Financial crises and the evaporation of trust

Kartik Anand, Prasanna Gai and Matteo Marsili

Abstract: Trust 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.

Date: 2009-11
New Economics Papers: this item is included in nep-fdg and nep-soc
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Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:0911.3099

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