property rights in transition

The Transition Process in Post-Communist Societies:

Towards a Political Economy of Property Rights

Karla Hoff1 and Joseph E. Stiglitz2

August 2003

Paper to be presented at the Annual Meeting of the American Political Science Association, August 30, 2003

Abstract. At the onset of Big Bang privatization in Russia, the dominant paradigm in the West was that granting individuals the control of property would create a constituency for the rule of law, where there is protection for private property rights. But this did not happen. This paper presents a sequence of simple models to explain this. The models focus on two technologies that can cripple the demand for the rule of law in equilibrium: (1) Asset stripping, which can give individuals a stake in prolonging the no-rule-of law state, and (2) bribery, which can lead to the protection of monopolies and so deter entry by political outsiders, who make up the natural constituency for the rule of law. The paper draws an analogy between the political environment and public goods. We argue that the combination of rationality, the public good property of the political environment, and equilibrium leads to very weak conclusions about the emergence of a constituency for the rule of law following Big Bang privatization.

1 Corresponding author: World Bank, [email protected]

2 Columbia University

It has for a long time been recognized that institutionsthe rules of the game in the broad

sense of political economyshape incentives and thus have an enormous influence on

economic growth. But economists have only recently begun to study the creation of the

rules of the game, rather than merely the behaviors of agents within a given set of rules

already in place.1 When neoclassical economists first began to study the formation of

property rights, many adopted a functionalist position, where the choice of institutions

was dictated by efficiency conditions (for example, Demsetz 1967 and North and

Thomas, 1970). But the fact that political interactions do not play out in idealized

competitive markets, but instead are often best modeled as interactions in markets with

externalities, or as bargaining games, suggests that one needs to be circumspect about

allegations of the efficiency of the process. In this paper, we present a series of simple

models to shed light on the political economy of property rights in the transition

economies.

The collapse of communism in Eastern Europe and the former Soviet Union in the

period 1989-91 provided an opportunity to observe and try to influence the creation of a

new set of rules of the game. In the early 1990s, the dominant paradigm in the West

regarding the transition was that granting individuals the control of property would create

a political constituency for the rule of law, where there is protection for private property

rights.2 All over the post-communist world, Western donors promoted Big Bang

1 As Abba Lerner (1972, p. 259) put it, traditional economics gained the title of queen of the social

sciences by choosing solved political problems (emphasis in original). 2The phrase dominant paradigm in the West is due to Sachs et al. (2000), and the paradigm is summarized in Murrell (1993). We use the term control in this context to distinguish it from ownership, which implies a clear legal framework defining rights and obligations. To be sure, in any society there is some legal framework, and control rights are circumscribed by that legal framework. For instance, in a highly primitive society one could imagine no enforcement of basic criminal codes, e.g. against murder and theft. In such a world, actual practical control rights are highly circumscribed: a person can do as he pleases with an asset only so long as no one takes it away from him. Larger

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privatization the mass transfer of state-owned assets to private agents (Przeworski et al.

1995, p. viii, at note 2). But there was no theory to explain how this process of

institutional evolution would occur and, in fact, it has not yet occurred in Russia, in other

former Soviet Union countries, in the Czech Republic, and elsewhere. A central reason

for that, according to many scholars, is the weakness of the political demand for the rule

of law.3 For example, Black et al. (2000) observe that in Russia, it was

hoped that broad private ownership would create a constituency for strengthening and enforcing [the new Civil and Commercial Codes]. That didnt happen. Instead, company managers and kleptocrats opposed efforts to strengthen or enforce the capital market laws. They didnt want a strong Securities Commission or tighter rules on self-dealing transactions. And what they didnt want, they didnt get (p. 1753, emphasis added).

While it is of course true that some legal framework will follow mass

privatization, we argue that the framework is not necessarily the rule of law. We focus

on two technologies that can cripple the demand for the rule of law in equilibrium:

(1) Asset stripping, which can give individuals a stake in prolonging the no-

rule-of law state, and

(2) Bribery, which can lead to the protection of monopolies and so deter entry

by political outsiders, who make up the natural constituency for the rule

of law.4

The two main sections of this paper focus, respectively, on these two

individuals (who can beat up on others) or those who can organize larger groups to fight in their defense have more effective control rights. 3 See Gray and Hendley (1997), Aslund and Dmitriev (1999), Pistor (1999) and others in the symposium

Demand for Law in the East European Constitutional Review, Black et al. (2000), Kitschelt (2001), and Stoner-Weiss (2001). 4 The empirical importance of both technologies is well documented. The extent of capital outflow in

Russia in the period 1995-2001 was $15-20 billion (Loungani and Mauro, 2001; Reuters, Feb. 20, 2002). Extensive data for the transition economies on bribery aimed at securing special treatment from the state is in Hellman et al. (2000).

