Social capital, social norms and the new institutional economics

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SOCIAL CAPITAL, SOCIAL NORMS AND THE NEW INSTITUTIONAL ECONOMICS

PHILIP KEEFER and STEPHEN KNACK

Douglass North (1990) describes institutions as the rules of the game that set limits on human behavior, now a universally-accepted definition. North and others especially underline the crucial role of informal social norms. They predict that, like all rules of the game, social norms should affect the economic prosperity enjoyed by individuals and countries – that they should have a crucial impact, for example, on economic and political development. In fact, substantial evidence demonstrates that social norms prescribing cooperative or trustworthy behavior have a significant impact on whether societies can overcome obstacles to contracting and collective action that would otherwise hinder their development. Much of this evidence comes from outside the new institutional economics, emerging instead from scholarly research in the field of “social capital.” A review of this evidence, and its implications for our understanding of the role of social norms and institutions, is therefore the focus of this chapter.

The definition of social capital is contentious, but Woolcock’s encompasses most of the literature when he defines it as the norms and networks that facilitate collective action (Woolcock 1998).¹ This distinction between norms and networks corresponds

1 Putnam (1993: 167) defines social capital as “features of social organization, such as trust, norms, and

networks, that can improve the efficiency of society by facilitating coordinated actions.” Most uses of the

term in the literature, however, do not limit it to those norms and networks that improve social efficiency.

Coleman (1990, ch. 12) defines social capital in terms of the quantity of obligations or informal “credit

slips” between parties that are likely to be repaid, thus implicating both networks (extent of obligations)

and norms (which affect likelihood of repayment). Social capital that is productive for some purposes may

be useless or destructive for others (Coleman, 1990: 302). For discussions of the definition and history of

roughly to Uphoff’s (1990) distinction between “cognitive” and “structural” manifestations of social capital. This chapter emphasizes work related to the first half of the definition, norms, but we also discuss research more firmly rooted in the second half, networks. In particular, we review social capital research examining the role of trust and trustworthiness in economic and political development; the effect of social norms on the financing of public goods; the role of voluntary association in building socially beneficial norms; and the role of social heterogeneity in undermining them. The importance of networks, including the voluntary associations stressed by Putnam (1993), is considered primarily in the context of the emergence and impact of norms, and we do not address the literature focusing on the informational advantages of networks.

Social norms “specify what actions are regarded by a set of persons as proper or correct, or improper and incorrect” (Coleman, 1990: 243). Norms and their accompanying potential rewards (for compliance) or punishments (for noncompliance) are not the sole determinants of decisions by rational actors, rather “affect the costs and benefits which individuals taken into account when exercising choice” (Coleman, 1987: 135). Norms have no legal or other formal basis, and may sometimes even be in conflict with laws (Coleman, 1990: 243). Norms defined in this way can apply to various social settings with a range of payoff structures. For example, norms can take the form of conventions, resolving coordination problems, such as prescribing that one should drive on the right hand side of the road. As used in this chapter, however, “norms” will be used more restrictively to apply to collective action problems with risks of opportunism,

the term “social capital,” see Woolcock (1998) and Sobel (2002), who respectively provide a sociologist’s and economist’s perspective. Durlauf (2002) and Portes (1998) criticize the use of vague and inconsistent definitions of social capital in the literature; Sobel (2002) agrees but argues that “a vague keyword is not sufficient reason to condemn a promising line of research.”

specifically the two prisoner’s dilemma variants with the most frequent real-world applications, voluntary provision of public goods and principal-agent games (sometimes called one-sided prisoner’s dilemma or trust games). Trust and trustworthiness are therefore central themes in the literature discussed here. Three conclusions emerge from a survey of this work. First, levels of trust and trustworthiness vary significantly across countries. Second, they have a significant effect on economic outcomes and development. Third, trust and trustworthiness are not simply the product of repeated games and formal institutions, which are the subject of enormous investigation in the new institutional economics and in the social sciences more generally. In order to explain the emergence and sustainability of trustworthy or cooperative behavior in principal-agent or voluntary public goods provision settings, one needs to examine as well such phenomena as the dynamics of social ostracism or participation in “dense horizontal networks.”

