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con¬rming beliefs. One of the most important purposes of
monetary policy is to maintain the value of money.

Money enables transactions to be anonymous. Those anonymous
transactions are concluded in one go, as when Becky buys CDs in
the department store of her town™s shopping mall and pays for the
purchases in cash. Millions of transactions take place each day

between people who have never met and will never meet. The
problem of trust is in great part solved in Becky™s world by building
con¬dence in the medium of exchange: money.

Because of an absence of good roads, electricity, and running water,
markets are unable to penetrate Desta™s village. Becky™s suburban
town, in contrast, is embedded in a gigantic world economy. Becky™s
father is able to specialize as a lawyer only because he is assured that
his income can be used to purchase food in the supermarket, water
from the tap, and heat from cooking ovens and radiators.
Specialization enables people to produce more in total than they
would be able to if they were each required to diversify their
activities. Adam Smith famously remarked that the division of
labour is limited by the extent of the market. Earlier we noted that
Desta™s household doesn™t specialize, but produces pretty much all
daily requirements from a raw state. Moreover, the many
transactions it enters into with others, being supported by social

norms, are of necessity personalized, thus limited. There is a world
of a difference between markets and communities as the basis of
economic activities because there is a world of a difference between
laws and social norms.

The models we have been studying capture those all-too-familiar
situations where cooperation requires institutions (arrangements
for implementing agreements, which specify who is to keep an eye
on whom, who is to report to whom, and so forth), but where non-
cooperation is a possible outcome even when those institutions are
in place. We know that certain institutions work smoothly in some
places, but not in others. A nation may adopt an enlightened
constitution, but whether its citizens can bring themselves to work
within it is a different matter. What people choose to do depends,
among other things, on their beliefs about one another. The theory I
am developing here doesn™t explain those beliefs; what it does is
to identify those that are self-con¬rming. Economists call them

rational beliefs. Nothing philosophically deep is meant by the term
˜rational™ here: rational beliefs are beliefs that are self-con¬rming,
nothing more. The models have also told us that, in a wide variety of
everyday situations, rational beliefs are not unique. Some give rise
to outcomes that protect and promote human well-being, others
thwart it. What gives rise to one set of rational beliefs rather than
another? Could it be culture?

In his famous work on the in¬‚uence of culture on economic
development, the sociologist Max Weber took a community™s
culture to be its shared values and dispositions, not just beliefs.
Studies as widely cast as Weber™s can™t easily be summarized, but
the causal mechanism Weber himself would seem to have favoured
in his work on the Protestant ethic and the spirit of capitalism leads
from religion, through personal practices and political culture, to
institutions, and thereby to economic outcomes.

Using culture to explain economic performance hasn™t been

popular among social scientists in recent decades; but there has
been a revival. For example, economists have constructed a
measure of trust in societies from the World Values Survey, which
in the early 1980s and 1990s surveyed 1,000 randomly selected
individuals in each of 40 countries and asked them if, generally
speaking, they would say that most people could be trusted or that
they could not be too careful in dealing with people. Trust was
measured by the percentage who replied that most people could be
trusted (the percentages were found to be pretty much the same in
the two surveys). The investigators controlled for differences in
GDP per head among the countries that were surveyed. The data
revealed that trust, on the one hand, and judicial ef¬ciency, tax
compliance, bureaucratic quality, civic participation, infant
survival rate, educational achievement, the performance of large
¬rms, and growth in GDP per head, on the other hand, moved
together. In statistical jargon, they were positively (and
signi¬cantly) correlated. Not surprisingly, the data also revealed
that trust and government corruption moved together, but in

opposite directions. The two variables were negatively (and
signi¬cantly) correlated.

We could conclude from the World Values Survey that trust is good
for economic growth and several other good things besides. But the
survey didn™t identify the reasons why the degree of trust in each of
the countries sampled was what it was. Nor could it identify the
reasons. This poses a problem. As trust doesn™t get created in a
vacuum, its presence cries out for explanation. Which means that
the presence of trust shouldn™t be used to explain the presence of
something else. What the statistical ¬ndings tell us is that such
emergent features of an economy as the degree of trust people have
in one another go hand in hand with economic progress, they tell us
nothing more. Statisticians remind the rest of us repeatedly that
correlation isn™t the same as causation. It is an instruction social
commentators have all too often ignored.

That said, to have observed a positive correlation between trust and
economic progress is informative because the theory we have been
developing here predicts positive correlation. If the correlation had
been negative, we would have been utterly surprised. We would
have questioned the ¬nding and gone back to the drawing board,
either by redoing the survey, or by trying to identify hidden
variables in the data that could account for it.

All this is in line with a train of thought regarding institutions that
I have been exploring here, that long-term relationships are often
substitutes for trust in government of¬cials to deliver public
services or for con¬dence in the ability of formal markets to
function adequately. Perhaps people enter into long-term
relationships when the other institutions that could serve similar
purposes are unreliable.

