American Economic Association

The Invisible Hand and the Grabbing Hand Author(s): Timothy Frye and Andrei Shleifer Source: The American Economic Review, Vol. 87, No. 2, Papers and Proceedings of the Hundred and Fourth Annual Meeting of the American Economic Association (May, 1997), pp. 354-358 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/2950945 Accessed: 18/12/2009 09:14

Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use.

Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea.

Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission.

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected].

American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review.

http://www.jstor.org The InvisibleHand and the GrabbingHand

By TIMOTHY FRYE AND ANDREI SHLEIFER*

In the 1990's, several East European econ- environment is a good deal friendlier to busi- omies went through radical liberalization. ness in Warsaw than in Moscow. Among them, Russia and Poland adopted similar packages of reforms, including almost I. Governmentin Transition complete price and trade liberalization, macroeconomic stabilization (which Poland There are three basic views of how bureau- accomplished five years before Russia), large- crats and entrepreneursinteract during transi- scale privatization (which Russia did four tion, as well as more generally. Under the years before Poland), and small-scale privat- invisible-hand model, the government is well- ization. While Poland startedtwo years earlier, organized, generally uncorrupt,and relatively both reform packages were radical. benevolent. It restricts itself to providing basic Despite the similarity of reform packages, public goods, such as contract enforcement, the Polish economy responded much better to law and order, and some regulations, and it the treatment.By the mid-1990's, it was grow- leaves most allocative decisions to the private ing rapidly, while the Russian economy at best sector. Many countries in eastern Europe, par- stopped shrinking. The formation and growth ticularly those hoping to join the European of small businesses was also more dramaticin Community (Jeffrey Sachs, 1994), have Poland. According to the European Bank for looked to this model in their reforms. Reconstruction and Development (EBRD, In the two alternative models, government 1996), in 1995 Poland had about 2 million plays a larger role. Under the helping-hand small private businesses, whereas Russia had model, commonly invoked in discussions of only 1 million with a population almost four China (Andrew Walder, 1995), bureaucrats times larger. Even if we allow, as the EBRD are intimately involved in promoting private does, that Russia had another 2 million unreg- economic activity: they support some firms istered private businesses, small-business for- and kill off others, pursue industrial policy, mation is still more lethargic in Russia. and often have close economic and family ties Why, despite similar reform packages, has to entrepreneurs.The legal frameworkplays a the Russian entrepreneurial response been limited role in this model, because bureaucrats weaker? Using a pilot survey of shop manag- adjudicate most disputes. Bureaucratsare cor- ers conducted in Moscow and in Warsaw in rupt, but corruption is relatively limited and the spring of 1996, we argue that a key reason organized. An extreme version of this model, for this outcome is there are very different re- the iron-hand model, is found in Southeast lationships between government and business Asian countries like Korea and Singapore. In in the two countries. In the survey, we ask transition economies, however, the helping- questions about the legal and regulatory en- hand model has been less prevalent. vironment in both cities. We find that the reg- In the final, grabbing-hand, model, govern- ulatory, and to some extent the legal, ment is just as interventionist, but much less organized, than in the helping-hand model. The government consists of a large number of substantially independent bureaucrats pursu- * Frye: Departmentof Political Science, Ohio State Uni- ing their own agendas, including taking bribes versity, and Columbia University, New York, NY 10027; (see Shleifer and Robert Vishny, 1993). Shleifer: Department of Economics, Harvard University, While these bureaucrats adopt the helping- Cambridge,MA 02138. We are grateful to Ed Glaeser and in Jim Hines for helpful comments, and to the HarvardInsti- hand rhetoric (Shleifer, 1996), reality they tute for InternationalDevelopment for financial supportof are scarcely guided by a unified public-policy this research. stance, and they remain largely independentof 354 VOL. 87 NO. 2 THE TRANSITIONFROM SOCIALISM 355

