Essays on Social Capital and Economic Growth Sumant K Rai A dissertation submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy University of Washington 2012 Reading Committee: Stephen J Turnovsky, Chair Oksana Leukhina Yu-Chin Chen Program Authorized to Offer Degree: Economics University of Washington Abstract In this thesis we present three models to analyze the dynamic relationship between social capital and economic growth. Throughout it is assumed that social capital increases with socialization while it decreases with labor migration. We consider two channels through which social capital affects the economy. First, social capital affects the innovation process (Chapter 2 and 3) and second, it affects the output (Chapter 3).
It has also been assumed that the same objective can also be achieved by improving appropriate formal institutions but doing so is costly. Chapter 1 introduces the topic and discusses related literature. Chapter 2 presents a simple model and shows that in the absence of formal institutions, a higher rate of innovation lowers R&D investment as it weakens the existing informal institutions. Social capital declines due to a decline in socialization time and also because of an increase in the labor migration rate.
As a result, rise in the rate of growth rate is lower that what would be predicted by a standard growth model (benchmark case). We show that formal institutions need to be developed in response to new technological breakthrough because of its detrimental impact on social capital. Chapter 3 extends the model by adding physical capital into the model and analyzes alternative ways to finance a chosen level of expenditure on formal institutions. We find that financing through lump sum tax is growth maximizing, however, tax on consumption results in highest improvement in welfare.
In the case where social capital affects output directly (Chapter 4), we analyze the impact of increase in the rate of innovation and an exogenous improvement in formal institutions financed by lump-sum tax. We find that while both shocks increase the rate at which the economy grows and decrease the stock of social capital; productivity adjusted physical capital and R&D investment declines when innovation rate goes up while they increase when the formal institutions are improved. They both result in long-run welfare gain. More effective formal institutions result in even higher economic growth and long-run welfare gain.
Essays on Social Capital and Economic Growth Sumant Kumar Rai Chair of the Supervisory Committee: Professor Stephen J Turnovsky Economics TABLE OF CONTENTS Page List of Figures. ii List of Tables. iii Chapter 1 Introduction. 1 Chapter 2 Social Capital and Economic Growth.
29 Chapter 3 Second-Best Optimal Taxation to Finance Formal Institutions. 50 Chapter 4 Productive Social Capital and Economic Growth. 82 i LIST OF FIGURES Figure Number Page Figure 2.1: Dynamic Responses to Innovation Shock .1: Dynamic Responses to Taxes .1: Dynamic Responses to Innovation Shock ( ) .2: Dynamic Responses to Improvement in formal Institutions ( ). 76 ii LIST OF TABLES Table Number Page Table 2.1: Long-Run Effects of increase in λ .2: Short-Run Effects of increase in λ (Case III).
73 iii ACKNOWLEDGEMENTS My deepest gratitude is to my advisor, Professor Stephen Turnovsky. I have been amazingly fortunate to have an advisor who gave me the freedom to explore on my own, and at the same time the guidance to recover when my steps faltered. His patience and support helped me overcome many crisis situations and finish this dissertation. Discussions and comments from Wahid Abdulla, Yu-Chin Chen, Richard Hartman, Fahad Khalil, Oksana Leukhina, and Aditi Mitra were helpful in completion of this thesis.
I would also like to thank seminar participants at the University of Washington and conference participants at ISNIE 2012 for their helpful comments. Financial supports provided by Professor Turnovsky is greatly acknowledged. Finally, my family and friends have supported and helped me along the course of this dissertation by giving encourangement and providing moral and emotional support I needed to complete my thesis. To them, I am eternally grateful.
I must extend my thanks to my wife, who chose to make greatest sacrifices for me, for her endless support and encouragement. iv DEDICATION To my late mother v Chapter 1 Introduction After the pioneering work by Coleman (1988, 90) and Putnam (1993, 2000), research on social capital has received enormous attention from economists. Social capital has been recognized as an important determinant of economic performance of a country.1 While a country with a high stock of social capital tends to grow faster than a country with a low stock of social capital, higher growth may itself be detrimental to social capital which, in turn, may hamper the growth performance. Putnam et al (1993) argued that a large part of the differences in per capita income between Northern and Southern Italy can be explained by the differences in their level of social capital, measured by membership in formal and informal groups and clubs.
Routledge and von Amsberg (2003), and Miguel (2003) argued that a higher growth rate erodes social capital by increasing the labor migration rate.2 Additionally, Putnam (2000) documents that social capital in the US declined monotonically since 1960s, but there was no apparent adverse impact on the US economy. Particularly, during the 1990s US experienced rapid economic growth, a period when there was a sharp decline in social capital. He identifies some possible determinants of this decline as rising female participation in the labor market, increase in geographical mobility, replacement of small stores by supermarkets, and individualization of leisure time. He, further, argued that during this period alternative (formal) sectors increased rapidly in response to decline in the strength of the 1 See Knack and Keefer (1997), Temple and Johnson (1998), Zak and Knack (2001), Beugelsdijk et al (2004),Guiso et al (2004), Akcomak and Well (2009) for details.