In the first part of this chapter, we document wide variation in trust and trustworthiness across countries and individuals. This variation potentially explains why only some individuals or countries can undertake or sustain exchanges that require credible commitment in the economic, political or social realms. Subsequently we review the connections among trust, trustworthiness and credible commitment. The final section of the paper concerns the large literature on the sources of trust and trustworthiness; we conclude that these attitudes do indeed have a significant normative aspect and cannot be viewed only as emerging from reputational forces or from formal, third party institutions.

1. VARIATIONS IN TRUST AND TRUSTWORTHINESS ACROSS COUNTRIES AND INDIVIDUALS

There are large differences in the extent to which people express either trust or trustworthiness, the focus of this chapter. A standard measure of trust used in crosscountry comparisons is the answer that people give to the World Values Survey question, “Generally speaking, would you say that most people can be trusted, or that you can’t be too careful in dealing with people?” Fewer than 10 percent of Brazilians, Peruvians and Filipinos in the World Values Surveys respond that most people can be trusted when asked this question. At the other extreme, more than 50 percent of Nordic respondents (Norwegians, Finns, Swedes and Danes) agree that most people can be trusted (Knack and Keefer 1997; Zak and Knack 2001).²

There is no similar standard measure of trustworthiness for a large sample of countries, but substantial evidence nevertheless suggests that societies differ on this dimension, as well. In an experiment conducted by Reader’s Digest, twenty wallets containing $50 worth of cash and the addresses and phone numbers of their putative owners were "accidentally" dropped in each of 20 cities, selected from 14 different western European countries. Ten wallets were similarly "lost" in each of 12 U.S. cities. The number of wallets returned with their contents intact was recorded for each city. Country-level proportions of the number of returned wallets are then calculated and exhibited a wide variation, from 30 percent of wallets returned in Italy, 45 percent in Portugal, 60 to 75 percent in different cities of the US, up to 100 percent in Norway and Denmark.

2 Of 79 countries in which this trust question has been asked in recent national surveys, the mean trusting

percentage is 27.8, with a standard deviation of 13.7.

Knack and Keefer (1997) develop a measure of trustworthiness from the World Values Survey data that they call “civic cooperation”. It is based on survey respondents’ beliefs about whether or not the following actions can ever be justified: claiming government benefits to which respondents were not entitled, avoiding a fare on public transport, cheating on taxes if they had the chance, keeping money that they had found, or failing to report damage they had accidentally done to a parked vehicle. Although we sympathize with Fukuyama’s (1995) claim that it is meaningful to label societies as high trust or low trust, trust and trustworthiness are in fact the product of individual behavior and decisions, and substantial individual-level deviations from societal averages are a regularity in the data. For example, there is wide individual-level variation within countries in the 50-point civic cooperation index.

Experimental evidence is consistent with this variation in the survey data. Glaeser et al. (2000) conduct an experiment in which they pair individuals; each pair meets and is then separated. One member of the pair, the sender, is given 15 dollars, and has the opportunity to send up to 15 dollars to the other member, the recipient. For each dollar sent, the “experimenter” gives an additional dollar to the recipient. The recipient then can return money to the sender. All rules of the game are known to all players. The amount of money sent is an indication of trusting behavior; the amount of money returned is an indication of trustworthy behavior. The amount sent averaged $12.41 in the experiment, but the standard deviation was quite high ($4.54), indicating that many participants sent much different amounts. Similarly, of the amount they received, senders on average returned 45.5 percent, but the standard deviation was 26.7 percentage points.³

In the original version of this experiment (Berg, Dickhaut and McCabe, 1995), players did not meet each

Experimental evidence has led some to question how accurate and meaningful are survey measures of trust and trustworthiness. Glaeser et al. (2000), for example, use their experiment to ask whether the survey question on trust (“can most people be trusted”) predicts trusting or trustworthy behavior by participants. Participant responses to this survey question turn out to predict trusting behavior only weakly. They do, however, predict trustworthy behavior, i.e. the willingness of recipients to return money to senders.

