# **I. Introduction**

Among government officials, policy makers, and key market observers, calls to restore confidence in the global financial system have become international mantra. In a March 2009 interview, for example, U.S. Federal Reserve Chairman Ben Bernanke stated, “[C]onfidence is key. People don’t know what’s happening. And they’re afraid. And they’re not sure . . . . and I think the way to get confidence is to show progress.” Zhou Xiaochuan, governor of the People’s Bank of China, indicated the danger of not repairing confidence in a press briefing the same month, declaring, “If we act slowly and less decisively, we’re likely to see what happened in other countries: a slide in confidence.” U.K. Prime Minister Gordon Brown and Italian Prime Minister Silvio Berlusconi, meanwhile, asserted in a joint statement that world leaders must “take whatever action is necessary to restore confidence, stabilize financial markets, and enable families and companies to get through the global recession.” Similar sentiment was expressed in the G-20 Leaders’ Statement issued in conjunction with the group’s London meetings in early April.

Restoring confidence is a crucial step in repairing financial markets and lifting the global economy out of recession. How to measure confidence, however, and in a larger sense how to go about restoring it, are more complex. In the former regard, there exists a variety of market and survey based indicators of consumer confidence, investment sentiment, and business confidence used to express the views and outlook of the investor, household or business community on the future course of markets or the economy at large. In the latter regard, much hope is being pinned on the ability of countries to undertake coordinated stimulus efforts. Initial policy responses by central banks addressed the lack of liquidity in financial markets, but were unable to stem the loss of confidence. Thus, broader measures were put in place to recapitalize banks, provide fiscal stimulus, and reform financial regulation. The G-20 meetings, in particular, were viewed as a chief forum for negotiating and planning the way forward. While the meetings begat promises for actions intended to improve confidence in both developed and developing countries, details of policy intentions and evidence of implementation remain to be seen.

This paper develops a framework for gauging changes in investor confidence that have potentially important financial and economic consequences. We start with the view that investors’ beliefs are embodied in market prices, and reflect expectations of economic fundamentals (including the paths of employment, trade, housing prices, and industrial production). Those expectations, in turn, are affected by recent investment performance and by government policy measures. Furthermore, investor confidence is likely to be linked to consumer confidence. Using this framework, we provide a gauge of the extent to which various measures of confidence deteriorated since the start of the crisis and link changes in confidence to various economic variables and events. We report on individual indicators as well as calculating common factors that express the extent of co-movement of different indicators. These indicators show the dramatic deterioration of confidence that occurred as the crisis unfolded, and the inadequacy of policy measures taken so far to reverse fully the deterioration of confidence.

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