2 Social capital is person and place specific. See Glaeser and Redlick (2009) 1 informal sector (social capital). during the 1980s both public and private spending on security rose rapidly as a share of GNP. By 1995 America had 40% more police and guards and 150% more lawyers and judges than would have been projected in 1970, even given the growth of population and economy”.
What is `social capital'? According to Putnam et al (1993), “social capital. refers to features of social organizations, such as trust, norms, and [social] networks that can improve the efficiency of society. Durlauf and Fafchamps (2004) identify three main underlying ideas behind social capital; first, it generates positive externalities in the society, second, these externalities are achieved through shared trust, and norms, and third, shared trust and norms arise from informal forms of organizations. In a nutshell, any form of social organization or informal institution that facilitates cooperation and coordination, reduces transaction costs or improves market efficiency can be regarded as social capital.
For example, since it is extremely difficult and prohibitively expensive to write complete and enforceable contracts in most cases, contracting parties, therefore, can lower these costs by writing a weaker incentive intensive contract.3 Social connections or social networks may also reduce the impact of the moral hazard problem.4 Granovetter (1995) argued that social networks play a useful role in channeling information about jobs and job applicants in the labor market. In many cases, social capital is necessary in resolving conflicts among competing interests, reducing the free riders problem and internalizing the externality in the provision of public good. 5 Guiso et al (2004) have shown that social capital plays an important role in the degree of financial development across different 3 Rob and Zemsky (2002) show that weaker incentive intensive contracts are desired when output strongly depends on partially observed cooperative efforts of workers. 4 Jackson and Schneider (2011) have shown that social connections significantly reduced the effects of moral hazard in New York City taxi industry.
5 See Coleman (1988) for details. 2 parts of Italy. Recently, Akcomak and Weel (2009) investigated 102 European regions and concluded that social capital increases growth by fostering innovation. To capture the dynamics of social capital, we assume that the stock of social capital increases when people socialize and decreases with labor migration.
6 We, further, assume that social capital is a by-product of an individual’s rational decision where the reason for socialization is the pleasure derived from social interaction and labor migration is the result of technological shocks to the economy. The assumption that social capital is an externality is in line with the observations made by Arrow (2000). He writes, “There is considerable consensus. that much of the reward for social interactions is intrinsic - that is, the interaction is the reward - or at least that the motives for interaction are not economic.
The relations between the market and social interactions appear to be two-sided. On the one hand. the market needs supplementation (for efficiency) by nonmarket relations [social capital]. On the other hand, labor or supplier turnover in response to price [changes] may destroy the willingness to offer trust or, more generally, to invest in the future of the relation''.
In related literature, Zak and Knack (2001), analyze the impact of trust on growth in a heterogeneous agent growth model. Consumers are randomly matched with investment brokers every period and decide how much time to spend in monitoring. Trust varies inversely with the level of monitoring. Routledge and von Amsberg (2003) analyze the impact of growth on social capital.
They argue that technological innovation results in reallocation of labor which reduces social capital. Other approaches that incorporate social capital into growth models use human capital (Sequeira and Ferreira-Lopes (2011)), degree of marketization (Bartolini and Bonatti (2009)), and participation in social networks as determinants of social capital (Beugelsdijk and Smulder (2009)). 6 Similar to time investment in Glaeser et al (2002). 3 This dissertation presents three models that analyze the dynamic relationship between social capital and economic growth where not only the positive impact of social capital on economic growth but also the detrimental impact of growth on social capital has been considered.
This relationship has been analyzed in a variant of Aghion-Howitt (1992) Schumpeterian growth model where a representative consumer makes labor-socialization and consumption-saving decisions. Chapter 2 introduces a simple model that captures the dynamics of social capital and economic growth. Following Zak and Knack (2001) and Guiso et al (2004), we assume that consumers can invest their savings only through investment brokers. These brokers are opportunists in the sense that given the opportunity they would cheat and run away with the money.
However, their ability to cheat (or the frequency of getting caught and money recovered) depends upon the strength of informal (social capital) and formal institutions. Therefore, a higher level of social capital increases investment and growth by reducing the broker's ability to cheat. 7 We consider three different institutional environments in this chapter. The benchmark case corresponds to the standard Schumpeterian growth model with a labor-socialization tradeoff where institutions are perfect and costless to maintain.
The other two cases consider imperfect institutional environments. The second case includes only informal institutions (social capital) and the third incorporates both formal and informal institutions. Using plausible parameter values, we show that in the absence of formal institutions, a higher rate of innovation lowers R&D investment as it weakens the existing informal institutions. Social capital declines through two sources, first, due to a decline in socialization time and 7 Alternatively, it can be argued that social capital raises the return from investment by reducing the cost of finding an honest broker or by reducing the cost of contracting because it may allow for writing a weaker contract.
4 second, because of an increase in the labor migration rate. As a result, rise in the rate of growth rate is lower that what would be predicted by a standard growth model (benchmark case). It has been argued that the reason for the failure of poor countries to catch up is the lack of institutions.