Innovation occurs not only in products and services, but in theories. And right now, today, this minute, what the world needs is a brand-new economic theory about recessions, their causes and cures. Because the old theory is utterly useless.

I have come to realize that what is happening now in the global crisis is not another business cycle, downturn or recession, but a global paradigm shift. And at its heart is the issue of trust. Trust is the currency, the fabric, the DNA of global markets. Trust keeps people’s money in the bank, and keeps supply and demand of financial assets in balance. Trust is vital and crucial, yet usually ignored, taken for granted like the love of a spouse or a monthly paycheck — until it disappears or is removed. Ordinary people, managers, leaders, poor and rich, have lost trust in the system. The damage caused by scoundrels like Madoff, who stole and destroyed $50 b., is incalculable. Trust me, he said. We did. And look what happened.

Until public trust is restored, the crisis will go on, and will get worse.

Here is how brilliant New York Times columnist David Brooks describes it, in his column today:

“…an economy is a society of trust and faith. A recession is a mental event and every recession has its own unique spirit. ….You can run up gigantic deficits, hire road builders and reduce the unemployment rate…but insecure people will still not spend and invest.”

So — what is the key question? It is not, how can we pump money into the system, or create demand, or get the banks to lend? 

The question is — how can we restore public trust in a system that betrayed them, lied to them and in some cases ruined their lives and took away their homes?  

No existing economic theory has the answer.  

In the 1930’s, John Maynard Keynes built a new theory to respond to the Great Depression. He was a bit late. His book was published in 1936. It came too late to influence policy.

I expect we will see new economic theories emerge. But they will appear in time to respond to the next global crisis, not to this one.    

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Outgoing U.S. Treasury Secretary Hank Paulsen’s TARP (“Troubled Asset Relief Program”) is a failure, perhaps even a disaster. It has streamed hundreds of billions of dollars into failed financial institutions. And still, they sink. The latest is Bank of America and Citigroup, in America, and Barclay’s in Britain.  

Why did TARP fail?

It failed to address the issue of trust.  

Banks continue to stall for time, hoping that global capital markets will recover and improve their asset position.  They delay reporting write-offs and huge losses. When people discover those impending losses, they lose credibility and trust in the banks, and dump their stock. All three banks mentioned above protest loudly that they are sound, that there is no reason for people to dump their stock. They don’t get it. It’s not about numbers. It is about trust. We just don’t trust the bankers.

What TARP should have done is split the failed banks into two pieces: “Toxic” (which is what the “T” in TARP really stands for, not troubled), or worthless, and “Non-toxic”. Keep the non-toxic. Sell off the toxic. Relaunch the bank, with only healthy assets.

This is what the Japanese should have done after their property bubble burst in 1990. They did not do it. The result: a 15-year recession. The world cannot afford a 15-year recession in America. Japan’s economy is a third the size of America’s. 

By following this approach, there is at least a chance that public trust in banks and in the financial system will be partially restored.

Without it, the crisis will be long deep and dark.

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