Lost trust: the real cause of the financial meltdown.

• Author: Yandle, Bruce
• Position: Essay

The financial collapse of 2007-2009 is recognized as having caused one of the most serious U.S. recessions since the end of World War II. To put this economic disruption into perspective, however, it is not enough simply to plumb the depths of lost wealth in real estate or equity investments or the near or actual collapse of banks, insurance companies, auto companies, and city governments. Diffused by the high connectivity of a global economy, this disruption must also be considered by the speed with which the knowledge economy repriced assets worldwide, by the rapid pace of bankruptcies that followed, and by the degree to which governments and central banks opened the stops and started pumping money into wounded firms and institutions in an effort to reboot the world economy. Moreover, we should consider the extent to which private firms became quasi--publicly owned as once-celebrated free-market captains of industry and finance lined up for government bailouts. In addition to the obvious banks, insurance companies, brokerages, and financial institutions, the queue for bailout includes cities, counties, states, and even real estate developers and homebuilders. (1)

If one could display credible charts comparing U.S. economic disruptions from the nineteenth century forward, the 2007-2009 collapse would not be likely to take the blue ribbon when measured in conventional terms, such as unemployment, business failures, and mortgage defaults. (2) But one trait might distinguish it from the rest. In this disruption, major elements of global credit markets were disrupted. For some major firms, credit markets stopped functioning. For example, French automotive giant Renault reported that money markets were frozen following the collapse of Lehman Brothers (Abboud and Gauthier-Villard 2009). The firm could not get access to the credit needed to function normally. Like many others, Renault had to slash operations to conserve cash. Municipalities, universities, and other borrowers accustomed to gaining access to cash through the municipal auction-rate market found the market completely closed. No transactions took place for weeks at a time.

The credit market pause of mid-September 2008 was not the result of bank runs triggered by central-bank credit cutbacks, where depositors and investors sought to get their money, as in 1933; nor did it evince a lack of liquidity, as in the panics of 1873, 1884, 1890, 1893, and 1907 (McDill and Sheehan 2006). The problem this time was lost trust. Indeed, the 2008 disruption is probably the only one that resulted from a sudden breakdown of assurance mechanisms--the generators of trust--rather than from action taken or not taken by misguided central bankers. Thorold Barker (2009) offers a timely comment along these lines, focusing on Wall Street executives' opportunistic behavior: "But beyond the power struggles, huge losses and increased regulation, there is a more fundamental threat to the industry: the destruction of trust." (3)

On September 17, 2008, following (1) the government takeover of AIG, the world's largest insurance company, (2) a government-arranged merger between a financially wounded Merrill Lynch and an assisted Bank of America, (3) government refusal to save Lehman Brothers, and (4) panic-inducing statements by top federal officials, individual agents worldwide lost trust in other economic agents and institutions ("The Doctor's Bill" 2008, 82). On September 18, banks began hoarding cash, corporations could no longer issue commercial paper except for much shorter terms and at much higher rates of interest, municipal-bond auction markets ceased to function, and London interbank lending collapsed. With heavy scrutiny focused on mortgage-backed and related assets, banks worldwide, by the International Monetary Fund's reckoning, saw the prospect of losing $10.0 trillion in write-offs ("When Fortune Frowned" 2008, 4). More than $1.3 trillion in U.S.-originated mortgage-backed securities suddenly had uncertain value ("When Fortune Frowned" 2008, 4). Included in the mess were approximately 2,500 mortgage-based securities backed by subprime mortgages (Steidtmann 2008).

Along with write-downs and other financial losses, critical assurance mechanisms for the purpose of engendering trust across economic agents collapsed. Major institution failure prevailed. Trust, a most fragile human sentiment, had taken a walk.

