Financial crises and the evaporation of trust
AbstractTrust lies at the crux of most economic transactions, with credit markets being a notable example. Drawing on insights from the literature on coordination games and network growth, we develop a simple model to clarify how trust breaks down in financial systems. We show how the arrival of bad news about a financial agent can lead others to lose confidence in it and how this, in turn, can spread across the entire system. Our results emphasize the role of hysteresis -- it takes considerable effort to regain trust once it has been broken. Although simple, the model provides a plausible account of the credit freeze that followed the global financial crisis of 2007/8, both in terms of the sequence of events and the measures taken (and being proposed) by the authorities.
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Bibliographic InfoPaper provided by arXiv.org in its series Papers with number 0911.3099.
Date of creation: Nov 2009
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Web page: http://arxiv.org/
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-11-21 (All new papers)
- NEP-FDG-2009-11-21 (Financial Development & Growth)
- NEP-SOC-2009-11-21 (Social Norms & Social Capital)
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