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Why social trust aids innovation and economic growth

From the archive | 15 March 2017

China Business Knowledge

A new study reveals the chemistry of a productive relationship

This article is republished with permission from China Business Knowledge, the knowledge platform of Chinese University of Hong Kong (CUHK) Business School. You may access the original article here.

Using a sample of 23 industries in 43 countries across a period of nearly two decades, CUHK Business School professor Wenrui Zhang teamed up with Fei Xie of the University of Delaware and Bohui Zhang from UNSW Business School to investigate the impact of social trust on technological innovation and a country's economic growth – in particular, the relationship between social trust and corporate innovation and how it 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 Zhang, a professor in the school of banking and finance at UNSW Business School.

"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 Zhang, economic activities are regulated by a 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 behaviour of firms involved in economic transactions.

"How social norms affect specific corporate policies and outcomes, especially those with long-term economic implications, remains 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," Zhang says.

'A key ingredient for innovation is a healthy amount of scepticism among collaborating parties'
- BOHUI ZHANG

Healthy scepticism

For the 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 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," Zhang says.

However, he warns that too much trust may stifle corporate innovation: "A key ingredient for innovation is a healthy amount of scepticism among collaborating parties. But when collaborating parties trust each other too much, they could develop affinity and reduce peer scepticism, and innovation activities may fail to deliver a desired outcome."

Specific channels

To test the hypotheses, the study utilised data from a large international sample of 10,205 industry-year observations across 43 countries during the period from 1990 to 2008.

To measure the level of social trust in a country, the researchers defined it 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 measured the innovation output by using the number of patents a country generates and the number of citations they receive post registration. This way, they could examine the quantity and quality.

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, a 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, the study 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 example, 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," Zhang says.

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 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."

According to Zhang, the higher trust countries include China, India, Indonesia, Korea, Saudi Arabia, Japan and New Zealand.

'Within firms ... a less hierarchical organisation structure or a flatter organisation structure will definitely encourage trust'
- BOHUI ZHANG

Innovative industries

In light of 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 Zhang.

The 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 have 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 the innovation process," says Zhang.

"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, 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 organisation structure or a flatter organisation structure will definitely encourage trust. Moreover, social equality will help enhance the social trust as well," he concludes.

Innovation

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<h1>Why social trust aids innovation and economic growth</h1>

<figure><img src="https://assets-us-01.kc-usercontent.com:443/4df0558d-5779-0012-00f2-b3fa06d6c950/a3b2c7df-2d4c-4c7f-a6af-0b4ae9c22a60/Social%20Trust.jpg?w=1320" alt="Social Trust" /><figcaption>Social Trust</figcaption></figure>
 This article is republished with permission from <a href="http://www.bschool.cuhk.edu.hk/faculty/cbk/index.aspx">China Business Knowledge</a>, the knowledge platform of Chinese University of Hong Kong (CUHK) Business School. You may access the original article <a href="http://www.bschool.cuhk.edu.hk/faculty/cbk/article.aspx?id=70106406">here.</a>
Using a sample of 23 industries in 43 countries across a period of nearly two decades, CUHK Business School professor Wenrui Zhang teamed up with Fei Xie of the University of Delaware and Bohui Zhang from UNSW Business School to investigate the impact of social trust on technological innovation and a country's economic growth – in particular, the relationship between social trust and corporate innovation and how it 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 Zhang, a professor in the school of banking and finance at UNSW Business School. 
"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 Zhang, economic activities are regulated by a 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 behaviour of firms involved in economic transactions. 
"How social norms affect specific corporate policies and outcomes, especially those with long-term economic implications, remains 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," Zhang says.
<blockquote>'A key ingredient for innovation is a healthy amount of scepticism among collaborating parties'- BOHUI ZHANG</blockquote>
<h4>Healthy scepticism</h4>
For the 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 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," Zhang says. 
However, he warns that too much trust may stifle corporate innovation: "A key ingredient for innovation is a healthy amount of scepticism among collaborating parties. But when collaborating parties trust each other too much, they could develop affinity and reduce peer scepticism, and innovation activities may fail to deliver a desired outcome." 
<h4>Specific channels</h4>
To test the hypotheses, the study utilised data from a large international sample of 10,205 industry-year observations across 43 countries during the period from 1990 to 2008. 
To measure the level of social trust in a country, the researchers defined it 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 measured the innovation output by using the number of patents a country generates and the number of citations they receive post registration. This way, they could examine the quantity and quality. 
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, a 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, the study 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 example, 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," Zhang says. 
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 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." 
According to Zhang, the higher trust countries include China, India, Indonesia, Korea, Saudi Arabia, Japan and New Zealand.
<blockquote>'Within firms ... a less hierarchical organisation structure or a flatter organisation structure will definitely encourage trust'- BOHUI ZHANG</blockquote>
<h4>Innovative industries</h4>
In light of 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 Zhang. 
The 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 have 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 the innovation process," says Zhang. 
"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, 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 organisation structure or a flatter organisation structure will definitely encourage trust. Moreover, social equality will help enhance the social trust as well," he concludes.

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