Effect of social capital on economic growth

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For about two decades, the importance of cultural factor in economic life has become an important topic in economics and development studies. To understand the role of cultural factors for economic development, numerous ideas and concepts have been proposed and used by various scholars. Among these also includes the concept of social capital. The broad concept of social capital refers to resources norms, values, networks, reciprocity or trust present in a community and can influence the social and economic outcomes of a community or individual. Robert Putnam's work on regional economic development in Italy brought the concept of social capital to economics and development studies. Several authors identify social capital as the 'missing link' in the traditional development models of growth (Grootaert, 1998). Despite its popularity, the social capital concept has been criticized by several authors arguing that the proof of association between social capital and economic development is still ambiguous and conflicting. One of the main criticisms on social capital effect on economic development is the ambiguity of its causal role i.e. the direction of the flow of causality is not clear. This paper focuses on identifying possible reasons for the problem of cause and effect associated with the concept of social capital and some possible ways to avoid or minimize this problem. An attempt has also been made to establish a clear causal link between social capital and economic development by providing conceptual foundation along with empirical evidences from the selected literature.

Problem of Cause and Effect

The empirical research on social capital suffers from different problems. One of the major problems with social capital is related to its measurement because of absence of a commonly accepted definition of social capital. Secondly, Empirical studies do not agree on the positive relationship between social capital and economic development. Thirdly, even if some studies provide prove of positive correlation between social capital and economic development, doubts still remain on the direction of the causality. On the one hand, several studies present a positive association between social capital and economic development On the other hand; some studies fail to find a significantly positive effect on economic development (Beugelsdijk and Schaik, 2005). Huber (2008) for example, argues that not all dimensions of social capital reveal explanatory power and some dimensions do not have a positive relationship with innovation or economic growth. There are various reasons for the variation in the conclusions of some studies about the causal effects of social capital on economic development

Firstly, some have pointed out that there is a considerable amount of ambiguity regarding the precise definition of social capital. These definitions differ considerably because they are based on different fields, context, levels etc. When social capital is defined so broadly it lacks specificity and substance and the causal mechanisms of specific dimensions will remain vague (Huber, 2008).

Secondly, Often outcome variables and the underlying causal variables are not satisfactorily differentiated and possible alternative causal factors are not controlled (Portes, 1998). According to Ports this problem is very much common in seeing social capital as a property of collectivities such as communities, regions or nations. But he further argues that this does not mean that conceptions of collective social capital are not reasonable in principle, but such a conceptualization would have to be more careful in separating causes and effects.

Thirdly, many empirical studies use only simple scatter plots, correlations, or ordinary least square regressions to empirically analyze the effect of social capital. This makes the direction of causality unclear. Besides this, there are also problem of bias caused by omission of some important independent variables. In reality there might be some other factors such as geography, institutions, education, etc that actually have influence on dependent variable (development of an economy). To avoid this problem, some studies use sophisticated statistical modeling techniques while analyzing the causal link between social capital and economic development. These studies, however, have not taken into consideration the strong assumptions involved in each modeling approach. Violation of these assumptions could limit the accuracy and validity of interpretation of the results of the causal analysis. Researchers should be careful with the statistical assumptions they make in estimating the effect of social capital as these assumptions are crucial to justify the use of any modeling technique.

Fourthly, in empirically analysis another major complication arises due to inconsistent estimation of parameter due to endogenous regressors. In econometric, a parameter is said to be endogenous when there is a significant association between the parameter and the error term. A common cause of endogeneity might be autocorrelated errors. In this situation, regression estimates measure only the magnitude of association, instead of the direction of causation which is important in studies on social capital as the results of the study have to be used for policy analysis. Hence in the regression models of social capital, the problem of endogeneity must be resolved to provide clear causal direction of social capital and economic growth.

Fifthly, the earlier studies mostly focus on the only quantitative analysis of measuring the level of existing stock of social capital and its association with economic development. A limitation of the quantitative social capital literature is that while it identifies interesting and statistically significant relationships between social capital and outcome variables, the causality is often not clear (Dudwick et al, 2006). As Coleman (1988) questions "whether social capital will come to be as useful a quantitative concept in social science as are the concepts of financial capital, physical capital, and human capital? According to him "Social capital's value lies primarily in its usefulness for qualitative analyses of social systems and for those quantitative analyses that employ qualitative indicators". Qualitative techniques allow for more in-depth analysis of social capital and are vital for examining the complex issues of causality (Dudwick et al, 2006). Integrating both quantitative and qualitative methods will allow better understand the effect of social capital on economic outcomes.

