The Recession's Invisible Victim Is Trust

Garett Jones - Economist at George Mason University.  Follow him on Twitter: @GarettJones

Part of growing up is having the scales fall from your eyes.  My parents raised me to be honest, and I think they did a pretty good job of it.  Somehow I got the idea that almost everyone else was the same way.  A few bad apples, sure. But a whole bunch?

Eventually I learned that quite a lot of people lie, hold back key truths, and steal. Just one story: At the information desk at the Louvre, the polyglot receptionist told me, "Actually, about half of all lost cameras are returned!"  She saw that as a good sign. I took it as evidence that Lex Luthor had it right: "People are no damn good."

Trust -- really, trustworthiness -- is hard to come by; that's a big part of information economics.  In the 70's and 80's microeconomists built on Akerlof's "Market for Lemons" model, which reminded us that a lot of life -- dating, the job hunt, hiring a plumber -- is like the market for used cars, where everyone knows deception is on the menu.

Eventually, macroeconomists decided that these ideas might help explain recessions. Maybe recessions are (among other things) times when we stop trusting each other. Maybe recessions are times when it's wise to stop trusting each other.

Bernanke was at the forefront of this research. My favorite Bernanke paper (with Mark Gertler) argued that the boom-bust cycle might be worsened by Luthor's Law.

In their model, just like in the real world, the people with money are rarely the people with good ideas.  But if the Money People lend to the Idea People in hopes of earning a profit, the Idea People might just spend it all on high salaries, ping-pong tables, and jobs for their friends.  After the money is spent, the Idea People can write in their annual report, "Things just didn't work out."  Alas, but what can you do?

Here's where the climax of Luthor's speech kicks in: "People will always need land... Remember, my father said, Land." One reason people need land is because it makes great collateral, at least in countries with good legal systems.  If an entrepreneur can bring some collateral to the table (land, bonds or stock in our day; in medieval Europe, a hostage) and credibly promise to hand it over to the Money People if things go south, then the trust problem---well, it won't be solved, but now the relationship at least has a fighting chance.

And in the real world, the Idea People use their home equity quite often: the Cleveland Fed says that 25% of new small businesses either pledge their homes as collateral or use a home equity line to get their businesses going.

Well, they used to anyway: since the recession, the same report says that business owners "faced demands for more collateral by lenders" and found it harder to use residential or commercial real estate as collateral.

The lesson: When the price of collateral falls, the quantity of trust falls. Less home equity (and less stock market equity) means less lending by the Money People. And less trust.

And when the quantity of trust falls, the Money People go back to running safe, low-return projects, the kind that don't depend on trust, on trustworthiness.  Worse, since the Idea People aren't making money, they'll find it harder to build up collateral, so that means less trustworthiness, less lending, far into the future.

Maybe that helps to explain why one-time shocks to the economy have effects that last for years and years: A one-time shock to collateral causes a long-lasting fall in trustworthiness, and a persistent loss of promising ideas.  Another reminder that Real Business Cycles are real.