1. Paper prepared for
International Conference of Political Economy: Adam Smith Today,
Kocaeli University, Turkey 1-4 October 2009
The Issue of Trust in Developing Countries:
Was Adam Smith Right and Are Modern Economists
Wrong?
Max Berre
Knowledge House Maastricht
Albert Schram
Maastricht University
Introduction
In low and middle-income countries, markets frequently fail to perform adequately. What makes the
malfunctioning of these markets particularly relevant is that the resulting welfare effects and
efficiency losses have a much larger social impact than in high income countries. Amongst the causes
on the one hand “hard” conditions regarding the legal system, and on the other hand “soft”
conditions concerning codes of business and personal behaviour have been highlighted (Sen 1999).
Hernando de Soto (2003) has pointed out the “hard” legal and institutional conditions which cause
“the failure of capitalism”, principally the absence of transferable and enforceable property rights
and enforcement of contract law. The absence of enforceable property rights, as well as the high cost
associated with legal or permitting procedures give rise to enormous quantities of “dead capital”.
This capital is de facto owned by the poor, but can not be used as collateral to obtain necessary
credit, thus in many cases excluding the majority of the population from the market economy (De
Soto 2003).
Although the “hard” institutional were of course different in 18th and 19th century Europe and in
today’s low and middle income countries, at general level we can observe similarities in the
imperfections of the working of markets. Amartya Sen (1999) citing Adam Smith’s Theory of Moral
Sentiments (1759), and An Inquiry into the Nature and Causes of the Wealth of Nations (1776), has
emphasized the "soft" conditions connected to trusting and trustworthy behaviour, and the upkeep
of ethical norms for a functioning market economy: “The development and use of trust in one
another's words and promises can be a very important ingredient of market success.”(Sen 1999).
Alvaro Vargas Llosa has worded the same idea more generally and strongly: “No institution can be
built on anything other than trust in order to function”.
In this article, we contrast a number of key writings in classical and neo-classical economic theory
with the recent behavioural and development economics literature, comparing the answers to the
question whether the existence of trust and the upkeep of ethical norms is a condition for the
development of market institutions, or conversely whether trust is a consequence of functioning
markets?
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2. First, we reflected on the approach to this question in the seminal works of Adam Smith’s Moral
Sentiments (1759) and Wealth of Nations (1776). Secondly, we reviewed some of the recent
literature on inter-cultural communication and in behavioural economics on trust experiments in
developing countries, and compared the results to arguments from classical and neo-classical
economics. In inter-cultural communication literature, trust is mainly viewed as a condition for
wealth creation through functioning market institutions. Conversely, in behavioural economics
trusting and trustworthy behaviour – reciprocity - is seen as a consequence of institutional
arrangements, including of course markets. In the light of these results, what if any light can Adam
Smith shed on the question whether trust is a condition, or a consequence of successful market
capitalism?
Finally, we report the results of a trust experiment done in Costa Rica in the vein of Berg, Dickhaut
and McCabe (1995), comparing trust level and experienced market operators and inexperienced
operators, i.e. economics undergraduates. The results of these experiments broadly endorse our
conclusions.
Trust in 18th and 19th Century Europe
Amartya Sen (1999) famously interpreted Adam Smith’s remarks on the ‘invisible hand’ as an
unintended consequence of production and consumption, rather than as a fundamental premise for
functioning markets. According to Sen, the ‘invisible hand’ can not be made into a doctrine justifying
minimal involvement of the state. Smith’s assertion that “It is not from the benevolence of the
butcher the brewer, or the baker that we expect our dinner, but from their regard to their own
interest”, can not be separated from Smith’s emphasis on trusting and trustworthy behaviour in
Moral Sentiments1, or the importance of the role of the state in administering justice, upholding
contracts and providing basic education in Wealth of Nations2.
We wish to take Sen’s observation a step further by pointing out the role of trusting and trustworthy
behaviour as a cause as well as a consequence of successful markets is present in Smith’s reasoning.
We also wish to underline the central place of trust in his thinking, and his attention for the mutually
reinforcing nature of trusting and trustworthy behaviour.
