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Berre schram conference_paper_v2_2oct2009_3.0

  1. 1. Paper prepared for International Conference of Political Economy: Adam Smith Today, Kocaeli University, Turkey 1-4 October 2009 The Issue of Trust in Developing Countries: Was Adam Smith Right and Are Modern Economists Wrong? Max Berre Knowledge House Maastricht Albert Schram Maastricht UniversityIntroductionIn low and middle-income countries, markets frequently fail to perform adequately. What makes themalfunctioning of these markets particularly relevant is that the resulting welfare effects andefficiency losses have a much larger social impact than in high income countries. Amongst the causeson the one hand “hard” conditions regarding the legal system, and on the other hand “soft”conditions concerning codes of business and personal behaviour have been highlighted (Sen 1999).Hernando de Soto (2003) has pointed out the “hard” legal and institutional conditions which cause“the failure of capitalism”, principally the absence of transferable and enforceable property rightsand enforcement of contract law. The absence of enforceable property rights, as well as the high costassociated with legal or permitting procedures give rise to enormous quantities of “dead capital”.This capital is de facto owned by the poor, but can not be used as collateral to obtain necessarycredit, thus in many cases excluding the majority of the population from the market economy (DeSoto 2003).Although the “hard” institutional were of course different in 18th and 19th century Europe and intoday’s low and middle income countries, at general level we can observe similarities in theimperfections of the working of markets. Amartya Sen (1999) citing Adam Smith’s Theory of MoralSentiments (1759), and An Inquiry into the Nature and Causes of the Wealth of Nations (1776), hasemphasized the "soft" conditions connected to trusting and trustworthy behaviour, and the upkeepof ethical norms for a functioning market economy: “The development and use of trust in oneanothers words and promises can be a very important ingredient of market success.”(Sen 1999).Alvaro Vargas Llosa has worded the same idea more generally and strongly: “No institution can bebuilt on anything other than trust in order to function”.In this article, we contrast a number of key writings in classical and neo-classical economic theorywith the recent behavioural and development economics literature, comparing the answers to thequestion whether the existence of trust and the upkeep of ethical norms is a condition for thedevelopment of market institutions, or conversely whether trust is a consequence of functioningmarkets? 1
  2. 2. First, we reflected on the approach to this question in the seminal works of Adam Smith’s MoralSentiments (1759) and Wealth of Nations (1776). Secondly, we reviewed some of the recentliterature on inter-cultural communication and in behavioural economics on trust experiments indeveloping countries, and compared the results to arguments from classical and neo-classicaleconomics. In inter-cultural communication literature, trust is mainly viewed as a condition forwealth creation through functioning market institutions. Conversely, in behavioural economicstrusting and trustworthy behaviour – reciprocity - is seen as a consequence of institutionalarrangements, including of course markets. In the light of these results, what if any light can AdamSmith shed on the question whether trust is a condition, or a consequence of successful marketcapitalism?Finally, we report the results of a trust experiment done in Costa Rica in the vein of Berg, Dickhautand McCabe (1995), comparing trust level and experienced market operators and inexperiencedoperators, i.e. economics undergraduates. The results of these experiments broadly endorse ourconclusions.Trust in 18th and 19th Century EuropeAmartya Sen (1999) famously interpreted Adam Smith’s remarks on the ‘invisible hand’ as anunintended consequence of production and consumption, rather than as a fundamental premise forfunctioning markets. According to Sen, the ‘invisible hand’ can not be made into a doctrine justifyingminimal involvement of the state. Smith’s assertion that “It is not from the benevolence of thebutcher the brewer, or the baker that we expect our dinner, but from their regard to their owninterest”, can not be separated from Smith’s emphasis on trusting and trustworthy behaviour inMoral Sentiments1, or the importance of the role of the state in administering justice, upholdingcontracts and providing basic education in Wealth of Nations2.We wish to take Sen’s observation a step further by pointing out the role of trusting and trustworthybehaviour as a cause as well as a consequence of successful markets is present in Smith’s reasoning.We also wish to underline the central place of trust in his thinking, and his attention for the mutuallyreinforcing nature of trusting and trustworthy behaviour.Regarding trust as a consequence, on Moral Sentiments Smith refers to the Roman concept ofnecesitudo as the development of friendly relations among people who frequently interact such astraders, noting it etymology