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technologies. Section 1 considers a set of assumptions seemingly highly favorable to

the creation of the rule of law: political power is widely dispersed; an investor can obtain

contract enforcement only through the rule of law, not by buying rules just for himself;

and all agents are better off building value under the rule of law than stripping assets

under no rule of law. Yet we show that a stable equilibrium may exist where the

constituency for the rule of law is very small.

Section 2 considers oligarchic entrenchment. Taking into account the

asymmetries in political power, some individuals may believe that they can extract for

themselves more rents from the arbitrary exercise of their economic influence than they

can obtain through any rule-bound system. Individuals for whom the rule of law is not

desirable may drive out those for whom it is desirable, and who would otherwise have

formed a powerful business constituency for the rule of law. We show that the

sequencing of reforms during the transition process may affect the ability of one group or

another to engender a pernicious or broadly beneficial institutional consolidation.

1. The Political Environment as a Public Good5

We present a model in which those with control rights over privatized assets are

powerless individually to obtain property rights protection la carte from the state, but

can collectively bring about the rule of law simply by demanding it in sufficiently large

numbers. To simplify, we consider a society in which the possible legal structures vary

only along the dimension of the security of property rights. The two possible legal

regimes in our model capture the ends of the spectrum. By the rule of law we mean well-

5 The idea developed here was briefly described in Hoff (2001). A dynamic extension of this model is in

Hoff and Stiglitz (2003b). Related models were recently developed by Berglof and Bolton (2002) and Sonin (2002).

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defined and enforced property rights, broad access to those rights, and predictable rules

symmetrically applied for resolving property rights disputes. By no rule of law we mean

a legal regime that does not protect investors returns from arbitrary confiscation, does

not protect minority shareholders rights from tunneling, and does not enforce contract

rights.6

A. A static model

Time consists of two periods. Each agent exercises some control rights over enterprises

in the first period, and chooses between two actions:

Build value: Make an irreversible investment to increase the enterprises value.

Strip assets: Strip the assets of the enterprise, whisk capital to a safe place, and

tunnel value out.

Technology is constant returns to scale. Each agent can earn a high return to

investment, vL , if the rule of law is established in the second period. If, however, the rule

of law is not established, then the return on investment is low, vN < vL. This

assumption captures the idea that in order to build value, an individual must interact with

others in the economy. He benefits from the rule of law because it enforces property

rights and contracts and expands his access to markets; without the rule of law, he risks

even being able to capture the return on his investment.

As an alternative to building value, an individual can strip the assets he controls:

whisk capital to a safe place, tunnel value out through self-dealing at the expense of

minority shareholders who do not have control rights over assets, and let the capital stock

6 We also include under no rule of law situations where the outcomes are predictable, but in the sense that

the judge always rule in favor of the person who bribes him the most.

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wear out.7 Russia implemented mass privatization on the basis of a governmental decree

stipulating only the most basic rights of shareholders and rules of corporate governance;

there was thus ample scope for those with control rights over firms to tunnel value out at

the expense of private shareholders, and to harvest public resources. Privatization

expanded the ability of firm managers to do that because it granted them greater

independence from the state.

We assume that individuals differ in their ability to strip assets. An individual of

type who strips obtains a return per unit asset. An agent with a higher value of

strips better. has a continuous distribution given by H().8 In the real world, many

factors would give rise to such differences. The ability to strip is larger, the greater (i)

the equity of minority shareholders, (ii) the size of the firms debt, and (iii) the ability to

harvest commodities that require little or no processing and that can be sold on thick

international markets where they are hard to trace.9 If these are roughly normally

distributed in the population of individuals with control rights over assets, then the

distribution of stripping returns will have the shape depicted in Figure 1. The horizontal

axis in the figure plots the percentile of the population, and the vertical axis plots the

payoff to stripping (per unit asset) for each percentile, beginning with the top percentile.