Regarding trust as a consequence, on Moral Sentiments Smith refers to the Roman concept of
necesitudo as the development of friendly relations among people who frequently interact such as
traders, noting it etymology suggesting that it was imposed by the necessity of the situation. Trade
relations would cause trusting and trustworthy behaviour. As to trust as a condition, Smith mentions
that mutual affection and love among different men as among different merchants is not a necessary
condition for their successful interaction, but that it can also derive from a “sense of utility”. This is
the “brewer, butcher, baker” theme.
It seems Smith describes in Moral Sentiments a virtuous cycle or mutually reinforcing process in
which “We trust the man who seems willing to trust us”, and conversely we are trusted because we
show trust. Similarly in Wealth of Nations, Smith discusses the issue of trust mostly in relation to
1
Smith, Moral Sentiments, Section IV "Frankness and openness conciliate confidence. We trust the man who
seems willing to trust us.”
2
Smith, Wealth of Nations, Ch II: “Commerce and manufactures can seldom flourish long in any state which
does not enjoy a regular administration of justice; in which the people do not feel themselves secure in the
possession of their property; in which the faith of contracts is not supported by law; and in which the authority
of the state is not supposed to be regularly employed in enforcing the payment of debts from all those who are
able to pay. Commerce and manufactures, in short, can seldom flourish in any state, in which there is not a
certain degree of confidence in the justice of government.”
2

3. credit. He emphasises that being trusted and obtaining credit depends on one’s “fortune, probity and
prudence” or in modern terms: financial success, moral integrity, and careful management.
Receiving trust and therefore credit is thus a consequence of trustworthy behaviour, which may or
may not be enforced by the state. The keeping of contracts and absence of “prodigality” are seen as
conditions for functioning market economy. The prodigal impoverishes the country “by not confining
his expense within his income, he encroaches upon his capital.” In Smith’s word: “If the prodigality of
some were not compensated by the frugality of others, the conduct of every prodigal, by feeding the
idle with the bread of the industrious, would tend not only to beggar himself, but to impoverish his
country.” Similarly, the so-called “projectors” try to obtain credit for highly risky investment, mostly
on the stock exchange, by promising huge profits. In the end, when none of these fortunes
materialize, the “projectors” carry a large number of credulous investors with them into financial
ruin. Then, as now, the lack of self-control and abuse of trust of others of these “prodigals and
projectors” cause immense damage.
Regarding trust, Smith makes some penetrating behavioural observations again comparing animals
and humans: “When an animal wants to obtain something either of a man, or of another animal, it
has no other means of persuasion, but to gain the favour of those whose service it requires. A puppy
fawns upon its dam, and a spaniel endeavours, by a thousand attractions, to engage the attention of
its master who is at dinner, when it wants to be fed by him. Man sometimes uses the same arts with
his brethren, and when he has no other means of engaging them to act according to his inclinations,
endeavours by every servile and fawning attention to obtain their good will.” The behavior of Smith’s
spaniel is showing trust, or putting oneself in a vulnerable position, with the purpose of inviting
reciprocity, in this case the Spaniels’s dinner.
Now comes the key phrase unlike animals in their non-civilized state: “He has not time, however, to
do this upon every occasion.” What is Smith referring to here?
We don’t have to limit ourselves to the Theory of Moral Sentiments or Wealth of Nations to discover
what Adam Smiths vision was on the role of contracts and trust. In 1763 he gave the “Lecture on
jurisprudence” which treat the subject extensively. p. 108 “Oaths we may observe are most in use
amongst barbarous and uncivilized nations; as they are there thought necessary to signify plainly the
will of the person; as the language is not fixt in its meaning; and in the state of the greatest barbarity,
an oath is thought necessary to confirm every thing that is deliverd. Contracts (as I said) at first could
be only made betwixt parties who were present; contrahitur tantum inter praesentes non autem
inter absentes. But when commerce was more extended, it was found necessary to extend the power
of making contracts.” So contracts, with exact wording and made on trust in absence with one of the
parties are the human artefact that avoids us from wasting time like the spaniel in the Wealth of
Nations.
