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6
Learning in Networks: Enterprise Behavior in the Former Soviet Union and Contemporary Russia

Yevgeny Kuznetsov

INTRODUCTION

This chapter examines enterprise behavior and enterprise learning in the former Soviet Union and contemporary Russia. Enterprise learning can be understood as a process of experimentation and repetition that enables tasks to be performed better and new production opportunities to be identified. In an economy with rudimentary—or missing—markets, enterprise learning will require significant start-up costs. First, quasi-market institutions must be created to take the place of the underdeveloped or missing markets required for adjustment. Only after these are in place can enterprises begin to adjust to them.

Institutions are defined broadly as any long-term explicit or implicit agreements about patterns of social behavior; that is, they constitute formal or informal social contracts. For example, in the absence of both firms that provide long-term leases and laws that would regulate this activity, enterprises must create quasi-leasing institutions themselves, inventing sophisticated barter schemes and ingenious forms of enforcement. The absence of market institutions necessitates the investment of already accumulated competencies (in managerial time and financial resources) to create an institution that will serve as a substitute for court-enforced leasing. Enterprise adjustment in a transitional economy is therefore somewhat similar to the complex of processes that firms in economies with antiquated physical infrastructure or pervasive government regulation must undergo. In all these cases, an entrepreneur incurs a number of start-up costs:



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Transforming Post-Communist Political Economies 6 Learning in Networks: Enterprise Behavior in the Former Soviet Union and Contemporary Russia Yevgeny Kuznetsov INTRODUCTION This chapter examines enterprise behavior and enterprise learning in the former Soviet Union and contemporary Russia. Enterprise learning can be understood as a process of experimentation and repetition that enables tasks to be performed better and new production opportunities to be identified. In an economy with rudimentary—or missing—markets, enterprise learning will require significant start-up costs. First, quasi-market institutions must be created to take the place of the underdeveloped or missing markets required for adjustment. Only after these are in place can enterprises begin to adjust to them. Institutions are defined broadly as any long-term explicit or implicit agreements about patterns of social behavior; that is, they constitute formal or informal social contracts. For example, in the absence of both firms that provide long-term leases and laws that would regulate this activity, enterprises must create quasi-leasing institutions themselves, inventing sophisticated barter schemes and ingenious forms of enforcement. The absence of market institutions necessitates the investment of already accumulated competencies (in managerial time and financial resources) to create an institution that will serve as a substitute for court-enforced leasing. Enterprise adjustment in a transitional economy is therefore somewhat similar to the complex of processes that firms in economies with antiquated physical infrastructure or pervasive government regulation must undergo. In all these cases, an entrepreneur incurs a number of start-up costs:

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Transforming Post-Communist Political Economies Capital must be invested to establish at least part of the required infrastructure. Time and financial resources must be devoted to complying with the tangle of regulations involved in setting up a firm. Intangible capital and financial resources must be marshaled in the effort to secure general adoption of the new institution. This chapter examines post-socialist transformation in terms of the emergence of new institutions, with their accompanying start-up costs, and suggests policies that would encourage firm-level investment in enterprise learning. The formation of market institutions is generally viewed in the current literature from one of two mutually exclusive points of view. In advanced market and semi-industrialized economies, it is viewed as a gradual process, with emphasis on continuity and path dependence (North, 1990). In contrast, the debate on post-socialist transformation stresses discontinuity and shocks, assuming that market institutions are created from scratch (Blanchard et al., 1994). This chapter reveals the importance of path dependence and continuity in institutional formation during transition through an examination of enterprise behavior in periods of drastic economic liberalization in both the former Soviet Union and contemporary Russia. It shows that both pervasive hierarchy failure (in the Soviet Union in the 1970s and 1980s) and market failure (post-socialist Russia) resulted in the formation of formal and informal networks sharing intangible capital, such as personal trust, reputation, and information that is tacit and difficult to transfer. The next section describes the theoretical framework for the analysis. On the basis of empirical studies of real-life planning, interviews with enterprise managers, and recently published memoirs of top planning officials, the chapter then proceeds to develop a model of Soviet planning in the 1980s as a continuing balancing of implicit obligations within producer-consumer networks. The section that follows examines the low-level equilibrium trap in which the Soviet economy foundered. The next two sections introduce and illustrate, respectively, the portfolio principle in learning. The final section presents conclusions. First, since the chapter presents relatively new evidence concerning the functioning of the economies of both the former Soviet Union and Russia, it is worth describing the source of that evidence. The conclusions presented here are based on a series of in-depth interviews with the top management of 24 enterprises in the Russian military-industrial sector, conducted between September 1993 and May 1994, with funding provided by the MacArthur foundation. We examined a broad set of issues, past and present, focusing on the manager's behavior, incentives, and priorities. It should be noted that this sample is biased, since, to maximize candor, we concentrated our efforts on