Figure 2 adds two horizontal lines to Figure 1 to show the return to building value

under the rule of law ( Lv ) and under no rule of law ( Nv ). The figure depicts the case

where most individuals are better off building value than stripping assets if the rule of

7 For a firm with multiple shareholders, the controlling shareholder might want to pursue both the value-

creating and the tunneling strategies, but that would not be sustainable, as investors would ultimately refuse to do business with a firm that defrauds them. 8 We simplify by focusing on stripping ability as the only source of differences across agents in the relative

returns to building value and stripping assets. Nothing depends on this simplifying assumption 9 An earlier paper that emphasized this factor is Stephan (1996).

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law is established, but better off stripping assets than building value if the rule of law is

not established. This is a central aspect of the situation that interests us: economic

behavior depends on the political environment.

We next consider that environment. In addition to choosing an economic action,

agents also reveal their preferences, e.g. by voting, over policies and institutions that

would establish the rule of law. Those who build value demand the rule of law because it

is the only legal regime that makes it possible to earn a high return on investment. In

contrast, asset-strippers, who follow a strategy of take the money and run and can

illegitimately profit from their control rights, do not gain from the rule of law and have

no reason to support the rule of law.10 In the static model, the economic strategy of an

individual thus determines his political position. Let x denote the fraction of individuals

who strip assets and thus do not demand the establishment of the rule of law. By

assumption, the probability of the establishment of the rule of law is increasing in the

size of the constituency that supports it and thus is decreasing in x: = (x) with 0.

The equilibrium is easy to depict in graphical terms (see the Appendix for a

mathematical treatment). An equilibrium is a fraction of the population, x*, whose return

to stripping assets exceeds the expected return to building value, *)(xv , where

.*)](1[*)(*)( NL vxvxxv +=

Figure 3 depicts one possible equilibrium. The figure consists of Figure 2 with the two

lines at Lv and Nv replaced by a single line representing the expected payoff to building

value when a population fraction x* does not support the rule of law.

10More generally, the establishment of the rule of law will reduce the ability to strip assets; see the model in Hoff and Stiglitz 2003a. Here we simplify by treating the return to asset-stripping as immediate and invariant to the legal regime that is ultimately established. The qualitative results do not depend on this simplifying assumption.

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Since the probability that the rule of law will be established is decreasing in x ,the

expected return to building value ( v ) is also decreasing in x. The three panels of Figure

4 illustrate (in boldface) three possible shapes of the )(xv curve. Superimposed on that

curve is the a dotted curve that represents the distribution of stripping abilities. The

figure captures both relationships described abovethe fact that the expected return to

building value depends on the political preferences of the agents, and the fact that agents

differ in their ability to strip and those who build value and demand the establishment of

the rule of law are the set of types for whom )(xv . In each panel of Figure 4 one can

represent all possible equilibria.

Panels A through C depict three cases. Panel A depicts the case where the expected

return to building value curve cuts the stripping ability curve in three places, and so there

are three equilibrium values of the constituency for the rule of law. The intersection at

x2* is unstable since at that point, the expected return to building value curve falls more

steeply than the stripping ability curve. Starting from such a point, the slightest

disturbance that increases the number of those who strip assets lowers the expected

return to building value by so much that the fraction of individuals who choose to strip

increases further. By the same token, a slight disturbance that decreases the number of

those who strip raises the relative return to building value (relative to stripping assets) by

so much that the fraction of individuals who choose to strip decreases further. Thus, in

practice, an unstable equilibrium would not occur. An equilibrium that is unstable is a

point of increasing (relative) returns to stripping assets.

Panel B depicts the case where there is a unique equilibrium because at no point does

the stripping ability curve cut the expected return to building value curve from below.

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Panel C depicts the case of majority rule: the curve that describes the return to

building value is a step function that equals Lv for x < and otherwise equals .Nv There

are two stable equilibria, one in which the rule of law is established with certainty, and

one in which it is not established with certainty.

The simple relationships captured in the model illustrate a paradox: even though

most individuals11 may be better off building value under the rule of law than stripping

assets under no rule of law, in equilibrium the demand for the rule of law may be weak.

