Lack of Trust – Caused by Institutional Corruption – Is Killing the Economy

Posted on May 4, 2012 by WashingtonsBlog

People Are Losing Trust In All Institutions

The signs are everywhere: Americans have lost trust in our institutions.
The Chicago Booth/Kellogg School Financial Trust Index published yesterday shows that only 22% of Americans trust the nation’s financial system.
SmartMoney notes today that more and more Americans are keeping valuables at home because they have lost trust in banks.
Robert Shiller said Monday:

Our whole economy has been affected by variations in confidence. Central banks are sort of trusted, but the actions they have often affect people’s confidence by appearance rather than substance. We’re not in the most trusting mood now.”

The National Journal noted last week:

Seven in 10 Americans believe that the country is on the wrong track; eight in 10 are dissatisfied with the way the nation is being governed. Only 23 percent have confidence in banks, and just 19 percent have confidence in big business. Less than half the population expresses “a great deal” of confidence in the public-school system or organized religion. “We have lost our gods,” says Laura Hansen, an assistant professor of sociology at Western New England University in Springfield, Mass. “We lost [faith] in the media: Remember Walter Cronkite? We lost it in our culture: You can’t point to a movie star who might inspire us, because we know too much about them. We lost it in politics, because we know too much about politicians’ lives. We’ve lost it—that basic sense of trust and confidence—in everything.”
***
After a 50-year decline, just 14 percent of respondents in a 2011 Gallup Poll said that the federal government could be trusted “a great deal

Gallup reported last month that – for the second year in a row – Americans said that gold is the safest long-term investment.   This  shows that Americans don’t trust the government.  Specifically, as Time Magazine points out:

Traditionally, gold has been a store of value when citizens do not trust their government politically or economically.

Indeed:

• A tiny percent of Americans believe that the U.S. government has the consent of the governed

• A higher percentage of Americans believed in King George of England during the Revolutionary War than believe in congress today

• Many Americans disbelieve the government’s rosy statements about the economy

• An NBC News/Wall Street Journal poll from November found that  76% of Americans believe that the country’s current financial and political structures favor the rich over the rest of the country

• The U.S. financial system is so corrupt and unregulated that many don’t believe the government and businesses’ promises to follow the rule of law … and simply won’t do business here anymore

It’s not just the U.S.
As the Economist reported in January, trust in institutions is plunging worldwide:

The latest annual “trust barometer” published by Edelman, a PR firm, on January 24^th [finds that] overall trust has declined in the leaders of the four main categories of organization scrutinized—government, business, non-governmental organizations and the media. Of the 50 or so countries examined, 11, nearly twice as many as last year, are now judged “sceptical”, with less than 50% of those polled saying they trusted these institutions. Trust in Japanese institutions plunged to 34%, from 51% in 2011, not surprising given the handling by leaders of the Tsunami and its aftermath. But the collapse in trust was even more striking in Brazil, the country in which trust was greatest in 2011, at 80%, but now, following a series of corruption scandals, has slipped to 51% (admittedly, still above America and Britain, among others).
This headline slump in trust is due, above all, to the public losing faith in political leaders. In 2011, across all countries, Edelman found that 52% of those polled trusted government; this year, it was only 43%. Government is now trusted less even than the media …. Trust in business fell slightly, from 56% to 53%, as did trust in NGOs, which still remain the most trusted type of institution, at 58%, down from 61% in 2011. As in previous years, the barometer is based on a poll of what Edelman calls “informed people”, which typically means professional and well-educated, though this year for the first time the views of the informed were benchmarked against a poll of the public as a whole. For each institution, the broader public was even less trusting than the informed, with government trusted by 38%, business 47%, NGOs 50% and the media 46%.

Lack of Trust Is Killing the Economy

Top economists have been saying for well over a decade that trust is necessary for a stable economy, and that prosecuting the criminals is necessary to restore trust. Indeed, as we have repeatedly noted, loss of trust is arguably the main reason we are stuck in an economic crisis … notwithstanding unprecedented action by central banks worldwide.
Economist Daniel Hameresh writes:

A number of economists have shown recently that income levels and real growth depend upon trust—trust greases the wheels of exchange.

