Regulation and Distrust

Brought to you by Aghion, Algan, Cahuc and Shleifer, this is one of the best papers so far this year.  It’s so good I’ll give you a longer than usual quotation from the opening pages:

In a cross-section of countries, government regulation is strongly negatively correlated with social capital. 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. 

We present a simple model explaining this correlation. The model turns on the idea that investment in social capital makes people both more productive and more civic (e.g., Coleman 1990). Compared to people who have invested in social capital, those who have not are both less productive and impose a negative externality on others when they produce (e.g., pollute).  The community (whether through voting or through some other political mechanism) regulates production when the expected negative externalities are large. But regulation itself must be implemented by government officials, who are corrupt if they have not invested in social capital. As a consequence, when production is restricted through regulation, investment in social capital may not pay off.  In this model, when people expect to live in a civil community, they expect low levels of regulation, and so invest in social capital. Their beliefs are justified, as lack of investment leads to incivility, high regulation, high corruption, and low production.  The model has two Pareto ranked equilibria.

…The model predicts, most immediately, that distrust influences not just regulation itself, but the demand for regulation…distrust fuels support for government control over the economy.  What is perhaps most interesting about this finding, and also consistent with the model’s predictions, is that distrust generates demand for regulation even when people realize that the government is corrupt and ineffective; they prefer state control to unbridled production by uncivil firms.

…We take evidence on the demand for regulation as supportive of causality running from distrust to regulation.  To test the reverse causality, we look at the experiment of transition from socialism, which we interpret as a radical reduction in government regulation in low trust societies.  Our 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 of trust in the short run.


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