Transcript Lawless Capitalism Grips Russian Business

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 Post
November 7, 2000
After the Big Bang:
Obstacles to the Emergence of the Rule of Law
in 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
The Result in Russia
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
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-ruleof-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
1.4
POL
GDP 2000/GDP 1989
1.2
SVN
HUN
UZB
1.0
SVK
CZE
BLR
EST
HRV
.8
ROM
KAZ
BGR
.6
LTU KGZ
RUSSIA
ARM
AZE
UKR
.4
R2 = 0.3452
GEO
MDA
.2
20
30
40
50
60
70
80
Index of insecurity of property and contract rights (BEEPS)
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.”
The “no-rule-of-law state”
“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
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
Controller
Strip assets
Build value
Political environment
Rule of
law
 [1 -]
Rule
of law
No rule
of law

bL
No rule
of law
bN
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
Payoffs

Dual stable equilibria
Strip assets
g IL
High equilibrium support for the rule of law
gI
Low equilibrium support for the rule of law
Switch line, *
N
Build value
0
1/
2
Stripping
abilitycurve
x
1
Increasing support for the rule of law
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?
Rule of law
No rule of law
Payoffs from ¼ to 1
depending on stripping
ability
OR
Payoffs: 1
?
Payoffs
1
1/
4
Switch line: *= ¼ + ¾ (1-x)2
0
2/
3
Increasing support for the rule of law
1
Stripping ability curve: x = 1 - 
x
Payoffs
A shift up in distribution of
ability to asset-strip
Initial conditions:
• Criminal networks
• Natural resource abundance
1
Policy:
• Capital account convertibility
1/
4
0
1
Increasing support for the rule of law
x
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”
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
53.15%
(1996)
63%
73%
3.7 score
Average for
countries with
less than 10%
natural resource
exports
Russia
Wall Street Journal
Rule of Law index
(10 = best,
0 = worst)
Payoffs
A fall in the returns to building
value
Initial conditions:
• Distortions in the economy
• Distance from the EU
• A corrupt privatization
1
Current policy:
• Restrictive macro-policy
1/
4
0
2/
3
Increasing support for the rule of law
1
x
Payoffs
A shift down in expectations that the
rule of law will be established
Initial conditions:
• No “market memory”
• Criminal networks
• Corrupt privatization
1
Current policy:
• Lack of prospects for EU accession
1/
4
0
2/
3
Increasing support for the rule of law
1
x
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
FLOW
STRIP
s N ( )  f   ,
DEPLETION OR
GROWTH OF
ASSET
~
z 1
s L ( )  f   [1   ]
BUILD
b j= f – I j
g~  1
~ 1
with g   g
Majority prefers building value under the
rule of law to stripping under no rule of law
VL
bL


1 g
s N ( )
1 z
In the rule-of-law state, ALL prefer to build:
s ( )

1 z
L
V
L
º S :L ( )
for all .
Two more value functions
S
V
N
N
( x , )
(x)
s

1 z
b

1 g


z

V
1 z
g

V
1 g
L
L
 S ( x, )
N
 V N ( x)

1st term: asset value if current expected flows
continued forever
2nd term: capital gain or loss from the transition to the
rule of law.

Economic and Political Behavior
V N ( x )  S N ( x,   )  0
Switch line for building value
V N ( x )  S N ( x,   )  0
Switch line for building va
uation benefit from no-rule-of –law for an agent who strips today:
 z[V LContinuation
 S N (x, )]benefit from no-rule-of –law for an agent who strips today:
L
N
)]
 z[V L 
 S N(x,z[pV)]  S= 0(x,. Switch
line for voting
p  z[V L  S N (x, p )]
=0
Switch line for voting
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.
θ
Dynamic model
III
Strip assets and
oppose the rule of law
θp
I (build value and
support the rule of law)
II
Strip assets and
support the rule of law
θa
0
1
Increasing support for the rule of law
x
Multiple equilibrium
levels of demand for rule
of law
θ
High demand for the rule of law
Low demand for the rule of law
Political switch line, θ*
Stripping ability
curves
0
1
Increasing support for the rule of law
x
Time path of expected GDP
High 
GDP along
expected
growth path
Low 
time, t
Summary of model: A tale of two distortions
1. Externalities from actions (stripping or
building value ) on the political and legal
environment
2. The legal regime is a public good
i
vote
j
vote
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 Street
Wall Street Journal, October 19, 2002
Future Work
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
Biasedness
Security of returns to
building value
Oligarchy