suggesting that it was imposed by the necessity of the situation. Traderelations would cause trusting and trustworthy behaviour. As to trust as a condition, Smith mentionsthat mutual affection and love among different men as among different merchants is not a necessarycondition for their successful interaction, but that it can also derive from a “sense of utility”. This isthe “brewer, butcher, baker” theme.It seems Smith describes in Moral Sentiments a virtuous cycle or mutually reinforcing process inwhich “We trust the man who seems willing to trust us”, and conversely we are trusted because weshow trust. Similarly in Wealth of Nations, Smith discusses the issue of trust mostly in relation to1 Smith, Moral Sentiments, Section IV "Frankness and openness conciliate confidence. We trust the man whoseems willing to trust us.”2 Smith, Wealth of Nations, Ch II: “Commerce and manufactures can seldom flourish long in any state whichdoes not enjoy a regular administration of justice; in which the people do not feel themselves secure in thepossession of their property; in which the faith of contracts is not supported by law; and in which the authorityof the state is not supposed to be regularly employed in enforcing the payment of debts from all those who areable to pay. Commerce and manufactures, in short, can seldom flourish in any state, in which there is not acertain degree of confidence in the justice of government.” 2
  3. 3. credit. He emphasises that being trusted and obtaining credit depends on one’s “fortune, probity andprudence” or in modern terms: financial success, moral integrity, and careful management.Receiving trust and therefore credit is thus a consequence of trustworthy behaviour, which may ormay not be enforced by the state. The keeping of contracts and absence of “prodigality” are seen asconditions for functioning market economy. The prodigal impoverishes the country “by not confininghis expense within his income, he encroaches upon his capital.” In Smith’s word: “If the prodigality ofsome were not compensated by the frugality of others, the conduct of every prodigal, by feeding theidle with the bread of the industrious, would tend not only to beggar himself, but to impoverish hiscountry.” Similarly, the so-called “projectors” try to obtain credit for highly risky investment, mostlyon the stock exchange, by promising huge profits. In the end, when none of these fortunesmaterialize, the “projectors” carry a large number of credulous investors with them into financialruin. Then, as now, the lack of self-control and abuse of trust of others of these “prodigals andprojectors” cause immense damage.Regarding trust, Smith makes some penetrating behavioural observations again comparing animalsand humans: “When an animal wants to obtain something either of a man, or of another animal, ithas no other means of persuasion, but to gain the favour of those whose service it requires. A puppyfawns upon its dam, and a spaniel endeavours, by a thousand attractions, to engage the attention ofits master who is at dinner, when it wants to be fed by him. Man sometimes uses the same arts withhis brethren, and when he has no other means of engaging them to act according to his inclinations,endeavours by every servile and fawning attention to obtain their good will.” The behavior of Smith’sspaniel is showing trust, or putting oneself in a vulnerable position, with the purpose of invitingreciprocity, in this case the Spaniels’s dinner.Now comes the key phrase unlike animals in their non-civilized state: “He has not time, however, todo this upon every occasion.” What is Smith referring to here?We don’t have to limit ourselves to the Theory of Moral Sentiments or Wealth of Nations to discoverwhat Adam Smiths vision was on the role of contracts and trust. In 1763 he gave the “Lecture onjurisprudence” which treat the subject extensively. p. 108 “Oaths we may observe are most in useamongst barbarous and uncivilized nations; as they are there thought necessary to signify plainly thewill of the person; as the language is not fixt in its meaning; and in the state of the greatest barbarity,an oath is thought necessary to confirm every thing that is deliverd. Contracts (as I said) at first couldbe only made betwixt parties who were present; contrahitur tantum inter praesentes non auteminter absentes. But when commerce was more extended, it was found necessary to extend the powerof making contracts.” So contracts, with exact wording and made on trust in absence with one of theparties are the human artefact that avoids us from wasting time like the spaniel in the Wealth ofNations.We need enforcement of contracts, which lower the amount of trusting behavior in which we haveto engage. Trust however can never be eliminated. This reminds us of de Soto’s idea of developmentas formalization, and North’s idea a system of effective, low-cost enforcement of contracts. Humans,unlike animals, have no time to engage in expressions of trust and friendship. Instead, they havecontracts, which require a proper administration of justice.Smith thus places trust as a central element in all human interactions, including production,consumption and trade. In his view, the enforcement of contracts by the state causes trust levels torise, markets to function, and trustworthy behaviour to increase. Conversely, trust is also a necessarycondition for successful functioning of markets. We know from recent advances in complexityeconomics, that positive feedback loops can have quite substantial effects in complex systems(Beinhocker 2006), and therefore the positive feedback of trusting and trustworthy behaviour couldbe quite substantial. 3