TABLE 1-ECONOMIC ROLEOF THE STATE radical economic reforms. Second, private DURING TRANSITION business in both countries is growing espe- cially fast in the capitals, which also makes the Legal Regulatory comparison appropriate. Model environment environment The shops were selected randomly from Invisible- Government is Government follows small-business directories (Business Karta hand not above law rules. Regulation is and uses power minimal. Little Moskvi and PanoramaFirmi) that include sev- to supply corruption. eral thousand entries. The survey includes a minimal public mix of private and privatized retail shops, each goods. Courts with a staff of 5-50 employees. Most (62 enforce percent) are food shops, but we also include contracts. Helping- Government is Government barber shops, book stores, dry-cleaning es- hand above law but aggressively tablishments, and small departmentstores. On uses power to regulates to promote average, Moscow shops employ more workers help business. some businesses. than Warsaw shops (23.4 vs. 14.8, t = 3.33), State officials Organized enforce corruption. which may be due to policies promoting very contracts. small businesses pursued by the Polish gov- Grabbing- Government is Predatoryregulations. ernment. On average, Warsaw shops have hand above law and Disorganized been in operation for almost 4.5 years, and uses power to corruption. Moscow shops for 3.3 years (t = -4.25). This extract rents. The legal is consistent with Poland startingits transition system does not almost two years before Russia. On average, work. Mafia Moscow shop managers are slightly older (44 replaces state vs. 42 years old, t = 1.18 ), have slightly more as enforcer. experience working in retail (16 vs. 14 years, t = 0.98), but slightly less experience as man- agers (8.7 vs. 10.5 years, t = -1.02) than their counterparts in Warsaw. Overall, we have courts, capable of imposing their will in com- broadly similar samples of shops in the two mercial disputes, and empowered to impose on cities. business a variety of predatoryregulations. In the extreme cases, the government becomes III. Results sufficiently disorganized that it loses its ability to ensure law and order and to provide basic Our questions on the legal environment ad- legal protections. As a consequence, contracts dress two issues: the effectiveness of court sys- become privately enforced. tems in dispute resolution and the role of These three models of government are protection rackets. Under the invisible-hand "ideal types," and all real governments are model, courts are effective in resolving dis- mixtures of the three. Our questions try to as- putes between private parties as well as be- sess how close local governments in Moscow tween them and the government, and there is and Warsaw are to these "ideal types" by fo- no room for protection rackets. Under the cusing on the legal and regulatory environ- helping-hand model, courts play a smaller ment. Table 1 summarizes the predictions of role, especially in disputes with the govern- the three models of government that we ment, but the government is powerful enough examine. to displace the rackets. Under the grabbing- hand model, government is ineffective in pro- II. The Survey viding basic services, courts are ineffective in resolving disputes, and in the extreme, agree- In March and April 1996, we surveyed 105 ments are enforced privately. The questions in small shops: 55 in Moscow and 50 in Warsaw. Table 2 look at these alternativepredictions. We chose Moscow and Warsaw for two rea- In both countries, courts are rarely used. sons. First, both Poland and Russia pursued Only 19 percent of shop managers in Moscow 356 AEA PAPERS AND PROCEEDINGS MAY 1997 and 14 percent in Warsaw reportedusing them TABLE 2-LEGAL ENVIRONMENT in the previous two years (t = 0.66). This may simply reflect the high costs of using courts in Question Warsaw (n) Moscow (n) t both countries. However, when asked whether Used courts in the they needed to use the courts but did not, 45 last 2 years? 0.14 (50) 0.19 (53) 0.66 percent of Moscow managers answered yes, Needed to use courts, but did whereas in Warsaw, only 10 percent did (t = not? 0.10 (50) 0.45 (53) 4.32 4.32). Either Moscow shop managers have Can use courts less faith in their courts, or they face more dis- against putes that potentially require court interven- government? 0.41 (46) 0.50 (52) 0.86 tion than do their counterpartsin Warsaw. Can use courts against When asked whether they "could use courts business to defend their rights if the government grossly partner? 0.45 (38) 0.65 (52) 1.97 violated their property rights," 50 percent of Contacted by Moscow respondents, and 41 percent of War- racket in the last six saw respondents, answered yes (t = 0.86). months? 0.08 (50) 0.39 (54) 3.91 Evidently, businesspeople in both countries Does one need have significant skepticism about the indepen- roof/umbrella dence and effectiveness of courts in disputes to operate? 0.06 (50) 0.76 (54) 10.10 with the government. On the other hand, when Notes: The table presents the fraction of affirmative re- "the government" is replaced with "a busi- sponses to questions in Moscow and Warsaw and the t test ness partner" in this question, 65 percent of of differences in responses. the Moscow respondents, and only 38 percent of the Warsaw respondents, answer yes (t = 1.97). One interpretationof this finding is not the greater credibility of the Russian courts, plays a greater role in Russia than in Poland. but the greater availability of alternative Since the respondentsin both cities are equally means of dispute resolution in Warsaw. Fi- skeptical about courts, the likely reason for the nally, we find that 57 percent of the Moscow higher incidence of protection rackets in Rus- shops have hired legal counsel, compared to sia is the greater failure of simple police pro- only 36 percent of Warsaw shops (t = 2.2). tection (order as opposed to law) in Russia. This may reflect greater interest in litigation, The next set of questions deals with the but more likely, lawyers are needed in Russia regulatory environment, and the closely re- to deal with bureaucrats. Overall, we find a lated problem of corruption (Table 3). We good deal of skepticism about the legal system begin with a naive question about the helping- in both countries. hand model. We ask, "Does the local govern- We also ask about private ratherthan public ment hinder, have no influence on, or help protection. In Russia, shopowners often pay small business?" The answer is basically the private security agencies to protect them from same in the two cities: it has no influence. At crime and to help resolve disputes. This insti- least in their stance toward small business, tution is known as "a roof" in Russia, and both countries are very different from the East "an umbrella" in Poland. We asked the re- Asian model. spondents whether it is true that one cannot We then ask several regulatory questions. operate a store in their city without a roof (an When asked how long it took to register their umbrella). In Moscow, 76 percent answered business, Moscow respondentsreported an av- yes, whereas in Poland only 6 percent did erage of 2.7 months, compared to 0.7 months (t = 10.10). A related question is whether a in Warsaw (t = 5.02). When asked how many shop managerhas been contacted by the racket inspections they had last year, Moscow man- in the last six months. In Moscow, 39 percent agers reported an average of 18.56, and War- of the respondents answered yes, whereas in saw managers 8.99 (t = 3.46). Moscow shop Warsaw only 8 percent did. These data make managers are also more likely to be fined by clear that private enforcement of law and order inspectors than their counterpartsin Warsaw: VOL. 87 NO. 2 THE TRANSITIONFROM SOCIALISM 357