Finally, Johnsan (2009) argue that the formation of networks and associations can be costly in terms of time and other resources. Therefore, for households with higher income acquire social capital more easily as formation of networks and association requires investment in terms of time and money. Demand for participation in social groups pursuing leisure activities is quite likely to rise with income because leisure is usually a luxury good (Grootaet et al. 2004). In this way, social capital becomes endogenous, and its estimated coefficient might be biased. Therefore it is suggested to use the instrumental variable techniques for social capital regression model to be unbiased. Instrumental variables technique uses the correlation between social capital and another variable, (the instrument) to estimate the impact of exogenous shifts in social capital on outcome indicator (Narayan and Pritchett 1997). Grootaert (1999) and Narayan and Pritchett (1997) have successfully used technique of instrumental variables analysis to check the robustness of their results.

Conceptual Link between Social Capital and Economic Development

The concept of social capital is based on the idea that social relationships and social norms are valuable resources that can improve the wellbeing of individuals, families, communities regions or even nations (Narayan & Pritchett, 1999; Fafchamps and Minten, 2002;; Knack and Keefer, 1997). In economics, social capital is seen as factor that affects economic growth and development in several ways. Firstly, Social capital can be seen as a separate key production factor that has a direct effect on economic growth through reducing transaction cost and facilitating sharing of information among the members of groups or networks. Secondly, social capital can also work indirectly through interaction with other factors of growth such as human and physical capital. Following are some conceptual mechanisms found in the literature on which the expected positive effects of social capital on economic development are based.

The most straightforward effect of social capital on economic growth is based on to its ability to lower transaction cost. In this respect cognitive feature of social capital such as trust (generalized and institutional), reciprocity, norms and values are believe to be more influential. According to Knack and Keefer (1997) much of the economic backwardness in the world can be explained by the existence of a lack of mutual trust (Knack and Keefer, 1997). Moreover, they argue that low levels of trust in a society can probably discourage its processes of innovation. Societies that posses high levels of trust among their members are less dependent on formal institutions. In addition, government officials in societies with higher trust may be perceived as more trustworthy, and their policy pronouncements are seen as more credible (Knack and Keefer, 1997). Interpersonal trust can also facilitate informal credit markets, if there is no well-developed formal system of financial intermediation, or where lack of assets limits access to bank credits (Knack and Keefer 1997). The case of mutual credit groups is one important example. The argument linking social capital with economic development is based on the premise that social capital can make other forms of capital more efficient through increasing the productivity of individuals and groups (Woodhouse, 2006).

As regards the role structural aspects of social capital in reducing transaction costs and fostering economic growth, theory is less clear than with respect to trust and norms (Beugelsdijk and Schaik 2005). In Coleman's interpretation, structural social capital facilitates economic exchange and coordinated action because social networks provide cheap and valuable information for economic decisions (Coleman 1990). Social relation which is made for other purposes might be used as a means of obtaining important information.Decisions by economic agents are often unproductive because they lack accurate information. In some circumstances most favorable decisions are difficult because of uncertainty caused by lack of information (e.g market or technology). In these situations social networks are considered powerful means to diffuse the information and knowledge, and thus lowering uncertainty. In a rural context, the information-sharing role of social capital is of key importance for information about market, credit and adoption of innovation. The ability of social networks to enhance economic development is also related to creation of trust. Granovetter (1983) stresses the role of concrete personal relations and of structures of such relations (i.e. social networks) in generating trust and discouraging opportunistic behaviors therefore fostering transactions and the economic performance.

Social capital affects economic performance by enabling cooperation without explicit contracting. In absence of trust between partners of an agreement, a complete needs to be written to avoid all confusion that might arise in the future. Such contracts are burdensome and expensive to write. However, if there is some degree of trust between partners of an agreement, some contingencies can be left out of the contract making it cheaper. Partners belonging to same social network often trust each other sufficiently. This trust on each other makes them agree on not to rely on costly written contract. Instead they can rely on the norms they share being a part of social network.

Narayan and Pritchett (1997) identify five channels through which social capital is able to affect a household's income level. Besides already discussed mechanisms i.e they add two more mechanism by which social capital enhances economic development of households: public sector efficacy and community cooperative action. According to them community cooperative action may facilitate the provision of services which benefits all the members of the community. Grootaert et al. (1999) also mention that social capital promotes sharing of information, and also reduces opportunistic behavior and helps in collective decision-making.