  4. 4. By contrast, in neo-classical economics trust is placed outside the realm of economics, and there islittle mention of trust as an element in human interactions. Marshall’s Principle of Economics, forexample, the issue of trust and trustworthiness is discussed a few times mostly in the context of thefirm in relation to employee skills and education. In Industry and Trade it is mentioned only once inthe context of relations between multiple owners in a joint stock company and its managers, or aswe would say nowadays in terms of a principal-agency problem. It seems here starts a tradition inwhich discussion of trust is placed outside the realm of economic debate, with exception of intra-firmrelations.One more modern example of the exogenous treatment of trust and other psychological variables isZak and Knack’s (2001) article “Trust and Growth”. It starts by noticing Smith’s attention for goodbehaviour, “probity” and “punctuality”, but then characteristically jumps to John Stuart Mill’snineteenth century view where these individual traits are linked to national characteristics. Nationsare seen as recipients containing higher or lower level of trust, e.g. the Dutch are just naturally morespendthrift and punctual than the Italians. What is worse than this type of categorical thinking, in themodelling the positive feedback loop between trustworthy behaviour leading to more trustingbehaviour is simply left out. There is no attention for trust as a consequence of market functioning,just as a necessary condition. All kinds of regularities are investigated in the article, but the essentialdynamics of the process are missed to a large extent. Gone are the subtleties and behaviouralinsights of Adam Smith, in come the gross categories and over-simplifications of John Stuart Mill.In sum, Adam Smith displays a profound insight into the psychological aspects of market agents.Moreover, he seems to understand the mutually reinforcing relationship between trusting andtrustworthy behaviour, and better functioning markets. Finally, he understands the resultingdynamics, outlining the virtuous circle where more cooperative and trustworthy behaviour, leads tohigher levels of cooperation and more trusting behaviour. Neo-classical economics after banning thetheme of “trust” from their models, fortunately are again including it as part of the renewedattention to economy as a complex system.Trust in Developing CountriesAlthough in neo-classical economics, as we saw trust as a topic was practically banned from thedebate, in development economics the topic continued to take centre stage (Henrich, Boyd et al.2004). Similar to other economists, Johnson and Mislin (2008) describe trust as the willingness to bevulnerable based on an expectation of cooperation, while trustworthiness is described as theindividual willingness to reciprocate said trust. Societies are seen as following a succession of stages,in which more trustworthy institutions develop, accompanied by more trusting behaviour.Institutions require trust to grow both for internal reasons of turnover, productivity, and monitoringcosts as well as for external reasons such as ease of operation within the environment. Institutionsalso need purposefully to create trust by increasing their visibility, displaying trustworthiness, andfostering of cooperation.Hernando de Soto describes development essentially as the replacement of informal and family orclan based institutions by formal constructs (De Soto 2003). He remarks there is no lack ofentrepreneurship in the developing world, but it does not produce wealth on a large scale because oflack of formal market institutions. This idea goes back to Gunar Myrdal who describe the difficulty ofextending trust outside the circle of the family or clan (1968). Douglas North (1990), who did much toopen economists eyes again to the role of institutions wrote: “The inability of societies to developeffective, low-cost enforcement of contracts is the most important source of both historical 4
