“Lawless Capitalism Grips Russian Business”

1. 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.

2. “Lawless Capitalism Grips Russian Business” - The Washington PostNovember 7, 2000

3. After the Big Bang: Obstacles to the Emergence of the Rule of Lawin Post-Communist Societies Karla Hoff and Joseph E. Stiglitz September 2003

4. 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

5.  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

6. 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.

7. 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)

8. I. Timeline for Russia • 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

9. Growth and property rights insecurity in 20 transition economies 1.4 POL 1.2 SVN HUN SVK UZB CZE 1.0 BLR EST GDP 2000/GDP 1989 HRV .8 ROM KAZ KGZ BGR LTU RUSSIA .6 ARM AZE UKR R2 = 0.3452 .4 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.”

10. 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

11. 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.

12. 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.

13. I. Static model: The controller’s dilemma–strip assets of build value

14. Notation π = probability that the rule of law is enactedx = fraction of agents who strip assets π = π (x) –a decreasing function

15. Equilibrium * = g - (x) I L-[1-(x)] I NSwitch lineAgents with a comparative advantage in stripping assets relative to * (i.e.,  > *) will choose to strip assets and thus x = 1 – H(*) Stripping ability curve

16.  Strip assets High equilibrium support for the rule of law Low equilibrium support for the rule of law Switch line, * Build value Stripping abilitycurve x 1/2 0 Increasing support for the rule of law Dual stable equilibria Payoffs 1

17. Example  = (1-x)2 ,  is uniformly distributed on [0,1], g – I L = 1 g – I N = ¼.

18. 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 Payoffs: 1 OR ?

19. 1 1/4 Switch line: *= ¼ + ¾ (1-x)2 Stripping ability curve: x = 1 -  2/3 Payoffs x 0 1 Increasing support for the rule of law

20. A shift up in distribution of ability to asset-strip • Initial conditions: • Criminal networks • Natural resource abundance • Policy: • Capital account convertibility Payoffs 1 1/4 x 0 1 Increasing support for the rule of law

21. Natural resource abundance, growth, and property rights insecurity 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) Fuel and mineral exports/ total exports 2000 GDP/ 1989 GDP 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

22. 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 1 1/4 x 2/3 0 1 Increasing support for the rule of law

23. 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 1 1/4 x 2/3 0 1 Increasing support for the rule of law

24. 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 politicalposition – for or against the rule of law. Stage 2. The new state (N or L) is realized, and agents receive state-contingent returns.

25. 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.

26. b j = f – I j BUILD with Technology and payoffs DEPLETION OR GROWTH OF ASSET FLOW STRIP

27. q L s ( ) > º q q L : L V S ( ) for all . - 1 z Majority prefers building value under the rule of law to stripping under no rule of law In the rule-of-law state, ALL prefer to build:

28. Two more value functions 1st term: asset value if current expected flows continued forever 2nd term: capital gain or loss from the transition to the rule of law.

29. Economic and Political Behavior .

30. 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.

31. III Strip assets and oppose the rule of law θp II Strip assets and support the rule of law θa I (build value and support the rule of law) Dynamic model θ x 0 1 Increasing support for the rule of law Increasing support for the rule of law

32. High demand for the rule of law Low demand for the rule of law Stripping ability curves Multiple equilibrium levels of demand for rule of law θ Political switch line, θ* x 0 1 Increasing support for the rule of law

33. High  Low  Time path of expected GDP GDP along expected growth path time, t

34. 2. The legal regime is a public good ai vote aj vote Summary of model: A tale of two distortions 1. Externalities from actions (stripping or building value ) on the political and legal environment

35. 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 (sinceVL > SL)  which ensures a constituency for rule of law  “beneficent” capitalism.

36. 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.

37. Caveats: The actual process of legal regime transition is not Markov1. 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)

38. 2. History affects the distribution of wealth and power Muckraking Governor Slain By Sniper on Moscow Street Wall Street Journal, October 19, 2002

39. 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 Security of returns to building value Biasedness Oligarchy