TABLE 3-REGULATORY ENVIRONMENT of corruption by asking how many different kinds of inspectors visited the shop. On aver- Question Warsaw (n) Moscow (n) t age, 3.58 different agencies conducted inspec- Local Hinders: 5 Hinders: 8 -0.19 tions of Moscow shops, compared to 2.65 in government No influence: 41 No influence: 39 helps small Helps: 4 Helps: 6 Warsaw (t = 1.84). If we accept the Shleifer business? (50) (53) and Vishny (1993) view that the amount of Time to register 0.72 (47) 2.71 (51) 5.02 business bribes increases with the number of indepen- (months)? dent bribe-takers,this evidence points further Inspections last 9.0 (49) 18.56 (55) 3.46 to the greater burden of corruption and regu- year? Percentage of 46 (49) 83 (52) 2.72 lation in Moscow than in Warsaw. shops fined In sum, our evidence indicates that shop- by inspectors last year? owners in neither country are particularlykeen Number of 2.65 (49) 3.58 (55) 1.84 on using courts, though the Russian respon- different have need for them. On the agencies dents a greater conducting other hand, private protection is used much inspections? more extensively in Russia than in Poland. How legally 3.6 (50) 5.1 (55) 3.91 vulnerable Regulations in Russia appearto be a good deal do you feel more oppressive to business than they are in on scale of I - 10? Poland. This is reflected in some measures of How often does 2.21 (47) 2.9 (53) 2.52 regulation, in the greater legal vulnerability one need to bribe that Russian respondents feel, and in the officials on greater burden of corruptionin Moscow. scale of I - 5? The more predatory stance of Moscow's government toward business is consistent with Notes: The table presentsresponses to questionsabout govement regulationand corruptionand resultsof t tests of the differencebetween Warsaw and Moscow. the greaterdynamism of such business in War- saw. One further finding corroborates this view. When asked to rate the problem of prod- uct market competition on a scale from 1 to 83 percent reported having paid fines com- 10, Moscow shop managers' average answer pared to 46 percent in Warsaw (t = 2.72). was 4.8, compared to 6.2 in Warsaw (t = 2.3). Fines are likely to be a good measure of Evidently, the Polish shopkeepers have their regulatory burden, as well as a proxy for rents extracted by competitors, while the Rus- corruption. sians have rents extracted by bureaucrats. One measure of the severity of the regula- tory burden is how concerned the shop man- IV. Conclusion agers are about being in violation of some regulations. To get at this issue, we ask shop We have presentedsome evidence from Mos- managers how "legally vulnerable" they feel, cow and Warsaw shops on their dealings with on a scale from 1 to 10. The mean answer in legal and regulatoryinstitutions. While neither Warsaw was 3.6, compared to 5.1 in Moscow government is an "ideal type," the evidence (t = 3.9), consistent with the greater regula- points to the relatively greaterrelevance of the tory burdenin Russia. Another measure of reg- invisible-handmodel to describePoland, and of ulatory burden is corruption, since a standard the grabbing-handmodel to describe Russia. way to get around the difficult regulations, re- The law-enforcementand regulatory evidence in quirements, delays, and fines is to pay a bribe. particularshows that Polish local governments We ask our respondents somewhat discretely: are more supportiveof business. This evidence how often does one need to bribe officials to is consistent with the greaterenergy shown by do business in your city, on a scale from 1 to small business in Poland than in Russia despite 5, ( 1, almost never; 2, rarely; 3, sometimes; 4, similareconomic reforms. often; 5, almost always). The mean response This conclusion suggests that, to understand in Warsaw was 2.2, compared to 2.9 in Mos- transition experiences, it is not enough to cow (t = 2.52). We also explore the structure know how much of a standardmenu of radical 358 AEA PAPERS AND PROCEEDINGS MAY 1997 reforms a country adopts. The regulatory Sachs, Jeffrey. Poland's jump to a market stance that national and local governments economy. Cambridge, MA: MIT Press, take toward business can perhaps explain as 1994. much as the package of reforms. This conclu- Shleifer, Andrei. "Origins of Bad Policies: sion also raises a broader question: why do Control, Corruption, and Confusion." Ri- different governments follow such different vista di Politica Econmica, June 1996, models? We defer a discussion of this question 86(6), pp. 103-24. to future work. Shleifer, Andrei and Vishny, Robert. "Corrup- tion." Quarterly Journal of Economics, REFERENCES August 1993, 108(3), pp. 599-617. Walder,Andrew. "China's Transitional Econ- EBRD. Transition report 1995. London: Eu- omy: Interpreting its Significance." China ropean Bank for Reconstruction and Devel- Quarterly, December 1995, (144), pp. opment, 1996. 963-79.