  5. 5. stagnation and contemporary underdevelopment in the Third World”. There are many differentviews on underdevelopment, or rather reasons why certain societies follow specific paths ofdevelopment.At this point, we need to devote some attention to recent theses on economic development, whichthrough their simplicity enjoyed wide attention, and have led to mono-causal explanations. Certainliterature in economic history has focused on cultural explanations, sometimes combined withreligion and historical accident as explanatory variables for the development of market institutions.The Weber hypothesis that only protestantism could have promoted the rise of modern capitalism inWestern Europe has been resurrected many times. For example, David Landes’ (1998) explanation ofLatin America’s failure to develop in the 18th and 19th century has a cultural, anti-catholic bias. Therapid economic growth in Ireland during the last two decades blows in the face of this type ofreasoning. Another extreme example if Lawrence Harrison (1985) who suggests underdevelopmentas a state of mind. Trust is exogenous in these conceptual models, and it is suggested trust is aninherent dimension of culture, which in turn is seen as mostly stable over time. Francis Fukuyama(1995) talks about high- and low-trust societies when explaining different levels of economicdevelopment . A rival, geographical and biological explanation of economics can be found inDiamond (1999), emphasizing the role of factor endowments and geography. In all these cases, thoseciting Landes, Harrison or Diamond leave out most of the qualifications and nuance that is present inthe original works. Since the impact of these books is an order of magnitude larger than most otherscholarly writing on the topic, this is a worrying phenomenon.Geert Hofstede, one of the most quoted social scientists in the world, deepened the analysis ofculture substantially by identifying its five principal dimensions. Since much of the ensuing literaturefocuses on inter-cultural communication, the emphasis is on distrust arising from different culturestrying to communicate with each other. Although “history does not claim any particular type ofcapitalism is inevitably and forever superior to everything else”, as the traditional Weber hypothesissuggested, Hofstede & Hofstede (2005) seem to identify a limitation of collectivist culture in thesense that “in the collectivist mind only natural persons are worthy of trust”(Hofstede and Hofstede2005).Since in fact in national statistics collectivism is almost perfectly correlated with low GNP per capita,there seems to be a major problem in developing countries with people trusting organizations andinstitutions (Hofstede and Hofstede 2005). The correlation of income levels with individualism andtrust indeed suggests the existence of a strong feedback loop determining the outcomes. Theliterature on inter-cultural communication is mostly concerned with measuring and examining thefive principal cultural dimensions of various societies, but trust is not analyzed as an independentconcept. The question whether institutions give rise to trust, or institutions created by trustingsocieties is therefore not discussed in great detail. Similarly, the idea that trustworthy behaviourfrom individuals or institutions, can cause trust levels to rise has not been greatly emphasized in theinter-cultural communication literature. Instead, trust is seen as the absence of distrust, the laterarising from culturally inappropriate communication.In complexity economics, the feedback loops regarding trust is discussed extensively. If we imagine apopulation in which some agents think the economic pie is fixed, while others have a non-zero-sumview, non-cooperative and cooperative strategies will vary. Learning effects determine that that in alow-cooperation society, non-zero sum attitudes are essentially contrary to survival, and cooperativeagents will over time become zero-sum agents. Once a society is past a threshold ratio of non-cooperators versus cooperators in a population, it becomes very hard to maintain large-scalecooperation, resulting in a "poverty trap". The dynamic interplay between cooperators and defectorscan thus strongly influence the evolution of norms and the level of trust in a society. Culturetherefore should not be seen as an immutable force, rather, it coevolves as people in a society 5
  6. 6. interact with each other. Cultural norms out of behavioural results, and behaviour results fromcultural norms.In behavioural economics, game theory has given strong incentive to the convergence of economicswith behavioural sciences. A game theoretical approach supports the idea that trust can begin withwell-developed institutions. Trust is mostly seen as a arising from functioning institutions. In thebehavioural economics literature it is suggested that apparently basic conditions for functioningmarkets create trust, and not the other way around. Unlike in complexity economics, however, thefeedback loop is not always taken into account.Trust experiments are an important part of behavioural economics, ever since the Berg, Dickhaut andMcCabe experiment (1995). Trust is created by properly enforcing existing laws and regulations,settling disputes, and by providing facilitating creativity and innovation. Most research consists oftinkering with some of the institutional arrangements, and then measuring the effects on trust orreciprocity. Overall, the literature on trust and trustworthiness points to the idea that trust is aconsequence of specific institutions and has highly specific origins.Behavioural economics studies examining developing countries reveal, for example, that frequentsocial interactions improve trust. This is especially the case if economic production depends oncoordination and cooperation. When productivity is more