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This paper investigates the relationship between trust and macroeconomic volatility. An illustrative model rationalizes the relationship between trust and volatility. In this model, trust relaxes credit constraints and diminishes investment’s procyclicality. I provide empirical evidence for the basic predictions of the model. Then, I show that higher trust is associated with lower macroeconomic volatility in a cross section of countries. This relationship persists when various covariates are taken into account. I use inherited trust of Americans as an instrumental variable for trust in their origin country to overcome reverse causality concerns. Using changes in inherited trust over the 20th century, I do not find clear evidence that increasing trust is also associated with decreasing volatility across time at the country level.

The cost of real macroeconomic volatility in terms of well-being has been shown by Wolfers (2003) to be important. Thus, all its potential sources deserve attention. This paper investigates the relationship between trust and macroeconomic instability. I first present an illustrative model linking trust to economic volatility through the procyclicality of investment and test its main prediction. Then, I show that higher trust is correlated with lower macroeconomic volatility in a cross section of countries. I focus on this relationship and show that it is robust to the introduction of various covariates. I address reverse causality by using inherited trust of Americans immigrants as an instrument for latent trust in their origin country. Then, using changes in inherited trust between 1910 and 1970, I show that there is little evidence that trust also reduces macroeconomic instability across time at the country level. In Fig. 1, trust is measured in each country by the share of people who answer “most people can be trusted” to the following question of the World Values Survey between 1981 and 2008: “Generally speaking, would you say that most people can be trusted or that you need to be very careful in dealing with people?”. Macroeconomic instability is represented by the standard deviation of real GDP per capita growth rate between 1970 and 2008. The negative relationship between these two variables is highly significant. Differences in trust explain up to a third of differences in volatility across countries.The fact that cultural traits such as norms of cooperation, civic spirit or beliefs regarding the behavior of others have an impact on macroeconomic performance has been massively explored by the literature.1 Most papers investigating the relationship between trust and economic performance from an aggregate point of view have focused on growth or economic development, emphasizing the role of investment. See for example Knack and Keefer, 1997 and La Porta et al., 1997, or Algan and Cahuc (2010) among others. In this paper, I depart from this literature by looking at macroeconomic stability, an unexplored economic outcome that may be partly explained by trust as suggested by the relationship presented above. Trust is an indicator of social capital. This later concept has been defined by Putnam (2000) as “the collective values of all social networks and the inclinations that arise from these networks to do things for each others”. Trust represents a set of beliefs that favor inter-personal cooperation within the society. Trust may thus favor economic performance, especially in decisions such as investment’s decisions. Trust may favor macroeconomic stability through three channels. First, since trust implies extended civic behavior, it may be associated with better economic management by the authorities if it reflects greater cohesion of the society. Indeed, it has been shown by Knack and Keefer (1997) that countries with higher trust have also better institutions. According to Acemoglu et al. (2003), countries with better institutions exhibit lower macroeconomic volatility. Hence, if trust deters the discretionary use of public expenditure it can thus implies weaker macroeconomic volatility due to less volatile policies. Second, the cohesion of society can also translate into social stability. As a consequence, civil conflicts, violence, and political instability in general are less frequent in high-trust countries. This may results in lower economic volatility since internal conflicts are a major source of shocks for any economy. Third, following Glaeser et al. (2000), trust, the most general dimension of social capital, is closely linked to trustworthiness.2 Hence, individual trust can be considered as empathy or as an individual commitment to behave well with other agents. This decreases costs of interactions and allows to build expectations and plans with greater certainty. In line with this reasoning, Knack and Keefer (1997) documented a positive relationship between trust and the share of investment in GDP. In this paper, I present an illustrative model à la Aghion et al., 2010b and Aghion et al., 2012 where credit constraints favor the procyclicality of investment. I then introduces trust as a way to relax credit constraints and thus to reduce investment’s procyclicality. I test the main predictions of the model, i.e. that more trust allows deeper financial development, that trust favors long-term investment, and that private investment’s procyclicality and volatility are lower in high-trust than in low-trust countries. Although explaining the deep mechanisms of these channels at the micro-economic level is beyond the scope of this paper, these three explanations are tested throughout the paper. I show that channels running through the quality of institutions or social cohesion do not fully explain the negative relationship between trust and macroeconomic volatility. The three channels mentioned above from trust, and social capital in general, to macroeconomic stability can be found under alternative and various forms in the literature that investigates the impact of culture and social capital on economic outcomes. In that dimension, this paper is closely related to all researches that document a link from social capital to economic outcomes. After the seminal work by Putnam (1993), lots of evidence about the impact of social capital on economic performance have been raised by scholars. Knack and Keefer (1997) showed that countries with higher social capital have also better institutions, higher and more equal incomes, and a better educated population. Similar evidence have been provided by Tabellini (2010) in the case of European regions. Guiso et al., 2008a and Guiso et al., 2008b presented some evidence about the way economic experiences from the distant past may shape current economic performance, through transmission of adequate norms. Dincer and Uslaner (2010) have found a positive relationship between trust and growth. More recently, Algan and Cahuc (2010) provide new evidence regarding the impact of trust on economic development. See also La Porta et al., 1997, Zak and Knack, 2001, Knack, 2001 and Tabellini, 2008 among others for additional developments. A key