COLLEGE OF EUROPE
BRUGES CAMPUS
EUROPEAN ECONOMICS DEPARTMENT
IN TRADE WE TRUST
The EU home bias puzzle in trade
Supervisor :Thierry MayerThesis presented by
Anya Margaret Ogorkiewicz
for the
Degree of Master of European Studies
Academic Year 2005-2006
Statutory Declaration
“I hereby declare that the thesis has been written by myself without any external unauthorised help, that it has been neither presented to any institution for evaluation nor previously published in its entirety or in parts. Any parts, words or ideas, of the thesis, however limited, and including tables, graphs, maps etc., which are quoted from or based on other sources have been acknowledged as such without exception.”
11, 547 words.
Abstract
It is this paper’s contention that the lack of trust between EU countries explains in part the invisible barrier that impedes intra-European trade.
An initial summation of the effects both trust and distance have on international trade leads to a discussion of the literature surrounding the phenomenon Obstfeld and Rogoff (2000) dubbed, “the home bias puzzle”. Trust is the oft-ignored underlying variable in economic science. Paramount to economic transactions, trust reduces transaction costs and abridges distances in international trade. Before empirically investigating the effects of the home bias in European bilateral trade flows, we appraise the literature portending to the effects cultural variables have on international trade flows.
The analytical chapter assesses the gravitational pull of the Eurozone. It opens on the theoretical trade framework of the gravity model, which we use in our empirical strategy to analyze the European home bias in trade. Consistent with Nitsch’s (2000) study, we calibrate the base gravity model with variables indicating bilateral trust, average origin country trust and average destination trust. After running OLS, GLS, 2SLS regressions on two different databases we conclude that the levels of trust Europeans have towards each other do influence the seeming deficiency of inter-Member State trade in the EU.
If one is to consider mistrust as a market imperfection problem, our study indicates a potential scope for EU-level social policies in the name of consolidating the Single Market.
Keywords
Home Bias
Trust
Gravity Model
European Union
International Trade
Table of Contents
Statutory Declaration
Abstract
Keywords
1Introduction
2Breaching the Distance - Trading in Trust
2.1Trust and Distance
2.1.1Trust: the underlying variable in economic science
2.1.2What is Distance?
2.2The home bias puzzle, a descriptive approach
2.2.1Definitions and Determinants
2.2.2Is the home bias overstated?
2.2.3The impact of trust, culture and institutions on trade flows
3The Gravitational Pull of the Euro zone
3.1The Underlining theory of the Gravity Model
3.2Empirical Strategy
3.2.1Data Analysis
3.2.2Estimation
3.2.3Interpretation
4Conclusion
Bibliography
Annex 1: Trust Matrix
Annex 2 : Descriptive Statistics
Annex 3: Estimation Output
«It can be plausibly argued that much of the economic backwardness in the world can be explained by the lack of mutual confidence»
Kenneth Arrow
“Gifts and Exchanges” Philosophy and Public Affairs, 1972, p. 357
“Borders? I have never seen one but I heard they exist in the minds of some people.”
Thor Heyerdahl, explorer and archaeologist
1
1Introduction
«Nous ne coalisons pas les Etats, nous unissons les hommes»[1] declared Jean Monnet at the dawn of the European Union. Half a century later, Europeans are united by a single currency, a single market and a judicial system that punishes deviation from the principle of an “ever closer Union” enshrined in EU law. Scholars still detect however, trade frictions in the EU in the absence of borders, tariffs, and exchange rate risk. This issue forms the subject of this paper.
This invisible trade barrier was first termed as the “border effect” to emphasize the cross-border aspect of the phenomenon that impedes trade over national frontiers. Empirical studies illustrate that, given both their level of economic activity and the distance separating trading partners, countries tend to trade less with foreign lands than expected. Subsequently scholars have enlarged the scope of this puzzle, calling it the ”home bias effect”, which implies that countries may prefer to trade with culturally and institutionally similar countries. High stakes are involved in resolving the home bias puzzle: if the cognitive distances between countries can be shrunk, the subsequent increase in bilateral trade would benefit all trading partners.