In addition to questions on trust, the World Values Survey
contained a list of character traits and practices, including thrift,
saving money and objects, determination, obedience, and religious

faith. The survey asked people to identify the one they regarded as
the most important. Based on their responses, political scientists
have constructed an index of culture that re¬‚ects the personal
motivation to achieve. Controlling for other factors, differences in
economic growth and the index of personal motivation were found
to go together “ they were positively and signi¬cantly correlated.

This ¬nding shouldn™t be given a causal interpretation either. The
motivation to advance oneself could depend on one™s expectations
regarding the chance that hard work pays off. Parents would instil
personal ambition in their children only if they were sanguine that
such ambition would not be thwarted by the social order. Women
wouldn™t rise beyond their station if they (rationally!) feared
retaliation against them for their temerity. Even an attitude can be a
determined rather than determining factor. When it™s the former,
an observed statistical link between the culture of, say, thrift and
economic progress should be interpreted as a relationship, nothing
more. I am using the term ˜culture™ here to denote differences in

the beliefs people hold about one another. Culture in this view is a
coordinating device.

Attitudes toward others and toward one™s institutions are
signi¬cant aspects of a society™s culture. The models we have
studied so far have focused on the latter. In what follows we look
at the former, by studying socially in¬‚uential behaviour.

Socially in¬‚uential behaviour
The fertility rate (TFR) in Desta™s world is more than twice as high
as in Becky™s world (Table 1). What accounts for the huge

In Chapter 6 we will explore such factors as the costs and bene¬ts
parents experience from having children and the relative ease with
which households have access to modern reproductive technology
and health care. Here we focus on socially in¬‚uential behaviour as a
possible factor. Conformity is one example. By conformity, I mean

imitative, or herd, behaviour. Reproductive behaviour is conformist
if, other things being equal, each household™s most desired size is
larger, the greater is the average household size in the group with
which it identi¬es.

In Figure 6, I have drawn a hypothetical curve, AB, which re¬‚ects
the dependence of the average household™s desired fertility rate (Y)
on the community™s fertility rate (X). It is upward-sloping,
re¬‚ecting conformist behaviour. I have so drawn AB that it
intersects the 45-degree line at three values of X: 2, 4, 7. The
hypothetical community would be at a reproductive equilibrium at
each intersection: as long as the community™s fertility rate is 7, the
average household would most desire 7; but if it is 2, the average
household would desire 2. So, conformism can be the reason for the

6. The relationship between the average household™s desired fertility
rate and the community™s fertility rate

existence of multiple reproductive equilibria. This means that
communities that are separated from each other, but are otherwise
identical, could behave very differently. In our example, it could be
that the TFR in some communities is 2, while in others it is 7. (A
TFR of 4 is also a reproductive equilibrium, but it is unstable,
meaning that if a community™s TFR were ever so slightly different
from 4, it would diverge from 4 even more with time.)

People tend to identify with more than one group. Often, our food
habits have been acquired from our parents, our work habits
in¬‚uenced by those in our profession, our leisure habits by our class,
and our reproductive goals by our religion or ethnic background. It
may be that we conform because we care about our status, and our
actions signal our willingness to be a part of our group. No matter
what the basis of conformism happens to be, there would be
practices encouraging high fertility rates that no household would
unilaterally wish to break. Those practices could have had a
rationale in the past, when mortality rates were high, rural

population densities were low, the threat of extermination from
outside attack was large, and mobility was restricted. But practices
can survive even when their original purposes have disappeared,
especially perhaps if people look over their shoulders at what others
are doing before deciding what they themselves will do.

Conformist behaviour would change over time if the reference
group on whose behaviour households base their own decisions
changes. Even within a group there are those who experiment, take
risks, and refrain from joining the crowd. They are the tradition-
breakers, often leading the way. Demographers have noted that
educated women are among the ¬rst to make the move towards
smaller families. Middle-class behaviour can also be the trigger for
change. A possibly even stronger pathway is the in¬‚uence
newspapers, radio, television, and the internet exert by transmitting
information about lifestyles elsewhere. In other words, the media
can be a vehicle by which conformism increasingly becomes based
on the behaviour of a wider population than the local community:

the reference group widens. Increased conformity with the
behaviour of people in distant lands can even be mistaken for
growth in individualism. We now have the beginnings of a theory of
demographic transitions, by which we mean a relatively brief period
of time during which the TFR cascades down from a high ¬gure to a
relatively low ¬gure. In recent years there have been signs of
demographic transitions even in parts of sub-Saharan Africa, where
the TFR has dropped from 7“8 to 4“5. But there remain parts of the
continent where the TFR remains nearly 8.

In her study of demographic change in Western Europe over the
period 1870“1960, Susan Cotts Watkins found that in 1870, before
the large-scale declines in marital fertility had begun in most areas
of Western Europe, demographic behaviour differed greatly within
countries. The fertility rate among provinces (counties, cantons)
differed considerably, even while differences within provinces were
low. There were spatial clusters within each country, suggesting the

importance of the in¬‚uence of local communities on behaviour. By
1960, though, differences within each country were less than they
had been in 1870. Watkins explained this convergence in behaviour
in terms of increases in the geographical reach national
governments enjoyed over the 90 years in question. The growth of
national languages could have been the medium through which
reproductive behaviour spread.