In 1998, Paul Zak (Professor of Economics and Department Chair, as well as the founding Director of the Center for Neuroeconomics Studies at Claremont Graduate University, Professor of Neurology at Loma Linda University Medical Center, and a senior researcher at UCLA) and Stephen Knack (a Lead Economist in the World Bank’s Research Department and Public Sector Governance Department) wrote a paper called Trust and Growth, arguing:

Adam Smith … observed notable differences across nations in the ‘probity’ and ‘punctuality’ of their populations. For example, the Dutch ‘are the most faithful to their word.’ John Stuart Mill wrote: ‘There are countries in Europe . . . where the most serious impediment to conducting business concerns on a large scale, is the rarity of persons who are supposed fit to be trusted with the receipt and expenditure of large sums of money’ (Mill, 1848, p. 132).
Enormous differences across countries in the propensity to trust others survive
today.
***
Trust is higher in ‘fair’ societies.
***
High trust societies produce more output than low trust societies. A fortiori, a sufficient amount of trust may be crucial to successful development. Douglass North (1990, p. 54) writes,

The inability of societies to develop effective, lowcost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the Third World.

***
If trust is too low in a society, savings will be insufficient to sustain positive output growth. Such a poverty trap is more likely when institutions -
both formal and informal – which punish cheaters are weak.

Heap, Tan and Zizzo and others have come to similar conclusions.
In 2001, Zak and Knack showed that “strengthening the rule of law, reducing inequality, and by facilitating interpersonal understanding” all increase trust. They conclude:

Our analysis shows that trust can be raised directly by increasing communication and education, and indirectly by strengthening formal institutions that enforce contracts and by reducing income inequality. Among the policies that impact these factors, only education, … and freedom satisfy the efficiency criterion which compares the cost of policies with the benefits citizens receive in terms of higher living standards. Further, our analysis suggests that good policy initiates a virtuous circle: policies that raise trust efficiently, improve living standards, raise civil liberties, enhance institutions, and reduce corruption, further raising trust. Trust, democracy, and the rule of law are thus the foundation of abiding prosperity.

A 2005 letter in premier scientific journal Nature reviewed the research on trust and economics:

Trust … plays a key role in economic exchange and politics. In the absence of trust among trading partners, market transactions break down. In the absence of trust in a country’s institutions and leaders, political legitimacy breaks down. Much recent evidence indicates that trust contributes to economic, political and social success.

Forbes wrote an article in 2006 entitled “The Economics of Trust”. The article summarizes the importance of trust in creating a healthy economy:

Imagine going to the corner store to buy a carton of milk, only to find that the refrigerator is locked. When you’ve persuaded the shopkeeper to retrieve the milk, you then end up arguing over whether you’re going to hand the money over first, or whether he is going to hand over the milk. Finally you manage to arrange an elaborate simultaneous exchange. A little taste of life in a world without trust–now imagine trying to arrange a mortgage.
Being able to trust people might seem like a pleasant luxury, but economists are starting to believe that it’s rather more important than that. Trust is about more than whether you can leave your house unlocked; it is responsible for the difference between the richest countries and the poorest.
“If you take a broad enough definition of trust, then it would explain basically all the difference between the per capita income of the United States and Somalia,” ventures Steve Knack, a senior economist at the World Bank who has been studying the economics of trust for over a decade. That suggests that trust is worth $12.4 trillion dollars a year to the U.S., which, in case you are wondering, is 99.5% of this country’s income.
***
Above all, trust enables people to do business with each other. Doing business is what creates wealth.
***
Economists distinguish between the personal, informal trust that comes from being friendly with your neighbors and the impersonal, institutionalized trust that lets you give your credit card number out over the Internet.

In 2007, Yann Algan (Professor of Economics at Paris School of Economics and University Paris East) and Pierre Cahuc (Professor of Economics at the Ecole Polytechnique (Paris)) reported:

We find a significant impact of trust on income per capita for 30 countries over the period 1949-2003.

Similarly, market psychologists Richard L. Peterson M.D. and Frank Murtha, PhD noted in 2008

Trust is the oil in the engine of capitalism, without it, the engine seizes up. Confidence is like the gasoline, without it the machine won’t move.
Trust is gone: there is no longer trust between counterparties in the financial system. Furthermore, confidence is at a low. Investors have lost their confidence in the ability of shares to provide decent returns (since they haven’t).

