Friday, May 1, 2015

The Economic and Social Costs of Distrust

The Scandinavian countries are known for being unique in a number of ways.  Surveys of positive characteristics (happiness, gender equality, trust) tend to find these countries leading the list.  These tallies can lead to the assumption that these countries have somehow learned how to do things right.  Michael Booth is an Englishman married to a Dane and living in Copenhagen.  He takes his readers on a tour of Sweden, Norway, Denmark, Finland and Iceland in his book The Almost Nearly Perfect People: Behind the Myth of the Scandinavian Utopia.  From the title one might conclude that Booth is going take the cover off a lot of ugly goings that have been hidden from the rest of the world.  What is actually provided is an interesting and often humorous account of the foibles and idiosyncracies of countries that have had quite different histories than the other European nations, and in many ways have been much more successful.

One of the interesting topics Booth discusses is the issues of trust and trustworthiness and the Danes belief that trust is an important contributor to the strength of their economy.

“All of the Nordic countries have high levels of trust, but the Danes are the most trusting people on the planet.  In a 2011 survey by the OECD, 88.3 percent of Danes expressed a high level of trust in others, more than any other nationality (the next places on the list were filled by Norway, Finland, and Sweden, respectively, and the United States was way down in twenty-first place out of thirty countries surveyed).”

“Other surveys show that Denmark is one of the very few countries in which trust levels have maintained an unbroken upward trajectory for the last half century.  And Transparency International’s annual corruption perception index currently ranks Denmark and Finland as the least corrupt countries in the world, with Sweden and Norway following close behind (the United States is in nineteenth place).”

Booth provides a few examples of exceptional trust that will seem extreme to easily panicked parents in other societies.

“….people do leave their kids sleeping in strollers outside cafés and shops, even in the cities, and they let their children commute to school alone, often by bicycle, from as young as six or seven years old.”

Any parent who might be appalled by this behavior should also note that the school days in the northern countries are generally cold and dark.

And then there is the compelling example of the returned wallets recounted by one of the Booth’s Danish sources.

“Back in the nineties there was an experiment done [1996, by Readers Digest] where wallets were left around in various cities and they counted how many were returned.  And the cool thing is that in the places where more people say they can trust others, the more wallets were returned.  I think they did an experiment with about forty wallets and the only two countries where all forty were returned were Norway and Denmark.”

It would seem to follow that people in a society who are trusting are also trustworthy

What is of interest here is the claim the Danes make about how all that trust contributes to their economic efficiency.  Booth provides these estimates of Danish specialists.

“Danish trust saves the justice system 15,000 kroner ($2,700) per person per year, for instance; others believe that as much as 25 percent of the economy can be accounted for by social capital.”

“The theory goes that, if there is trust in a society, then its bureaucracies will be more straightforward and effective—the cost and time of transactions between companies will be reduced and less time will be spent paying lawyers to draw up costly contracts, and in litigation.  A handshake is free.  Anyone who has tried to conduct business in France will have quickly become aware of the massive inconveniences involved with living in a society where the default setting is to assume the other person is trying to pull your trousers down.”

The more complex the work involved, the more important it is to have workers who can be trusted to carry out their tasks diligently.

“….the more skilled a job is, the more difficult it is to check up on whether an employee is carrying out his or her duties as they should be, and so trust becomes that much more important.  It is tricky and costly to check that high-level consultants, architects, IT technicians, or chemical engineers are working as they should, so trust becomes that much more important, which is one reason why high-trust societies such as Denmark, Finland, and Sweden excel in advanced industries like pharmaceuticals and electronics and attract foreign companies operating in these fields.”

Are these claims about trust and its economic impact being overstated?  Probably not.  Consider this OECD article by Diane Coyle: The Cost of Mistrust

“In today’s advanced economies, though, the degree of trust involved is extraordinary. Manufactured items typically involve complex supply chains of many links that extend over continents, with demanding requirements for quality or timeliness. Globalisation has linked many more people than ever before, from different legal frameworks and different cultures. Digital technologies have brought together new communities of people participating in all kinds of social and economic innovations, often inspired by a remarkable idealism.”

“Perhaps even more demanding in terms of trust is that more than two-thirds of economic activity in OECD countries consists of services, the quality of which is often unknowable until purchased and consumed. In contrast to the 1960s assembly-line economy of standardised products, it has become difficult in the modern economy to monitor the effort of individual workers or the quality of their work. For example, the manager of computer programmers will not know how good their software code is until the project is finished and the software either functions or not. The manager of care workers cannot monitor how well they look after the pensioners in their charge, or how kind they are to the people in their care, short of doing the job alongside them.”

Coyle is concerned that surveys of trust in institutions show that it has been declining in most countries for many years.

“….the evaporation of trust in some key institutions is directly damaging for economic growth. The general distrust of business, not only banks but also spreading to energy companies, e-retailers, food producers and others, will tend to encourage unnecessary (as well as necessary) regulation and contribute to the climate of uncertainty holding back investment.”

An article in The Economist provides a good example of the costs associated with being untrustworthy.

“To ensure that it meets the 750 new rules on capital imposed in the aftermath of the financial crisis, JPMorgan Chase employs over 950 people. A further 400 or so try to follow around 500 regulations on the liquidity of its assets, designed to stop the bank toppling over if markets seize up. A team of 300 is needed to monitor compliance with the Volcker rule, which in almost 1,000 pages restricts banks from trading on their own account.”

An article by Arturo Franco provides Mexico as an example of a country suffering from rampant distrust in Mexico: The Unbearable Cost of Distrust.