We need enforcement of contracts, which lower the amount of trusting behavior in which we have
to engage. Trust however can never be eliminated. This reminds us of de Soto’s idea of development
as formalization, and North’s idea a system of effective, low-cost enforcement of contracts. Humans,
unlike animals, have no time to engage in expressions of trust and friendship. Instead, they have
contracts, which require a proper administration of justice.
Smith thus places trust as a central element in all human interactions, including production,
consumption and trade. In his view, the enforcement of contracts by the state causes trust levels to
rise, markets to function, and trustworthy behaviour to increase. Conversely, trust is also a necessary
condition for successful functioning of markets. We know from recent advances in complexity
economics, that positive feedback loops can have quite substantial effects in complex systems
(Beinhocker 2006), and therefore the positive feedback of trusting and trustworthy behaviour could
be quite substantial.
3

4. By contrast, in neo-classical economics trust is placed outside the realm of economics, and there is
little mention of trust as an element in human interactions. Marshall’s Principle of Economics, for
example, the issue of trust and trustworthiness is discussed a few times mostly in the context of the
firm in relation to employee skills and education. In Industry and Trade it is mentioned only once in
the context of relations between multiple owners in a joint stock company and its managers, or as
we would say nowadays in terms of a principal-agency problem. It seems here starts a tradition in
which discussion of trust is placed outside the realm of economic debate, with exception of intra-firm
relations.
One more modern example of the exogenous treatment of trust and other psychological variables is
Zak and Knack’s (2001) article “Trust and Growth”. It starts by noticing Smith’s attention for good
behaviour, “probity” and “punctuality”, but then characteristically jumps to John Stuart Mill’s
nineteenth century view where these individual traits are linked to national characteristics. Nations
are seen as recipients containing higher or lower level of trust, e.g. the Dutch are just naturally more
spendthrift and punctual than the Italians. What is worse than this type of categorical thinking, in the
modelling the positive feedback loop between trustworthy behaviour leading to more trusting
behaviour is simply left out. There is no attention for trust as a consequence of market functioning,
just as a necessary condition. All kinds of regularities are investigated in the article, but the essential
dynamics of the process are missed to a large extent. Gone are the subtleties and behavioural
insights of Adam Smith, in come the gross categories and over-simplifications of John Stuart Mill.
In sum, Adam Smith displays a profound insight into the psychological aspects of market agents.
Moreover, he seems to understand the mutually reinforcing relationship between trusting and
trustworthy behaviour, and better functioning markets. Finally, he understands the resulting
dynamics, outlining the virtuous circle where more cooperative and trustworthy behaviour, leads to
higher levels of cooperation and more trusting behaviour. Neo-classical economics after banning the
theme of “trust” from their models, fortunately are again including it as part of the renewed
attention to economy as a complex system.
Trust in Developing Countries
Although in neo-classical economics, as we saw trust as a topic was practically banned from the
debate, in development economics the topic continued to take centre stage (Henrich, Boyd et al.
2004). Similar to other economists, Johnson and Mislin (2008) describe trust as the willingness to be
vulnerable based on an expectation of cooperation, while trustworthiness is described as the
individual willingness to reciprocate said trust. Societies are seen as following a succession of stages,
in which more trustworthy institutions develop, accompanied by more trusting behaviour.
Institutions require trust to grow both for internal reasons of turnover, productivity, and monitoring
costs as well as for external reasons such as ease of operation within the environment. Institutions
also need purposefully to create trust by increasing their visibility, displaying trustworthiness, and
fostering of cooperation.
Hernando de Soto describes development essentially as the replacement of informal and family or
clan based institutions by formal constructs (De Soto 2003). He remarks there is no lack of
entrepreneurship in the developing world, but it does not produce wealth on a large scale because of
lack of formal market institutions. This idea goes back to Gunar Myrdal who describe the difficulty of
extending trust outside the circle of the family or clan (1968). Douglas North (1990), who did much to
open economists eyes again to the role of institutions wrote: “The inability of societies to develop
effective, low-cost enforcement of contracts is the most important source of both historical
4

5. stagnation and contemporary underdevelopment in the Third World”. There are many different
views on underdevelopment, or rather reasons why certain societies follow specific paths of
development.
