Economists conventionally treat an individual’s political interests as determined by his preferences and endowments. For many purposes, that’s a useful approach. But for other purposes, it may not be. In particular, in the case of large-scale institutional change, each individual’s own political interests may depend on the behaviors of others. Issues of coordination arise. In that case, we need to consider the equilibrium set of individuals’ economic actions and political positions. This paper tries to do that. The paper is motivated by a particular puzzle—the weak demand for the rule of law in Russia, the Czech Republic, and other countries of the former Soviet empire. But the paper also applies more generally to economies with weak institutions and with assets to steal. In this broader context, the paper can be thought of as a theory of anarchy.
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Economists conventionally treat an individual’s political interests as determined by his preferences and endowments. For many purposes, that’s a useful approach. But for other purposes, it may not be. In particular, in the case of large-scale institutional change, each individual’s own political interests may depend on the behaviors of others. Issues of coordination arise. In that case, we need to consider the equilibrium set of individuals’ economic actions and political positions. This paper tries to do that.
The paper is motivated by a particular puzzle—the weak demand for the rule of law in Russia, the Czech Republic, and other countries of the former Soviet empire. But the paper also applies more generally to economies with weak institutions and with assets to steal. In this broader context, the paper can be thought of as a theory of anarchy.
“Lawless Capitalism Grips Russian Business”
- The Washington PostNovember 7, 2000
After the Big Bang:
Obstacles to the Emergence of the Rule of Lawin Post-Communist Societies
Karla Hoff and Joseph E. Stiglitz
September 2003
The Hope
• “Privatization offers an enormous political benefit for the creation of institutions supporting private property because it creates the very private owners who then begin lobbying the government...for institutions that support property rights.”
Murphy-Shleifer-Vishny 1998
Broad private ownership [didn’t create] a constituency for strengthening and enforcing [the new Civil and Commercial Codes]. Instead, company managers and kleptocrats opposed efforts to strengthen or enforce the capital market laws. They didn’t want a strong Securities Commission or tighter rules on self-dealing transactions. And what they didn’t want, they didn’t get.
Black et al. 2000
The Result in Russia
Central Argument
• Individuals choose the “rules of the game” in an incomplete market setting. Actions have externalities mediated through
the political environment.
which
May lead agents to take actions that give them an (ex post) interest in prolonging the no-rule-of-law state—an effect that isn’t internalized because the rule of law is a public good.
What I am going to talk about
I. Overview of Russian privatization
II. Static model of the demand for the rule of law (coordination game)
III. Infinite period model (Markov)
I. Timeline for Russia
1990 planning for mass privatization
1991 dissolution of USSR
1992 Big Bang – voucher privatization starts
1994 14,000 medium & large enterprises privatized 70% insiders
14% outsiders 16% government
1995 “Loans for Shares”
1995-2001 Massive capital flight ~$15 - $20 billion per year
Growth and property rights insecurity in 20 transition economies
Index of insecurity of property and contract rights (BEEPS)
GDP
200
0/G
DP 1
989
R2 = 0.3452
80706050403020
1.4
1.2
1.0
.8
.6
.4
.2
BLR
UKR
ARM
GEO
AZE
UZB
RUSSIAKAZ KGZLTU
POL
BGRROM
HRVEST
CZESVKHUN
SVN
MDA
The index of insecurity is the fraction of respondents who disagreed with the statement: “I am confident that the legal system will uphold my contract and property rights in business disputes.”
“Corruption in the organs of government and administration is literally corroding the state body of Russia from top to bottom.”
Speech by President Yeltsin, 1993
“Russia is the only country we know where…even retail businesses often operate from behind unlabeled doors
Black et al., 2000
The “no-rule-of-law state”
Question: Could individuals choose the “wrong” rules of the game?
• In choosing his economic action, each individual takes the political environment as given, and ignores the effect of his economic decision on how other people believe the system will evolve and, thus, how others invest and vote.
• Each individual votes for the regime that enhances his own welfare—and stripping may give him an interest in prolonging the absence of the rule of law.
II. Static Model
Agents
• A fixed set of agents have control rights
• Agents differ in their ability to strip,
• They seek to maximize expected wealth.
I. Static model: The controller’s dilemma–strip assets of build value
Strip assets
Controller
Build value
Political environment
Rule of law
No rule of law
[1 - ] bL b N
Rule of law
No rule of law
Notation
π = probability that the rule of law is enacted
x = fraction of agents who strip assets
π = π (x) –a decreasing function
Equilibrium
* = g - (x) I L - [1-(x)] I N Switch line
Agents with a comparative advantage in stripping assets relative to * (i.e., > *) will choose to strip assets and thus
x = 1 – H(*) Stripping ability curve
Dual stable equilibria
1
0x
Increasing support for the rule of law
1/2
Switch line, *NIg
LIg Strip assets
Build value Stripping abilitycurve
High equilibrium support for the rule of law
Low equilibrium support for the rule of law
Payoffs
Example
= (1-x)2 ,
is uniformly distributed on [0,1],
g – I L = 1
g – I N = ¼.
Rule of law is the Pareto efficient “rule of the game” –Will agents vote for it?
Payoffs from ¼ to 1 depending on stripping ability
No rule of law Rule of law
Payoffs: 1OR ?
