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New Institutional Economics: Identifying social capital

Expanding the elusive idea of social capital and weaving it into the NIE framework for the purpose of better analysing public and social policy issues

I had briefly discussed the importance of social capital in my article 'Tragedy of the Commons' in these columns on November 19, 2019. Here, I propose to expand the idea of social capital and incorporate it into the NIE framework to make it more realistic and better suited to analysing public and social policy issues.

Physical CAPITAL, Human CAPITAL and Social Capital

In economics, the idea of physical capital as a factor of production is as old as the discipline of economics. Later, there were mathematical models also proposed to measure physical capital. Concepts such as discounted value and depreciation further refined the treatment of physical capital in various growth models and economic theories. Similarly, the idea of human capital has also been around for a while. In economic theory, education has been dealt with as human capital by Adam Smith as far back as 1776. In trying to explain the cause of the prosperity of nations, he isolated two factors: one, the importance of economies of scale and two, the importance of skill formation and human qualities. The second factor is popular today as 'human capital'. The neoclassical model specified by Solow (1956) found a large 'residual' in explaining economic growth. Later work by Solow (1957) himself and other growth theorists (Romer 1986; Krugman 1987) attributed this 'residual' to school education and human capital. In the neoclassical tradition, another important approach to education was put forward by Gary Becker in 1964. Proposing the 'Human Capital Theory', Becker regarded education as an investment that conferred benefits at the individual level as well as the collective level. Unlike physical and human capital, social capital is still not widely used and accepted in economics. However, more and more research, particularly in public policy and New Institutional Economics has been referring to concepts such as 'trust' and 'credible commitment'. Let us turn to this now.

To be sure, the concept of social capital is rather contentious and has eluded a consensus. Fine's 'Theory of Social Capital' (2005) is a detailed discussion on the origins of social capital, its elasticity and flexibility as a concept and a lack of focus because of a surfeit of applications and definitions. He compares the approach to social capital to Mcdonaldisation of social theory, which means that social capital is what a researcher or social scientist wants it to be. Just as there can be numerous ways to put together a Mcdonald's burger and just as a Mcdonald's outlet can be found in any local market anywhere in the world, the concept of social capital is widespread and lacks focus.

While there are many such critiques of social capital, I believe that it is a powerful concept that can help better analyse many complex public policies and social policy questions. Recall that the Nobel prize winner, Douglass North had defined institutions to include both formal and informal constraints affecting human behaviour. The informal constraints included norms, which is perhaps an ingredient of social capital. In other words, if we take the macro view of institutions that North took, a community which follow norms would have a higher level of social capital and may be better placed to participate in various government and non-government policies and programmes. Let us discuss these issues in more detail below.

Various Theories

The origin of the term social capital is credited to Hanifan, the state supervisor of rural schools in West Virginia. Writing in 1916 to urge the importance of community involvement for successful schools, Hanifan used the term social capital to describe, "those tangible substances [that] count for most in the daily lives of people: namely goodwill, fellowship, sympathy, and social intercourse among the individuals and families who make up a social unit…". Putnam (2000) states that the same idea was independently rediscovered in the 1950s by Canadian sociologists to characterise club memberships in suburban areas, in the 1960s by urbanist Jane Jacobs to study good neighbourliness in today's metropolis, in the 1970s by economist Glenn Loury to analyse the social legacy of slavery, and in the 1980s by French social theorist Pierre Bourdieu and by German economist Ekkehart Schlicht to unpack the socioeconomic resources inherent in social networks. Coleman (1988,1990) integrated the basic tenets of rational choice theory and social structure and sought to reconcile contradictory ways of explaining human behaviour in economics and sociology. Becker (1993) and Becker and Murphy (2000) extended Coleman's work by integrating price and utility theory with social capital theory. Lin (2001) provides a theory of social capital and characterises social capital as resources embedded in networks, available to individuals or groups to achieve their objectives.

While the approach to social capital proposed by Bourdieu and others has been discarded, Gary Becker's approach as one of rational choice and utility maximisation has been set aside by even fellow economists. As Gary Akerlof, a Nobel prize-winning economist once put it: "Gary Becker knows how to spell b-A-n-A-n-A, but doesn't know where to stop." What Akerlof meant was that there was a limit to applying the rational choice model and couldn't be applied to issues such as social interactions, culture, trust etc. Among the many approaches to social capital, it is worth delving a little more into Coleman's formulation and Putnam's proposals.

James Coleman's approach

Coleman (1988, 1990) wanted to reconcile two contrary views of human behaviour: 'Homo Economicus vs. Homo Sociologicus.' One view, characteristic of the work of most sociologists looks at the actor as a socialised being and action as governed by norms, rules, and obligations. The other view, noted in the work of most economists (especially of the neoclassical persuasion and New Institutionalists), takes the actor to be a utility maximising, self-interested individual. Coleman's theoretical enterprise has been to introduce the principle of rational action and utility maximisation into the social context and show how this can explain individual action in particular contexts as well as account for social organisation. According to Coleman (1988, 1990), the concept of social capital is a tool that drives this theoretical enterprise. This is why he collaborated with the high priest of neoclassical economics, Gary Becker at the University of Chicago.

For Coleman, social capital has two elements: it is an aspect of the social structure and it facilitates certain actions of the actors within the social structure (1990, p.302).