At this point, we need to devote some attention to recent theses on economic development, which
through their simplicity enjoyed wide attention, and have led to mono-causal explanations. Certain
literature in economic history has focused on cultural explanations, sometimes combined with
religion and historical accident as explanatory variables for the development of market institutions.
The Weber hypothesis that only protestantism could have promoted the rise of modern capitalism in
Western Europe has been resurrected many times. For example, David Landes’ (1998) explanation of
Latin America’s failure to develop in the 18th and 19th century has a cultural, anti-catholic bias. The
rapid economic growth in Ireland during the last two decades blows in the face of this type of
reasoning. Another extreme example if Lawrence Harrison (1985) who suggests underdevelopment
as a state of mind. Trust is exogenous in these conceptual models, and it is suggested trust is an
inherent dimension of culture, which in turn is seen as mostly stable over time. Francis Fukuyama
(1995) talks about high- and low-trust societies when explaining different levels of economic
development . A rival, geographical and biological explanation of economics can be found in
Diamond (1999), emphasizing the role of factor endowments and geography. In all these cases, those
citing Landes, Harrison or Diamond leave out most of the qualifications and nuance that is present in
the original works. Since the impact of these books is an order of magnitude larger than most other
scholarly writing on the topic, this is a worrying phenomenon.
Geert Hofstede, one of the most quoted social scientists in the world, deepened the analysis of
culture substantially by identifying its five principal dimensions. Since much of the ensuing literature
focuses on inter-cultural communication, the emphasis is on distrust arising from different cultures
trying to communicate with each other. Although “history does not claim any particular type of
capitalism is inevitably and forever superior to everything else”, as the traditional Weber hypothesis
suggested, Hofstede & Hofstede (2005) seem to identify a limitation of collectivist culture in the
sense that “in the collectivist mind only natural persons are worthy of trust”(Hofstede and Hofstede
2005).
Since in fact in national statistics collectivism is almost perfectly correlated with low GNP per capita,
there seems to be a major problem in developing countries with people trusting organizations and
institutions (Hofstede and Hofstede 2005). The correlation of income levels with individualism and
trust indeed suggests the existence of a strong feedback loop determining the outcomes. The
literature on inter-cultural communication is mostly concerned with measuring and examining the
five principal cultural dimensions of various societies, but trust is not analyzed as an independent
concept. The question whether institutions give rise to trust, or institutions created by trusting
societies is therefore not discussed in great detail. Similarly, the idea that trustworthy behaviour
from individuals or institutions, can cause trust levels to rise has not been greatly emphasized in the
inter-cultural communication literature. Instead, trust is seen as the absence of distrust, the later
arising from culturally inappropriate communication.
In complexity economics, the feedback loops regarding trust is discussed extensively. If we imagine a
population in which some agents think the economic pie is fixed, while others have a non-zero-sum
view, non-cooperative and cooperative strategies will vary. Learning effects determine that that in a
low-cooperation society, non-zero sum attitudes are essentially contrary to survival, and cooperative
agents will over time become zero-sum agents. Once a society is past a threshold ratio of non-
cooperators versus cooperators in a population, it becomes very hard to maintain large-scale
cooperation, resulting in a "poverty trap". The dynamic interplay between cooperators and defectors
can thus strongly influence the evolution of norms and the level of trust in a society. Culture
therefore should not be seen as an immutable force, rather, it coevolves as people in a society
5

6. interact with each other. Cultural norms out of behavioural results, and behaviour results from
cultural norms.
In behavioural economics, game theory has given strong incentive to the convergence of economics
with behavioural sciences. A game theoretical approach supports the idea that trust can begin with
well-developed institutions. Trust is mostly seen as a arising from functioning institutions. In the
behavioural economics literature it is suggested that apparently basic conditions for functioning
markets create trust, and not the other way around. Unlike in complexity economics, however, the
feedback loop is not always taken into account.
Trust experiments are an important part of behavioural economics, ever since the Berg, Dickhaut and
McCabe experiment (1995). Trust is created by properly enforcing existing laws and regulations,
settling disputes, and by providing facilitating creativity and innovation. Most research consists of
tinkering with some of the institutional arrangements, and then measuring the effects on trust or
reciprocity. Overall, the literature on trust and trustworthiness points to the idea that trust is a
consequence of specific institutions and has highly specific origins.
