GHEI: The price of eroding trust

As suspicion advances, prosperity retreats

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In the latest act of the unfolding Internal Revenue Service scandal, Lois Lerner, the head of the agency’s tax-exempt organizations office, faced with allegations of improper targeting of conservative groups, invoked the Fifth Amendment’s protection against self-incrimination. The entire episode is swiftly degenerating into a bipartisan battle for political advantage.

The justification that the IRS has long been used by those in political power against their opponents is symptomatic of the larger problem in the United States. Years of redistributionist rhetoric, bailouts to firms who should have been responsible for the risks they took, subsidies flowing to the politically connected, and the replacement of flexible social norms by rigid top-down regulations are causing erosion of trust and whittling of social capital; that is, norms and institutions that allow peaceful cooperation and exchange to take place. Eventually, this decline in trust in both our public institutions and civil society will be reflected in slower economic growth and a society that is less prosperous than it could have been.

According to the Legatum Institute, the United States dropped from 10th to 12th in the institute’s Prosperity Index from 2009 to 2012, even as the world as a whole grew more prosperous. The broad-based Prosperity Index includes measures for personal freedom, social capital, governance, and entrepreneurship and opportunity. The United States fell one place for governance, two for social capital, a depressing four for personal freedom, and a shocking eight in entrepreneurship and opportunity in those four years. The economy measure fell by seven places in one year alone between 2011 and 2012. Worse, as the Legatum Institute’s site explains, the decline in the entrepreneurship and opportunity measure is explained to some extent by “a decline in citizens’ perception that working hard gets you ahead.”

This is long-term bad news, with effects that will persist for far longer than the various scandals currently swirling around Washington. Trust in other people, in private institutions and in public institutions is critical to economic growth, and trust is what we are losing. The slow erosion of civil society ultimately is the greater danger we need to address lest we get caught in a stagnation trap.

In a 2001 study, Claremont University economist Paul Zak and World Bank economist Stephen Knack examined 37 countries and found that higher levels of interpersonal trust were associated with higher rates of growth. As Mr. Knack explains, “Interpersonal trust can complement or substitute for formal property rights, reducing transactions costs and encouraging investment,” with a concomitant positive impact on growth.

In addition to interpersonal trust, such as trust between family members, trust matters at the firm level, and even at the macro level of the society or nation. There are at least three ways in which higher trust can encourage economic growth. Conversely, lower trust acts as a drag on growth.

Higher levels of trust reduce transaction costs. The higher the trust level, the lower the need for monitoring and enforcement contracts. People who trust each other are likely to spend fewer resources in litigation. According to the Legatum Institute, lower levels of trust are associated with higher levels of regulation. Lower trust adds the cost of regulatory compliance as an additional drag on growth. Second, as Nobel laureate Elinor Ostrom explained, high-trust societies are more likely to solve problems caused by free riders or external costs, such as overfishing, because people are more willing to cooperate. They are also less likely to take advantage of public programs designed to help the needy. As trust erodes, more people are likely to game the system. This results in demands for more monitoring, which is costly and further drags down growth.

Third, high-trust societies create an environment that is more conducive to innovation. If you can focus your energy and time on creating new products instead of worrying whether your partner is robbing you, or whether the government is going to expropriate your new invention, you are going to be more productive, and the innovation is going to contribute to economic growth. Erosion in trust reverses this virtuous cycle. Low-trust societies tend to view entrepreneurship with hostility and in need of regulation, further aggravating the problem.

Trust in one other and in our institutions can be lost all too easily. We seem to be heading down that path already. If we wish to prevent the loss of potential innovation and growth, and improvements in standards of living, we need to resist behavior that degrades trust, both in public institutions and civil society as a whole.

Nita Ghei is policy research editor at the Mercatus Center at George Mason University.

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