Role of Institutional Trust and Confidence in Economic Relationships - Literature review Example

Role of al Trust and Confidence in Economic Relationships Introduction In economics, aspects of trust and confidence play a significant role in sustaining social and economic networks in the society. Trust and confidence serve as the foundation blocks of institutionalized social and economic relationships. Breakdown of thrust and confidence leads to a subsequent breakdown in the mentioned relationships. In contemporary societies, the ability to build and maintain trust determines the level of economic growth within a given economic setting. This means that the society’s economic performance depends largely on the underlying level of confidence held by parties involved. On the contrary, loss of trust leads to inevitable collapse of economic and social networks; hence causing economic recession. Typically, trust and confidence are built and maintained by social, economic and political institutions. Actions of these institutions are influential in creating the required perception of confidence in the society. According to Bernholz (2003), breakdown of social and economic networks is attributed to a preceding breakdown of institutional trust. This essay seeks to evaluate practical situations in the real world where loss of institutional trust affected economic networks and lead to recession. Undeniably, trust is a metaphorical heart of today’s complex and globalized economic systems. Trust influences the attitudes of agents and persons in the society towards economic institutions and even governance systems. According to Gyorffy (2012), absence or decline in trust invariably leads to change in public perception; hence threatening the ability to sustain existence of existing social and economic networks. Hypothetically, slight breakdown of confidence and institutional trust have substantial impacts on economic and social networks previously formed in today’s globalized society. Specifically, economic challenges like recession and depression results from breakdown of institutional trust. Economic transactions today comprise of numerous market exchanges involving transference of funds in exchange of goods and services. In order for trust to prevail, institutions involved in facilitating occurrence of transactions must maintain high level of confidence towards transacting parties. According to Jean (2000), institutions involved in maintaining trust and confidence include banks, trade unions and political systems like parliaments and other legislative authorities. In order to ensure continued trust, all these institutions must create an environment characterized by genuine economic goodwill and transparency. Actual incidences of breakdown in institutional trust happened recently in the European nations of Greece and Cyprus. The economic predicaments experienced by both Greece and Cyprus were somehow interrelated. Cyprus experienced increasing decline in confidence of its banking institution. According to Stephen (2013), Cyprus banks engaged in greedy and unethical banking practices, thus causing unprecedented banking crisis in the Southern European nation. First, Cyprus banks started accepting non-core deposits from wealthy foreign clients from Russia and the Middle East. Technically, non-core deposits are dangerous to financial institutions because once such deposits are received, they must be invested elsewhere. In this case, Cyprus banks invested the deposits in real estate, an industry with significant risks of collapse. Apart from the housing investments, Cyprus banks decided to invest in the Greece foreign debt. Anderson and Janet (2011) mentioned that shortly after the investments, Greece was forced by the International Monetary Fund together with the European Union to write-off approximately 50% of its total debt in an effort to obtain a bailout from the giant economic union. Consequently, Cyprus lost proportionately all investments already made on Greece debt. These incidences marked inception of breakdown of institutional trust in both nations. Theoretically, loss of institutional trusts will affect economic relationship between one nation and other trading partners globally. Economic relationships between two agents are the basic units of large economic networks. Greece and Cyprus are part of the European Union economic network. This means both nations had mutually beneficial economic relationships with other nations within the European Union. Health economic relationships are essential in generating valuable returns to partners involved in any economic activity. Kenen and Peter (2005) said that lack of institutional trust and confidence compromise on the strength of economic relationships. As a result, economic activities between other nations and the mistrusted nation may be severed causing substantial economic damage. In addition, impacts resulting from loss of trust spills over to social networks already formed. Technically, economic agents like banking institutions and governmental agencies foster creation and sustainability of economic networks between two trading partners. Strong economic networks lead to subsequent creation of strong social networks between consumers of the two trading partners. Any severing of economic ties means a corresponding breakdown of social networks already build. At this juncture, it is appropriate to examine the role of interpersonal and institutional trust in economics. At a personal level, trust is an essential building block of reputation. Earle and Heinz (2012) says that trustworthy persons have high reputation and vice versa. Mostly, social and economic interactions involve strangers. Such interactions commence and progresses because of mutual trust between interacting partners. However, any slight sign of mistrusts compromises on the future of interactions