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Transforming Post-Communist Political Economies firms whose top management were recommended to us as trustworthy. Annex 6-1 summarizes the sources of sample bias and describes the sample. To test the quality of the information obtained through the above surveys, we performed an experiment at the beginning of the project. Two teams were sent to the same enterprise: one used a formal, closed-ended questionnaire to collect information on standard economic indicators such as profit, output level, and the like; the other included enterprise insiders who were authorized to pursue whatever avenue of inquiry they deemed interesting. In most cases, the first team labeled the enterprise in question a failure, while the second defined it as a qualified success, with real long-run economic potential. The difference is accounted for not only by pervasive underreporting,1 but also by the more fundamental difficulty of defining the boundaries of the firm. Because of the broad array of disequilibrium processes inherent in transition, including privatization and firm-level decentralization, the firm is currently best described as a fluid constellation of personal networks with constantly changing boundaries. Given both the difficulty in working with such a fluid definition and the available micro-level information, one must be prepared for certain stylized facts presented in this chapter to be somewhat speculative. Finally, it should be noted that the chapter reflects the evolutionary perspective on post-socialist transformation pioneered by Murrell (1992, 1993) and Stark (1992, 1994, 1996). In the Russian case this perspective has received extensive empirical corroboration in the surveys of Russian industries lead by Ickes and Ryterman (1994). THEORETICAL FRAMEWORK The value of a law firm is related only marginally to the book value of its assets; what matters is its reputation and its personal network of clients. Similarly, an important share of a bank's capital—including information about customers, customer and organizational networks, reputation, technical and organizational know-how, the culture of the organization, and its ability to change—is intangible.2 This capital is also tacit and difficult to transfer. The more uncertain the environment, the more substantial is the role played by intangible capital. For organizations operating in emerging and transitional markets, and in particular those involved in intertemporal trade, intangible capital will be of paramount importance. 1   The more entrepreneurial the manager, the less reliable the economic indicators she/he produces. For example, no intelligent manager would display any profit (since it tends to be taxed away), and to avoid excess wage tax, the manager would hire labor ''on paper" (indicating that actual employment would be much higher than that reported). 2   In the case of the bankruptcy of a bank, this information capital is not easily sold or otherwise transferred to other firms, which is precisely why such a failure imposes high social costs.

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Transforming Post-Communist Political Economies Institutional venture capital funds provide a good example. Since personal knowledge is critical in this area, one would expect to see the emergence of an informal venture capital market where successful business owners would reinvest their wealth in promising young companies. Even in advanced market economies, one can observe the coexistence of informal and formal venture capital markets.3 This example of stable equilibrium in which informal and formal capital markets coexist is important because informal institutions are usually perceived as a spontaneous response to the failure of formal markets. Yet as this example demonstrates, informal networks and formal institutions not only coexist, but are mutually supportive. Informal investors provide financing at the initial, "embryonic" stage of a project, and as it matures into the "infant" stage, hand it over to the formal capital market. This concept of the life cycle of an institution with various stages is useful in the analysis of economies with rudimentary formal markets. Imagine an economy in which intangible capital is embedded in personal networks.4 These networks may also include or overlap with formal institutions, such as banks and other financial institutions. A relevant example is the grupos economicos in Latin America—these are extremely diversified entities that often comprise assets without any apparent synergy, but that are united by a network of extended family ownership. Imagine that an economy characterized by such entities undergoes a combined institutional and demand shock, which is typical in countries that can no longer afford gradual macroeconomic stabilization and structural adjustment. What will happen with existing networks? More specifically, what will be the after-shock allocation of the intangible capital embedded in these networks? Which new institutions will arise? Because of the assumption of a shock, North's (1990) scheme of gradual marginal evolution of institutions appears not to be applicable. The following theoretical framework combines insights of Schumpeter (1934) and Kindleberger (1978). 3   William Wetzel, who heads the Center for Venture Research at the University of New Hampshire (Meeks and Bohner Lewis, 1995), estimates that in the United States there are as many as 250,000 informal investors who, relying on "neighborhood networks," in 1994 invested $10-20 billion in more than 30,000 companies in their own back yards. To put this informal activity into perspective, in 1994 $4.2 billion in institutional venture capital funds was raised and invested in fewer than 4,000 companies. Another 181 companies raised $1.1 billion in deals of $10 million or less in the initial public offering market (Meeks and Bohner Lewis, 1995). In the United States, the country with the most advanced formal venture capital market, the informal market is at least as significant as the formal one. 4   From the perspective of public choice theory, a network is defined as a club good that is only partially excludable. In general, a club is a voluntary group deriving mutual benefit from sharing one or more of the following: production costs, the members' characteristics, and/or a good characterized by excludable benefits (Cornes and Sandler, 1986). We focus here on the following club goods: personal trust, reputation, and agreement to enforce each other's obligations.