Behavioural economics studies examining developing countries reveal, for example, that frequent
social interactions improve trust. This is especially the case if economic production depends on
coordination and cooperation. When productivity is more individualized, then trust is lower. Among
the studies of rural peoples in developing countries, Indonesian whale fishermen appear at the
higher end of cooperation spectrum, while tribes in the Peruvian Amazon are at the lower end. The
main difference between lifestyles is characterized as highly independent households in the Peruvian
Amazon compared to dependence on cooperation in whale fishing and in marketing the whale for
economic survival in Indonesia (Cárdenas and Carpenter 2005). According to both Johnson and Mislin
(2008) and Cárdenas Chong and Ñopo (2008), empirical research reveals that expectations of
reciprocity or cooperation are the main driver of trust in trust games, and the main driver of
cooperation decisions in other behavioural experiments.
In a more indirect fashion, Cárdenas and Carpenter (2005) and Wolfe (2002) describe the growth of
economic clusters and learning regions as depending on trust in order to develop, taking up a theme
initiated by Alfred Marshall (1919), and recently further developed by Paul Krugman (1992). Porter
(1998), Saxenian (1994), and Storper (1997) argue that communication and interaction by agents
which might form a cluster depend on high levels of trust. These clusters in turn, become engines of
economic growth, productivity growth, and knowledge growth within a country. Here trust is seen as
a condition.
Additionally, Carpenter (2006) mention the crisis phenomenon whereby shared trauma wipes out
any previously standing mistrust and goes on to create trust and cooperation. According to Klein
(2007) however, this effect is only temporary and in fact must be seized upon in order to create more
lasting structures in order to maintain high cooperation level in the long term. There are some
empirical obstacles. Mainly, that trustworthiness is not the only motivation for cooperation.
Cárdenas and Carpenter (2005), other reasons include altruism, unambiguous self-interest, and risk-
seeking.
Of critical importance, is how precisely an institution should attempt to enforce and foster
cooperation. In a corporate governance context, for example, Monks and Minnow (2008) find that
industry self-regulation and formal regulation are complements . That is, an increase in the depth or
scope of formal regulation leads to a symmetrical increase in industry self-regulation, while a fall in
one leads to a fall in the other. Monks and Minnow (2008) therefore reject the idea that industry-
self-regulation might act as a substitute for formal regulation.
6

7. Barr (2001) and Barr and Kinsey (2002), and Carpenter, Daniere et al. (2006) all find similar results
concerning social sanctioning in trust experiments in developing countries. Specifically, that social
sanctioning among players in the trust game leads to immediate and sustained increases in
cooperation rates (Barr 2001; Barr and Kinsey 2002; Carpenter, Daniere et al. 2006; Carpenter,
Daniere et al. 2006). Barr (2001) demonstrates that in rural communities in Zimbabwe, where Barr’s
“trust game” experiment included a discussion round where naming and shaming could take place,
players who witnessed the criticism of others but were not themselves criticized contributed the
highest cooperation increases. In relying solely on direct regulation meanwhile, Cárdenas et al.
(2008) find that in trust experiments, regulation worked well early on, but to underperformance
relative to successful enforcement of cooperation via “cheap talk.”. Taken together, the implications
of the literature are that social sanctioning norms should be taken into account and facilitated by
institutions. Formal regulation moreover, should be planned around social sanctioning because
effective social sanctioning is more adept at improving trustworthiness than formal regulation. At the
same time, formal regulation should try to encourage effective social sanctioning rather that
functions in parallel to formal regulation rather than instead of it.
Unfortunately, the social sanctioning approach is not without its limitations. The so-called second-
order dilemma whereby non-cooperation may go unsanctioned by players due to the cost of
punishment to the punisher may ultimately limit the effectiveness of social sanctioning schemes.
Taken alongside the results from Johnson and Mislin (2008) as well as from Cárdenas Chong and
Ñopo (2008), the concept takes the logical shape that institutions create trust by guaranteeing
cooperation and reciprocity, or by insuring at least partially the risks involved with trusting
(Cárdenas, Chong et al. 2008; Johnson and Mislin 2008).