In 2009, Paola Sapienza (associate professor of finance and the Zell Center Faculty Fellow at Northwestern University) and Luigi Zingales (Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business) pointed out:

The drop in trust, we believe, is a major factor behind the deteriorating economic conditions.
***
As trust declines, so does Americans’ willingness to invest their money in the financial system. Our data show that trust in the stock market affects people’s intention to buy stocks, even after accounting for expectations of future stock-market performance. Similarly, a person’s trust in banks predicts the likelihood that he will make a run on his bank in a moment of crisis: 25 percent of those who don’t trust banks withdrew their deposits and stored them as cash last fall, compared with only 3 percent of those who said they still trusted the banks. Thus, trust in financial institutions is a key factor for the smooth functioning of capital markets and, by extension, the economy. Changes in trust matter.

They quote a Nobel laureate economist on the subject:

“Virtually every commercial transaction has within itself an element of trust,” writes economist Kenneth Arrow, a Nobel laureate. When we deposit money in a bank, we trust that it’s safe. When a company orders goods, it trusts its counterpart to deliver them in good faith. Trust facilitates transactions because it saves the costs of monitoring and screening; it is an essential lubricant that greases the wheels of the economic system.

In 2010, a distinguished international group of economists (Giancarlo Corsetti, Michael P. Devereux, Luigi Guiso, John Hassler, Gilles Saint-Paul, Hans-Werner Sinn, Jan-Egbert Sturm and Xavier Vives) wrote:

Public distrust of bankers and financial markets has risen dramatically with the financial crisis. This column argues that this loss of trust in the financial system played a critical role in the collapse of economic activity that followed. To undo the damage, financial regulation needs to focus on restoring that trust.

They noted:

Trust is crucial in many transactions and certainly in those involving financial exchanges. The massive drop in trust associated with this crisis will therefore have important implications for the future of financial markets. Data show that in the late 1970s, the percentage of people who reported having full trust in banks, brokers, mutual funds or the stock market was around 40%; it had sunk to around 30% just before the crisis hit, and collapsed to barely 5% afterwards. It is now even lower than the trust people have in other people (randomly selected of course).

In his influential 1993 book Making Democracy Work, Robert Putnam showed how civic attitudes and trust could account for differences in the economic and government performance between northern and southern Italy.
Political economist Francis Fukiyama wrote a book called Trust in 1995, arguing that the most pervasive cultural characteristic influencing a nation’s prosperity and ability to compete is the level of trust or cooperative behavior based upon shared norms. He stated that the United States, like Japan and Germany, has been a high-trust society historically but that this status has eroded in recent years.
Chris Farrell notes:

Trust matters. It’s kind of like a recipe or a software protocol that allows for economic exchange and all kinds of innovation.
***
There’s compelling evidence that both higher levels of trust in institutions and a belief in the general trustworthiness of individuals in society carry large economic benefits. Sociologists, political scientists and economists have all showed in an impressive body of research that higher levels of trust increase trade and even foster economic growth,.

Dallas Fed president Richard Fisher said last year that a growing distrust of the nation’s political institutions is keeping businesses on the sidelines.
Forbes notes in March that a lack of trust was one of the main factors hurting the Greek economy:

There are a number of issues that have contributed and exacerbated the levels of distrust. For instance, Greece, with the help of Goldman Sachs, concealed the state of their finances for over a decade until they ran into this major debt crisis. Because they failed to disclose the extent of their financial problems, the EU and other players in the global credit market are extremely reluctant to cooperate or put faith in the representations made by the Greek leadership.
***
If the leadership in Athens cannot reestablish trust with the citizenry and develop open and honest communication amongst themselves, their constituents, and the individual leaders of the financial institutions involved, the agreements they make will not even be worth the paper they are written on.

Ken Eisold – an internationally respected authority on the psychodynamics of organizations – writes:

Most of us view trust as valuable and desirable, something that improves the quality of our personal lives.  We seldom take the next step and view it as indispensable, a vital ingredient in society – and in the economy. But all credit is based on trust, and the fundamental problem in a credit crisis is not just the lack of “liquidity” but also the absence of trust, the trust that is essential to all financial transactions.”

But the problem is not that people should be more blindly and naively trusting. The problem – as Eisold points out – is that the institutions have to act in a more trustworthy manner:

The essential point is not that people need to be encouraged to trust. Most of us want to trust and have the basic capacity to trust. We need institutions that are trustworthy.