The current financial crisis that has destabilized markets over the past weeks is at its root a crisis of trust. Originally thought of as a liquidity crunch growing out of the sub-prime mortgage debacle, the problem is not liquidity. The Federal Reserve and other central banks have flooded the system with liquidity, to little effect. Rather, even healthy financial institutions have recently begun hoarding cash, unwilling to trust counter-parties for fear of a sudden bankruptcy. Without this free flow of capital to credit-worthy businesses, companies are unable to fund day to day operations. This crisis of trust is threatening to paralyze the entire economic system.

Yet this trust deficit has been present in the system for a while. The sub-prime mortgage problem that ignited the current meltdown well over a year ago itself grew out of a crisis of trust. Consider the sequence of events: mortgage brokers assured sub-prime borrowers that their loans could be easily repaid, rating agencies gave these loans high credit ratings based on limited data, and banks accepted these ratings even though they were counter-intuitive on their face, as high ratings made it more profitable to sell these loans into the broader market. Each party, from the initial borrower to the final purchaser of what are now referred to as “toxic” loans, made the unfortunate mistake of trusting each other and the process.

The entire episode is an excellent example of the importance of trust in the functioning of a market. While a strong economy can withstand small violations of trust, over time the costs of mistrust overwhelm the system. Additionally, trust is precious and fragile, and once broken it is difficult to recover. As a result, our economy may take a while to recover from this current trust crisis. Yet as it does (which it surely will) businesses that can demonstrate real trustworthiness will have a real advantage in the new economy.