A Trust Crisis

TLDR: The authors conjecture that the changes in economic activity from late 2008 to early 2009 is due to a drop in trust, and present new survey evidence consistent with this hypothesis. But they do not explain why the US economy started to slide into a deep recession.

Abstract: We conjecture that the changes in economic activity from late 2008 to early 2009 is due to a drop in trust. We present new survey evidence consistent with this hypothesis. I. INTRODUCTION If a modern Rip Van Winkle had fallen asleep 2 years ago and woken up in January 2009, he would have wondered what had happened to the US economy. In 2007, 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. By 2009, we were quickly sliding into a deep recession. Banks were not lending and com- modity prices were 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 or a clear slowdown in innovation. The government had kept taxes low. The Federal Reserve had kept interest rates low and cut them even further. What happened? Everyone agrees that this crisis originated in the financial system. When Lehman Brothers defaulted and AIG had to be rescued by the government in September 2008, the economy was still doing all right. The rate of growth during the second quarter was still a comfortable +2.8%. How could the default of an investment bank, with very limited lending to the real economy, have had such a disastrous effect?