Regulation and Trust: Substitutes?
A new paper by Philippe Aghion (see picture) and co-authors makes the point that "in a cross-section of countries, government regulation is strongly negatively correlated with social capital (trust). We document, and try to explain, this highly significant empirical correlation. The correlation works for a range of measures of social capital, from trust in others to trust in corporations and political institutions, as well as for a range of measures of regulation, from product markets, to labor markets, to judicial procedures."
So what?
The main point is that culture (as measured by distrust) and institutions (as measured by regulation) co-evolve. Culture shapes institutions, and institutions shape culture. The causality runs in both directions. Unfortunately, it is very difficult to test this prediction of the model using instrumental variables, since many exogenous factors that influence trust might also directly influence regulation, and vice versa. For example, one can think of using legal origins as instruments for regulation (see, e.g., Djankov et al. 2002), but to the extent that colonizing Europeans who transplanted legal traditions also transplanted aspects of culture, the instrument would not be valid.
The evidence on the demand for regulation is supportive of causality running from distrust to regulation. To test the reverse causality, the authors look at the experiment of transition from socialism, which they interpret as a radical reduction in government regulation in low trust societies. Their model predicts that such a reduction should lead to 1) a reduction in output, 2) an increase in corruption, 3) an increase in demand for government control at a given level of trust, and 4) a reduction in trust in the short run. Some of these predictions are known to be true in the data, while the authors present some evidence supporting the others.
There are not that many radical reform experiences, so transition economies come in handy. New Zealand is another good example.
This paper is exciting because it crosses economics with sociology. Several Nobel prizes have gone to people who connect disciplines: for example, Tullock on law and economics, Kahneman and Tversky on psychology and economics. Is there another one in the making?
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Ahem. "The evidence on the demand for regulation is supportive of causality running from distrust to regulation. To test the reverse causality, the authors look at the experiment of transition from socialism, which they interpret as a radical reduction in government regulation in low trust societies."
Call me dumb, but I have absolutely no idea what the above sentence means. Could you please rewrite the article in plain English please?
Posted by: Ari T. | Jul 16, 2008 9:19:27 PM
To Ari T:
Dense language indeed. The point the Aghion et al paper is trying to make is that when people do not trust other people to behave, they ask for more regulation. To make sure that everyone is held to a higher standard.
Once, however, regulation becomes too restrictive, many people rationally choose to disredard it, creating a "non-level playing field." This in turn creates distrust and motivates even higher regulation. Sounds depressing.
Countries do come out of it, but they typically need some sort of a jolt. Could be a financial crisis, or a new government in place, or an economic downturn.
Posted by: Simeon | Jul 22, 2008 3:09:44 PM
I haven't read the paper in details yet, only skimmed through it, but when I first saw the title, my first reaction was one of curiosity and then "oh, f***!", because I have it as a title of my dissertation. It's such an intuitive idea that everyone remotely interested in economics thinks it's obvious that there is such a connection. According to some - so obvious that it makes no sense writing about it. It took me time to convince my academic advisor that it's worth working on the link between regulation and trust.
Surprisingly, despite the intuitiveness of the idea, no one had written about it till a month ago. Now that a Harvard economist has published a paper, I can at least say to the senior members of the department that I was on the right track - the finished paper looks pretty well.
Posted by: Aleksandar Kosuliev | Aug 17, 2008 3:05:57 PM
Dear Aleksandar:
Sounds like your dissertation is on one of the hottest topics in economics these days. Since I published this blog, I have come upon several other good papers that look at what distrust means for organizing economic activity. And a recent conversation with a top Harvard economist suggests editors are excited about this topic: mainly because it merges economics and sociology.
If you send me your paper, we can feature it too.
Posted by: Simeon | Aug 19, 2008 9:22:28 AM
Dear Simeon,
I am still in the beginning (a good thing, actually, as my basic idea overlaps with Aghion et al - it will allow me to make ad hoc changes and avoid repetition), so it won't come out soon, but I will gladly send it to you. Even if it's not up to the highest academic standards, I can benefit from criticism.
Posted by: Aleksandar | Aug 21, 2008 10:47:28 AM