Trust in networks

Recently there has been a small surge in the economics literature addressing the role of trust in the economy. Experiments have shown that trust is extremely important for understanding economic processes. Trust does not fit very well with the traditional concept of “homo economicus”: Rational behavior is not trusting. The building and confirmation of trust usually requires sacrifices of resources, contradicting the utility and profit maximizing hypotheses of the homo economicus.

The Scientific American recently posted an article that looks at the evidence for trusting behavior from behavioral economics, in particular trust experiments and brain scan evidence from neuro-economic experiments.

I want to add my own two cents worth to this. First, trust building is directly related to the functioning of socio-economic networks. The better the functioning of these networks and the denser these networks, the better the development and building of trust. This in turn forms the foundation for a better functioning economy. (A neglected aspect in traditional neo-classical economics.)

On the other hand, network building is firmly founded on the presence of trust and behavioral norms of trusting behavior. The higher the level of trust in the society, the better one is able to build and maintain social networks.

This two-way street between trust building and network building lies at the foundation of my research on networks. It now seems that more and more evidence confirms the justification of these and similar theories of network formation. Here I also refer to the recent work of Markus Mobius and his co-authors.

Limitations of behavioral economics

Over the past months during the current economic recession and financial crisis, there has developed a published opinion as if so-called behavioral economics could explain the crisis. Behavioral economics emanates from observations in economic and game theoretic experiments that human subjects do not behave rationally, but are clearly bounded in their reasoning about decisions. Subjects are now routinely put under MRI scans to see which parts of the brain are used in which decision situations.

The main problem with behavioral economics is that it is staunchly methodological individualistic; the center of decision-making remains the singular individual. I think that consequently it cannot satisfactorily explain the economic world and certainly not the current financial crisis. This crisis has its origin in a failure of trust between contracting parties in the financial sector of the main economies; as argued before, it can be called a true trust crisis. Trust is fundamentally an interpersonal phenomenon and should be explained through sufficiently developed social theories. These theories cannot longer be founded on methodological individualistic arguments, but should rather be based on more interactive and social considerations.

Methodological individualism has as its singular strength that it is particularly open to successful mathematical and statistical modeling. As such economics is the outcome of a long history of methodological individualistic modeling. Its world-view is essentially alien to regular human interaction and more suited to model behavior of decision makers with autistic tendencies as recently pointed out by Tyler Cowen in his discussion of academics. In his Behavioral Economics Cowen takes that a step further and promotes the idea that we essentially should become more autistic, thereby essentially arguing that the world should actually adapt to economic theory rather than the reverse. It fits with a long history of economists trying to fit the world to their limited understanding and promoting individualism as a “good” behavioral mode, thus denying the fundamental sociality of the human condition.

I think that economics should rather adapt to understand the world better and at least soften-up on the issue of methodological individualism. Recently, Paul Romer presented an innovative way to look at history from such a more social perspective. However, to be successful at looking at the economy from such a social perspective, economists need to abandon their trusted methodologies. They should recognize the utter complexity of the economy and allow the use of a wide range of techniques to be used to understand it. This not only implies the use of mathematical analytical modeling, large-scale measurement of economic activities, and simple experimentation in the laboratory, but also the use of simulation models and statistical approximations as used in theoretical physics. As it stands now, economics remains rather irrelevant and marginal a science.