aspect of this literature is whether beliefs such as trust are altered by the economic environment. A first approach considers that norms and values of a society are very sticky and slow moving parameters, therefore weakly altered by current events. On the opposite, a second approach emphasizes the changes in beliefs induced by changes in the current economic situation. My view is closer to the former approach. In this paper, I assume that trust is a latent component of a society. Consequently, I consider that latent culture is unaffected by macroeconomic volatility. The first set of results presented in this paper explicitly relies on this assumption. Indeed, I first measure trust through the widely used question of the World Values Survey, using the share of trusting people as a proxy for generalized trust at the country level during the last quarter of the 20th century. This variable is negatively and significantly correlated with macroeconomic volatility between 1970 and 2008. However, the hypothesis that the current level of trust may be impacted by current macroeconomic outcomes cannot be fully rejected. For example, it has been shown by Giuliano and Spilimbergo (2009) that people who experienced recessions during early adulthood are likely to have lower individual social capital. Hence, a measure of trust that is unaltered by macroeconomic instability is required to rule out reverse causality concerns. Subsequently, I confirm earlier results by using inherited trust of Americans as an instrument for the latent trust in their origin country. This method, inspired by Carroll et al. (1994) and used by Fernández and Fogli, 2006 and Fernández and Fogli, 2009 among others, overcome reverse causality. Using this instrumental variable strategy confirms the negative relationship between trust and volatility. Accordingly, the main result presented in this paper is that trust decreases macroeconomic volatility in space, i.e. across countries. However, this does not mean that higher trust is associated with higher economic stability at the country level. In order to investigate this question, I use a time-varying measure of trust. Such a measure does not exist for a long period of time because values surveys have only been conducted and generalized since the eighties. Consequently, to overcome data shortage regarding the time variation of trust, I use the methodology developed by Algan and Cahuc (2010) to track changes in trust using changes in inherited trust measured with different waves of Americans immigrants. This method allows to exploit the changes in trust over the 20th century. There seems to be no clear evidence that countries which have experienced an increase in trust also experienced a decrease in macroeconomic volatility. In regressions presented in this paper, trust is proved to be an important determinant of macroeconomic stability across countries. However, it is not the only one. Following Lucas (1988), a rich literature has examined the key determinants of macroeconomic volatility. One part of this literature focuses on market failure, often credit constraints, as a source of economic fluctuations (see Kiyotaki and Moore, 1997 and Gertler and Kiyotaki, 2010 and followers). Other papers, such as Koren and Tenreyro, 2007 and Koren and Tenreyro, forthcoming pointed the role of industrial structure to explain how economies react to shocks. The illustrative model à la Aghion et al., 2010b and Aghion et al., 2012 presented in this paper illustrates how trust may play a role in explaining economic volatility through access to credit. Empirical evidence advocate in favor of trust impacting macroeconomic volatility on top of its traditional determinants, including institutions facilitating financial development such as the protection of property rights or legal origins. Another part of this literature focus on the institutional and political context. For example, Alesina and Drazen (1991) argue that stabilizations are delayed because interest groups fight to know who will bear the economic burden. In the same vain, Rodrik (1999) shows that the greater latent social conflicts in a society and the weaker its institutions of conflict management, the larger the effects of external shocks on growth. In the case of less developed countries, Acemoglu et al. (2003) state that macroeconomic fluctuations arise from turbulence created by politicians in weakly institutionalized economies. See also Fernández and Rodrik, 1991, Francois and Zabojnik, 2005 and Acemoglu et al., 2008 for a focus on reforms feasibility. This literature points out the important role of institutions quality in economic management. My results suggest that trust acts on top of formal institutions. This leaves open the possibility of a joint interpretation of institutions and trust, or norms of cooperation in general, these two variables mutually reinforcing, as stressed by Francois (2008). The remaining of this paper is organized as follows. I present and discuss the illustrative model in Section 2. In the same section, I also provide simple evidence on the basic predictions of the model. and briefly discuss how alternative interpretation of the model could be tested. The data used in this paper and the estimation strategy are presented in Section 3. In Section 4, I present simple cross section estimates. Results using inherited trust as an instrument for trust in cross section and panel estimations are presented in Section 5. This allow to overcome reverse causality between economic fluctuations and trust. The within-country relationship between trust and macroeconomic volatility which turns out to be insignificant. Finally, Section 6 briefly concludes.

In this paper, trust has been shown to be negatively associated with macroeconomic instability in a cross section of countries. Higher trust weakens the standard deviation of real GDP per capita growth rate, and limit the amplitude of downturns. Using trust of Americans as a latent indicator of trust in their origin country, I provided additional evidence of these effects, avoiding potential reverse causality concerns. Applying the same method to track changes in trust across the 20th century, I do not find any evidence that higher trust is accompanied by lower macroeconomic volatility over time at the country level. I present an illustrative model that suggests that trust lower macroeconomic volatility by its action on investment’s procyclicality. In the last section, I test the basic predictions of this model, i.e. that more trust allows more deeper financial development, that trust favor long-term investment, and that private investment’s procyclicality and volatility are lower in high-trust than in low-trust countries. This advocates the idea that trust weakens economic volatility by orienting private investment toward long-term activities. All in all, evidence presented in this paper suggest that trust is likely to be a key determinant of macroeconomic stability. This set of aggregate results calls for further research to investigates both theoretically and empirically how trust translate to more stable investment at the individual level.