Despite those results, there are strong reasons to think that survey results capture aggregate levels of trust in a society. First, we would not expect trusting attitudes to survive for long in a society with few trustworthy people. Second, there is substantial direct evidence of aggregate-level correlations between trust and trustworthiness. Barr (2003) conducted experiments similar to those of Glaeser et al. (2000) in 24 Zimbabwean villages with 141 pairs of players, but did not allow the subjects to know the identity of their partners prior to or during the experiment, unlike Glaeser, et al. The Zimbabwe data indicate a high level of correlation between trusting and trustworthy behavior across villages. Measures of trust and trustworthiness from the World Values survey are also highly correlated: the civic cooperation index designed by Knack and Keefer (1997), reflecting socially trustworthy behavior, is significantly correlated (at .39) with the trust measure at the country level, again controlling for per capita income. Finally, the percentage of wallets returned in the Readers Digest experiment, certainly an objective and behavioral measure of trustworthiness, is correlated at .44 with responses to the “found” money question in the World Values Survey, and more generally with standard measures of trust and honesty derived from the Survey, even controlling for per capita

other, and the amounts sent and returned were somewhat lower than in Glaeser et al. (2000).

income (Knack 2001). Figure 1 depicts the simple correlation between returned wallets and trust survey responses across countries.

Trusting survey responses (percent)

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				DNK	NOR
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		• • •	GBR	USA^---^'	•
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.2 .3 .4 .5 .6 .7

TRUST

Figure 1: Returned Wallets and Trust Across Countries

The variation across individuals, within countries, in social norms of trust and trustworthiness has important implications. Fukuyama (2000) points out that norms of trust and trustworthiness may have either a narrow or wide “radius”. Norms that overcome collective action problems and build trust within but not between families, social classes or ethnic groups often impose negative externalities on non-members of these groups. These narrow-radius norms can have adverse implications for welfare at the societal

level, much as clientelism, as viewed by Keefer (2002), may leave clients better off than they would be in a society lacking either formal institutions or the informal institutions of clientelism, but likely has negative effects on non-clients.⁴ Strong intra-ethnic trust in an ethnically heterogeneous society may restrict the scope for transacting and lead to segmented markets, reducing gains from specialization and economies of scale (Greif 1994). The same strong ties that help members of a group can be used to exclude other (often disadvantaged) community members from the benefits of collective action (e.g. Pantoja 2002).

On the other hand, if a larger fraction of society, due to social norms, can be relied upon to fulfill contracts and fulfill their obligations under the social compact, trustworthiness can be said to be of wide radius.⁵ In societies characterized by wide radius trustworthiness, individuals are not only reliable partners in contractual exchange, whether political or economic, but can also be relied upon to act in the interest of others at some expense to oneself by, for example, returning lost wallets to their owners (with the cash), or incurring the costs of providing a public good such as supervising politicians.

2. TRUST AND TRUSTWORTHINESS AND THE PROBLEM OF CREDIBLE COMMITMENT

As many of the contributions to this volume make clear, a central issue in the new institutional economics is the disruption to human interaction caused by the inability to

4 Even within an extended family, norms of sharing resources can reduce the incentive for a family

member to start a business (Portes, 1998). Banfield (1958) attributed incompetent government and poverty

in a poor Italian village to “amoral familism” preventing cooperation among citizens.

5 Knack and Keefer (1997) refer to norms that overcome large-numbers collective action problems and

build trust at the level of communities or societies (as opposed to between pairs of traders or other small-numbers settings) as norms of “civic cooperation,” or “civic norms.” These are simply norms of trustworthiness operating at the level of the social compact.

make credible commitments. The absence of credible commitment disrupts three types of human interaction: economic exchange; relationships among voters and politicians; and the “social compact”. Social norms that produce trust and trustworthiness can solve the problem of credible commitment in each of these spheres.

Problems of credible commitment in economic, political and social interaction

The ability of one party to an exchange to make credible promises to another party opens up a whole range of economic possibilities that would otherwise be unattainable. Absent the credibility of promises, risks of opportunistic behavior by contracting parties force them to turn to spot market transactions rather than to rely on contracts across time and space. Spot markets are sufficient to allow some gains from trade, but do not capture many or most of the potential benefits from specialization. They are incompatible with, for example, financial contracts, where creditors loan money to debtors on the promise of future repayment; employment contracts, where managers hire employees to accomplish tasks that are difficult to monitor or measure; and fixed investments, where investors rely on assurances by firms and governments that their assets will not be expropriated. Trust is obviously important in this context. Where the parties inherently trust each other, transactions that require credible promises are easier to consummate.

