After the Big Bang? Obstacles to the Emergence of the Rule of Law in Post-Communist Societies

After the Big Bang? Obstacles to the Emergence of the Rule of Law in Post-Communist Societies By KARLA HOFF AND JOSEPH E. STIGLITZ* In recent years economists have increasingly [Such] institutions would follow private been concerned with understanding the creation property rather than the other way around of the “rules of the game”—in the broad sense (pp. 10–11). of political economy—rather than merely the behaviors of agents within a set of rules already But there was no theory to explain how this in place. The transition from plan to market of process of institutional evolution would occur the countries in the former Soviet bloc entailed and, in fact, it has not yet occurred in Russia and an experiment in creating new rules of the many of the other transition economies. A cen- game. In going from a command economy, tral reason for that, according to many scholars, is the weakness of the political demand for the where almost all property is owned by the state, 1 to a market economy, where individuals control rule of law. As Bernard Black et al. (2000) their own property, an entirely new set of insti- observe for Russia, tutions would need to be established in a short period. How could this be done? company managers and kleptocrats op- The strategy adopted in Russia and many posed efforts to strengthen or enforce the capital market laws. They didn’t want a other transition economies was the “Big strong Securities Commission or tighter Bang”—mass privatization of state enterprises rules on self-dealing transactions. And what as quickly as possible. The rationale for this they didn’t want, they didn’t get (p. 1753). experiment was articulated, for example, by An- drei Shleifer and Robert W. Vishny (1998): What explains the gap between what emerged in the 1990’s and what the reformers Privatization then offers an enormous po- hoped would emerge? This paper provides an litical benefit for the creation of institu- explanation based on a simple model in which tions supporting private property because the economic actions and the political positions it creates the very private owners who of individuals are interdependent.2 Individ- then begin lobbying the government ... to create market-supporting institutions ... uals who control assets make both economic choices—to build value or strip assets—and political choices, e.g., by voting over policies that would establish the rule of law. An indi- * Hoff: World Bank, 1818 H Street NW, Washington, vidual’s economic decision affects his political DC 20433 (e-mail: [email protected]); Stiglitz: Depart- ment of Economics and Graduate School of Business, Uris position. If, for example, an individual strips the Hall, Columbia University, New York, NY 10027 (e-mail: [email protected]). We thank Avinash Dixit, Jeffry Frieden, Michael Hiscox, Philip Keefer, Steve Knack, Gary 1 On Russia, see Cheryl Gray and Kathryn Hendley Libecap, Branko Milanovic, Jean-Philippe Platteau, Arijit (1997), Anders Aslund and Mikhail Dmitriev (1999), Sen, Anqing Shi, Ken Sokoloff, and seminar participants at Katharina Pistor (1999), and others in the symposium “De- University of California-Berkeley, Harvard University, mand for Law” in the East European Constitutional Review, Pennsylvania State University, Princeton University, Herbert Kitschelt (2001), and Kathryn Stoner-Weiss (2001). UCLA, the World Bank, the NEUDC, meetings of the On Russia and other transition economies, see Black et al. American Political Science Association, and the MacArthur (2000) and EBRD (2001, 2002). Research Network on Inequality and Economic Perfor- 2 The model developed here was briefly described in Hoff mance for discussions and valuable suggestions. Stiglitz (2001, pp. 166–68). Related models were recently developed acknowledges financial support from the Ford, MacArthur, by Leonid Polishchuk and Alexei Savvateev (2001), Erik Ber- and Mott Foundations. The findings and interpretations ex- glof and Patrick Bolton (2002), and Konstantin Sonin (2003). pressed in this paper are those of the authors and do not Hoff and Stiglitz (2004) provide a diagrammatic exposition of necessarily represent the views of the World Bank. a simple case of the model presented here. 753 754 THE AMERICAN ECONOMIC REVIEW JUNE 2004 assets he controls instead of building value, then of a market economy before communism, an he has some reason to oppose the establishment historical legacy of corruption, a corrupt privat- of the rule of law as it would constrain his ization, abundant natural resources, open capital ability to strip. Further, when enough individu- markets, and a hyperinflation in 1992–1993 that als oppose the rule of law, the probability that it by destroying private savings aggravated the will be established falls, which reduces the eco- consequences of imperfect capital markets and nomic incentives of other asset holders to invest made asset stripping appear