This paper investigates the bilateral trade patterns within the EU15 – the 15 European countries that participate in the European Single Market Programme and share a common currency, eliminating from the outset two “natural” causes of the home bias effect: exchange rate risk and national tariffs. These and similar rationalizations fall in line with today’s orthodox theories. It is this paper’s contention however, that “transaction cost economics” is more adept at assessing the credence of the explanation we propose: trust or the lack thereof. This paper seeks to determine whether it is the lack of trust between EU countries that explains at least in part the invisible barrier that impedes intra-European trade.
The first chapter examines the definitions and determinants of both trust and distance as they relate to trade, before introducing the home bias puzzle. Beyond the puzzle’s definition and “common causes”, it is necessary to investigate the literature assessing its impact as well as the literature arguing that the home bias puzzle is wildly overstated; before then reviewing the relevant literature concerning the impacts of trust and culture on international trade flows.
The second chapter comprises an analytical investigation of the effects of trust on bilateral EU15 trade levels, by first specifying the basic structure of the gravity model, the underlining theory; and the relevant equations. After describing our empirical strategy, the paper concludes with an interpretation of the results obtained.
2Breaching the Distance - Trading in Trust
Our main inquiry relates to the extent that trust may breach the distances between trading partners. The first section begins by defining the two most important variables to our study: trust and distance. The second part introduces the home bias puzzle through the framework of transaction cost economics, and is concluded by an overview of previous literature studying the impact of cultural variables, such as trust, on international trade flows.
2.1Trust and Distance
To quote Kenneth Arrow (1972), “virtually every commercial transaction has within itself an element of trust, certainly any transaction conducted over a period of time.”[2]International trade is so rife with unforeseen and insecure contingencies that, without a certain degree of reciprocal trust, trade between two dissimilar parties would surely be much lower. Trust is however, rarely taken into account in orthodox trade theories. Rather, it is often abusively assimilated to cultural priors which cannot be easily assessed through orthodox theory. Trust must therefore be disentangled from cultural variables, before it is possible to analyze the underlying notion behind trust or lack thereof. If individuals trust each other, it is because there is a certain affinity or connection between them that is conditioned by the subjective distance, agents judge between themselves. The notion of distance therefore, constitutes a natural bridge between the concept of trust and that of the home bias puzzle.
2.1.1Trust: the underlying variable in economic science
What is trust? According to the Merriam-Webster Dictionary, trust is defined as:
(1 a): an assured reliance on the character, ability, strength, or truth of someone or something. [3]
Trust is a bilateral concept that refers to a subjective relationship between two or more agents. In economics, trust is paramount to economic transactions. According to Sandelien (2003) economic trust is “one agent’s sentiments of expectations towards another agent’s positive behavior with respect to oneself, in a situation involving risk.”[4]It is, for example, the determining element of the confidence individuals have in their money, that “businesses must believe that their banks look after their money. Individuals must be convinced that the government will protect their property right. These – and many other types of trust – are prerequisites for a modern society”.[5]Bornhorst et al.(2004) touch the essence of economic trust when they state that preceding each economic transaction, agents must first select a transaction-worthy partner. This choice of partners is notably determined by “the agent’s beliefs about the prospect of building trust and reciprocity with potential partners [and] experience will play a role as well.”[6]
In behavioral economics, trust is depicted in a game with multiple interactions, where the agents discount their future gains by a certain factor. The rational explanation for trust is that “individuals are inclined to trust each other due to pay-offs in the long run.”[7] Both agents use the “trigger strategy,” where they choose to cooperate up to the point where one of the agents fails to do so, switching both agents’ strategies to non-cooperation. The frequent interaction aspect of this game portrays a learning curve where trust increases with each period. Without an initial level of trust however, the interaction cannot begin, which suggests that a different source of trust exists.
