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The economic value of trust

It is common to receive our salaries at the end of the month. So it was for Kingfisher Airlines employees, until things came to a pass where not only were they not paid salaries for months, but also learnt that the company had cheated them by not submitting tax deductions made from their salaries to the income tax department.

Imagine a significantly large number of companies doing what Kingfisher has done to their employees within a short time. Would people be ready to work for a month without being paid? What if the police openly collude with a gang of car thieves? Would your car insurance premium go up by a significant amount?

In short, the point is, trust is not just a benign virtue, it is crucial to the functioning of any complex economy.

The importance of trust in the smooth functioning of a society and economy has not been lost on scholars and policymakers, ever since ancient times. Most laws have been formulated to provide the legal basis for mutual trust in commercial transactions.

Kautilya’s Arthashastra, for example, says that if a person selling goods on someone else’s behalf fails to garner the best price for the sale, he should bear the burden of the loss and adequately compensate the owner. The treatise even calls for punishing the leader of a traders’ caravan if he abandons one of his members.

Today, courts and legal systems provide security against being fleeced. But what keeps the question relevant is that despite having similar laws, societies can differ in the amount of trust they place on each other and their institutions. These differences can have significant economic ramifications.

Political scientists and economists tend to use the concept of “social capital” to denote the level of trust in any society that can help the society develop stronger democratic and market institutions.

In an influential 1993 book, Making Democracy Work: Social Capital in Modern Italy, which has since then spawned a huge body of research on the subject, Harvard University political scientist Robert Putnam highlighted the importance of social capital in determining the shape and strength of political and economic institutions.

Putnam argued that the northern and central parts of Italy were more prosperous, law-abiding and better governed than the southern parts, which were also dominated by the mafia, because of high levels of social capital in the former regions. He traced the origins of the differing levels of social capital to the differing histories of the regions: while the central and the northern parts had witnessed flourishing republics for a long stretch of their history, the south was controlled by a powerful monarchy.

A 1995 paper co-authored by Putnam and John Helliwell, an economist at the University of British Columbia, found that social capital and equilibrium income levels were positively related in various states of Italy. The study went on to show that when local governments were given more power in the country, the erstwhile pattern of convergence in incomes across states reversed itself. States that had more social capital did much better in terms of growth in GDP per capita, while those with little of it fell behind.

Helliwell and Putnam took three indicators to measure social capital: civic community, institutional performance and citizen satisfaction. The first was based on factors such as newspaper readership and willingness to vote in elections; the second looked at measures of bureaucratic responsiveness and the third was drawn from direct surveys on satisfaction levels with the government.

In a recent World Bank working paper, Helliwell and his co-authors argue that since social trust also has the potential to augment future incomes, it should be treated as any other capital asset.

The paper goes on derive an income equivalent of social trust by using data from the Gallup World Poll—a survey conducted in 132 countries—to compare changes in the well-being levels associated with a change in income and trust levels. Their findings are startling, to say the least. For example, in Sweden and Denmark, the income equivalent of social trust translates into asset values of more than 50% of the existing national wealth. The figure is just 8.4% for Bangladesh.

Not all social capital works for the betterment of the society though. Sometimes, higher levels of trusts within a closed social group can facilitate honest intra-group transactions, but discriminate against others in a significant way, leading to the concentration of economic and political power with a select minority. Sometimes, it can also promote inefficiency.

In their book Saving Capitalism from the Capitalists, Raghuram Rajan and Luigi Zingales give the example of the diamond trading community of Palanpuri Jains in Gujarat to highlight the twin effects of high social capital within a community.

The business involving handling an extremely valuable commodity thrived on mutual trust in a closely knit social group. With the business expanding, the community is finding it hard to control instances of wrongdoing (such as couriers absconding with consignments and traders losing a customer’s money in the stock market), but is still not open to allowing outsiders who could bring in professionalism and modern business practices.

A 2011 paper by Daniel Aldrich of Purdue University found that villages which had high levels of social capital were more efficient in organizing relief work when a tsunami hit Tamil Nadu in 2004.

However, not everybody gained from this efficiency. Villages with uur panchayats (hamlet-level councils structured by caste and occupation) were able to seek better relief not just by coordinating among themselves, but also by reaching out to NGOs and relief agencies in a better manner. But minorities, women and other peripheral groups in these villages lost out in the aid-distribution process, the study found.

“Especially in societies where racism, caste discrimination, and other forms of social persecution persist, such governance institutions may bring negative externalities,” Aldrich wrote.

The persistence of ethnic and caste divides may sometimes lower trust levels, making it difficult for regions with ethnic diversity to agree on the provision of common infrastructure or public goods—although, as an earlier Economics Expresscolumn by Sumit Mishra pointed out, there are a few examples within India where such trust barriers have been bridged.

What determines the level of social trust in modern societies? In a 2002 paper published in the Journal of Public Economics, economists Alberto Alesina and Eliana La Ferrara used data from General Social Survey from 1974 to 1994 in the US to answer this question.

The survey had asked respondents the question whether most people can be trusted. The authors found that being subject to traumatic experiences, belonging to a discriminated group (blacks in particular), being economically unsuccessful or living in a racially mixed locality led to a person being less trustworthy of others.

In a 1999 IMF conference paper, Francis Fukayama argued that excessive state intervention could lead to declining levels of social trust and hence social capital. This happens because interventionist states such as the 20th-century Soviet Union and medieval France discouraged their citizens from indulging in horizontal dealings with each other in their quest to centralize everything through the state, he argued.

In 2000, Putnam wrote a book called Bowling Alone: The Collapse and Revival of American Community. The book was based on a 1995 paper that had looked at declining inter-personal interaction and social capital. There were more people watching the TV show Friends than with friends in the US.

Fifteen years later, Putnam co-authored another paper, called Still Bowling Alone? The Post-9/11 Split. It notes that after a national crisis in the US (the 9/11 attacks), things changed for the better. The percentage of college freshmen discussing politics in the past year was at an all-time high in 2010. This figure had been declining from 1967 to 2001 and started rising after the terror attacks in the US.

Interestingly, this effect was confined to those who were in “impressionable adolescent years”. For adults, the increase in community-mindedness after the attacks had vanished by 2002.

To conclude, it is worth quoting from Putnam’s classic Making Democracy Work: Social Capital in Modern Italy.

“The final lesson from this research is that most institutional history moves slowly. Where institution building (and not mere constitution writing) is concerned, time is measured in decades,” he wrote. “... History probably moves even more slowly when erecting norms of reciprocity and networks of civic engagement, although we lack the benchmarks to be sure... Building social capital will not be easy, but it is the key to making democracy work.”

Economics Express runs weekly, and features interesting reads from the world of economics and finance.

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