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Transforming Post-Communist Political Economies A shock (displacement) provides new opportunities that may involve high risk. This particular blend of opportunities and uncertainties is likely to bring forward an entrepreneur who simultaneously does the following: Reaps the opportunity by undertaking a nonmarginal amount of learning in adapting existing institutions to the new situation. Reduces uncertainty by carving out new networks from existing ones, thus realigning personal trust and reputation inherited from previous periods. The following characteristics of this carving-out process are important: Enterprise learning—a process involving investment in the accumulation of new skills and the formation of new networks. Because of the fixed costs involved, learning is subject to increasing returns. As a result of increasing returns, there is a multiplicity of after-shock equilibrium institutional configurations. The entrepreneur has a choice with regard to the magnitude of the initial investment in learning. This choice largely determines which equilibrium institutional configuration will emerge. In turn, the entrepreneur's choice depends largely on his/her planning horizon: the longer the planning horizon, the larger the investments in organizational learning will be. The particular blend of formal and informal institutions depends on the government's legal framework. If this framework provides low transaction costs for doing business, informal networks will have an incentive to register as legal entities and become subject to government supervision and regulation. (This applies to firms of various sorts, including alliances such as joint ventures and coproduction agreements, and lobbying organizations.) If transaction costs are high, informal economic activity that takes place outside the government taxation and regulation systems will flourish. In this case, networks will perform functions the government is unable to perform. To summarize, enterprise learning includes the processes of acquiring competencies and accumulating social capital, as well as forming the social networks that will enable firms to put both capital and competencies to productive use. During the post-socialist transformation, the interaction among these various facets of enterprise learning has created an unusually rich and diverse set of transformation options. THE SOVIET ECONOMY AND ENTERPRISE NETWORKS This section summarizes and reinterprets as a set of stylized facts the results of a number of empirical studies of Soviet planning conducted at the end of the 1970s and during the 1980s. As is customary in macroeconomics, we distinguish between the short-run (related to working capital turnover), and long-run (related to investment allocation) consequences of these planning activities.