between persons. Similarly, institutional trust is built on mutual expectation. Each party involved in economic interaction has a definite role. For example, Cyprus banks had a role of providing financial services to its domestic and foreign clients. On the other hand, clients play a role of paying the bank for services provided. Both roles are built on trust and confidence. According to Patrick (2013), wealthy Russians who deposited their money in Cypriot banks trusted the nation’s financial institutions. Correspondingly, Cypriot banks trusted economic and political institutions of Greece. That is why they invested the funds in Greece foreign debt. In a similar manner, Greece trusted institutions and governance structures of the European Union. Therefore, all economic relationships between agents involved were built on mutual trust and confidence. At this point, one may be interested in knowing what aspects foster creation of mutual trust between parties in an economic relationship. Like social and emotional relationships, economic relationships develop as a result of the seven forms of trust which include fidelity, physical safety, predictability, discretion, truthfulness, reliable governance and security. Wealthy Russians deposited their money in Cyprus because Cyprus was a tax heaven which offered substantial financial security for their money. Anders (2013) says that Cyprus trusted Greece because of its physical proximity coupled with mutual truthfulness about their economic progresses. Finally, Greece had confidence on the European Union because of the community’s superior governance system and inherent fidelity to its members. Operational confidence resulted from previous interactions between all the involved economic agents. In addition, institutional trust is attributed to the definite roles played by parties involved. Based on previous experiences, banking institutions from Cyprus had blind faith on the reliability and security of investing in Greece foreign debt. Cyprus knew that Greece have structures governmental and financial institutions that will ensure safety of investments. On the other hand, foreign clients of Cypriot banks believed that there are efficient economic and political mechanisms that ensure safety of their fortunes. In this context, it is undeniable that each agent involved in the economic relationship trusted how other parties use institutions. At this juncture, one must appreciate the fact that Greece was confident about the role played by the European Union in safeguarding its economic interests. In fact, Greece continued borrowing from foreign institutions like Cypriot banks because of the cover provided by political and economic institutions of the European Union. According to Matthew (2010), European Union should uphold the agreement regarding the use of credible economic rules and effectiveness of institutions in fostering safety of member states. However, there was significant breach of the agreement by economic giants like France and Germany. The breach plunged Greece into an abyss of economic dismay. After appraising the real nature of Greece’s financial situation, other strong forces within the European Union pressured the International Monetary Fund to take appropriate actions. Consequently, the IMF demanded that Greece employ efficient economic expediencies, thus forcing Greece to write-off its foreign debt. At this point, there was an apparent breakdown of institutional trust and confidence in EU’s governance structures. Actually, Greece did not join European Union until in 2001. After its incorporation into the giant economic community, Greece took advantage of its new financial safety and started borrowing. During the expanded borrowing campaign, key member so UE, especially, France and Germany provided no tangible advice to its new member. In this context, there was an apparent decline of institutional trust within the EU. By 2007, Greece had bitten more than it could chew. Its foreign debt had amplified to unprecedented levels. At this point, Greece still trusted on the European Union. This explains why it took the advice of Germany and France and started the foreign debt Investment Plan. In the middle of a huge financial crisis, Cyprus was experiencing surplus of non-core deposits. According to Smith (2012), the Investment Plan proved as one of a viable option for Cypriot banks simply because it trusted both the European Union and institutions in Greece. In this context, it seems all institutions together with members of the public held common knowledge of operational confidence. Each party trusted that the other party knows about the value of institutional confidence, and that they know how to use institutions to enhance the confidence. At this juncture, it would be contextual to acknowledge the aspect of notional trust in economic relationships. From the preceding sections, it is undeniable that all agents involved in the Greece-Cyprus economic crisis had common trust on governance systems and relevant economic institutions. However, all the involved parties had the right to trust in institutions because of the existing social and economic relationships in the European Union. According to Feng (2005), governance systems are obliged to ensure formulation of objective foreign policies. This means one nation should not provide a misleading advice to another nation, both on matters of social and economic aspects. However, governance systems of member states of European Union failed to act ideally, and in turn provided subjective advices to Greece during the borrowing campaign. Apart from trust in governance systems, both Greece government and creditors held similar notions on operational confidence. Even Cyprus with a wide knowledge of Greece’s foreign indebtedness held the same notion of operational confidence. Actually, these notions stemmed