The policy outcomes driven by political competition crucially depend on credibility. Persson and Tabellini (2000) show that the effects of institutional change are dramatically different in societies where political promises prior to elections are credible and in societies where they are not. For example, the shift from majoritarian to proportional electoral rules increases the rents that politicians can extract for themselves when political competitors

cannot make credible pre-election promises to voters, but reduces rents when they can.⁶Keefer (2002) shows that young democracies perform substantially worse on many margins than older democracies, controlling for income per capita and other characteristics. He argues that this is due to the peculiarities of political promises in young democracies. Where trust in politicians is narrowly confined to a few voters who have personally interacted with the politicians, one definition of clientelism, political competition need not improve public policy.

The credibility of political commitments also influences the ability of politicians to undertake reforms or respond to crisis, the theme of a large literature (e.g., Acemoglu and Robinson 2001). Socially beneficial reforms would always occur if the winners could compensate the losers. However, spot markets for reform, where compensation is paid at the moment that reform is approved, are notoriously difficult to construct. On the one hand, for numerous reasons, not the least of which are tight budget constraints, governments can rarely offer losers the cash value of the present value of their losses. The government can circumvent this problem by offering future compensation. Non-credible governments do not have this option, however. For example, power sector subsidies are a crippling burden on Indian states. The majority of farmers who benefit from power subsidies are poor and receive collectively a small fraction of the total subsidies. Their support for reform should be easy to buy, and sufficient. Still, even in one of the most progressive Indian states, Andhra Pradesh, reforms of the power sector have proven to be intractable.⁷ One reason for

6 Majoritarian electoral rules are those where the number of seats per electoral district is small and citizens

vote for candidates rather than parties; proportional representation rules are those where electoral districts

are larger and citizens vote for party lists.

7 See, for example, “Power Politics--Process of Power Sector Reform in India,” by Navroz Dubash and

Sudhir Rajan, in Economic and Political Weekly, Sept 1, 2001.

this is that poor farmers do not believe government promises to compensate them in exchange for eliminating the subsidies.⁸

Human interaction obviously extends far beyond interactions in the economic and political spheres. Smoothly running societies also benefit from a well-developed and credible “social compact” – the unwritten commitments that citizens have made to each other. In many societies, the extent of these commitments is highly circumscribed because everyone believes that most individuals will shirk on their responsibilities under the compact, even though all would be better off if no one shirked. Societies in which such beliefs are widespread are limited in their ability to collect taxes, enforce laws, even to maintain clean streets.⁹ Societies in which decisions of individuals are influenced by social norms are likely to exhibit less shirking on the social compact – i.e. to be more trustworthy -- and hence able to govern themselves at substantially lower cost. Evidence on the influence of social norm s on the problem of credible commitm ent

The larger the fraction of people in a society who share norms prescribing cooperative or trustworthy behavior in collective action settings, the more likely is the society to have overcome problems of credible commitment in the economic, political and social spheres. That is, in the language of Fukuyama, where wide-radius trust and trustworthiness are prevalent, contracting parties can dispense with costly monitoring of performance. Individuals in these societies can spend less to protect themselves from being exploited in economic and political transactions. Written contracts are less likely to be

8 Wealthier farmers are at the center of efforts to organize farmers collectively in support of continued

price ceilings on power. If they are excluded from attempts to buy off opponents of power sector reform,

they have little interest in continuing to organize farmers – but it is only collective action by farmers that

guarantees farmers that they can act against governments that renege on their promises. If wealthier

farmers are included in the buy out attempts, the cost of reform goes up substantially.

