Tuesday, May 31, 2011

The economic value of trust in a society

Vijay K. Mathur

Published in Standard-Examiner, May 28, 2011

Trust (confidence), is an implicit contract between entities -- private and public -- including governments and nations. Even explicit contracts are facilitated by trust. As argued below, trust has economic value in a society. Corruption and fraud in any society inflict the most damage to trust.  Almost every day we hear about corrupt practices of politicians, financial brokers and advisers, law enforcement officers, bankers, hedge fund managers and many others groups of people and institutions. Politicians' activities, guided by contributions from deep-pocketed lobbyists, do not create trust among voters who elected them to do the common good.

Those contributions amount to legalized bribery. In fact an International Monetary Fund study by Deniz Igan, Prachi Misra and Thierry Tressel in 2009, found a significant positive relationship between lobbying by financial institutions for special favors from policy makers and the recent financial crisis.  Department of Justice data show that during 2001-2006, 6,899 individuals were charged with public corruption offences and the Justice Department obtained 5,876 convictions nationwide. In 2010, Consumer Sentinel Network of Federal Trade Commission received 725,087 consumer complaints for fraud costing $1.7 billion.  In recent years, Utah has witnessed the rise of "affinity fraud" where LDS Church members abused the trust of fellow members by enticing them to participate in bogus investment schemes.

Corruption and bribery (a hidden price) feed upon each other and lead to dysfunction of markets, private and public institutions, and ultimately loss of confidence and trust in democracy. Kenneth Newton and Pipe Norris, in their working paper at the Kennedy School of Government of Harvard University, would argue that loss of public confidence in institutions representing pillars of the society poses a major threat to democracy. The clear example of this loss of trust in government and its institutions can be found in the recent bailout of the financial institutions during the current severe recession of 2008-09, even though the bailout was necessary to save the economy from the brink of another depression.  In fact, this lack of trust has also spread to our financial institutions. We can see the damaging effects of bribery and corruption on the economies of India, many countries in Africa, Asia, Middle East and Eastern Europe.

How is corruption related to trust in people and institutions? Professor Eric M. Uslaner, of the University of Maryland, states that, "Corruption flouts rules of fairness and gives people advantages others don't have." Since corruption often accompanies bribery either in kind or money, it gives advantage to rich people over people with modest means in the allocation of resources.  Thus, loss of fairness in the allocation of resources and/or income fosters distrust. Economic inequality, according to Professor Uslaner, is the source of corruption, because "corruption and inequality wreak havoc with our moral sense."

The loss of trust in people, institutions and governments imposes high costs on a society. For example, besides the psychological cost to victims of fraud and corruption, people have to spend time and money in drawing up contracts for minor transactions; businesses have to spend more resources to monitor shirking by employees, thus affecting production and quality control; quality of health care will be costly to implement and administer. In the political arena, loss of trust in politicians may be short-lived, but each time corrupt practices and/or political favors to rich lobbyists come into the limelight it undermines confidence in the political process and institutions. In fact, many surveys find that majority of voters lack confidence in Congress.

The loss of trust in government institutions encourages many to engage in the misuse of resources allocated for government programs. Corruption, fraud, bribery and politics motivated by rich influence-peddlers end up in a self-reinforcing vicious circle that ultimately poses grave threats to democratic institutions at all levels of government.

Reviving trust in ethnically diverse and increasingly unequal-income societies like the U.S. poses a greater challenge than in homogenous and more income-equal societies. A recent study for States in the U.S., by Oguzhan C. Dincer in the April 2011 issue of Contemporary Economic Policy, found that after controlling for many other factors' effect on trust, an increase in ethnic polarization and income inequality significantly decreases trust. The finding on the effect of income inequality on trust is especially revealing.  As Professor Raghuram Rajan cogently argues in his book, "Fault Lines," "the most important example of the first kind of fault line, ... is rising income inequality in the United States, and the political pressure it has created for easy credit."

Building trust has to start with the leaders in business and government who recognize the fault lines. We have to move away from easy credit as the path of least resistance, as Professor Rajan argues, to the path of opportunities in education and jobs with a future to Americans.  Short-lived episodes of distrust must not be allowed to become the norm, because distrust is contagious. Loss of trust will impose a high price to free markets and democratic institutions.

Mathur is former chair of the economics department and professor of economics, Cleveland State University, Cleveland, Ohio. He also writes original blogs for the Standard-Examiner at http://blogs.standard.net/economics-etc/.

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