November 14, 2012

Trust and productivity

Relatively recent academic evidence explains how productivity works in places with underdeveloped legal institutions and cultural norms.
In 2009, Hsieh Chang-Tai and Peter Klenow found that a big part of the reason why China and India are so much poorer than the United States is that wildly unproductive firms are more likely to survive in those countries than in America.
After running a novel experiment, Nicholas Bloom, of Stanford University concluded that these firms were so unproductive because they were horribly managed (as opposed to having worse workers or inferior equipment). He speculated that the unproductive firms were able to survive because better-managed businesses were limited in their ability to expand thanks to uncooperative capital markets and, intriguingly, a dearth of trustworthy managers.

The problem is not the absence of people who know how to run businesses but the society at large.

In another paper, Mr Bloom and his colleagues argued that entrepreneurs in poorer countries are reluctant to trust people who are not directly related to them to manage any part of their enterprises. They are afraid that people from outside the family will steal from them and that the judicial system will not protect them. This (not unjustified) fear limits the ability of good firms to expand. Once you run out of siblings and cousins, you can't open more factories. The result is that bad firms are not driven out of business. Conversely, countries with higher levels of "social capital," i.e., trust, generally have higher productivity and are therefore richer, precisely because good firms have more resources available to drive out the bad ones and increase the standard of living through creative destruction.

This was the inspiration behind Paul Romer's ill-fated Charter Cities project, which ran aground in Honduras. The goal was to import the values and institutions of societies with high levels of "social capital" to poor countries in the hope that it would allow them to become richer and more productive. Ironically, the Honduran mission failed precisely because the agency that was supposed to ensure transparency refused to allow outsiders to audit agreements made between the government and private firms.
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