relatively more at- and so affects their “votes.” Individuals’ de- tractive. Some of the policy frameworks im- mands for the rule of law are thus interdepen- posed on Russia (such as excessive monetary dent, and it is appropriate to consider the tightness) had unintended consequences, among circumstances in which the equilibrium does which was the inhibition of the movement to- and does not lead to the establishment of the wards the rule of law.4 Thus, the model helps rule of law. explain why what happened in Russia actually In this paper, we examine this interde- happened. pendence within a highly stylized general- equilibrium framework under conditions that I. A Short Background on the Big Bang in we would interpret as very favorable to the Russia emergence of the rule of law. In the model, those with control rights over privatized assets In December 1991, the USSR was dissolved. are powerless individually to obtain property In the next year, Russia implemented Big Bang rights protection a` la carte from the state or to reforms, including a mass privatization program establish an oligarchy that privileges their own that distributed equity to managers and workers interests, but can collectively bring about the and sold shares at public auctions. By July rule of law by voting for it. If in this model mass 1994, 14,000 medium and large state enter- privatization creates a constituency for the rule prises (70 percent of Russian industry) had been of law, it does not mean that Big Bang privat- transformed into joint-stock companies. Be- ization is an effective strategy to establish the cause worker and outside ownership was so rule of law (for capitalists who are political dispersed, management exercised effective con- insiders could still capture the state and estab- trol in most employee-owned firms (Roman lish a legal regime that privileged their own Frydman et al., 1996, and Joseph R. Blasi et al., interests). But if privatization does not do that 1997).5 under the circumstances explored here—which Mass privatization was initiated before insti- we show may well be the case—then the para- tutions to support the rule of law, particularly digm of institutional change that justified quick concerning corporate governance, were in privatization should be viewed with consider- place. Such institutions are imperfect in all so- able skepticism.3 cieties, but between Russia and most other de- Our model identifies factors that reduce the veloped, capitalist societies there was a political demand for the rule of law. Many of qualitative difference. There were, for instance, these are present in Russia: lack of experience 4 There were other consequences, such as the growth of 3 Shleifer and Daniel Treisman (2003) have argued that barter, that also adversely affected the market economy. although investor protection, corporate governance, and 5 The privatization itself went through several stages, control of corruption remain weak in Russia, these flaws are and interestingly, some of the failures at the early stages typical of middle-income capitalist democracies today, and gave rise to forces that made privatizations in later stages of the United States during parts of the nineteenth century. even less supportive of the “rule of law.” Mass privatization However, legal historians of the United States in the nine- turned out to be unpopular because it did not deliver the teenth century present a very different view of the overall promised economic improvement. Facing very uncertain security of property rights and the functioning of the courts, reelection prospects, President Yeltsin entered into a deal in which seems to contrast quite a lot with the situation in 1995 that led to the privatization in 1995–1997 of some of Russia. See, e.g., Lawrence M. Friedman (1985, p. 275), Russia’s most valuable enterprises through a program who states that in the United States, “The 19th century was known as “loans for shares.” The program gave rise to the the golden age of the law of contract,” and Black et al. term “oligarchs” to refer to the small group of bankers and (2000, p. 1782), who describe in Russia a “lawless climate, industrialists who obtained billions of dollars in state assets in which managers could justify self-dealing by claiming at very low prices in exchange for help in reelecting Pres- (sometimes correctly) that they had done nothing illegal.” ident Yeltsin. VOL. 94 NO. 3 HOFF AND STIGLITZ: AFTER THE BIG BANG? 755 countries for which such data are available.6 The horizontal axis plots the fraction of firms in the survey that report that they do not trust the legal system to uphold their property and contract rights. The vertical axis plots the ratio of GDP in 2000 to GDP in 1989. In the six economies where property rights are most insecure, GDP contracted sharply—by official statistics, the contraction was more than 30 percent. II. A Static Model of the Demand for the Rule of Law A.

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