9 See Levi (1988) and Scholz and Lubell (1998) for the importance of informal norms and trust in revenue

collection.

needed and they do not have to specify every possible contingency. Individuals have more resources available for innovation and investment, as they can devote fewer resources to protecting themselves – through tax payments, bribes, or private security services and equipment – from unlawful (criminal) violations of their property rights. Norms of civic cooperation reduce enforcement costs by leading individuals to internalize the value of laws and regulations even when the probability of detection for violation is negligible.

Substantial evidence suggests that trust and trustworthiness matter for interactions that rely on credible commitment. At the individual level, there is ample experimental evidence along the lines of the experiment conducted by Glaeser et al. (2000), showing that recipients who expressed trusting attitudes (the belief that most people can be trusted) returned 10 percent more money to senders than did other recipients (i.e., they were more trustworthy) controlling for other recipient characteristics.¹⁰

Individual level evidence does not lend itself easily to understanding the broader problems of credible commitment in the context of economic and political development. Nevertheless, a wide range of cross-country evidence also demonstrates the importance of trust and trustworthiness. Fukuyama (1995) attributes cross-national differences in economic performance to variations in trust and “spontaneous sociability.”¹¹ Among the nations he discusses in detail, he classifies the U.S., Japan and Germany as high-trust societies, and France, Italy, China, Korea, Hong Kong and Taiwan as low-trust societies. In statistical cross-country tests, Knack and Keefer (1997) find that a ten percentage point increase in the number of citizens who express trusting attitudes is associated with an

10 The controls were the amount originally transferred by the sender to the recipient, whether the pair of

participants were of different genders, the gender and race of recipient, and whether recipients were in their

first year of college (the participants were all Harvard undergraduates).

"The ability to associate depends, in turn, on the degree to which communities share norms and values

and are able to subordinate individual interests to those of larger groups" (Fukuyama, 1995: 10).

increase in per capita economic growth of almost one percentage point per year. The effects of trust on growth turn out to rival those of the fraction of children enrolled in primary education. Using a broader sample and different specifications, Zak and Knack (2001) report similar results.

These results could be affected by reverse causation: the trust coefficient could be biased upward if growth increases trust (for example, by making people more optimistic), or downward if growth decreases trust (for example, by disrupting traditional social and community ties as in Olson 1963 or Miguel, Gertler and Levine 2002). However, Zak and Knack (2001), following La Porta et al. (1997), use religious composition variables as instruments and find that the exogenous component of trust remains significantly related to growth.

Trust and other manifestations of social capital may also matter fundamentally to the survival of democratic government. Paxton (1999) and Inglehart (1999) argue that a culture of trust is necessary for governments to be willing to surrender power to the opposition, and therefore for the survival of democracy. Inglehart (1999) finds a strong correlation between trust and stability of democratic institutions, using cross-country data. In a classic comparative study of the U.S., U.K., Germany, Italy, and Mexico, Almond and Verba (1963) argue that a stable democratic political system depends on a strong “civic culture” with high interpersonal trust and active involvement in voluntary associations.

Studies linking trust and broad outcomes, such as growth and regime survival, have been complemented by work that looks at specific channels through which informal norms underlying trust and trustworthiness might affect these broad outcomes. Using survey data, Knack and Keefer (1997) report that citizens’ confidence in government –

the credibility of government – is significantly greater in higher-trust nations.¹² La Porta et al. (1997) and Knack and Keefer (1997) demonstrate that countries with more trusting citizens exhibit higher ratings in foreign investor risk assessments on subjective measures of governmental efficiency, corruption, and infrastructure quality.¹³ Knack (2002) reports similar results for the American states, using more “technocratic” measures of governmental quality.

These results suggest that norms prescribing cooperation and trustworthiness enhance governmental effectiveness. Boix and Posner (1998) and Knack (2002) argue that they do this by helping voters overcome the collective action problem in monitoring and sanctioning public officials. Key to citizens’ oversight of government officials is their willingness to collect and assess information about government performance and their willingness to take action (such as voting, writing letters, signing petitions, demonstrating etc.) to convey their preferences to officials and to expel poor performers. The purely self-interested citizen would neglect both tasks, and free-ride on the efforts of others. The citizen motivated by a norm of civic cooperation (one manifestation of trustworthiness) becomes more informed about politics and public affairs, and more willing to vote or in other ways exercise “voice” options, creating checks on the ability of politicians and bureaucrats to enrich themselves or narrow interests with which politicians might be allied.