The explanation depends on social interactions. In society, there is always an

environment in which individuals make their decisions; there is no analog to the

physicists vacuum. One of the most important aspects of that environment are the

behaviors of others. When other individuals exploit their opportunities for stripping, they

will not demand the rule of law, for they do not need it and do not benefit from it. If the

demand for the rule of law is weak, the rule of law is not likely to be established. In a

political environment where the constituency for the rule of law is weak, many

individuals will have an interest in taking what they can quickly rather than waiting for

the establishment of property rights protection that would permit them to build more

valuable assets. Therefore many individuals will strip, which can make that set of

behaviors an equilibrium.

In the 1990s a highly charged debate occurred between Russian studies scholars

and the Western economists who advised the Russian government on transition policy.

Russian studies scholars generally argued that the Soviet inheritance would make it very

11 All but a fraction of the individuals equal to x0 in Figure 4A. The reader can easily check that the

paradox can occur even if the stripping ability of every individual is less than the return to building value under the rule of law. In that case, one equilibrium will be at x = 0 (unanimous demand for the rule of law), but other equilibria may also exist where the demand is very weak. Hoff and Stigllitz (2002) provide a numerical example of this case.

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difficult for Russia to quickly undertake real reform. They emphasized that the USSR

lacked experience with the market, responsive institutions such as distribution and

marketing infrastructure, an independent judiciary, or a history of the rule of law (see

Goldman 1996, Braguinsky and Yavlinsky 2000, and Kotkin 2000). They pointed out

that during the long period of Soviet rule, a parallel, informal structure had grown up

alongside the official Party structure, in which people engaged in illegal trades, often at

the expense of the State.12 The parallel structure survived the collapse of the Soviet rule

and made it easy to strip public assets (Anderson 1995).

On the other side of this debate, many Western economists argued that the Soviet

legacy did not matter. In their view, rapid privatization of state enterprises (the Big

Bang) both solved the problem of committing government to the marketsince a mass

privatization would be difficult to reverseand ensured a political constituency for

institutions that would support the market. It was argued that there was no Soviet

man, only economic man. Given democracy and privatization, those economic men

who benefited from privatization would create an automatic and irresistible lobbying

force for the rule of law.

The model sheds light on this debate. In the model individuals are economic

men. Nonetheless, spillovers mediated through the political environment can block the

emergence of a strong demand for the rule of law. Ones political position both depends

on the political environment and is a constituent part of the political environment. The

diffuse spillovers may mean that, in effect, no one demands what he might have been

12 This idea is also captured in the following humorous exchange (quoted in Kotkin, 2001, p. 113)

I think, says Ivan to Volodya, that we have the richest country in the world. Why asks Volodya. Because for nearly 60 years everyone has been stealing from the state and still there is something left to steal.

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expected to want (in a setting that abstracted from those spillovers). The Soviet legacy

can reduce the likelihood of the emergence of a demand for the rule of law through

several channels. First, if there are multiple equilibria, history helps to select the

equilibrium that will exist. What people see has happened in the past affects what they

believe will happen in the future; expectations can affect agents behavior and so lead to

the selection of the bad equilibrium.

Second, many aspects of the Soviet legacy would tend to influence the position

of the two curves in the modelthe stripping ability curve and the )(xv curve. Any

change in the parameters of the model that shifts up the stripping ability curve leads to an

increase in x at a stable equilibriumand accordingly to a decrease in the value of the

equilibrium. A large enough upward shift can eliminate the good equilibrium. We will

describe such a situation loosely as making a wealth-creating equilibrium less likely.

By the same token, any change in parameters that results in a downward shift in the )(xv

curve has similar effects to an upward shift in the stripping ability curve. We establish

the comparative statics results formally in the appendix, but here we consider the

applications to the initial conditions in the former Soviet Union.

One condition was the absence of civil society institutions (churches, the press,

political clubs, a history of a free press) with countervailing power to hold the state to

account and through which individuals could try to coordinate efforts at legal reform. In

contrast, Poland had powerful social networks, including the Catholic Church and the

Solidarity trade union. The Soviet legacy would tend to depress the probability of the

near-term establishment of the rule of lawshifting down, at any level of x, the values

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(x) and hence the )(xv curve.13 The institutions inherited from the Soviet period also

tend to enhance the ability to strip (shifting up the stripping ability curve), while the

absence of a marketing and distribution infrastructure would tend to lower the returns to

investment (lowering the )(xv curve). Such initial conditions, through the economic

actions and political positions they engender, tend to make a wealth-creating equilibrium

less likely.