The sociological model of trust by comparison, strives to explain the preliminary faith individuals show towards each other. Trust is viewed as a public good that is reflected in the individual’s identity, whether cultural, moral or based on social obligations. In behavioral economics, agents that display this type of trust are altruistic, for an altruistic agent increases his welfare by increasing the welfare of the other agents. The norms and values that guide the individual’s decision are based on a certain lack of diversity amongst players. Such trust exists when a player identifies with the other’s ethic, religious, political, familial, (etc…) insignia and acts accordingly.
Bornhorst et al.(2004) recognize that diversity has a “substantial impact on agents’ initial beliefs regarding partners as well as the evolution of their interactions over multiple transactions.”[8] This diversity, reflected through a person’s cultural affinity, determines the initial level of trust.
2.1.1.1Hofstede’s four cultural dimensions
Linders et al. (2005) note that cultural distance is conventionally assessed through Hofstede’s (1980) four dimensions of national culture.[9] Hofstede (1980) analyzed survey data from 116,000 IBM employees in 40 countries and ranked each country on a scale from 0 to 100 indicating how people from different cultural backgrounds perceive the following four societal dimensions:
(a)Power distance –How different people accept an unequal distribution of power and status as a way of organizing social systems.
(b)Uncertainty avoidance – The degree to which people are willing to trade a high risk/high reward situation for low risk/ low reward. It signifies “the extent to which people are uncomfortable with uncertain, unknown or unstructured situations.”[10]
(c)Individualism versus Collectivism – A society’s emphasis on the role of individualism and collectivism: notably experienced through the type of wage bargaining in place in a given society.
(d)Masculinity versus Femininity – The extent to which a society assesses the importance of one type of stereotypical value over another.
Hofstede’s (1980) measures of cultural distance rely on the degree of uncertainty avoidance that characterizes a given population. His uncertainty avoidance index (UAI) – previously employed in assessing trade flows for perceived cultural distances – may explain the degree of trust underlying international trade patterns.
2.1.1.2Sandelien’s five factors that determine trust
Sandelien (2003) identifies five factors that determine trust and regroups the factors in three categories: predictability, controllability and interdependence. Within the first category, he cites two factors: (a) reputation/history of interaction/information and (b) similarity/identity/moral bonds.
(a)Reputation: refers to a history of past interaction that provides information about the other party’s consistency over a long period of time. Trust can be institutionalized through a middleman acting as a “bridge of trust”[11] where the two agents trust the middleman more than each other.
(b)Similarity: of ethnicity, religion, social belonging, and gender are “subjective sentiments of perceived equality”[12]. This trust -inducing factor is based on the assumption that someone similar will not act opportunistically. In essence, a similarity in religion or social belonging may outwardly signal that certain norms and values are shared, which in turn may create an initial level of trust. As an example, Sandelien (2003) cites the Japanese business culture where “a history of trusting business norms [established] a ‘culture of trust’ in the culture pattern.”[13]
The controllability category consists of the dyadic aspects of contracts and sanctions.
(c)Contracts/sanctions: determine trust by establishing control and transparency, most notably when sanctions are automatic and non-biased towards either party.
The final category of interdependence presents two final variables:
(d)Altruism: The situation in which one party has interest in the well-being of the other party: often present in family relationships. According to the author, emphasizing common goals can also be assimilated to this notion.
(e)Asymmetry: One party has an upper hand or outright power over the other party. Sandelien (2003) doubts whether asymmetry is a determinant factor of “trust” despite it leading to cooperation, since asymmetry corresponds rather to a situation of fear or bondage towards the stronger party.
The notion of trust thus overlaps cultural variables, since it draws from both rational and sociological sources. Orthodox theory struggles with the concept of trust, since the neoclassical world operates on the strong assumption that transactions are costless actions, and market imperfections are at most ephemeral in nature. According to Sandelien however, mistrust is a market imperfection problem, and one that cannot be resolved by equilibrating supply and demand.
Building on Coases’s (1937) foundations that firms were created in order to internalize transaction costs, Willliamson (1998) developed the theory of transaction cost economics: the “science of contracts”. Since contracts are inevitably incomplete, trust can complete contracts by diminishing transaction costs. How does trust diminish transaction costs?
