Trust and Economic Outcomes

For some time now, I have assigned students in my Political Economy class a well-known paper by Knack and Keefer on social capital and its connection to economic development.  Kenneth Arrow (1972) also argued that trust was a predictor of economic success.  In short, trust is an important element in market exchange.  Glaaeser et al (2000) have dealt with the same issue, finding that both trust and trustworthiness rise when individuals are socially closer to each other (for example, of the same race or nationality).  Of course, trust need not be of the informal and personal type we normally think of when we hear the word; instead, it could be “institutionalized” trust that facilitates exchange between complete strangers over the Internet, for example . It’s not so much that I trust the stranger who is selling something to me on Amazon but there are institutional mechanisms in place that allow the transaction to happen anyway.

The General Social Survey (GSS) has included a question for many years that sheds a bit light on trust of the more personal type (the GSS survey question is vague and it’s not entirely clear how we should interpret it, but it is still pretty widely used in the literature and is hopefully a reasonably good proxy for social capital).  I’m not entirely sure why this has happened, but the extent to which we trust each other has declined noticeably over the last couple of decades according to the GSS.  Here’s the percent of respondents to the GSS who said they can generally trust other people:

If this indicates declining levels of trust and an erosion of our civic ethics, we should be concerned; as Adam Smith told us long ago, trust and reciprocity are foundations of market exchange.  The less we trust each other, the greater the costs of transacting and the more rules we must have in place to structure our transactions (government plays an important role in establishing those rules, of course, but has its own problems including the likelihood of rent-seeking).  As Jerry Evensky once wrote:

When trust is shaken, individuals pull back and the system contracts.  Where trust grows, individual energy and creativity are unleashed and the system grows.  In Smith’s vision of humankind’s progress, trust is the central theme.

Is Economic Theory Useful in the Modern World?

Writing for The Atlantic, Bill Davidow tries to make the case that economic theory is outdated and largely obsolete.  While economic theory has its share of problems, Davidow fails to focus on them and instead writes as if things haven’t changed since the 18th century; even then, he mischaracterizes Classical economics by writing, in part:

Much of the economic theory that guides government policies and the actions of business — developed when the world was far less connected than it is today — is out of date. Theories that were once right are now wrong.

 

Adam Smith’s “invisible hand” provided invaluable guidance to markets and did an excellent job of allocating resources in a less connected world. As long as the markets were local, externalities less important, and moral and government authority policed unsavory behavior, there was no better system.

 

Moral authority is the powerful thumb of the invisible hand.

Was the mercantilist world in which Adam Smith wrote about economics really one dominated by “local” markets?  Smith lambasted mercantilist trade policies partly because they were preventing England from fully engaging in the the emerging global marketplace.  The world – at least the nascent market economies in Europe –  had been, even by Smith’ age, far from local.  Thomas Mun, a prominent mercantilist writer, penned a well-known article called “England’s Treasure by Foreign Trade” in 1630.  David Hume’s price-specie flow model appeared in the mid-18th century.  Smith’s own work appeared  roughly a quarter century later and  David Ricardo’s famous model of comparative advantage in 1817.  One would be hard-pressed to read Classical economics and come to the conclusion that their theories applied only to a world of “local” markets.

Moreover, Adam Smith’s “invisible hand”  was much more complex than Davidow suggests: Smith’s metaphor – used once, by the way, in the entire Wealth of Nations - was not really about allocating resources.  In fact, Smith used it in writing about why merchants preferred to invest their capital at home rather than abroad; of course, that had unintended benefits for the economy:

By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisiblehand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.

Smith was an advocate of a system of natural liberty that would allow self-interest to promote the “progress of opulence,” but the invisible hand has taken on a life of its own since then.  There still seems to be no clear scholarly consensus on just what Smith meant by the phrase, so I’ll leave it aside for now.

Davidow seems to have missed the fact that economic theory has evolved since the 18th century.  It is true that the direction it has evolved has not always been desirable (in fact, his definition of the invisible hand’s allocative functions should be linked not to 1776 but to 1948 when Paul Samuelson converted a metaphor into a mathematical model which had little relation to the original), but it has not remained static.  Davidow has ignored the recent advances in fields such as experimental economics, behavioral economics and economic history.  All of those fields have challenged some of the assumptions that he criticizes and have enlightened our understanding of how the economic world works.  There is, as in any discipline, much more to do but we should not lose sight of the progress and we should try to get the intellectual history right before making sweeping claims about the illegitimacy of the theories.

Interview with Vernon Smith

Some interesting background on experimental economics and the housing bubble: