurts the economy

By Howard Davies

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.’ Nobel laureate Kenneth Arrow made the same 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.

Within Europe, there is powerful evidence showing that countries where mutual trust levels are 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.

In fact, the evidence for a crisis of trust is rather difficult to interpret. In Britain, recent survey results are ambiguous. Surveys promoted by financial firms tend to show that trust in them has not diminished much, and that people continue to trust them even more than they do the National Health Service or the BBC. Surveys promoted by the BBC tend to show the reverse.

Banks quote statistics to show that they are more trusted than supermarkets, whereas supermarkets cite evidence that the opposite is true, and are expanding into financial services in the belief that the public will trust them more than they trust the banks. The market will prove one side right before too long.

In the United States, there is now a more systematic, independent survey promoted by economists at the University of Chicago Booth School of Business. Their financial trust index, based on a survey of financial decision-makers in US households, did show a sharp fall in trust late last year and early this year, following the collapse of Lehman Brothers.

That fall in confidence affected banks, the stock market and the government. The survey also showed that declining trust was strongly correlated with financial behaviour: 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. Falling trust had real economic consequences.

Fortunately, the latest survey published in July shows that trust in banks has begun to recover sharply. This has been positive for the stock market. There is also a little more confidence in the government’s response than there was at the end of last year. The latter point 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 the University of California, Los Angeles recently demonstrated that there is a relationship between trust and individuals’ income. A pan-European opinion survey, carried out over many years, allows us to relate the two. It asks simple but powerful questions about how far individuals are inclined to trust those with whom they deal.

The data shows, intriguingly, that those who show levels of trust well below the average for their country are likely to have lower incomes. Is that just because low-income people feel that life is unfair and therefore distrust those around them? It would seem not, since it is also true that very trusting people have lower incomes than the average.

In other words, 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.

When anyone I do not know says ‘trust me’ – an irritating conversational tic – I usually close my wallet. Perhaps most academics – who are at the lower end of the skill and qualification-adjusted income scale – do the same. Maybe we should trust one another more – but not too much.

The writer, former chairman of Britain’s Financial Services Authority and a former deputy governor of the Bank of England, is currently director of the London School of Economics.

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