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Transforming Post-Communist Political Economies Short-Run Planning as a Policy Surprise In studying the process of real-life, short-term (yearly) planning, Medvedev (1982) finds no significant correlation between planned and actual increments in output (i.e., the difference between the current- and previous-year levels).5 Rather, he finds that plans change on a daily basis, and that no one expects them to be fulfilled. He concludes that it is not planning that directs enterprise behavior, but rather "informal interaction between enterprises,"6 the scope of which goes far beyond Kornai's (1980) vegetative system of control. If the plan is a trajectory rather than a point, how can one define good planning? In other words, how does the planner set out to achieve the plan's objectives? Medvedev (1982) provides abundant evidence that a good planner creates small and unpredictable oscillations in the plan's trajectory. This may or may not create imbalances in plan implementation, but these oscillations will capture various slacks (X-inefficiencies) in enterprise production. The deliberate creation of (small) imbalances thus becomes the planner's major tool for checking the opportunistic behavior of his agent, the enterprise manager.7 "Change of Regime" Through Organizational Innovation as a Means to Secure a Planner's Impact A plan can best be understood as an initial agreement that shapes and constrains subsequent network interaction. Thus one might hypothesize that there may be situations in which it is worthwhile for an enterprise to obtain an initially taut plan, if doing so enhances its future bargaining position. An analysis of Soviet economic realities in the 1980s shows that such a situation became more the rule than the exception. In the construction sector, where the problem of breaches of contracts (plans) among planners, construction agencies, and production ministries—consumers of the construction services—became pervasive, every party involved tried to secure a taut initial plan. For 5   If one looks at absolute levels, there is bound to be a large correlation between plan and actuality. The quality of planning is then best described in terms of increments, since it is change rather than the status quo that interests a planner. 6   The notion of a plan being an outcome of horizontal bargaining with the planner as a broker is systematically explored by Hungarian economists such as Laky (1985), Antal (1985), and Kornai (1980). 7   Evidence that a plan is a trajectory and planning is a continuing interaction in a network of planners and producers makes the well-known hypothesis of planning "from the achieved level" trivial. If opportunistic behavior is so pervasive and the level of uncertainty/complexity is so high that every transactor involved in "planning" expects mutually agreed-upon action (the plan) to be violated on a daily basis, it is perfectly rational for the process coordinator (the planner) to make the first approximation of such an agreement solely on the basis of his/her former knowledge.

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Transforming Post-Communist Political Economies the producer, a taut plan meant more resources for its implementation. For the consumer, it increased the probability that construction would start. For the planner, it implied more leverage over the producer (threatening a penalty in case of failure to implement the plan). Over time, a planning regime of this type becomes destabilizing: plans increasingly become the result of signaling and bargaining games among relevant economic actors, and lose any relation to and sometimes even influence on the real sphere of action. To restore his/her influence, the planner may resort to a change in the planning regime—changing the expectations of all parties involved through changes in planning and accounting procedures, through mergers and/or redivisions of ministries, and most important, through personnel changes within ministries and enterprises. Starting in the mid-1970s, the Soviet economy became notorious for organizational innovations of this kind. These changes are usually interpreted as merely a bureaucratic imitation of activity. However, I would stress that organizational changes, and even organizational shocks, were a vital part of the regime changes necessary for central planners to maintain any degree of control over the economy. Exchange Relations Within Relevant Networks If a planner is powerless to enforce plans (except for a brief period of time following a change of regime), what determines actual economic outcomes? Empirical research by Naishul (1992), Shironin and Aven (1987), and Lavrovski (1988) produced evidence that the Soviet economy was governed not in a hierarchical fashion (in which the behavior of subordinates is administratively restricted), but in a network fashion (in which relatively autonomous agents operate on the basis of mutually agreed obligations that restrict their behavior). This research paints a picture of an economy in which everything—power, status, physical goods, money in enterprise bank accounts—becomes the object of trade and exchange. It also means there are relatively stable, "virtual" prices for all these goods that can be derived from the routine transactions in which they are exchanged. The view of the Soviet system as one of exchange rather than hierarchy 8 calls into question its standard division into a shadow sector, operating outside the plan, and the formal sector, based on the plan. Once the plan is understood as the outcome of horizontal bargaining among various parties, the planner is revealed as merely a broker, and the line between the shadow and formal economies becomes blurred indeed. 8   It is difficult to summarize the evidence provided by the cited authors. An illuminating example is an explanation of the 1991 coup failure provided by Naishul (1992). He aptly notes that the coup plotters were under the false impression that they were living in a command economy, and thus all their orders would promptly be implemented, whereas they should have known that even in the army one must provide some benefit in order to accomplish anything.