In times of financial distress, central banks can provide liquidity and lay the groundwork for creating money. Governments can increase spending, reduce taxes, and purchase sick assets. Presidents can exhort, and captains of industry can capitulate. These costly actions can matter, and may indeed generate an economic response. But none of these actions, alone or together, can rekindle trust once the flame has flickered out. (4)

What caused assurance mechanisms to fail? What triggered lost trust? And how does the trigger point fit into the larger explanation of the credit collapse?

In this article, I describe the anatomy of the credit collapse and identify a series of necessary but not sufficient conditions for collapse to occur. As a result of politically expanded markets and other policies, three assurance mechanisms designed to buttress trust--independently determined credit ratings, international accounting standards, and credit-default swaps--became trust solvents that seriously undermined the basis for believing in the creditworthiness of individual agents and their institutions. As the solvents did their work, assurances were dissolved, trust evaporated, and financial markets ceased to function effectively. I begin with a discussion of how trust evolves in the formation of markets. Then I describe the institutional skeleton that accommodated the globally expanding U.S. subprime mortgage problem. Finally, I focus on the enabling agents of trust that connected global investors and creditors, whose demise ends the story.

Trust and Market Morality

Practically all market transactions depend on some degree of trust. Consider some simple actions. I fill the tank of my car with fluid from a pump at a 7-11 store I have never visited, trusting that the fluid passing through the hose is gasoline. I walk into a large TESCO superstore in Prague, a store and company I have never patronized, and buy a supply of groceries, including fresh fruit, soups, and coffee. I consume the items without a second's concern about their safety. I e-mail my broker and tell him I want to buy a thousand shares of stock. He writes back and tells me that I must talk with him because for securities are based on voice transactions. My broker trusts my voice, but not my e-mail. Written contracts do not work effectively in this setting. My broker is employed by a firm with a wonderful name and brand--at least such seems to be the case because, quite honestly, I have never checked the firm's financial strength. Indeed, the whole idea of a firm and financial strength is an abstraction. Trust is somehow rooted in individuals. Within all these examples, truth telling and promise keeping are typical features of ordinary commercial life. The marketplace is infused with trust. How did this condition come into being?

F. A. Hayek (1991) tells a compelling story about rational thought, the extended order, and market morality. In his story, market morality--truth telling and promise keeping and other behavioral norms or rules--evolved over the millennia through market interaction. Hayek sees trust-forming rules as resting between instinct and reason in the spectrum of bases for human action. In his story, trust plays a vital role in small-group settings, where informal rules and traditions form a basis for trust. Trust generated by other devices then delimits the reach of an extended order that enables resource-conserving transactions and specialization to extend across space and time. Simply put, in the absence of market-generated, trust-forming devices, transacting parties cannot afford enough police and regulators to induce honest behavior among ordinary people. Trust and trust-assuring mechanisms can be low-cost substitutes for police, regulators, and court actions.

The formation of the law merchant in the early Middle Ages, a private law process that extends to modern times, is a case in point. The law merchant, a body of evolving judge-made law that formed in merchant-organized courts, was developed by adventurer merchants who traveled extensively from their home countries. "[G]eographic distances often prevented direct communication, let alone the building of strong personal bonds that would facilitate trust.... Internationally recognized commercial law arose as a substitute for personal trust" (Hamowy 2008, 286). The law merchant was a private, market-driven phenomenon that did not emerge from or depend on government action. (5)

James Buchanan develops another explanation of ethical behavior in a small-numbers setting (1994, 66-71). He describes a social process in which interacting individuals signal a willingness to assist each other, to share resources in the absence of having formal or informal contracts. The process he describes fits into Hayek's story about trust and its evolution. Sam Fleischacker (2004) offers a somewhat similar interpretation of Adam Smith's oft-quoted statement about the baker, the brewer, and the butcher in their connection with providing the evening meal. He suggests that more attention be paid to the sentences just preceding the more famous ones: "[M]an has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and shew them that it is for their own advantage to do for him what he requires of them" (Smith ([1776] 1904, 14) Fleischacker emphasizes the importance of being able to "interest" and "shew" one's...