Knowledge, trust and recourse: imperfect substitutes as sources of assurance in emerging economies Assurance and trust Bruce L. Benson Uncertainty prevents Introduction1 in production and trade.’2 Arguments such as these voluntary interactions, but There is no assurance problem when information is fail to recognise that trust is an alternative to institutions of trust and/or free and complete, but such perfect knowledge does recourse, and that there are non-state sources of recourse can substitute for not exist anywhere except in some economists’ recourse. knowledge by making mathematical models. Information is so scarce in the promises relatively credible. real world that trust or recourse often must substitute Building trust Trust and various sources of for knowledge in order to make promises credible. It is widely recognised that repeated dealings create recourse are imperfect While trust and recourse are both substitutes for an environment conducive to the development of substitutes, however, as knowledge, however, they are not perfect substitutes trust, because incentives to employ co-operative demonstrated by for each other.Trade-offs mean that under some strategies (for example, live up to promises) arise. In consideration of the circumstances trust provides a superior solution to emerging economies, repeated-dealing arrangements trade-offs between trust assurance problems, while recourse may be more must be established, however. For instance, McMillan based on repeated dealings, desirable under other conditions. Furthermore, there and Woodruff, in their study of emerging trade in recourse to informal private are alternative institutional mechanisms for the Vietnam explain that an entrepreneur tends to be sanctions such as reputation provision of recourse, and they also are imperfect very cautious when considering a potential trading threats, ostracism sanctions substitutes.The following paper examines some of partner.3 He often visits the plant of the firm he is and third-party dispute the trade-offs between alternative institutional considering in order to see if the facility appears to resolution through formal sources of trust and recourse in emerging markets. be permanent and efficient. He inspects the output commercial organisations Some of the economies of formerly communist and of the plant, asks other trusted traders if they have operating under customary newly independent Eastern Europe, still-communist dealt with or know about the potential partner, and law, and the state’s coercive China and Vietnam,and non-communist Asia, the so on.The information gathered can never be perfect legal system. The problems East Indies,Africa and Latin America may be but if it is positive, a small trade is often arranged. If of knowledge and interest growing, but some are stagnant and others are in that one works out, the next one is larger. It is only imply that, though not decline.While ‘experts’ point to many factors that after several deals that the transactions reach a level perfect, private sources of slow or prevent economic growth, many now that involves a substantial commitment.This can take trust and recourse are recognise that the pace of development is a function time, of course, and that is obviously one of the superior in emerging of the institutional environment.The fact is that drawbacks of relying on trust relationships. markets to state-provided many of these economies can be described as Traders may be able to gain the trust of others recourse. low-trust societies. relatively quickly by investing in signals that Trust, a willingness to make oneself vulnerable to demonstrate a commitment to fair dealing. For another even in the absence of external constraints, instance, Nelson explains that the advertising of certainly can evolve to support trade, as explained experience goods serves two primary functions for below, but it takes time and it can be limited to the rational buyer, and neither of these functions relatively small trading communities. If traders are focuses on the provision of direct information about going to be willing to deal with others that they do the experience quality of commodities that are not trust, recourse in the form of credibly threatened advertised: first,‘advertising relates brand to function’ sanctions against breaches of contract (perhaps and provides information about the general uses of supported by third-party dispute resolution) is a the product, but second and more important, the necessary substitute.The legal systems in many volume of advertising is a signal to buyers that shows countries with emerging economies do not provide the extent of committed investment by the seller.4 consistent and predictable recourse, however. According to Nelson, then, what matters most to a Nonetheless, many consultants and academics rational buyer is not what advertising says about contend that the solution to the assurance problem quality, but simply that it is a recognisable investment must come from the state. In writing about law in in non-salvageable capital: brand name.Advertising the newly independent countries of the former may not be as important in an emerging economy as Soviet Union, for instance, Ioffe maintains that it is in a developed economy, but there are other legislation of commercial law ‘must now be non-salvageable assets (such as elaborate store fronts, comprehensive [due to]… the emergence of gaps in charitable contributions, community service) that can Bruce L. Benson is DeVoe Moore the law [and] the restructuring of the former Soviet serve the same function. Essentially, investments in Distinguished Research Professor, economy which requires new legal regulation’; and non-salvageable assets are offered as a bond to ensure Department of Economics, Florida State University, Tallahassee, later that ‘the commercial code, not taken literally, credibility. Buyers must be aware of such FL 32306, USA. must encompass all forms of economic activity, both commitments, and if so, as Klein and Leffler explain, 12 the marginal cost to buyers of measuring such to such investments are delayed and very uncertain, specialised or non-salvageable investments must also incentives to make them tend to be relatively weak, be less than the prospective gains:‘If the consumer and the emergence of commerce based on such estimate of the initial sunk expenditure made by the sources of recourse also can be quite slow. Much of ECONOMIC firm is greater than the consumer estimate of the this uncertainty is due to the state, however.As AFFAIRS firm’s possible short-run cheating gain’ then they will Pejovich notes,‘The arbitrary state undermines the March 2001 tend to trust the seller.5 Furthermore, when effective stability and credibility of institutions, reduces their recourse is not available, firms have very strong ability to predict the behaviour of interacting incentives to make such investments (incentives that individuals, raises the cost of activities that have could be much weaker if they were relying on some long-run consequences, and creates conflicts with third party to impose sanctions). the prevailing informal rules … [M]ost countries in Eastern Europe [and many other parts of the world] From trust to reputation and recourse are arbitrary states.’6 When property rights are Most arguments about the inability of private parties insecure due to potential arbitrary and/or to co-operate without the backing of a coercive opportunistic behaviour by government (for instance, power are explicitly or implicitly prisoners’ dilemma changes in tax policy to capture the quasi-rents that arguments.As suggested above, however, the one-shot arise with investments in reputation), incentives to prisoners’ dilemma analogy does not characterise invest in reputation or to count on future dealings most kinds of commercial interactions, even in are weak and the kinds of private sanctions discussed emerging economies.When repeated dealing here are likely to be relatively weak. But that also arrangements and/or non-salvageable investments are means that the state cannot be relied upon to provide valuable, traders obviously have recourse. If a trader consistently effective recourse, as traders clearly partner fails to live up to a promise, commits fraud recognise (even if policy ‘experts’ do not). McMillan or behaves opportunistically, the victim can threaten and Woodruff’s interviews of entrepreneurs in punishment. Sanctions can involve tit-for-tat or exit Vietnam show that despite their frequent reliance on in repeated dealing arrangements, for instance, but informal sanctions (tit-for-tat, exit, spreading non-salvageable investments create a potential threat information about non-cooperative behaviour), these that is even stronger: a threat to spread information entrepreneurs do not want the state to get involved about non-cooperative behaviour.Traders have strong in contract enforcement because they do not trust incentives to avoid dealing with a firm they believe the state either.7 may not be trustworthy, so if the spread of information is sufficiently effective a spontaneous Formalising spontaneous sanctions: recourse through boycott can be anticipated. Such an ostracism threat trading organisations can be a very powerful source of recourse, since the Both commitments and threats can be made more offending firm will lose all of the value that attaches credible, and some uncertainty can be eliminated, if to its non-salvageable asset.Therefore, in order to individuals with mutual interests in long-term