from economic conventions and social norms within the region. Cyprus, Greece and other nations within the European Union operates with similar financial conventions, specifically embedded by the common currency treaty. In addition, the notional trust is attributed to mutual confidence in institutional infrastructure. Technically, economic trust is sustained by presence of finite credit default guidelines. According to Michael and Theodore (2013), Cyprus knew that in case Greece experiences a substantial economic crisis in the foreseeable future, its investments in form of bonds and loans will be secured by conventions of credit default obligations. European Union is known to have a strong credit default program which shields creditors from eventual default by borrowers. However, creditors cannot be shielded from substantial changes like debt write-offs. In this context, Cyprus was oblivious of any detrimental eventuality. In fact it was short sighted by the immediate need to invest in either loans or bonds because of surplus in non-core deposits. In this case, notional trust subsequently led to breakdown of institutional trust and confidence in governance systems. After the Cyprus banking crisis, foreign clients were no longer willing to deposit their funds in the nation’s banking institutions. The Greece-Cyprus crisis showed that there is limited regulation of financial undertakings in Cyprus. In ideal situations, banking institutions should not be allowed to stock non-core deposits beyond a certain threshold. According to Oliver and Williamson (2005), this is because non-core deposits from foreign clients must be invested promptly; hence increasing economic risks associated with such funds. Economic regulatory bodies in most nations like the US set a maximum threshold of 20% non-core deposits to any banking institution. However, Cypriot banks had freedom for unlimited acceptance of non-core deposits. Such unlimited regulations undermine reliability of banking institutions in terms of fund’s safety. After the crisis of debt write-off, most foreign clients in Cyprus banks withdrew their capital and fled to safer economic zones. In addition, domestic clients were no longer willing to keep their savings in Cyprus banks. Therefore, collapse of institutional trust lead to corresponding breakdown in economic relationships between clients and banks in Cyprus. Additionally, breakdown in economic and social relationships could be seen in Greece. Failure of the European Union to lift Greece out of the abyss of economic predicaments severed numerous economic relations both inside and outside of Greece. Initially, creditors play a significant role in causing a false book of economy in the nation. For once, people in Greece could access jobs easily and the nation’s purchasing power was high. According to John (2012), many merchants from other global markets were rushing to Greece to make a fortune because its economy was booming. Despite the increased borrowing, people of Greece trusted on its governance systems and economic institutions to make good use of the money. However, the institutions continued pumping false hope to its citizens and the outside community. Eventually, economic collapse commenced. Potential creditors and foreign merchants in the country fled to safer economic environments. Citizens of Greece who had solely trusted the nation’s institutions started facing the impacts. People could no longer access jobs, their savings disappeared in financial institutions and there was substantial destruction of livelihoods. In this context, trust and confidence in institutions had evaporated, causing a subsequent breakdown in economic relationships with other global economic agents. Conclusion In conclusion, it is undeniable that trust, and specifically institutional trust is important for economic prosperity. Actually, trust is an economic privilege. In case Greece tries to borrow additional capital from creditors, it may not be successful because of trust issues. In the case of Cyprus, trust could be increased by raising the role of regulatory institutions in the country. Inasmuch as unregulated financial environment promotes free enterprise, such an environment has to deal with unprecedented economic risks. Martin (2004) says that institutional freedom must be objectively regulated in order to enhance aspects of confidence and trust. In addition, oversight institutions must be established in order to bring perpetrators of economic crimes to book. Apparently, both Greece and Cypriot economic predicaments were abysmally executed by either governance systems or financial institutions from ill-intentioned countries within the European Union. Therefore, establishment of independent oversight institutions will prevent further severing of economic relationships and depressions brought by breakdown of institutional trust. References Anders, A. (2013). The Last Shall be the First: The East European Financial Crisis. Los Angeles: Peterson Institute. Anderson, M. & Janet, K. (2011). Greece: Third Review under the Stand-by Arrangement. 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Massachusetts: MIT Press. Matthew, L. (2010). Bust: Greece, the Euro and the Sovereign Debt Crisis. Harrisburg: John Wiley & Sons Publishing. Michael, M. & Theodore, P. (2013). Understanding the Crisis in Greece: From Boom to Bust. Cardiff: Palgrave Macmillan. Oliver, E. & Williamson, J. (2005). The Economic Institution of Capitalism. Harrisburg: Simon and Schuster Publishing. Patrick, W. N. (2013). Key Fats on Cyprus: Essential Information on Cyprus. Cambridge: Cambridge University Press. Smith, A. (2012). Cyprus: Financial Sector Assessment Program. London: Oxford University Press. Stephen, W. (2013). European Union Economic Diplomacy: The role of EU in external economic relations. Farnham: Ashgate Publishing. Read More