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 two-stage 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.

Keywords: Trust, Growth, Regulation

JEL Classifications: D11, D63

Working Paper Series