Trust, Governance, and Growth: A Simultaneous Equation Approach

Abstract

This thesis aims to establish the empirical relationship between trust, governance, and economic growth. Initially, a conceptual model grounded in institutional economic theory is developed to help guide the subsequent empirical model. Aspects unique to the conceptual model, as compared to previous literature, include a hypothesized interdependent relationship between trust, governance, and growth. Feedback effects imply two, distinct paths that countries can take. High initial trust endowments create a social environment conducive to high-quality, formal institutions, that ultimately sets a country on a trajectory of high economic growth. Conversely, a trust-governance trap exists, where countries with low initial trust endowments create poor formal institutions that result in sustained levels of low economic growth. An empirical model that reflects the interdependent relationship between trust, governance, and growth is then established. Contrary to previous studies, trust and governance are modeled econometrically as a non-recursive system of equations with feedback effects. In this empirical form, trust and governance are shown to be positively related to one another. Statistically significant total effects imply the existence of the hypothesized trust-governance trap. European colonization, social diversity, and income inequality play important roles in determining the nature of the relationship. Finally, modeled in a similar, simultaneous fashion, trust is shown to have a significant, sizable, positive effect on long-term economic growth (1970-2009). A major contribution is the extension of the empirical sample to a much larger set of countries, more representative of the world at large. Results are tested for robustness to the exclusion of statistical outliers and countries that exhibit trust values inconsistent with the dimensions of trust hypothesized to be theoretically related to economic development.