More transient forms of herd behaviour are fads and fashions.
Imagine that each person can choose one of two actions, P and Q.
Suppose that everyone has an intrinsic preference for P, but that
people also like to conform. To model this, imagine that each person
would choose P over Q if the proportion of people choosing Q is
expected to be less than 65%, but that each person would choose Q
over P if the proportion is expected to exceed 65%. The ¬gure 65%
is a critical mass. (Mathematicians would call the critical mass a
separatrix.) Once again, simple herd behaviour could lead everyone
to adopt Q, even though they would all have preferred that everyone
had adopted P. A dynamics similar to the one I have just sketched to

describe demographic transitions shows that fads and fashions can
disappear without much prior notice.

Competitiveness (trying to ˜beat the Jones™s™) can also lead to
socially in¬‚uential behaviour. Surveys in which people in Desta™s
world were asked to report how happy they were as compared to the
past have con¬rmed that income matters to the very poor: reported
happiness was found on average to have increased with rising
incomes. But similar surveys have found that income doesn™t
contribute to happiness among people who have a good deal more
than the basic necessities of life. Those who are poorer in Becky™s
world are certainly less happy; but even though there was economic
growth in the periods covered by the samples, the distribution of
declared happiness remained pretty much the same.

A possible explanation is that, when income levels are reasonably
high, the extent to which someone feels happy is in¬‚uenced by his
income relative to the average income of his reference group. In the

presence of such a competitive urge, a ˜rat race™ ensues and
resources are wasted. The multiple equilibria are of growth rates in
incomes. In each equilibrium people grow richer on average and
consume more, but don™t feel any happier.

Chapter 3

People throughout history have been known to devise ingenious
ways to cooperate. One way is to make the bene¬ts and burdens in
one engagement depend not only on what takes place there, but also
on what happens in some other engagement. In Desta™s village the
same set of households share the local commons, offer one another
loans, join the iddir, and help one another out in times of need. The
interesting point isn™t that the same group of people are in a number
of long-term relationships (who else is there to form long-term
relationships with?), but that the relationships are tied to one

Tied engagements
To see how ties can help, suppose that in the patron“client
relationship we studied in the previous chapter, the discount rate A
(the patron) uses to value the future bene¬ts of cooperation with B
(the client) exceeds 25% (or ¼) per year. We know that for want of
trust, the pair would be unable to form a partnership. But now
imagine that, in addition to the annual ¬‚ow of $4,000 worth of
working capital A has access to, he has access to an annual ¬‚ow of a
different type of working capital, worth $3,000 to him. B doesn™t
have the skills to work with that capital, but someone named C
does. The time C would need to work A™s capital into a marketable
product is worth $1,000 to her. Like B, person C doesn™t have access

to the market for products. The product can fetch $6,000 in the
market and A is in a position to procure it. A considers approaching
C with a proposal to form a partnership: the $6,000 would be used
¬rst to compensate the pair; the surplus would then be divided
equally between them. Each would enjoy a pro¬t of $1,000
annually. For what values of r is a partnership between them viable?

As C™s motivations in the potential relationship are similar to B™s in
the previous example, we needn™t study them again. But we do need
to work through A™s reasoning, because the numbers matter. So let
us start in year 0. Suppose C has adopted grim. If A advances his
capital to her but reneges on the agreement once she has produced
the output, he gains $3,000 ($6,000 minus $3,000) that year. Set
against it is the $1,000 he would lose every year, starting in year 1.
That loss, calculated in year 0, is $1,000/r. If 1,000/r is less than
3,000, A will renege. If, on the other hand, 1,000/r exceeds 3,000,
A can do no better than to adopt grim himself. Since 1,000/r

exceeds 3,000 if and only if r is less than 1/3 (approximately 33%),
the pair are able to form a long-term relationship if A™s discount rate
is less than 1/3 per year. So suppose r is less than 1/3. Then A is
able to form a relationship with C, but not with B (r exceeds ¼,
remember; and 1/3 exceeds 1/4).

We are now able to show that A could form a relationship with B if
the three were to tie the pair of undertakings. Let the proposal be to
create both partnerships, but with the understanding that if any
party in any year was to act opportunistically, both relationships
would be terminated. In order to formalize this, let the rule of
behaviour adopted by B (respectively, C) now read: begin by
cooperating with A and C (respectively, B) and continue to
cooperate so long as no one has broken their agreement, but cease
cooperating with everyone following the ¬rst defection by any one
in either relationship. Similarly, let the rule of behaviour adopted by
A now read: begin by cooperating with B and C and continue to
cooperate so long as no one has broken their agreement, but cease
cooperating with everyone following the ¬rst defection by any one

in either relationship. Each of the parties has adopted grim once
again, but grim here comes with an added sting.

It™s easy enough to con¬rm that B would adopt grim if A and C

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