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by David Sharp, Founding President of the Australian Adam Smith Club (Melbourne) and author of Economic Simplicities

The study of trust and its implications is a sub-set of economics, in particular, the study of its relationship to trade. Trade creates wealth. Amongst animals, it is a unique attribute of mankind. As Adam Smith famously observed, “No dog exchanges bones with another.” Trade has enabled us to achieve a standard of living that our early ancestors could not have imagined. The level of world trade in 2010 was estimated by the World Bank to total in value approximately US$16 trillion. Trust plays a key role in trade. Trade involves an exchange of goods or services, either for other goods or services, or for money. Trust, it is sometimes said, greases the wheels of exchange; its presence or absence explains the difference between rich and poor nations.

All trades involve an exchange, which exchange gives rise to an opportunity for one or other of the parties to the exchange to cheat or defraud the other. This is particularly the case when the execution of the trade involves the granting of credit, or a delay between one party’s exchange and that of the other. Even where the exchange is simultaneous however, such opportunity arises. The opportunity for a party to make an immediate profit from dishonest trading provides an incentive to cheat or defraud.

Economists have sought to understand and explain how such incentive to cheat and defraud, which exists within the structure of trade, and hence acts as a barrier thereto, can be neutralized and overcome, and trade itself be engendered and expanded. They have concluded that to a large extent the answer is the existence of trust. Trust is widely considered to be something essentially immeasurable. Economists have therefore focused on those factors which they believe result in the creation and expansion of trust, or conversely its destruction and loss. We can consider some of them.

Trade — the act or process of buying, selling or exchanging something.

Trust — reliance on a person or thing, or an aspect thereof, such as a person’s integrity.

Credit — another word for debt, sometimes used as a synonym for trust.

Trustor — one who places reliance on the future performance of another, in return for the trustor’s transfer of property or provision of services.

Trustee — the recipient of another’s trust.

Institution — an established and structured pattern of behaviour or of relationship, accepted as a fundamental part of a culture.

Personal Knowledge
The simplest and most direct way to engender trust, for the purpose of a potential trade, is to know, personally and favourably, the person with whom one is dealing. Such relationship is an asset that has value for the parties, which value increases as trade between them grows. However the value of such goodwill is lost if either party succumbs to the temptation to cheat or defraud the other. Unless the benefit so obtained exceeds the value of what is lost, it is unlikely to occur. But such deterrence is limited. If trade were to be confined to those who, from personal experience, are known to be honest and trustworthy the volume of trade must be, and remain, relatively small. To expand volume significantly, it is necessary to trade with strangers.

Reputation & Brands
A more remote source of trust than personal relationship is reputation. A person who has acquired the reputation in a community of being trustworthy is likely to engender trust in others who do not know him or her personally, but are aware of such reputation. The building of such reputation can be facilitated by use of a brand. A good brand acquires a good reputation, which then leads to a growth in trade.

Credit Bureaus and Rating Agencies
Generally speaking, people wishing to trade with strangers will place their trust in institutions. In such way, trust in the suitability of strangers as trading partners can be enlivened and expanded. Such institutions are numerous and tend to arise to meet various specific needs. Two such institutions are credit bureaus and rating agencies.

Credit is often lauded as a major contributor to modern civilization. As Daniel Webster [1782-1832] the American statesman claimed: “Credit is the vital air of the system of modern commerce. It has done more-a thousand times more-to enrich nations than all the mines of the world.”

Credit bureaus acquire information about individual’s trading and credit history, which they then sell to other people seeking to ascertain whether such person is trustworthy. Rating agencies exist to provide a standardized rating of securities issued by governments, corporations, universities, churches and so forth in order to assist investors determine how trustworthy they are. There is a subtle but significant difference between rating agencies and credit bureaus; typically rating agencies are paid by the organization that is issuing the securities they are rating.

Guilds & Professional Associations
In placing trust in institutions when contemplating a trade, parties can factor in the likelihood of being cheated or defrauded, and determine the role that a particular institution will play in preventing this from happening, or whether it will assist them if it does. One of the roles guilds and professional associations perform is to set and enforce standards upon their members. If an outside party has trust in such institutions, it is more likely that they will deal with their members.

Courts & Law
Throughout history, extensive trade and superior legal systems have tended to co-exist. Medieval Venice for example was the trading capital of the world. As those who know Shakespeare’s play The Merchant of Venice will probably be aware, Venice was famed for its legal system, which unlike that of other Italian city-states of the time was not based on Roman Law, but was largely unique to Venice. In particular, it eschewed partiality, dispensing justice equally to Venetian and foreign traders alike. Similar stories are told today about the legal systems of the undoubted successful trading cities of Singapore and Hong Kong. Trust in such legal systems encourages trade.

An example of an institution which developed to fill the need of traders was the Law Merchant. During the Middle Ages, few commercial law cases were handled by state courts. They were too slow, costly and cumbersome for the needs of the merchants. Rather disputes between merchants were settled by merchant judges who applied internationally known and accepted customs and principles, which, like the law of the sea, had evolved over time. Merchants could and did place their trust in such legal system, which provided law for traders. Compliance with judgments was enforced by the possibility of exclusion from the various municipal trade fairs, the major trading events of their day, or a general boycott by other traders. Interestingly, a similar system of dispute resolution has developed in recent times on the internet, to cater for the rapidly growing internet trade

Current Issues
Economists in the area of trust economics are working on a variety of issues. They include assessing the likely effect on trade of a widespread loss of trust in various institutions, such as the legal or banking systems. Another issue is the significance if any of the difference between public and private institutions, and if or how efforts could be directed towards improving their performance.