Trust is the underlying issue for economic recovery, not confidence. Various packages proposed or underway in the U.S. and other nations are intended to boost consumer confidence. But, despite efforts in the financial sector, the gap in trust may be widening. And new Treasury Secretary Geithner may be prising it further open.
In economics, consumer confidence means the expectations that consumers have about the future performance of the economy. More confidence and higher expectations boosts consumer spending, which stimulates producer investment and bank lending. Hence, the various stimuli proposed or underway across the globe. The reason they may not work stems from the trust issue. Trust in economics means reliance on a party to fulfil their obligations. This ranges all the way from a simple exchange of a coin for candy to complex financial deals, where each party has a range of obligations and exposures to a number of counter-parties.
But from the corner store to the financial boardrooms, no trust means no deal. Governments and central banks around the world are supporting banks, and flooding them with liquidity. This reduces counter-party risk and thus supports inter-bank trust and helps re-build bank lending. But behind this, a mountain of mistrust remains.
Let me count the ways:
Policy settings of central banks: The job of central banks is to deliver a stable monetary platform for economic transactions. So, can we trust them to deliver? The bubble was fed by monetary policy which focussed on controlling a narrow measure of inflation and countering any sign of a downturn. Such an approach, with its inherent asymmetry, can no longer be trusted. Central banks are busy countering the present crisis and let us wish them well. But beyond that, they now have no reference point for their policy. Only the most rabid Keynesian would maintain tax-spend-and-print as alternative long term settings. What we thought we could trust has gone, with no sign of a replacement. Both Benanke and Geithner "grew up" under the old doctrine at the Fed.
Expertise and professionalism in financial markets. The job of financial markets is to provide low cost intermediation; the job of financial institutions is to serve their clients, their shareholders and - in the case of banks - their counter-parties (other banks). No need to ask whether we trust them anymore to deliver. The only positive aspect is that government actions internationally have reduced counter-party risk. If they hadn't, we would be facing calamity. Whatever the mixture of greed, incompetence and bad-luck, the aura of professionalism over Wall St and the City of London has gone. The implosion of jobs will take out many of the best as well as the worst people. Expertise in the new world will be slow to build; so will trust. Geithner, inevitably, is close to the old guard, as was his predecessor.
Government's role in financial markets. Government's job used to be seen as light handed regulation and monitoring, with the occasional hand on the tiller or well judged intervention to keep things tidy. Well, that didn't work so now government's job is much bigger – heavy handed regulation, oversight, and ownership with plenty of interventions expected. Do we trust them? Well, political enthusiasms lay behind the propulsion of Fannie Mae and Freddie Mac (and before that the S&Ls) into agents of destruction, and political pressures prevented earlier problems with those bodies being dealt with in a timely fashion. In terms of monitoring by government agencies, we all know the Madoff story. And now political pressure is on for banks to worry less about their balance sheets and more about helping loan defaulters and keeping housing prices up. So, service as normal. Maybe Geithner can do better but so far the only evidence is to the contrary.
Debt and credit. Creditors (including buyers of debt instruments) need to be able to trust debtors and sellers of debt. Over-leveraging by banks and households and international distribution of toxic debt brought on the crisis. To prevent mayhem, governments are taking on much of the bad debt themselves by various means. So, the risk and the need for trustworthiness are shifted to them. The trust in government that is required by taxpayers (who will have to meet the costs of extra debt incurred by government) and by creditors rises as government debt rises. At one point will a trust deficit set in? Geithner and Obama seem keen to hasten a show-down with China. It's a tricky, two dependency between the U.S. and China. But, ultimately, "the borrower is servant to the lender" (Proverbs 22:7).
Government expenditure. In relation to households and the productive sector, the job of government is to provide a robust framework for doing business and undertake expenditure where households or producers are less well placed to do so, or to meet broad social goals. Let's be generous and assume that hitherto government has been pretty good on this. But now governments have taken on two new tasks: not only rescuing the financial sector, but also compensating for the downturn in consumer and producer expenditure triggered by the crisis. As I've argued elsewhere, the increase in saving and consequent downshift in consumption is likely to be both big and long term. So, the role of government in filling in for lack of consumption will likely be long lasting too (as in Japan). There will be a long term increase in government expenditure as a percentage of GDP.
This exacerbates the debt problem above but also raises the question of how far government is trustworthy in substituting for lost consumption – stepping in for households and producers in the marketplace. To the extent they are not, their activities and debt raising needs may crowd out the private sector and reduce consumption further as households save more to counterbalance government profligacy.
So, five questions – four of which relate to central institutions:
- On monetary policy, do central banks know what they are doing beyond monetary easing?
- On financial markets, do we think the private sector can recover and become effective?
- On government's role in financial market, do we think government can fulfil its greatly enlarged role effectively?
- On debtors and creditors, do we think the government can convince creditor and taxpayers about the huge debt risks it is taking on?
- On expenditure, do we think government can do a better job of spending than households and the productive sector?
The present crisis will be resolved satisfactorily if there are high trust responses to all those questions and those high trust responses turn out to be correct. If there is substantial lack of trust in just one of these areas, then the recovery will be much more difficult – even if the high trust response would have been correct. That is because, as I said earlier, no trust means no deal. Central government has considerable powers of coercion and compulsion domestically. But government actions will be gravely undermined if there is lack of trust. That's what ruling with consent means. And with foreign creditors, even the U.S. government lacks powers of coercion. It can only rely on the U.S. dollar remaining the least bad option.