individualized, then trust is lower. Amongthe studies of rural peoples in developing countries, Indonesian whale fishermen appear at thehigher end of cooperation spectrum, while tribes in the Peruvian Amazon are at the lower end. Themain difference between lifestyles is characterized as highly independent households in the PeruvianAmazon compared to dependence on cooperation in whale fishing and in marketing the whale foreconomic survival in Indonesia (Cárdenas and Carpenter 2005). According to both Johnson and Mislin(2008) and Cárdenas Chong and Ñopo (2008), empirical research reveals that expectations ofreciprocity or cooperation are the main driver of trust in trust games, and the main driver ofcooperation decisions in other behavioural experiments.In a more indirect fashion, Cárdenas and Carpenter (2005) and Wolfe (2002) describe the growth ofeconomic clusters and learning regions as depending on trust in order to develop, taking up a themeinitiated by Alfred Marshall (1919), and recently further developed by Paul Krugman (1992). Porter(1998), Saxenian (1994), and Storper (1997) argue that communication and interaction by agentswhich might form a cluster depend on high levels of trust. These clusters in turn, become engines ofeconomic growth, productivity growth, and knowledge growth within a country. Here trust is seen asa condition.Additionally, Carpenter (2006) mention the crisis phenomenon whereby shared trauma wipes outany previously standing mistrust and goes on to create trust and cooperation. According to Klein(2007) however, this effect is only temporary and in fact must be seized upon in order to create morelasting structures in order to maintain high cooperation level in the long term. There are someempirical obstacles. Mainly, that trustworthiness is not the only motivation for cooperation.Cárdenas and Carpenter (2005), other reasons include altruism, unambiguous self-interest, and risk-seeking.Of critical importance, is how precisely an institution should attempt to enforce and fostercooperation. In a corporate governance context, for example, Monks and Minnow (2008) find thatindustry self-regulation and formal regulation are complements . That is, an increase in the depth orscope of formal regulation leads to a symmetrical increase in industry self-regulation, while a fall inone leads to a fall in the other. Monks and Minnow (2008) therefore reject the idea that industry-self-regulation might act as a substitute for formal regulation. 6
  7. 7. Barr (2001) and Barr and Kinsey (2002), and Carpenter, Daniere et al. (2006) all find similar resultsconcerning social sanctioning in trust experiments in developing countries. Specifically, that socialsanctioning among players in the trust game leads to immediate and sustained increases incooperation rates (Barr 2001; Barr and Kinsey 2002; Carpenter, Daniere et al. 2006; Carpenter,Daniere et al. 2006). Barr (2001) demonstrates that in rural communities in Zimbabwe, where Barr’s“trust game” experiment included a discussion round where naming and shaming could take place,players who witnessed the criticism of others but were not themselves criticized contributed thehighest cooperation increases. In relying solely on direct regulation meanwhile, Cárdenas et al.(2008) find that in trust experiments, regulation worked well early on, but to underperformancerelative to successful enforcement of cooperation via “cheap talk.”. Taken together, the implicationsof the literature are that social sanctioning norms should be taken into account and facilitated byinstitutions. Formal regulation moreover, should be planned around social sanctioning becauseeffective social sanctioning is more adept at improving trustworthiness than formal regulation. At thesame time, formal regulation should try to encourage effective social sanctioning rather thatfunctions in parallel to formal regulation rather than instead of it.Unfortunately, the social sanctioning approach is not without its limitations. The so-called second-order dilemma whereby non-cooperation may go unsanctioned by players due to the cost ofpunishment to the punisher may ultimately limit the effectiveness of social sanctioning schemes.Taken alongside the results from Johnson and Mislin (2008) as well as from Cárdenas Chong andÑopo (2008), the concept takes the logical shape that institutions create trust by guaranteeingcooperation and reciprocity, or by insuring at least partially the risks involved with trusting(Cárdenas, Chong et al. 2008; Johnson and Mislin 2008).A behavioural experiment held in Costa Rica comparing experienced industrial managers andstudents, clearly indicates how trusting and trustworthy behavioural patterns can develop as aconsequence of exposure to efficient market institutions by analyzing the differences betweenstudents and managers who trade in international commodity markets. In a traditional trustexperiments students showed low levels of trusting behaviour and reciprocity. While managersexhibited trust in institutions, students tried to get away with “cheating”. Even regarding learningeffects, students were “slower” than managers, probably because the lacked the fundamentalunderstanding