Both need incentives to rebuild their shaken trust.
What lies at the heart of the current financial crisis? An important clue: It's similar to a problem I faced this summer with my 6-year-old nephew.
Playing around at the beach one day, I said to him, "Here, let me flip you into the water." "NO!" he said with panic, and from then on, I couldn't get him to play. "I promise not to flip you," I told him. But though we love each other, he would not believe me. What to do? I was face-to-face with the "promise problem."
The promise problem goes like this: "How do I know you will keep your word? How do I know you'll do what you say?" And that, in a nutshell, is what is shaping our economic lives – more than economics or mob psychology.
Like my nephew, investors now look at borrowers' promises and shout, "NO!" For good reason, each seems to wonder, "How do I know borrowers will pay what they promise?"
One basic solution is to use something called a trust support – any mechanism or arrangement that can help boost trust when a mere promise won't cut it. The right trust supports can make a big difference.
To the point: "I promise not to flip you," I told my nephew, "and if I do, I'll give you $10." This instantly changed everything and for the rest of the afternoon we played happily together.
What changed? I gave him a trust support. There were many I might have tried. I might have asked his mother to vouch for me, or let the lifeguard watch me carefully. Here, I offered to penalize myself and compensate him if I broke my word. It worked. I'd made my commitment reliable enough for him to accept it. And then I followed through.
Thankfully, trust supports don't just work with 6-year-old boys. Normally, they are crucial to institutions such as the housing market, preventing bad promises, strengthening others, and managing risks. Alas, by neglect, error, and corruption the housing market's normal trust supports failed. We wound up with bad promises and toxic bank assets.
The test we face today is whether we can solve the promise problem well enough to restore investor confidence in banks and other borrowers. Fortunately, we have solved the problem in many kinds of previous crises.