This piece was written by Dimitri Zenghelis, who leads the Wealth Economy project at the Bennett Institute, Cambridge. He is also a Senior Visiting Fellow at the Grantham Research Institute at the LSE, where, from 2013-2017, he was Head of Climate Policy. For more like this, see our environmental policy newsfeed.
Wealth is our best measure of prosperity. It captures a stream of benefits into the indefinite future, not just today’s income.
These future benefits include the consumption of goods and services, of course. But they also accrue from living in a trusting, stable and fair society. People are evidently willing to forgo current economic goods to secure the latter, so it is appropriate to consider these intangible social assets as part of our wealth.
But what exactly is this social capital and how important is it for prosperity?
Social capital encompasses personal relationships, civic engagements and social networks as well as the social norms and values which shape acceptable behaviour. Social capital is a resource for individuals, whereby people access support and opportunities, but it is also a public resource for society in general. The shared norms and rules enable cooperation and reduce the costliness of economic exchange by building trust.
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As a result, social capital is often referred to as the glue that holds societies together. Without it, there can be little or no economic growth or human wellbeing.
This notion has strong intuitive appeal, but social capital has proven hard to pin down, not least because it encompasses so many interrelated elements. Most of these elements relate closely to generalised trust across a society and the functionality of key institutions. Generalised trust enables social and economic cooperation. Some argue that “social capital” can therefore be best understood as a means to creating trust.
We gain direct utility from living in a trustworthy society
A key channel from social capital to economic outcomes is reduced transaction and monitoring costs, allowing the efficient allocation of resources in goods, labour and capital markets.
Society wastes resources when people distrust and are dishonest with each other. The economic literature on repeated games and punishment shows why cooperation makes social sense when people expect to interact in the future. Yet people are surprisingly cooperative over and above what theory suggests is in their immediate self-interest. This probably reflects the fact that we gain direct utility from living in a trustworthy society; perhaps for evolutionary reasons, social connectedness brings most humans intrinsic pleasure.
The World Bank has begun to measure the “true wealth” of nations, taking into account economic and natural capital, as well as “intangible” productive capital. The latter is regarded as consisting primarily of human, social and institutional capital. The Bank estimates that intangible capital may make up between 60% and 80% of total wealth in most developed countries. Further studies show that much of this is social capital.
Robust social capital based on trust, civic engagement and effective institutions goes hand-in-hand with economic wellbeing and economic growth.
One influential study found that a moderate increase in a survey-based measure of country-level trust significantly increases economic growth (not just the level of activity). Workers in poor countries turn out to be three to five times less productive than those in the United States, taking account of the quality of machines and skill levels available for production. Yet when these same workers migrate, they quickly earn salaries comparable to those of workers in their new countries.
Something unrelated to the amount of physical and human capital available seems to be holding back productivity in poor countries.
Governments can and should invest in the quality of economic and political institutions
It is of course likely that generalised trust and the quality of governance are a result of, as well as a cause of, productivity growth and higher reported wellbeing. These feedback mechanisms mean sustained, carefully targeted policy interventions could trigger a virtuous cycle of good governance and higher productivity. Governments can and should invest in the quality of economic and political institutions.
A number of studies find that the quality of institutions and economic policies explains a significant part of the variation in growth rates across countries. Others find that the quality of governance and institutions is important for explaining rates of investment. Good institutions, checks on government that limit corruption, and environments that encourage social inclusion, creativity, and enterprise tend to attract investment and benefit from learning, experience, and innovation.
The changes in governance and economic policy when Deng Xiaoping reformed Maoist mainland China, or the reforms in South Korea after Park Chung-hee replaced Syngman Rhee offer historical examples. Even unsavoury regimes have sometimes engendered economic stability for middle-class entrepreneurs.
Cross-sectional evidence also illustrates institutions exerting different economic influences on culturally similar societies: East and West Germany during the Cold War; North and South Korea; mainland China compared to Hong Kong and Taiwan. In all these cases, institutional change preceded — and appeared to cause — changes in productivity.
When Daron Acemoglu and James Robinson asked in their bestseller Why Nations Fail?, they concluded that the main determinant of economic prosperity was functioning, inclusive and law-based institutions.
The centrality of institutions explains the infamous “resource curse”: some countries with large endowments of primary commodities fail to benefit from subsequent economic growth when politically powerful groups enrich themselves through unabated rent-seeking and corruption. Corruption causes significant dissipation of resources. In rich countries, increasing focus is being paid to the role of institutions and generalised trust in explaining growing disaffection and populism among the “left behind”.
This year’s Nobel Prize winner Paul Romer pointed out that innovation which drives endogenous growth is not limited to technological capital and knowledge capital; it also applies to rules, governance, and policies, all of which drive total factor productivity.
Any policies not built on strong foundations of trust and effective institutions will fail
He argues that social rules often hold back the potential introduction and exploitation of new technology. Indeed, new technologies are potentially harmful if not accompanied by rules that make growth sustainable — for example, rules that limit pollution, soil degradation, and overfishing; or rules that regulate economic rent seeking from innovation via patents or market power.
The policy response to climate change, perhaps the most pressing social challenge of our generation, and to coping with the challenges presented by new technologies such as AI, big data and automation requires institutions that enable the implementation of a range of policies with winners and losers. Any policies not built on strong foundations of trust and effective institutions will fail.
This is why improving the quality of statistics and information on the social capital is vital. Even partial success in developing metrics while acknowledging what is missing, can better help inform policy and business decisions.
The New Zealand Treasury already augments GDP with a small dashboard recording access to key assets including social capital. Our Wealth Economy project aims to improve the measurement of social capital and enhance statistical research globally. The aim is to establish guidelines for standardised comparative measures.
The potential returns for society are hard to overstate. — Dimitri Zenghelis
This piece was first published on the Bennett School blog.
(Picture credit: Unsplash)