Would I invest in my sibling’s venture? Well, if I am sure that he or she is not going to squander it away on a trip to Vegas, why not? Would I invest in the same venture, if it is proposed by a total stranger? Perhaps not.  I would be wary of this opportunity, having no idea who the person is. Now in any real-world economy, the investment decision is much more complex than that, depending not only upon the set of investment alternatives but also on the strategic interaction between the investors.  A simple way to explain this is through a game used by Denise Hazlett in her 2007 paper titled “A Classroom Investment Coordination Experiment”. In this game, there are four firms making simultaneous investment decisions. These firms can either make a high (H) or a low (L) level of investment. If a firm chooses a high level of investment, it can produce more goods. However, unless the other three firms also choose a high level there will be a fall in the national income and households will not be able to afford these goods. Therefore, unless all its fellow firms are investing a high level, a firm is better off investing a low level. The table below describes the payoffs to a firm, depending upon the investment decisions of the other three firms.

Number of other firms choosing H 0 1 2 3
Profits for H 0 1 3 5
Profits for L 2 3 4 4

 

If the firm in question chooses H while the other three firms choose L (Column 1 of the table) then that firm would earn 0 profits; the economy being in recession, a high level of investment does not get translated into higher revenues. On the other hand, when there are three firms choosing a high level of investment (Column 4 of the table), the remaining firm will benefit from investing a high level itself, making use of the expansionary state of the economy.

This game has two pure-strategy Nash Equilibria, one where all the firms choose to invest L (LLLL), causing a recession, and one where all the firms choose to invest H (HHHH), causing an expansion. Notice that higher the number of firms choosing H, higher is the combined profits of the firms, the maximum being when all four firms choose H. Not only that, HHHH is the best outcome for an individual firm too as it earns the highest possible profits in that case. What this means is that out of the two NEs, HHHH is Pareto-superior. However, choosing H is risky because the firm cannot be certain of what its counterparts would choose. A firm must believe that everyone else in the group will choose H for its best response to be H (Hazlett, 2007). If the uncertainty related to investment decisions persists, firms will be averse to making high investments and the economy would be closer to, or at, LLLL.

When can a firm be sure of its fellow firms choosing a high level of investment? In a four-firm economy such as above, talking amongst themselves might assure the firms of each other’s decision. As observed in Hazlett’s experiment, direct communication between the players does improve coordination in investment decisions. With more and direct communication, one has fewer reasons to suspect opportunistic behavior from others, making coordination easier. However, any sort of direct communication between investors is implausible to accomplish in a real-world economy.  And even if it was achievable due to some miracle, in order to be absolutely certain, a firm has to truly believe what the other firms are communicating. Or simply put, a firm has to trust the other investing firms.

How is social trust established in an economy? This is where one needs to bring in the distinction made earlier, of trusting a family member against trusting a stranger. The former is the kind of trust that comes naturally, almost instinctively, to us while the latter is the kind of trust that emerges from the intricacies of a society. Countries with high social trust have better governance, a stable political environment, and a binding rule of law, to say the least.

Unfortunately, social trust in India is far from being optimal. People in general are untrusting of the government and the corrupt behavior of politicians and bureaucrats only substantiates the cynicism that prevails. This wariness is further compounded by the long and winding judicial process in the country, the average life of a case being 10-15 years.  As of January, 15th 2017, there are around 2.81 crore cases pending and 5,000 judge posts empty in India.  

As mistrust becomes the new normal, subconsciously or through force of habit, we become more pessimistic. The lack of social trust not only interferes with the routines but also with the investment decisions. This could be one of the reasons why India has been stuck in the low investment equilibrium (LLLL) for about 70 years now.  To push an economy towards a high investment equilibrium (HHHH), the investment climate needs to be made risk-free, optimistic and trusting. India needs a structural reform to overhaul this conception of mistrust in the economy.

While the jury is still out on the overall impact of Demonetization, this move by the incumbent government has infused some level of trust in the people. Politicians in the country are perceived to be self- interested, motivated to undertake policies that will prove useful in the next election. Structural reforms involve long and slow-churning policies with few or no immediate results. Demonetization has signaled that the acting government is not shying away from undertaking these much-needed reforms. Through Demonetization, the Modi government has shown a strong commitment towards the fight against corruption in India and has managed to build social trust in the country.  

Having said that, India still has a long way to go. While Demonetization has nudged the economy out of the low trust equilibrium(LLLL), serious structural reforms are needed to achieve and sustain the High Trust Equilibrium (HHHH). Failing to do so, Demonetization will become nothing but a political stunt in the minds of the people, throwing the country back into the LLLL equilibrium.

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