of how to operate in markets (Alpizar, Requate et al. 2004).Although at all times it is hard to generalize from experiments, even from a large number of them,they seem nevertheless to confirm that learning about, and experience with market institutions cansignificantly change behaviour. Trust is both a cause of and condition for functioning markets, andexposure to well-functioning markets develops more trusting and trustworthy behaviour.In sum, most of the recent literature in behavioural economics, and in particular publicationsreporting on trust experiments carried out in developing countries seem to have lost some of thesubtleties and attention for positive and negative feedback loops that we found in Smith. Someexperiments however have picked up on the mutually reinforcing nature of markets on the one hand,and trusting or trustworthy behaviour on the other. It is important to resuscitate his view thattrusting and trustworthy behaviour is both a condition and a consequence of functioning markets. 7
  8. 8. ConclusionsIn modern macro-economics, trust was seen as a condition for market interactions. In micro-economics, the discussion on trust was mostly limited to intra-firm relations and principal agencyproblems. In modern behavioural economics trust is again seen as a emerging from specificinstitutional arrangements. Recently, complexity economics has added the importance of positiveand negative feedback loops, in explaining phenomena such as the correlation of high GDP per capitaand trust. It suggests that the dynamics of cooperative, non-zero sum agents, and non-cooperativezero-sum agents in a given society will give rise to “tipping points” or threshold levels. If cooperationlevels fall below a certain thresholds, societies can become stuck in a poverty trap.Neo-classical economic models which treat trust as exogenous and don’t include feedback loops, orexplanations focusing on national cultural characteristics can not explain this non-linearity. Culturecan not bee seen as an immutable force, causing societies to get stuck in low trust levels. Rather, itevolves as cooperative and non-cooperative agents interact with each other. Therefore, trust andtrustworthy behaviour are both a product of experience of functioning institutions, and determinethe shape and effectiveness of these institutions. Just as Adam Smith hinted.We suggest to transcend the false “condition vs. consequence” dichotomy regarding the relationbetween trusting and trustworthy behaviour on the one hand, and functioning market institutions onthe other hand by reverting to Adam Smith’s original approach in which trust is again placed at thecenter stage of economic interactions and is seen both as a consequence rather than a condition orcause. In Adam Smith trust is more than a condition for market interaction, it is also a consequenceof behaviour. How institutions feed trust, and how trust and reciprocity, or trusting and trustworthybehaviour, mutually reinforce each other was mentioned frequently in Wealth of Nations and MoralSentiments. This opens the way for a conceptualization in which the mutually reinforcing nature oftrusting and trustworthy behaviour, or in other words trust and reciprocity, is fully taken intoaccount, and in which trust is seen again as both a necessary condition as well a consequence ofsuccessful market interaction.There are some implications of our approach for the formulation of development policy. Since trust isa condition for functioning markets, there is no relief from getting the basic rights. We suggesttherefore policy should be focussed on creating "hard" conditions for market development, ratherthan decrying low trust levels, and seeing them as part of a culture, which then is often interpretedas being immutable. Equally important, however, is fostering mutually reinforcing process of trustand trustworthy behaviour by tinkering with specific elements of institutions. Societies in whichtrusting and trustworthy behaviour is eventually rewarded and the opportunistic behaviour punishedwill be more successful, whether in the developing or developed world.In sum, trusting and trustworthy behaviour are most likely both a cause and a consequence ofsuccessful institutions, among which market institutions are of primordial importance in determiningeconomic growth and development. What works, and what does not work will eventually determinethe levels of cooperation, and trusting and trustworthy behaviour. Our experimental results in CostaRica confirm that exposure to functioning market institutions strongly influences trusting andtrustworthy behaviour positively.ReferencesAlpizar, F., T. Requate, et al. (2004). "Collective versus Random Fining: An Experimental Study on Controlling Ambient Pollution." Environmental and Resource Economics 29: 231-252. 8
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  10. 10. Wolfe, D. A. (2002). Social Capital and Cluster Development in Learning Regions. Knowledge, Clusters and Learning Regions. J. A. Holbrook and D. A.Wolfe. Kingston, School of Policy Studies, Queen’s University: 53-87.Zak, P. and S. Knack (2001). "Trust and Growth." The Economic Journal(11): 295-321. 10