Public trust, the law, and financial investment☆

Abstract

How does trust evolve in markets? What is the optimal level of government regulation and how does this intervention affect trust and economic growth? How do professional fees affect trust formation? In a twostage theoretical model, we analyze the trust that evolves in markets, given the value of social capital, the level of government regulation, and the potential for economic growth. We show that when the value of social capital is high, government regulation and trustfulness are substitutes. In this case, government intervention may actually cause lower aggregate investment and decreased economic growth. In contrast, when the value of social capital is low, regulation and trustfulness may be complements. We analyze the optimal level of regulation in the market, given the conditions in the economy, and show that the absence of government intervention (a Coasian plan) is suboptimal in a culture in which social capital is not highly valued and when the potential for economic growth is low. We finally evaluate the effects of fees on the trust that forms in various cultures (high vs. low value to social capital) and compare our results with the implications of classic agency theory. Overall, our theoretical analysis in this paper is consistent with the empirical literature on the subject and we highlight novel predictions that are generated by our model. * We would like to thank

Regulation and Distrust*

“…Aghion, Algan and Cahuc (2008) show that minimum wage policies undermine the ability of firms and workers to learn about each others' cooperative attitudes, and that low cooperation in turns creates a demand for wage policies. Carlin et al (2007) argue, similarly to our paper, that trust and regulation are substitutes in financial markets.…”

Culture and Institutions

“…The LITS provides evidence on twenty-eight post-Communist countries in Europe and Central Asia, and it has questions on preferences for market versus planned economies. 68 Similar conclusions have been reached by Pinotti (2012), Carlin, Dorobantu, and Viswanathan (2009), and Francois and Ypersele (2009). Pinotti (2012, looking at the correlation between trust and regulation, shows that variations in entry regulations around the world mostly reflect demand pressures from people at large, as captured by differences in trust.…”

“…He shows that, keeping constant the trust-driven component of demand for government intervention across countries, regulation is no longer associated with worse economic outcomes. Carlin, Dorobantu, and Viswanathan (2009) look at how trust evolves in the market, what the optimal level of government regulation is, and how this intervention affects trust and economic growth. They show that when the value of social capital is high, government regulation and trustfulness are substitutes.…”

Culture and Institutions

“…The LITS provides evidence on 28 post-Communist countries in Europe and Central Asia, and it has questions on preferences for market versus planned economies. 69 Similar conclusions have been reached by Pinotti (2012), Carlin, Dorobantu, and Viswanathan (2009), and Francois and Ypersele (2009). Pinotti (2012, looking at the correlation between trust and regulation, shows that variations in entry regulations around the world mostly reflect demand pressures from people at large, as captured by differences in trust.…”

“…He shows that, keeping constant the trust-driven component of demand for government intervention across countries, regulation is no longer associated with worse economic outcomes. Carlin et al (2009) look at how trust evolves in the market, what the optimal level of government regulation is, and how this intervention affects trust and economic growth. They show that when the value of social capital is high, government regulation and trustfulness are substitutes.…”