If global financial markets were to adopt an official play, it would probably be J.M. Barrie’s “Peter Pan.” Everyone who has seen it knows the climactic scene: Peter, seeking to revive Tinker Bell, breaks the fourth wall between stage and audience by asking if everyone in the crowd believes. The resulting show of support gives Tink the strength to go on, allowing good to triumph over evil. But what would happen if no one clapped? Would the crowd look at each other awkwardly and, after a while, file out of the theater quietly, leaving the stage bare of all things magical?

In recent months, global financial markets came closer to this “Peter Pan” moment than they had in seven decades. Trading involves an act of faith—the faith that what is acquired can be resold or will return some form of value. Investors’ faith in the value of securities supported by mortgage collateral was seriously shaken. Indeed, securities even tangentially related to the mortgage market were called into question. It became difficult for any one institution to discern how many dubious mortgage-backed securities it held and to determine whether its capital would provide a sufficient buffer should the value of those securities plummet in a general market rout. Without sufficient information to discriminate among institutions, investors stepped back from all of them.

The Federal Reserve has attempted to “restart the applause”—that is, to shore up the credit markets and pump liquidity back into the financial system—by exposing its balance sheet to credit risk through new facilities and an open invitation to investment banks to use its discount window. But liquidity is a lubricant to facilitate trade, and a central bank cannot prevent a relative price from changing if investors begin to rethink the underlying value of a set of securities. It’s unclear how much of the recent repricing represents a temporary withdrawal from risk-taking and how much of it represents a legitimate reappraisal of the odds of repayment.

Federal Reserve officials need to remember that temporary facilities are supposed to be, well, temporary.

The problem is that this market disfavor will not lift until participants show evidence that they understand another lesson from “Peter Pan” about life in an uncertain world: “belief” is not the same thing as “the suspension of disbelief.” Every major group of participants in the trillion-dollar subprime mortgage market acted as if those two concepts were the same thing.

Households with few other avenues for wealth creation lived beyond their means, in the hope that economic gravity would not exert its force on house prices (at least not until they resold their homes). Mortgage brokers often sought no more assurance of future repayment than a signature. And why not? After all, their own compensation stemmed from selling loans, not from collecting repayment. 

Meanwhile, underwriters took that raw material of mortgages and somehow convinced themselves that the law of large numbers would make the whole better than the sum of its parts, even though many of those pieces needed double-digit house price growth to make economic sense. Credit rating agencies, encouraged by their own fee structure, listened attentively to underwriters’ assurances of the power of pooling and of their ability to predict despite a limited track record. And final investors—with the implicit encouragement of regulatory and accounting rules—substituted the judgment of the rating agencies for their own due diligence.

“Peter Pan” is also about accepting adulthood, or requiring a mature set of beliefs. For the large and complex financial institutions at the center of the global trading network, this means recognizing the need for more capital. Until capital arrives, those financial firms will be unwilling to take risks and will have to continue trimming their balance sheets. As a result, markets will be illiquid and new loans will be difficult to get.

Regulators, meanwhile, must identify the underlying problem with the current incentive structure. They should encourage market participants to act on their true beliefs, and they should impose penalties on those who suspend disbelief. But that is unlikely to be accomplished in the heat of the crisis.

Finally, Federal Reserve officials need to remember that temporary facilities are supposed to be, well, temporary. Letting events in the financial world drive the size and composition of its balance sheet may leave the Fed poorly positioned to address new challenges in the future.

Vincent R. Reinhart, a former Federal Reserve economist, is a resident scholar at the American Enterprise Institute.