Friday, October 10, 2008

Measuring trust in the world market

Performance of Libor 3 month. Source.

Strictly defined, the Libor is the 'London interbank offered rate.' Practically defined, I just heard a commentator on CNBC (I didn't catch his name) say something to the effect that the Libor is "a measurement of trust between banks."

Using the practical definition, the data suggest social relations among economic organizations -- in this case, banks -- are constrained by severe distrust. This means that all the 'liquidity' that the central banks pump into the system basically will be worthless in solving the problem because banks, no matter how much money they have, don't feel certain that any potential lending partners are reliable.

The image above shows the drastic up-tick in the cost of interbank lending. The key implication is that the pro-active monetary policy we have recently seen from the world's central banks is limited in its effectiveness in the face of wild uncertainty and distrust. It is not a lack of money but rational distrust that is shutting down economic growth. Somehow, someway, the economic leaders who are governing this crisis must find a way to change the way banks and other economic actors are interpreting their surroundings. Right now, it is rational to distrust. Until this is changed, the crisis will continue.

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