A behavioural experiment held in Costa Rica comparing experienced industrial managers and
students, clearly indicates how trusting and trustworthy behavioural patterns can develop as a
consequence of exposure to efficient market institutions by analyzing the differences between
students and managers who trade in international commodity markets. In a traditional trust
experiments students showed low levels of trusting behaviour and reciprocity. While managers
exhibited trust in institutions, students tried to get away with “cheating”. Even regarding learning
effects, students were “slower” than managers, probably because the lacked the fundamental
understanding of how to operate in markets (Alpizar, Requate et al. 2004).
Although at all times it is hard to generalize from experiments, even from a large number of them,
they seem nevertheless to confirm that learning about, and experience with market institutions can
significantly change behaviour. Trust is both a cause of and condition for functioning markets, and
exposure to well-functioning markets develops more trusting and trustworthy behaviour.
In sum, most of the recent literature in behavioural economics, and in particular publications
reporting on trust experiments carried out in developing countries seem to have lost some of the
subtleties and attention for positive and negative feedback loops that we found in Smith. Some
experiments however have picked up on the mutually reinforcing nature of markets on the one hand,
and trusting or trustworthy behaviour on the other. It is important to resuscitate his view that
trusting and trustworthy behaviour is both a condition and a consequence of functioning markets.
7

8. Conclusions
In modern macro-economics, trust was seen as a condition for market interactions. In micro-
economics, the discussion on trust was mostly limited to intra-firm relations and principal agency
problems. In modern behavioural economics trust is again seen as a emerging from specific
institutional arrangements. Recently, complexity economics has added the importance of positive
and negative feedback loops, in explaining phenomena such as the correlation of high GDP per capita
and trust. It suggests that the dynamics of cooperative, non-zero sum agents, and non-cooperative
zero-sum agents in a given society will give rise to “tipping points” or threshold levels. If cooperation
levels fall below a certain thresholds, societies can become stuck in a poverty trap.
Neo-classical economic models which treat trust as exogenous and don’t include feedback loops, or
explanations focusing on national cultural characteristics can not explain this non-linearity. Culture
can not bee seen as an immutable force, causing societies to get stuck in low trust levels. Rather, it
evolves as cooperative and non-cooperative agents interact with each other. Therefore, trust and
trustworthy behaviour are both a product of experience of functioning institutions, and determine
the shape and effectiveness of these institutions. Just as Adam Smith hinted.
We suggest to transcend the false “condition vs. consequence” dichotomy regarding the relation
between trusting and trustworthy behaviour on the one hand, and functioning market institutions on
the other hand by reverting to Adam Smith’s original approach in which trust is again placed at the
center stage of economic interactions and is seen both as a consequence rather than a condition or
cause. In Adam Smith trust is more than a condition for market interaction, it is also a consequence
of behaviour. How institutions feed trust, and how trust and reciprocity, or trusting and trustworthy
behaviour, mutually reinforce each other was mentioned frequently in Wealth of Nations and Moral
Sentiments. This opens the way for a conceptualization in which the mutually reinforcing nature of
trusting and trustworthy behaviour, or in other words trust and reciprocity, is fully taken into
account, and in which trust is seen again as both a necessary condition as well a consequence of
successful market interaction.
There are some implications of our approach for the formulation of development policy. Since trust is
a condition for functioning markets, there is no relief from getting the basic rights. We suggest
therefore policy should be focussed on creating "hard" conditions for market development, rather
than decrying low trust levels, and seeing them as part of a culture, which then is often interpreted
as being immutable. Equally important, however, is fostering mutually reinforcing process of trust
and trustworthy behaviour by tinkering with specific elements of institutions. Societies in which
trusting and trustworthy behaviour is eventually rewarded and the opportunistic behaviour punished
will be more successful, whether in the developing or developed world.
In sum, trusting and trustworthy behaviour are most likely both a cause and a consequence of
successful institutions, among which market institutions are of primordial importance in determining
economic growth and development. What works, and what does not work will eventually determine
the levels of cooperation, and trusting and trustworthy behaviour. Our experimental results in Costa
Rica confirm that exposure to functioning market institutions strongly influences trusting and
trustworthy behaviour positively.
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