B. Forward-looking individuals

The preceding sections presented a chicken and egg model where the political

environment could lead individuals to adopt certain economic strategies and, given those

economic strategies, they would not support the rule of law. But shouldnt forward-

looking behavior affect voting, so that an individual can strip today and also demand the

rule of law for the sake of the benefits it would provide in the future? If so, even an

asset-stripper might vote for the rule of law.

To explore this argument, we have extended the model to a dynamic framework (Hoff

and Stiglitz 2003b). In our extension, two variables play a key role. First, a current

decision to strip assets reduces the stake that an individual has in the future legal regime.

Second, a current decision to strip reduces his relative return from the rule of law

(relative to the absence of the rule of law) because the establishment of the rule of law at

the end of given period constrains his ability to strip. Past actions to strip or build value

13 We have modeled only those individuals who control privatized firms (of which there were over 14,000

in Russia by 1994) because the question that motivates our analysis concerns their political demands. We have not addressed the political influence of others in society. Such influence is increased by institutions that provide for freedom of the press and broad access to information about government and publicly owned firms. Formally, such institutions would tend to reduce the relative political power of the majority owners and managers of firms and so lower (x).

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thus exert historical pressure on future actions.

In the dynamic model, if the expected probability of transition to the rule of law is

low, then the relative return to building value is low (for both the current income and the

expected return to increasing the asset base are reduced). Thus some individuals will

rationally strip. If they strip, the asset base that will remain to invest in in the future

shrinks; this reduces the future benefit from the rule of law. A second consequence of

stripping is that the immediate establishment of the rule of law would lower the agents

current income by constraining their ability to tunnel, to harvest public assets, to withhold

payments of debt and taxes and wages. And so the immediate establishment of the rule

of law imposes a cost on asset-strippers. Hence, some individuals who strip assets will

rationally vote to postpone the establishment of the rule of law state. We show that this

can make the no-rule-of-law regime persist, period after period.

In choosing his economic action, each individual ignores the effect of his economic

decision on how he himself votes, how other people believe the system will evolve and,

thus, how others invest and vote. A single individuals vote has a negligible effect on the

probability that the rule of law is established. There are thus two distortions of individual

behavior associated with the public good nature of votes.

Figure 5 illustrates this idea schematically. Consider two individuals, 1 and 2.

Each persons economic action influences his political position (an intertemporal

incentive effect), as indicated by the horizontal lines. How each person votes influences

the political environment and thus the other persons action (a spillover effect), as

indicated by the slanted arrows. Each individual, in attempting to influence societys

choice of legal regime, focuses on the impact on himself, not on others. Economic

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choices that affect political outcomes beget spillovers that affect economic choices.

A deeper point is that if there were perfect capital markets (with non-

governmental enforcement), then the prospect of the establishment of the rule of law in

the future would make it in the interest of each individual to take actions that maximize

the social value of the assets he controls because he could capture that value. In that

case, all individuals would build value and all would support the rule of law. The

imperfections in capital markets cause the inefficient behaviors that, in turn, cause the

opposition to the establishment of the rule of law. An economy with perfect capital

markets may have been the economic model in the minds of those who implicitly made

the functionalist argument for the emergence of a strong demand for the rule of law; but

privatization occurred prior to the creation of effective capital markets.

2. Oligarchic Entrenchment

In practice, the privatization in Russia was more adverse to the establishment of the rule

of law than the preceding analysis would suggest, for it led to the creation of a small

group of oligarchs, with vast fortunes and influence over the media and political

processes. In this section we analyze some aspects of what might be called an

oligopolistic model.14 Three salient differences between that world and the one

analyzed above should be noted. (i)In such a world, of course, it is not true that

participants will believe that their actions will have no affect on the behavior of other

participants. (ii) The oligopolists/oligarchs will typically obtain significant rents and will

accordingly direct some of their political energies to the preservation of these rents. To

14 An early analysis of this problem is Hellman (1998), in which the early winners from partial reform in

transition economies block continuation of reforms in order to earn rents.

