If confidence is the gasoline, then trust is the oil in the engine of Capitalism!

Being able to trust people might seem like a pleasant comfort, but economists are starting to believe that it’s rather more important than that. Trust is about more than whether you can leave your house unlocked; it is responsible for the difference between the richest countries and the poorest.

“If you take a broad enough definition of trust, then it would explain basically all the difference between the per capita income of the United States and Somalia,” ventures Steve Knack, a senior economist at the World Bank who has been studying the economics of trust for over a decade. (Any prices for computing - it’s 99% of the US economy!!)

“Virtually every commercial transaction has within itself an element of trust,” writes economist Kenneth Arrow, a Nobel laureate. When we deposit money in a bank, we trust that it’s safe. When a company orders goods, it trusts its counterpart to deliver them in good faith. Trust facilitates transactions because it saves the costs of monitoring and screening; it is an essential lubricant that greases the wheels of the economic system.

Since last two years, world clearly don’t trust the big banks and financial companies.

Trust is gone: there is no longer trust between counterparties in the financial system. The Fed has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that uncertainty that the balance sheets of financial firms are credible. So even though the Fed has flooded the credit markets with cash, spreads haven’t budged because banks don’t know who is still solvent and who is not.

Bank lending won’t get going again until trust in the markets can be restored. Fighting a Great Depression era problem probably won’t help. More transparency, which means more write-downs and failures, is probably necessary if we’re going to get through this. Unfortunately, we’re still sailing in the opposite direction.

BAD BANK .... is this the only solution

This week, banks ran into yet deeper crisis - the sector is in more trouble than was feared.

In October, following a British lead, governments around the world recapitalised their banks. This drastic measure saved the sector from collapse. But, as the events of this week have demonstrated, the banks are still on the ropes. Bank of America required $20bn of capital and guarantees from the US taxpayer and Anglo Irish Bank was nationalised to halt a run by depositors. Deutsche Bank, revealed striking fourth-quarter losses. Banks are not lending, but are hoarding capital in readiness to absorb losses from existing bad loans and securities. Governments must now act swiftly to move ahead of the crisis. Ad hoc nationalisation of insolvent banks and recapitalisation of impaired ones is simply not enough. Governments must act to draw out the poisonous uncertainty caused by the toxic assets held by solvent banks.

The first option is to create a “bad bank”: in this model, the state would buy up toxic securities from a range of banks and hold them. This would force participating banks to declare large losses, but by removing these illiquid assets from the balance sheet, create certainty about their solvency. It would be a difficult policy to run: it would involve pricing assets that have proved unpriceable and require enormous, up-front costs. The US Treasury’s $700bn troubled asset relief programme was originally intended as a bad bank programme, but changed focus for these reasons.

A better solution, albeit one that must be worked out bank-by-bank, is the insurance model used at Citigroup and, this week, at Bank of America. Governments can, for a fee, issue insurance on the value of a bank’s unpriceable assets, making up the difference if they fall below an agreed floor price. Investors would know that the bank is secure – as with the bad bank model – but it reduces the need for already stretched finance ministries to find money immediately. Simply writing the insurance makes it less likely it will even be needed.

Even after that, however, governments may need to do yet more. They may guarantee credit yet further, perhaps even lending directly, in sectors where commercial lenders have all pulled out. Countries that used to rely on credit from abroad that has now disappeared, as is the case in the UK, may still be stretched even if their domestic banks extend themselves fully. Fixing the banks will not cause a return to growth: we are now caught in the jaws of a global recession. It is, however, a necessary precondition for recovery.