“Trust is at the heart of Mexico’s challenges today. The lubricant of the economic engine, trust enables market exchanges, reduces transaction costs for business, upholds security and peace, and makes institutions and the political system work. Distrust, in turn, creates unnecessary costs, incentivizes negative behaviors, and can become a huge burden for productivity and for growth.”

“Mexicans’ reported levels of trust and confidence in a wide range of institutions have been declining for many years. Between 2013 and 2014, virtually every institution, from the police to the church, from television stations and universities, to political parties, Congress and the president, have suffered from rising public distrust. What is worse, perhaps, is that investor confidence has also eroded.”

Tax collection is one of the first functions to suffer from distrust.  Besides a lack of enthusiasm for shipping money to a system in which one has little faith, no one wants to be the last honest tax payer.

“A 2012 report by Global Financial Integrity estimated that, between 1970 and 2010, more than $800 billion was lost in Mexico to tax evaders using myriad schemes to avoid contributing to the country’s coffers.”

Lynn Stout provides an interesting discussion of how trust and distrust can increase or decrease the efficiency of social and economic interactions in her book Cultivating Conscience: How Good Laws Make Good People.  She points out that people will tend toward prosocial behavior unless conditions are present that indicate such behavior would not be reciprocated in a transaction.  In other words, people will be trusting or trustworthy if they expect to see the same behavior in others.  There are a few exceptions to this rule in that some people are actually the self-interested actors beloved by economic theorists.  She likes to refer to them as psychopaths.

The element of trust is critical in establishing social and commercial transactions.  The latter are generally defined by a signed contract which defines the major components of the transaction.  In practice, these contracts are preferably left “incomplete.”

“A formal contract that addressed each and every possible contingency would be prohibitively expensive and time consuming to draft, and probably too heavy to carry.  Rather than try to draft a complete contract, the parties might reasonably content themselves with a short, incomplete contract that addresses only the most important and obvious aspects of their proposed exchange and leaves other matters to be dealt with in the future should they arise.”

Both parties are forced, for efficiency’s sake, to assume the other is trustworthy.  When the element of trust is not there and one party believes that contingencies must be formally dealt with in a contract, the dynamic of the interaction can be drastically altered.  By signaling a lack of trust in a partner in an interaction one actually encourages that person to behave in a more self-interested or selfish manner.

“This ‘signaling’ problem has long been understood by family lawyers, who find that couples planning to marry often avoid prenuptial agreements not because they are confident that they won’t divorce, but because they feel that asking for a prenuptial agreement shows a lack of trust that could poison the marriage.  Experimental gaming supports these couples’ reluctance.”

“This possibility is an example of the phenomenon social scientists call ‘crowding out’ or ‘motivational crowding.’  The basic idea is that if we treat a contract partner as purely self-interested, we signal that we believe the social context is one where selfishness is appropriate and expected.  This signal raises the odds our partner will in fact behave self-interestedly.”

Stout provides a good example of how an expression of distrust can quickly degrade an interaction.  Consider after-school day care where children are supervised by teachers until a parent can pick them up after work.  There is a time assigned for latest pickup so that the teachers can get to their own homes at a convenient time.  As might be expected, occasionally parents would be late in arriving and the teachers were inconvenienced.  Researchers convinced six of these after-school programs to institute a policy of fining the parents who were late.  In each case, the number of late-arriving parents increased significantly.

“From an economic perspective, these results seem bizarre.  How can raising the cost of an activity prompt people to ‘buy’ more of it?  The answer, according to crowding out theory, is that by changing the social context to look more like a market, fining parents who arrived late decreased the ‘psychic cost’ of arriving late, signaling that lateness was not a selfish social faux pas but a market decision parents were free to make without worrying about the teachers’ welfare.  By emphasizing external material incentives, the day-care centers crowded out ‘internal’ incentives like guilt and empathy.”

In other words, the “contract” worked more efficiently when it was based on trust and trustworthiness than when trust was eliminated from the interaction.

It seems possible that the Denmark’s claim that its economy benefits greatly from the efficiencies associated with a trusting and trustworthy society is true.  If that is the case then it is important to try to understand what is it about Danish, and Scandinavian societies in general, that leads to such high levels of trust.

Booth raised this question with the Danes and was provided with two possible explanations.  Interestingly, the assumptions about the source align nicely with political assumptions that would be familiar to all in the United States today. 

From the right side of the political spectrum are those

“…who argue that the Danes have always had high levels of trust and social cohesion, and that these date back to long before the advent of the welfare state.  Top of this camp’s agenda is the downscaling of Denmark’s welfare state, which they feel has become unsustainable, and the reduction of Denmark’s taxes; they place less emphasis on economic equality and more on motivating society’s wealth-generators to improve Denmark’s poor productivity growth.”

From the political left we have those who point to the welfare state itself as the source of the high level of trust.  A respected Danish professor provides that point of view.

“….it is because of the equality and our tax rates and the welfare state.  The trust is based, on my understanding, on the welfare state period.  You trust your neighbor because you know that your neighbor is paying tax just like you are, and when that neighbor gets sick, they get the same treatment as you, they go to the same school.  That is trust: that you know that, regardless of age, sex, fortune, family background or religion, that you have the same opportunities and safety net.  You don’t have to compete with your neighbor, or be envious of your neighbor.  You don’t have to cheat your neighbor.”

From the perspective of those living in a society where trust is difficult to find and depending on the “wealth-generators” to improve society has been a dismal failure, the argument from the left must appear enticing.

The Scandinavian nations are conducting the most definitive social experiments yet.  Political scientists, economists, and social scientists should all be flocking there to figure out what has happened, what is happening, and what is going to happen.

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