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the extent that they succeed, the legal framework that emerges will not be one that

promotes economic efficiency.15 (iii) In some cases, the oligarchs may actually be against

a rule-based system, believing that they can extract for themselves more rents from the

arbitrary exercise of their economic influence than they can obtain through any rule-

bound system. Such a result is predicated on the existence of plausible constraints on the

kinds of rules that they can impose, e.g. under the political process, they may be

restricted from writing down rules that are too patently discriminatory. Because

bargaining goes on behind closed doors, the oligarchs may be able to achieve more

under such behind-the-scenes bargaining than through any rule-based system. They may

be willing to bear the risks associated with the non-rule based system, given the amount

that the oligarchs as a whole would have to transfer to the non-oligarchs under the

alternative.

In this section, we first set out an hypothesis about the logic of reform, and then

sketches a simple model to shed light on the equilibrium constituency for the rule of law.

A. An hypothesis about the logic of political constraints

At the outset of the collapse of socialist institutions in Russia and Eastern Europe, most

observers agreed that were it politically feasible to establish quickly the rule of law to

underpin a market economy as or before state enterprises were privatized, it would be

desirable to do so. It was, however, argued that it was politically infeasible to do so. This

section explores the possible implications of that statement.

15 To be sure, one might argue that these problems would be eliminated if all the wealth were given to a

single individual; a monopolist would have an incentive to promote economic efficiency. From this perspective, the problem with the privatization is not that it was too undemocratic, but that it was too democratic. But in few countries would political processes condone such an arbitrary exercise of power; and monopolies are efficient only under highly restrictive conditions, e.g. that they can act in a perfectly discriminating way, which requires perfect information.

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Assume two reforms a and b are under consideration. Let Pab denote the power of

the coalition in favor of a over b. The statement that a particular coalition is stronger in a

certain circumstance than another coalition means that it is either larger, or that those

within the coalition are willing or able to provide more resources to pushing for (or

against) a certain set of proposals than another set of proposals.

It is alleged that a is not politically feasible, and b is observed to occur. Together

this implies that

Pbs > Pas , Pbs > Ps and Pas < Ps..

The coalition in favor of b over the status quo (Pbs) is stronger than the coalition in favor

of a over the status quo (Pas), the coalition in favor of b over the status quo is stronger

than the coalition in favor of remaining in the status quo (Ps), and the coalition in favor of

a is weaker than the coalition in favor of remaining in the status quo.

Consider one such alternative reform and look at the reform process from the

perspective of reformers within a government that is divided between reformers (R ) and

nomenklatura (N).16 Reformers are considering two alternative reforms: Reform r:

Regulation and restructuring, followed by privatization; Reform p: privatization without

prior regulation and restructuring.

Let Pps(R) denote the political power of the reformers in favor of p over the status

quo, and let Pps(N) denote the political power of the nomenklatura in favor of p over the

status quo. We suppose for simplicity that power is additive.

The usefulness of the logic of reform can be seen in evaluating the following often-

heard assertions:

16 This formalizes the idea of a divided government in Boycko, Shleifer, and Vishny, 1996.

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A. The reform p is politically feasible, but r is not. Formally,

Pps(R) + Pps(N) > Ps(R) + Ps(N) (3)

Prs(R) + Prs(N) < Ps(R) + Ps(N) (4)

B. The nomenklatura are currently using their control over the public sector to obtain rents for themselves, impeding its efficiency.

C. Privatization will result in owners who have the incentive to use those resources efficiently. That is, while p is feasible but r is not, p will result in increased efficiency. Those who get control rights under the privatization will use their new power to lobby for reforms in the legal structure (which by hypothesis were not feasible earlier) that will protect property and contracts and restrict anti-competitive practices. That is, reforms that could not be implemented initially, can be implemented later.

Two implications follow. First, under the assumption that regulation is socially

efficient, (3) and (4) imply that before privatization actually occurs, bargaining within

government fails to yield the efficient outcome.17 Second, (4) implies that if reformers

have no power under the status quo,18 and yet privatization is feasible, then for the

nomenklatura privatization and the status quo are equivalent. That, in turn, implies that if

privatization occurs, then government officials must prefer privatization to the rents that

they receive under state ownership.

There is a clear, and highly disturbing, implication: there must be more

corruption (in dollar value to those currently in power) associated with the privatization

process than with the process in which enterprises remain under government control.

