CONTRIBUTOR / Paola Sapienza
DONALD C. CLARK/HSBC CHAIR IN CONSUMER FINANCE
PROFESSOR OF FINANCE
KELLOGG SCHOOL OF MANAGEMENT / Finance
A fundamental aspect of finance is credit, and credit comes from the Latin word ‘credere’, which means to trust. Virtually every commercial transaction has in itself an element of trust, and research shows a remarkable correlation between communities that tend to exhibit anonymous trust and economic growth, which suggests that the link between trust and economics could be finance.
In 1972, Ken Arrow, Nobel Prize–winning economist, said that virtually every commercial transaction has within itself an element of trust. Indeed, he actually went on saying that it can be plausibly argued that much of the economic backwardness in the world can be explained by the lack of mutual confidence.
Since then, economists have correlated generalized trust, the concept that whether people tend to trust each other in an anonymous way with economic growth, and they found the remarkable correlation between these two variables.
It was actually, though, quite puzzling why there was such a strong correlation between the way people tend to interact in certain communities and economic prosperities.
So, economists start wondering, what is the missing link between these two variables?
One of the hypotheses postulated is that the missing link could be finance. Why? Well, in finance, a fundamental element is credit. And indeed, the word “credit” comes from ‘credere’ in Latin, which means to trust. Why is that so?
It takes a lot of trust for people to depart with their money in exchange for a promise. And this is fundamentally the way finance works.
We delegate a broker, an insurance company, a bank, we put our money in their in their hands in exchange of a future promise. And for a long time, we’re not going to see the money that we gave to them.
Now, finance is very, very important for economic prosperity. We know from years of research that without finance, allocation of resources doesn’t happen properly and economic prosperity doesn’t happen.
BUMPER: Exploring Trust through the Stock Market
Given the hypothesis postulated by economists that finance is the missing link between trust and economic prosperity, economists start investigating empirically whether indeed trust facilitated development of financial contracts in various economies.
They started studying the willingness people have to invest in the stock market.
Investment in the stock market has been one of the puzzling features in financial economics, because we know by observation that many people deliberately stay away from the stock market even when they would benefit from investing in it.
Therefore, it was reasonable to think whether, besides all the other variables that economists generally considered as determinant of investing in the stock market—such as risk aversion—trust was a big player in this decision.
Economists studied whether people that have lower generalized trust are less likely to invest their money in risky investment, such as putting their money in the stock market or even opening a checking account.
And they found a remarkable correlation between the level of generalized trust that individuals have with their willingness to invest their own money.
They also found a remarkable correlation between areas where there is a generalized low level of trust and the development of financial markets in general, suggesting that indeed this link between trust and economics could be indeed going through finance.