Cultural Biases in Economic Exchange∗

How much do cultural biases affect economic exchange? We try to answer this question by using the relative trust European citizens have for citizens of other countries. First, we document that this trust is affected not only by objective characteristics of the country being trusted, but also by cultural aspects such as religion, a history of conflicts, and genetic similarities. We then find that lower relative levels of trust toward citizens of a country lead to less trade with that country, less portfolio investment, and less direct investment in that country, even after controlling for the objective characteristics of that country. This effect is stronger for good that are more trust intensive and doubles or triples when trust is instrumented with its cultural determinants. We conclude that perceptions rooted in culture are important (and generally omitted) determinants of economic exchange. ∗We would like to thank Giuseppe Nicoletti for providing the OECD dataset, Michele Gambera for providing the Morningstar portfolio data, and Roc Armenter for excellent research assistantship. We also thank Franklin Allen, Marianne Baxter, Patricia Ledesma, Mitchell Petersen, Andrei Shleifer, Rene Stulz, and Samuel Thompson for very helpful comments. We benefited from the comments of participants to seminars at the European University Institute, Wharton, Northwestern University, the University of Chicago, University of Wisconsin, NBER Corporate Finance, International Trade, and Behavioral Meetings. Luigi Guiso acknowledges financial support from MURST, and the EEC. Paola Sapienza acknowledges financial support from the Center for International Economics and Development at Northwestern University. Luigi Zingales acknowledges financial support from the Center for Research on Security Prices and the Stigler Center at the University of Chicago. We always have been, we are, and I hope that we always shall be detested in France. Duke of Wellington The Webster dictionary defines culture as “the customary beliefs, social forms, and material traits of a racial, religious, or social group.” In this paper we focus on the first dimension of culture (i.e., customary beliefs) and we ask how these customary beliefs (as those expressed by the Duke of Wellington) impact economic choices. In doing so we face both a theoretical and an empirical challenge. From the theoretical point of view, we need to explain how these customary beliefs may enter into the standard economic model. Since Muth (1960, 1961) and Lucas (1976) nearly all research in economics has endogenized beliefs, under the rational expectations assumption that subjective and objective beliefs coincide. But the assumption that agents share common prior beliefs (necessary for rational expectations) is increasingly under attack. The common-prior assumption is quite restrictive and does not allow agents to ”agree to disagree” (Aumann (1976)). Perfectly rational people might have different priors. In fact, the common use of the word rational only requires beliefs to be Bayesian. But the Bayesian paradigm does not address the question of the rationality of prior beliefs (Gilboa, Postlewaite, and Schmeidler, 2004). One possible way out is to develop a framework for a rational choice of prior beliefs by an individual. This is the avenue pursued by Brunnermeier and Parker (2004) in their optimal expectation approach. Alternatively, one can analyze empirically how these prior beliefs are influenced by culture. Paraphrasing Einstein we identify culture as ”the collection of prejudices acquired by age eighteen.”1. This is the avenue we will follow in this paper. In particular, we focus on the effect that customary beliefs have on international trade and investments via the effect they have on the degree of trust citizens of a country have toward citizens of other countries. In a world where contract enforcement is imperfect and/or where it is impossible or prohibitively expensive to write all future contingencies into contracts, the degree of mutual trust is an essential component in any economic exchange. Lack of trust will prevent otherwise profitable trade and investment opportunities. In relational contracts what matters is personalized trust, the mutual trust people developed through repeated interactions (Grief, 1993). For the development of anonymous markets, however, what matters is generalized trust, the trust people have toward a random member of an identifiable group (e.g., McEvily et On the economic effect of prejudice see the pioneer work of Becker (1957)