17 Subtracting (3) from (4) gives Prs(R) - Pps(R) < - [ Prs(N) + Pps(N) ], which can,

equivalently, be written as Prp(R) < - Prp(N). In words, the power of the reformers to impose regulation rather than privatization is less than the power of the nomenklatura to resist regulation rather than privatization. 18

That is the case where Pps(R) = Ps(R) = 0

17

Privatization may allow those currently in power to extract the present discounted value

of future rentsin effect, to capitalize corruption. This was not difficult to do in the

1990s in Russia. A common method was to convince the local privatization committee

to physically bar anyone outside ones own group from participating in the privatization

auction. One oligarch, after explaining how he proceeded, commented,

We didnt shoot anyone and we didnt violate any laws. These are the normal business practices in Russia(Klebnikov, 2000, p. 131).

The point is that the logic drives us at least to consider as a serious possibility that

privatization provided an enormously powerful tool for redistribution towards those

currently in political power.

To be sure, one may still decide that privatization enhances welfare, because the

distortions associated with rent extraction in the one-time privatization process are less

than those associated with rent extraction out of on-going government operation. That is,

Hypothesis C may be true even if the corruption under privatization is greater, in some

sense, than under government ownership. The model we sketch below will question that

implication in the context of societies with ill-defined property rights. The premise of the

model is that incumbents have the ability to shape economic institutions in their favor

after privatization, and political outsiders can reveal their preferences for more public

protection of property rights only after they have entered a business activity.19 In the

model, the method of privatization may have implications for political evolution, i.e. for

the power of various coalitions in the future, and thus, for the design ofor even the

existence ofthe rule of law.

19 Under that assumption, those who argued that quick privatization would create a constituency

for free market institutions, including the rule of law, were looking for lobbyists in the wrong place.

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B. A Model of entrenchment

The economy has a continuum of goods. Each good is produced in its own sector. In a

proportion of these sectors, there is a single, privatized firm. In addition, in every sector

there is a competitive fringe of potential entrants. After the agents in the competitive

fringe have moved, the legal framework is established and agents obtain payoffs

conditional on the legal framework.

The probability of the establishment of the rule of law, , depends on the size of

the constituency that supports it. By assumption, only agents who are active in business

have the information and the concentrated interests to lobby government and thereby

reveal their preferences.

In each sector, individuals in the competitive fringe are of measure one and are

indexed by f. A higher value f corresponds to a higher fixed cost of production. f is

uniformly distributed on [0,1].

In a monopolized sector, the payoff to new entry is negative, and so there is no

new entry. In a non-monopolized sector, the payoff to entry is y f if the rule of law is

established and otherwise it is - f. We assume that y (0,1). Then there is a critical value

of f,

f* = y

which is the type of the marginal entrant who is just indifferent between entering or not.

The fraction of potential entrants in the competitive fringe who choose to enter is

f*[1-]: this is because a fraction 1- of the sectors is not monopolized, and a fraction f*

of the competitive fringe of each of these sectors enters.

We write the probability of the establishment of the rule of law, , as a function of

19

the size of the constituency for it. The equilibrium value f* solves

0 = y(f*[1-]) - f* .

which says that the difference between expected return and fixed costs for the marginal

entrant is zero. There always exists at least one equilibrium, and it is stable if

f (f*) = y[1-] < 1.

Restructuring, which reduces , gives the constituency for the rule of law (f*[1-])

a double boost: evaluated in the neighborhood of a stable equilibrium, a fall in not only

increases the set of sectors into which new entrants flow, but also increases the number of

new entrants in each sector by

0]1[1*

//*

>

=

=

yfy

fddf

The outcome of a high value of and weak support for the rule of law may

actually be worse than that captured in this simple model. In the absence of the rule of

law, political insiders can monopolize new sectorssectors which were not monopolies

before privatization. 20

3. Conclusion

This paper has described two technologiesstripping assets and briberythat may

block the emergence of the natural constituency for the rule of law. We have drawn an

analogy between the political environment and public goods. The combination of

20 A notorious example of the capture of new markets is the takeover of the Lada car distribution

in Russia. A police investigation in 1997 (following an earlier attempted investigation had ended with the assassination of the chief investigator), found that gangsters connected to the automaker had waged a kind of war to establish the monopoly. There was evidence of more than 65 murders of company managers and business rivals (Klebnikov 2000, p. 368).

20

rationality, the public good property of the political environment, and equilibrium leads

to very weak conclusions about the emergence of a constituency for the rule of law

following Big Bang privatization.

