Economics & Finance
• 7 minute read
How Trust Affects a Country’s Economic Growth through Innovation
The importance of trust in business has been widely recognized. However, how does trust influence a country’s economic growth? What is the relation between social trust and innovation development?
By Fang Ying, Senior Writer, China Business Knowledge @ CUHK
Using a large sample of 23 industries in 43 countries from a period of nearly two decades, CUHK Business School professor Wenrui Zhang teamed up with his collaborators, Fei Xie of the University of Delaware and Bohui Zhang of the University of New South Wales, to investigate the impact of social trust on technological innovation and a country’s economic growth, in particularly, the relation between social trust and corporate innovation and how such a relation translates into economic growth and productivity improvement in a country.
“Does social trust affect an economy’s long-term growth? This is what we’d like to find out in our research,” says Prof. Zhang, Assistant Professor in the Department of Finance. “To answer this question, we focus on innovation as it’s a key contributor of long-term economic growth in the 20th and 21st centuries.”
According to Prof.Zhang, economic activities are regulated by legal system and social norms. While the enforcement of legal rules can be effective, it is also difficult and costly to implement. On the other hand, the detection of social norm violations is easy and the punishment by the society is swift. Hence, social norms can play an important role in regulating the behavior of firms involved in economic transactions.
“How social norms affect specific corporate policies and outcomes, especially those with long-term economic implications, remain unknown. We decided to look at the issue by focusing on interpersonal trust which is a key dimension of social norms, and technological innovation which is an important value driver and growth engine for firms,” he says.
Two Competing Hypotheses
For the purpose of this study, the researchers proposed two competing hypotheses: “A higher level of trust in a society may enhance corporate innovation”, and “A higher level of trust in a society may impede corporate innovation”.
There are three reasons underlying the first hypothesis. First, a higher level of trust can facilitate coordination in a firm or across firms by encouraging innovators to share ideas and knowledge which can potentially boost the innovation. Second, a higher level of trust can provide a greater tolerance for failure by allowing innovators to take actions without fear of the adverse consequences. Third, innovative firms typically have an expanded set of investment opportunities. As a result, they are more likely to exhaust internal capital and rely heavily on external equity finance.
“As such, we believe that a higher level of trust can reduce investors’ concern, lower firms’ financial constraints and allow firms to pursue long-term investment,” Prof. Zhang says.
However, Prof. Zhang warns, that too much trust may stifle corporate innovation. He says: “A key ingredient for innovation is a healthy amount of skepticism among collaborating parities. But when collaborating parties trust each other too much, they could develop affinity and reduce peer skepticism, and innovation activities may fail to deliver a desired outcome.”
To test the hypotheses, the study utilizes data from a large international sample of 10,205 industry-year observations across 43 countries over the period from 1990 to 2008. To measure the level of social trust in a country, the researchers define social trust as the average response in each country and year to the question in the World Values Survey: “Generally speaking, would you say that most people can be trusted or that you need to be very careful in dealing with people?” Then they measure the innovation output by using the number of patents a country generates and the number of citations they receive post registration. This way, they can examine the quantity and quality of innovation input.
Boosting Innovation through Three Channels
The results show that the level of social trust in a country is positively related to the innovation output, and this relationship is both economically and statistically significant.
To be specific, 15% increase in a country’s social trust leads to a 59% increase in the number of patents and a 55% increase in the number of citations. This result is consistent with the first hypothesis that a higher level of trust in a society enhances innovation. What’s more to the study is that it also identifies the specific channels through which social trust has such a positive effect on innovation: Collaboration channel, tolerance channel, and funding channel.
Regarding the collaboration channel, the study reveals that the effect of trust on innovation is more pronounced in countries with weaker contract enforceability or poorer intellectual property protection, for examples, Korea, Mexico, China, Saudi Arabia and India. “This suggests that social trust, as an effective informal contract mechanism, enhances innovators’ collaboration and thus spurs innovation,” Prof. Zhang comments.
As for the tolerance channel, the study shows that social trust plays a more important role in spurring innovation in countries with weaker legal protections to innovators, for instance, Brazil, Chile, Japan and New Zealand. “The finding is consistent with the argument that social trust as a tolerance mechanism promotes firms’ innovation by reducing innovators’ concern about the consequence of innovation failure,” says Prof. Zhang.
“We believe that the innovation created in a high-trust environment contributes more to a country’s long-term economic growth.” Prof. Wenrui Zhang
In terms of funding, the study finds that the effect of social trust on innovation is stronger for countries with weaker auditing and accounting standards, or lower financial information transparency, such as Argentina, Indonesia, Russia and Turkey. “Our finding suggests that social trust can boost innovation by improving innovative firms’ information transparency,” he says.
According to Prof. Zhang, among these countries, the higher trust countries are China, India, Indonesia, Korea, Saudi Arabia, Japan and New Zealand.
Impact on Long-term Growth
Given these results, does social trust affect a county’s long-term growth through innovation? The answer is yes.
Given that an economy grows due to either improvement in productivity or capital accumulation, the study calculates both industry value added growth as total growth and the growth of industry total factor productivity (TFP) for each country and industry.
The research finds that social trust has a positive effect on these two indexes. More importantly, it finds that such positive effect is mainly driven by innovative industries. That is to say, social trust promotes industry value added growth and industry TFP growth mainly through enhancing the innovation output in innovative industries.
“In our study, we observe such positive relationship between trust and economic growth. Particularly, trust promotes economic growth and productivity gains, mainly in industries with more innovation potential,” says Prof. Zhang.
Unlike previous studies, this study is the first to examine the effect of trust on corporate innovation from a large dataset in a multi-country setting.
Moreover, while previous studies on international innovation has identified a number of country-level variables that explain differences in innovation output, this study provides the first evidence on whether a country’s informal institutions, in particular social trust, affect the innovation process, as well as the evidence on an important channel through which trust promotes value creation in a country.
“We identify innovation as a channel through which trust affects economic growth, and further confirm the beneficial role of trust in innovation process,” Prof. Zhang says. “We believe that the innovation created in a high-trust environment contributes more to a country’s long-term economic growth.”
As such, in terms of boosting the innovation development in industry, Prof. Zhang suggests that firms or governments should help create an environment for cultivation of social trust.
“This is especially important for innovative industries. Within firms, for example, a less hierarchical organization structure or a flatter organization structure will definitely encourage trust. Moreover, social equality will help enhance the social trust as well,” he concludes.