Search costs, the costs of matching supply and demand, can be diminished if a company operates within a trustworthy network of business relations, or if it trusts in another’s reputation. Trust reduces negotiation costs, the costs of concluding a contract, because when the two parties to the contract trust each other, their contracts need to be less exhaustive on prices, qualities and sanctions. Furthermore, it diminishes control costs, the costs of monitoring an agreement, when a trusting relationship between buyers and sellers guarantees quality, delivery time, etc. Trust as reflected in Sandelien’s three categories acts as a safeguard against opportunism, and breaches the cognitive distance that separates agents involved in an economic transaction. Distance is indeed an essential concept to our paper; after assessing this notion as a multidimensional concept we will discuss whether distance has been abridged in a globalized world.
2.1.2What is Distance?
Both the impact of trust and the existence of a home bias are conditioned on distance, whether perceived or real. Distance is however, a broader concept than Hofstede’s uncertainty avoidance index suggests, with subjective aspects present within all notions of trust, the home bias puzzle and the gravity equation that will be used to estimate the effect of trust on the home bias puzzle.
2.1.2.1Distance - a multidimensional concept
Distance is a fluid concept. For instance, international metropolises are closer to each other than to secondary cities despite the actual distance covered “as the crow flies”.[14] Beyond actual mileage, Gatrell’s (1983) classification distinguishes between four different types of distances:
-Time Distance: the time required to travel between two entities;
-Economic Distance: the costs of traveling from one area to another;
-Cognitive Distance: the subjective perception of distance; and
-Social Distance: the distance between networks or social classes could be assimilated to Hofstede’s cultural distance.
These four types of distances, independent of actual longitude and latitude, can thus be expanded or contracted according to both perceptions and technological advances, such as transportation improvements. The next paragraph examines distance reducing factors and whether globalization has had an impact on cognitive distances.
2.1.2.2Do networks and ICT contract distances?
Travel time and cost influence the cognitive perception of distance - and thus of trust - by making foreign entities physically more accessible. Two other relevant variables however, influence the perception of distance: the cultural networks existent in the foreign land and the penetration of information and communication technology (ICT) – both consequences of globalization.
Rauch (2001) argues that unlike standardized goods bought on organized markets, the price of differentiated goods, of variable quality, has to be negotiated. The risks of moral hazard are substantial, raising the stakes in choosing the appropriate trading partner. National and regional institutions reduce costs associated with researching business opportunities and potential partners. In global environments however, where language and cultural barriers subsist, ICT is said to further diminish information costs. However, the Internet cannot yet check if your chosen partner is trustworthy. Leamer and Storper (2001) suggest that the Internet makes long-distance “conversations” not “handshakes” – in sum, ICT can’t start business relationships but can only maintain them.
Brun et al (2002) tested the idea that communication only strengthens already existent relationships, and found that, long distance trade between new partners is unaffected by ICT. More specifically, they observed that distance is increasing between poor countries, but elasticity to trade between rich countries is decreasing. Globalization is therefore marginalizing poor countries, whereas it reduces the cognitive distance between rich countries. One solution is to induce trade within cultural networks where risk of opportunism is lessened.
According to Rauch (2001), “an economic network can be defined as a group of agents that pursue repeated and enduring exchange relations with one another.”[15] Trade within co-ethnic networks, such as those spread through globalized migration, heavily depend on two key factors: information and trust. Information flows concerning markets, participants and the trustworthiness of external partners to the network, reduce search costs and allow for international arbitrage. Trust is determined through frequent interactions, knowledge transfers about past conducts, and various forms of conduct monitoring. Network-maintenance however, demands frequent interactions and broad information channels. Consequently, less interaction and poorer information, due to the breadth of distance separating partners in the same network, reduce trust levels. Furthermore, studies have discerned that whereas within networks trust is increased, between co-ethnic networks, the sentiment of trust is lower. This is because co-ethnic networks are predominately local in character, indicating that instead of increasing trade over long distances they may actually inhibit it.