These conclusions shed new light on the problem of the sequencing of reforms. A

desirable sequence is one where the political legitimacy of the privatization process, and

the institutions that impose restraints on government and on corruption, are such as to

make it easier to provide security for investors and new entrants, and harder to strip

assets. Big Bang privatization, in contrast, may have the opposite effect, and may

thereby put in place forces that delay or impede the establishment of a constituency for

the rule of law.

One more lesson turned up in our analysis. If restructuring prior to privatization

is not politically feasible, then Big Bang privatization is likely to lead to an outcome

where the beneficiaries block entry to preserve their rents and, in doing so, affect the

political environment both directly and indirectly through the level of entry into non-

monopolized sectors.

Without privatization, control would have resided in the hands of government

officials, who would also have stripped assets (the process occurred widely under

perestroika and came to be known as spontaneous privatization). The point is that their

ability to strip was enhanced by official privatization,21 and that privatization prior to

restructuring created the means and incentives to use ones wealth and influence to

preserve monopoly rents and bar entry of new firms.

21 Whether inefficient stripping by government is better or worse than inefficient stripping and

monopolistic rent-seeking by the private sector is a question that is outside the scope of this paper.

21

Appendix

In the Appendix, we show that an equilibrium of the model of Section 1 always exists and derive its comparative statics properties.

A. Existence of equilibrium

An equilibrium is a value of x that solves

1 - x* = H ( *)(xv ) (1)

which states that for a fraction 1- x* of the agents, the return to stripping assets is less

than the expected return to building value. Recall that H (.) is the distribution of the ability to stirp. PROPOSITION. 1. An equilibrium always exists. If 0 < x* < 1 is an equilibrium where

1]*)[(*))(( }{ NL vvxxvh , (2) then there are also at least two other equilibria, one with a greater and one with a lower probability of the establishment of the rule of law. On the other hand, if for all x,

1])[())((

22

value by as much as or more than it lowers the return of the marginal asset-stripper, which induces movement away from the initial equilibrium.

B. Comparative Statics PROPOSITION 2(i) . We first define three shift parameters. Let the parameter denote any factor that shifts down the distribution of asset stripping abilities and so shifts up the stripping ability curve:

);( HH = with 0ddvj

and j = L, N

and denote any exogenous factor that increases the probability of the establishment of the rule of law:

);( x= with 0> for )1,0(x and otherwise = 0.

An increase in or shifts up the expected value of investment curve. Evaluated in the neighborhood of a stable interior equilibrium,

dx*/d > 0, dx*/d < 0, and dx*/d < 0.

(ii) There is a social multiplier: Parameter changes have both a direct effect on the demand for the rule of law, when all agents treat the actions of other agents as fixed, and an indirect effect of the same sign, as agents respond to the change in actions by others.

PROOF. (i). The equilibrium in (1) can now be written as a value of x such that 1 - x* = H ( )*);( xv ) (1)

with )(xv = [ ] NL vxvx );(1)();( + . At a stable equilibrium, 0 < 1 + h d v /dx D (using Proposition 1). Using the implicit function theorem gives

0>=D

Hddx

; 0)1(

23

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Figure 1. The stripping ability curve

10

Percentile of the population

Payoffs (per unit asset)

Stripping ability curve

Figure 2. Payoffs to building value depend on the legal regime

10



vL, payoff to building value under the rule of law

vN, payoff to building value in the no-rule-of-law state

Percentile of the population

Figure 3. An equilibrium level of demand for the rule of law (1- x*)

10x



x*

v(x*) , expected payoff to building value at x*

Figure 4A. Two stable equilibrium levels of demand for the rule of law

10 x0 x1*

Decreasing support for the rule of law

Strip assets

Build value



Good equilibrium

Bad equilibrium

x3*x2*

v(x), expected payoff to building value as a function of the demand for the rule of law

vN

v L

x

Figure 4B. A case where equilibrium is unique

10 x*

Strip assets

Build value



Equilibrium

x

v( x )

Figure 4C. Two stable equilibrium levels of demand for the rule of law under majority rule

10 x1*

Strip assets

Build value



Good equilibrium

Bad equilibrium

x3*x2*=

vN

v L

v( x )

x

Figure 5. Economic actions affect an individuals own votes, and votes influence how others act; individuals internalize neither of these effects.

Person 1: Economic actionvote

Person 2: Economic actionvote