As with trust and economic performance, there is a potential for endogeneity bias in tests linking trust to government performance. For example, high-trust societies may

This test controlled for income per capita and primary and secondary educational enrollment. The

dependent variable was a composite of citizens’ confidence in the civil service, legal system, police, and

education system.

La Porta et al. control for per capita income, include all countries with available data, and use trust

values from the early 1990s. Knack and Keefer control for income and education, exclude formerly-communist nations, and use the earliest-available observation on trust (typically, the early 1980s).

be better at keeping their governments honest, but the honesty and efficiency of government officials can in turn affect trust. “If government leaders, judges and bureaucrats are corrupt, market participants can more easily justify and rationalize their own dishonest behavior” (Drobak 1998, 103; also see Gambetta 1988, 158-63). If a government provides services effectively, communities may run more smoothly, with less crime and social strife, generating more trust and civic cooperation. However, studies using religious composition variables as instruments have found that the exogenous component of trust remains significantly related to government performance (Knack, 2002; La Porta et al., 1997).

The findings linking trust and trustworthiness in societies with government effectiveness and performance echo the findings of Putnam’s (1993) pathbreaking work on the Italian regions. Putnam, however, relied primarily on measures more closely linked to the “network” aspects of social capital than the “norms” aspect from which the trust and trustworthiness discussion springs. Social capital researchers focusing on the “network” aspect, in an empirical context, ask whether people in a community or society are linked in dense horizontal relationships such as those that emerge from participation in civic activities, sports clubs, neighborhood associations and singing societies. Roughly speaking, the more dense are these horizontal relationships and the larger the fraction of the population that participates in them, the more social capital exists.

A growing literature has followed Putnam in examining the effects of horizontal networks or associational activity on economic and political outcomes in a society. Although the discussion in this chapter is focused on the normative aspects of social capital, the network approach to social capital is relevant for two reasons. First, the

examination of associational activity in societies may allow investigators to skirt the difficulties raised by the potential endogeneity of measures of trust and trustworthiness. Costa and Kahn (2003a), starting from the premise that trust and trustworthiness are endogenous, consciously focus on horizontal networks rather than social norms directly. Second, the causal path from associational activity through to economic or political outcomes may pass through trust and trustworthiness.

Narayan and Pritchett (1999) find for a sample of Tanzanian villages that higher levels of associational membership are associated with higher household incomes. Isham and Kähkönen (2002) show that in villages in Sri Lanka and India with more active community groups and associations, household participation in design of community-based water projects is higher, and monitoring mechanisms are more likely to be in place. Participation and monitoring in water projects, in turn, were associated with improved health and reduced time devoted to collecting water.

Not all studies yield results consistent with Putnam’s earlier findings, however. In their study of neighborhoods in Bangladesh, Pargal, Gilligan, and Huq (2002) found that associational activity in a community at best weakly predicted whether that community was successful in organizing collective action. The presence of associations that provided “private” goods or services (sports clubs and women’s organizations) in the neighborhood were associated with a reduced likelihood of success in organizing voluntary waste management services, while associations providing “public” goods or services (neighborhood watch groups, and welfare, library and religious groups) had effects that were significantly positive only for some model specifications.¹⁴

Number of associations were measured prior to the formation of any voluntary waste management

In addition, the effects of associational activity may break down at higher levels of aggregation. Membership in groups is unrelated to measures of government performance across the American states (Knack, 2002) and across countries (Knack and Keefer, 1997), controlling for income, education and other variables.¹⁵ This pattern is consistent with the possibility that the activities of some groups impose negative externalities on non-members, which are not captured in household-level or even community-level analyses. Knack and Keefer (1997) and Knack (forthcoming) also find little difference in the effects of group activity, even after controlling for the type of group. They distinguish groups that might act as redistributional coalitions, with adverse economic impacts (Olson, 1982), from those that do not. However, when group memberships are divided into “Olson” groups (mainly professional associations and unions) and “Putnam” groups (social or other groups that engage in little or no lobbying on economic issues), neither type tends to be significantly associated with economic performance.

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