Empirical Evidences

There is considerable available evidence which suggests that social capital is important for economic development. It is beyond the scope of this paper to discuss every study that has attempted to measure social capital and its effect on economic variables. However, below is an overview of empirical works that are considered pieces of high quality research in the social capital literature. These empirical researches on the effects of social capital have not only a clear theoretical basis but also used the methods and approaches to check the robustness of their results to address the question of causality.

Putnum et al (1993) highlight the significance of resources such as social organizations, networks, norms, and trust in determining the failure or success of any community. In their famous work "Making democracy work" Putnam et al (1993) present the results on the institutional performances of the 20 new Italian regions. Comparing these regions, Putnam and his colleagues conclude that Northern regions have efficient, reactive, reliable administrations, to the highest satisfaction of their citizens. On the other hand, Southern regions were found exactly the contrary. These differences between North and South, according to their results, could not be fully explained by differences in wealth, political inclination, demography or geography. In fact, it is the factor of social capital they measured that largely explains the difference in economic performance between North and South Italy. Thus social capital was found to have influential role in the better quality of government and better economic performance of Northern Italy.

Sabatini (2005) carries out an empirical assessment effects of social capital to the quality of economic development in Italy. The analysis uses three main social capital dimensions i.e. bonding, bridging and linking social capital. The causal relationship between social capital's and developments different dimensions is assessed through principal component analysis and structural equations models. The analysis provided by Sabatini confirms the Putnam's claims about positive role of social capital in economic development.

(Beugelsdijk and Schaik (2005) analyze the relationship between economic growth and social capital for 54 European regions. The core question of this study was to test whether regional differences in economic growth are related to social capital. In this study two main dimensions of social capital (associational activity and generalized trust) were operatinalaized. The study confirms the presence significant positive relationship between regional economic growth and active membership. The study also concludes that it is not only the existence of network, but it is the active involvement in these networks that stimulate regional economic growth.

Narayan and Pritchett (1997) study relationship between the extent of associativeness and economic performance in rural Tanzania. They find that the households that participated most actively in collective organizations also had higher income level. The social capital they accumulated provided them individual and also collective benefits in various ways. These used better agricultural methods than those which did not participate. Their participation provided them with useful information that led them to use more agricultural chemicals, fertilizers and improved seeds. These household also had better information on the market as compare to others. Social capital also made the household to cooperate more actively at the community level.

Knack and Keefer (1997), on the basis of 29 market economies over the period 1980-1992 found that two indicators of social capital (trust and civic cooperation) positively associated with higher per capita income growth and investment levels. According to the results, one-standard deviation increase in a survey-based measure of country level trust increases economic growth by more than one-half of a standard deviation.


Summing up this discussion, there are several causal mechanisms through which social capital positively affect economic growth, both directly and indirectly. Most of these mechanisms work through reducing transaction costs, sharing of information, reduction of transitional cost and opportunistic behavior and diffusion of innovation. However, empirical evidence shows that the different dimensions of social capital are not equally beneficial for economic growth.

While interpreting and comparing the empirical results, few important aspects should be taken into consideration. Ignoring these aspects makes it difficult to agree on a unified pattern of the economic effects of social capital. When attempting to apply the concept of social capital to economic development, attention should not be given only to the correlation but flow of causation should also be in mind of the researchers. In many studies results of only simple statistical techniques such as scatter plots, correlations or simple least square regressions are presented. This leaves the direction of causality unclear. Also, selection of independent variables should be making in such a way that no potentially correlated variable left out of the model causing omitted variable bias. Care should be taken in generalizing and comparing the results of empirical studies as the effects of social capital seem to vary with respect to context and level of the analysis. Social capital has the ability to channel resources through social networks, not a substitute for the other capitals such as technology and infrastructure. Social capital can only complement the other growth factors to generate economic outcomes.

Estimating a causal effect is difficult but not impossible. Concerns about causality should not paralyze the research on social capital or should not regard social capital unfairly. The same problem of causality has been associated with human capital. Just as estimates of the effect of social capital are considered biased, same question can be raised regarding estimates of the effect of human capital on wages because of unobserved factors. For example, if smarter educated workers earn more, then the correlation between education and earnings will reflect higher pay that is due to higher natural ability. The problem of direction of causality, although posing serious problems for empirical research on social capital's effect on economic development, this problem, however, is not insoluble. The issues discussed in this paper to addresses the problem of causality associated with social capital concept and to improve the estimation of social capital effects, may help to arrive at a more validate and clear conclusion regarding the effect of social capital on economic outcomes.