'Bowling in America'

Putnam (1993, 1995a, 1995b, 2000) set the trend for empirical studies, which quantified social capital. Other empirical studies on social capital have come out of the World Bank Social Capital Initiative (Philip Keefer and Stephen Knack, 2005).

Putnam's 1993 study was on the performance of local government in Italy. This work was, in turn, inspired by Tocqueville's work on democracy in America. In the 1830s, Tocqueville toured America to explore the reasons for the vitality of American democracy as opposed to a weak democratic ethos in France. He found the answer in the propensity of Americans to form voluntary associations.

Putnam measured social capital by looking at citizen engagement in community affairs. He did so by looking at the membership of citizens in clubs, newspaper readership, church membership, parent-teacher associations, labour unions etc. For Putnam, social capital is a characteristic of the aggregate community and civic engagement leads to a tight web of social interactions and greater trust. Thus, cooperation begets cooperation, setting in motion, a 'virtuous circle'. Putnam applied these ideas to the regional government in Italy and found that the performance of the government and social institutions was influenced by citizen engagement in community affairs.

Later, Putnam extended his analysis to examine social capital in America (1995a, 1995b, 2000) and found that membership to bowling league clubs among other things was declining. In his latest book, Putnam has elaborated on his earlier findings. The general conclusions are the same: in politics, civic life, religious life and the workplace, fewer Americans are joining associations and getting involved in face-to-face interaction with their neighbours and colleagues. In short, social capital, as defined by Putnam, in America has declined since the 1960s.

While Coleman's approach to social capital has been discredited for the same reasons as Becker was criticised, Putnam's analysis has been more robust and has stood the test of time. It is still largely accepted. However, Putnam's approach has also been criticised.

One of the earliest and most comprehensive critiques of Putnam's thesis was offered by Margaret Levi (1996). She questioned the origins of the expectation that people will trust each other and follow rules, the mechanisms that maintain such an expectation of mutual trust and how do such expectations promote good government. Levi also criticised Putnam's use of the concept of path dependence (originally proposed by Douglass North) to show different paths of development and different equilibria in North and South Italy. While North Italy witnessed positive effects of social capital and a virtuous equilibrium resulted, South Italy witnessed a vicious equilibrium. Levi contends that Putnam does not use the concept of path dependence rigorously. Even though past events constrain today's choices, they are not the only determinants of decisions at all points. Path dependence implies that preceding steps in a particular direction lead to further movement in the same direction. This is well captured by the idea of increasing returns. In a process exhibiting increasing returns, four features are important: unpredictability, inflexibility, nonergodicity (small events are remembered) and the potential inefficiency of the path taken (Arthur 1989). In an increasing returns process, the probability of further steps along the same path increases with each move down that path. This is because of learning effects: relative benefits of the current activity compared with other possible options increase as the process is mastered. According to Levi, these concepts have not been used to illustrate the differential paths that North and South Italy took. Levi was also not convinced by mechanisms identified by Putnam which lead to a growth in the trust. According to her, it is not clear how membership in soccer clubs or bird-watching societies would lead to a high level of civic engagement and therefore more efficient government performance. Putnam's argument is that the membership in such clubs leads to a high level of social capital in the form of dense networks of civic engagement and generalised trust. This leads to overcoming collective action problems in lobbying the government and therefore betters government performance. Levi concedes that this might happen but says that this is hardly a theory that identifies the mechanisms of production, maintenance, and growth of social capital. Further, Putnam claims that trust is an important component of social capital but does not offer a definition of trust. Finally, Putnam establishes a link between civic engagement, good governance and democracy. However, according to Levi, the links are not clear. The causation from membership of clubs to generalised trust to good governance is not convincing. As Levi puts it, the causal chain between bird watching and political activism is not clear.

Other critiques of Putnam were offered by Jackson and Miller in 1996 (they disagreed that political culture, of which social capital was a component, drove other outcomes), Skopcol in 1996 (that Putnam's analysis had no role for the government), and Brehm and Rahn, Wills in 2000 and Fukuyama in 2000 (both make the point that social capital has not declined but just transformed to new forms of social and economic engagement through information technology etc.)

Operationalising Social Capital

In the above discussion, the concept of social capital has been discussed primarily at the macro-level or as a resource that a collectivity or community uses as a public/collective good to lower transaction costs of organising themselves. There is another interpretation of social capital at the micro-level proposed mainly by sociologists such as Lin, Burt and Granovetter. The micro approach focuses on individuals investing in social relations and how embedded resources in these social relations (the use of social capital) are used by individuals to meet their objectives. I believe that both the macro and micro views have to be relied on to answer questions of public and social policy. It can also be woven into New Institutional Economics (NIE) and enrich our analytic tools. Hence, I interpret social capital to be a collective resource that can be accessed by an individual, group or collectivity to overcome their collective action problems and lower transaction costs of organising themselves. In other words, social capital is the resources, real or potential, gained from relationships. These relationships, in turn, facilitate the action of individual actors. Social capital can appear in a number of forms: trustworthiness of the social environment (which means that obligations will be honoured), as a source of information in social relations (lowers information costs) and, as norms and effective sanctions (lowers monitoring and sanctioning costs). In the coming articles, we will elaborate further on weaving social capital into the NIE framework and then use the NIE plus social capital framework to analyse public and social policy questions.

The writer is an IAS officer, working as Principal Resident Commissioner, Government of West Bengal

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