Switch line: *= ¼ + ¾ (1-x)2
0 1x
Increasing support for the rule of law
Stripping ability curve: x = 1 -
2/3
1
1/4
Payoffs
0 1x
Increasing support for the rule of law
1
1/4
A shift up in distribution of ability to asset-strip
Initial conditions:• Criminal networks• Natural resource abundance
Policy:
• Capital account convertibility
Payoffs
Natural resource abundance, growth, and property rights insecurity
Fuel and mineral exports/
total exports 2000 GDP/ 1989 GDP
Percent who believe legal system will not “uphold my contract
and property rights in business disputes”
Wall Street Journal Rule of Law index
(10 = best, 0 = worst)
Average for countries with less than 10%
natural resource exports
6.81%
89%
40%
7.5 score
Average:10 - 20%
15.22% 84% 42% 6.9 score
Average:greater than 20%
41.88%
66%
68%
4.2 score
Russia 53.15%(1996)
63% 73% 3.7 score
0 1x
Increasing support for the rule of law
2/3
1
1/4
A fall in the returns to building value
Initial conditions:• Distortions in the economy• Distance from the EU• A corrupt privatization
Current policy:• Restrictive macro-policy
Payoffs
0 1x
Increasing support for the rule of law
2/3
1
1/4
A shift down in expectations that the rule of law will be established
Initial conditions:• No “market memory”• Criminal networks• Corrupt privatization
Current policy:• Lack of prospects for EU accession
Payoffs
III. Dynamic extension of the model “But let them steal…They will then become owners and decent
administrators of their property.” (Chubais, quoted in Freeland, 2000)
Agents live forever. In each period:
Stage 1. Agents observe the current state
(N or L) and choose an action – to build value or strip – and a political position – for or against the rule of law.
Stage 2. The new state (N or L) is realized, and agents receive state-contingent returns.
Transition to the Rule of Law as a Markov Process
The probability of transition from the no-rule-of law regime to the rule of law depends on the level of support in the current period:
πt = π (xt)
The rule of law is an absorbing state.
We explore a subset of possible equilibria where, as long as the no-rule-of-law prevails, the level of support is the same in each period.
Technology and payoffs
FLOWDEPLETION OR
GROWTH OF ASSET
STRIP
]1[)(
,)(
fs
fsL
N 1~ z
BUILD b j = f – I j 1~ g
with 1~ gg
Majority prefers building value under the rule of law to stripping under no rule of law
z
s
g
bV
NLL
1
)(
1
In the rule-of-law state, ALL prefer to build:
.)(1
)( : allforS
zs
V LL
L
Two more value functions
),( xS N ),(11
xSV
z
z
z
s NL
)(xV N )(11
xVVg
g
g
b NL
2nd term: capital gain or loss from the transition to the rule of law.
1st term: asset value if current expected flows continued forever
Economic and Political Behavior
0),()( xSxV NN S w i t c h l i n e f o r b u i l d i n g v a l u e
C o n t i n u a t i o n b e n e f i t f r o m n o - r u l e - o f – l a w f o r a n a g e n t w h o s t r i p s t o d a y :
)],([ xSVz NL
)],([ pNL
p xSVz = 0 S w i t c h l i n e f o r v o t i n g
0),()( xSxV NN S w i t c h l i n e f o r b u i l d i n g v a l u e
C o n t i n u a t i o n b e n e f i t f r o m n o - r u l e - o f – l a w f o r a n a g e n t w h o s t r i p s t o d a y :
)],([ xSVz NL
)],([ pNL
p xSVz = 0 S w i t c h l i n e f o r v o t i n g
.
Why can’t society “grandfather” the control rights of the asset strippers?
Dynamic consistency problem--
The security of such rights depends on the social consensus that underlies them. Not just any distribution of property can be protected under the rule of law.
Dynamic modelθ
I (build value and support the rule of law)
θa
θp
Increasing support for the rule of law
0 1
Increasing support for the rule of law
x
III
Strip assets and oppose the rule of law
II Strip assets and support the rule of law
Multiple equilibrium levels of demand for rule
of law
Stripping ability curves
Political switch line, θ*
θ
0 1
Increasing support for the rule of law
x
High demand for the rule of law
Low demand for the rule of law
Time path of expected GDP
GDP along expected
growth path
time, t
High
Low
Summary of model: A tale of two distortions
i vote
j vote
1. Externalities from actions (stripping or building value ) on the political and legal environment
2. The legal regime is a public good
Rapid privatization: neither a cul de sac nor a sure way to create a
demand for law
Under the no-rule-of-law state, some agents strip assets
(since VN < SN ) which gives them an interest in prolonging
the no-rule-of-law state weakening the constituency for the rule of law
“criminal” capitalism .
Under the rule of law, agents choose to build value
(since VL > SL) which ensures a constituency for rule of law “beneficent” capitalism.
And (2) the tortoise may beat the hare
If VN < SN , there may exist an equilibrium where many strip and so many wish to prolong the no-rule-of-law state.
Big Bang privatization may put in place forces that delay the rule of law.
Caveats: The actual process of legal regime transition is not Markov
1. History affects norms
“Vladimir Rushaylo has flatly denied the allegations that 70 per cent of all Russian officials are corrupted … ‘Only those who have links with the organized criminal gangs can be regarded as corrupted officials. Do not mistake bribe-taking for corruption,’ the Russian Interior Minister stressed. (BBC, March 13, 2001)
2. History affects the distribution of wealth and power
Muckraking Governor Slain By Sniper on Moscow StreetWall Street Journal, October 19, 2002
Here we made 3 very special assumptions:
• No individual agent exercises power• Only 2 possible legal regimes: one good for investment, the other bad• A fixed set of agents (no new entry)
We relax these assumptions in on-going work, where our focus is the conflict between “rules for all” (rule of law) and rules biased in favor of the powerful
Rule of law
Oligarchy
Security of returns to building value
Bia
sedn
ess
Future Work
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