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Transforming Post-Communist Political Economies Investment Allocation In the 1980s, Soviet economic analysts tended to portray the investment allocation process as determined by bargaining among various industrial interest groups and ministerial hierarchies. The central planner, who was allegedly responsible for the elaboration and implementation of the nation's investment strategy, was seen as having been effectively "captured" (see Gaidar, 1990; Glaziev, 1990; Rassokhin, 1985). Thus there was no such thing as a centrally devised and implemented industrial or development strategy. Gaidar (1990) argues that there is little evidence for Kornai's hypothesis that investments will be allocated to alleviate bottlenecks and shortages. Instead, investment allocation is a function of interest group bargaining and the monopoly power of the relevant hierarchy, neither of which is directly linked to the shortage of goods or services provided.9 Gaidar (1990) gives an illuminating account of the interaction among actors during the process of investment plan formation, which explains why the "normal level of shortage" of some goods is not the only, and may not even be the primary, variable in the allocation of the relevant investment. The key factor is obtaining the support of all parties on whom completion of the investment process is dependent: the construction agencies, the ministries providing equipment and other necessary inputs, and the local authorities where the project will be physically located. Withdrawal of support by any participant will bring the investment project to a halt, no matter what the central planner's intentions. To avoid this situation, the primary beneficiary of the investment project must buy the support of all of the other parties involved—usually by guaranteeing a mutually agreed-upon amount of the project's future output to each of them. Failure to allocate sufficient resources to ensure of the investment plan results in a long construction cycle precisely because any relevant party may choose to withdraw its obligations. Drastic Regime Changes and Credibility Because of the inertia of customary law in the Soviet Union, the best enterprises (in the productive efficiency sense) had to elaborate quite sophisticated signaling and bargaining games to secure the desired capital allocations. A simple strategy of this kind will illustrate. Suppose that 2 or 3 years in advance of the desired capital replacement, a signal is sent to the top authority saying that unless capital allocations are forthcoming, immediate deterioration in the performance of the plant in question will be unavoidable. Such signals usually have zero information value (since everyone sends them), but since the 9   Civil construction aimed at soil improvement had a negative marginal social product, yet the relevant hierarchy was in the process of expanding rather than downsizing at the time of the regime's collapse

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Transforming Post-Communist Political Economies enterprise in question is the best of its kind, will be considered bluffing. The plant manager's next step is to make the enterprise perform substantially below its capacity for a year or two. This move will not be considered bluffing, simply because there is a risk involved for the manager: she/he could easily be sacked by the regional party authority. This move is intended to send a signal to the central authorities that the ministry to which the enterprise is subordinate is not able to manage its best enterprises—a signal that will substantially enhance the bargaining position of the enterprise. Eventually, to remedy an unfavorable impression in the eyes of the top authority, the ministry will allocate the required capital. Note that the strategy of the enterprise hinges on surprise, i.e., moves that are substantially different from expectations. In the next capital replacement cycle, the manager will have to play a somewhat different game. Note that considerations of allocative efficiency are nowhere in sight: the interaction among the decision makers is entirely in terms of signals designed to maximize their bargaining positions vis-à-vis each other. As economic agents learn how to play these games, the economic environment becomes more complex. To implement a policy move that affects many powerful interests, the planner must design an organizational shock of increasing intensity. Given the sclerosis of the Soviet ruling elite during the period under discussion, this reveals the complete impotence of central planners to implement any development strategy. Suffice it to say that the need for strong policy moves to accomplish even minimal deviations from an equilibrium did not go unnoticed, and expectations of continual policy overshooting appear to have been very strong among Soviet enterprise managers. In other words, Soviet planners had to administer organizational shocks to ensure the credibility of policy moves—however minor. Viewing the process of Soviet planning as a string of minor regime changes initiated to counteract the inertia of horizontal networks is important for understanding the enterprise sector's reaction to Gaidar's 1992 price liberalization. Among the salient features are the relative autonomy of enterprise decision making, enterprises' ability to deal with pervasive uncertainty, and the readiness of the enterprise sector to meet the central planner/reformer with institutional innovations that were bound to modify the impact of the original policy move. In this context we can interpret the behavioral response of the enterprise sector to the price liberalization as it emerges from our case studies. Among most enterprise managers, the Gaidar reform was interpreted as a relatively dramatic regime change, but one that still conformed to the style of the game they were accustomed to playing: the shift was simply from bargaining/signaling over real resources to bargaining over a single resource—money. Enterprise managers quickly recognized that they could be even more innovative in playing this game, simply because a shortage of money could be temporarily accommodated by institutional innovation—the creation of substitutes

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Transforming Post-Communist Political Economies for liquidity, a trick hardly possible with real resources. Since the government provided no indication that enterprises would be penalized for any such efforts, a series of socially destructive institutional innovations rapidly followed. Most important, existing horizontal business networks were galvanized through mounting inter-enterprise arrears. The view suggested here of real-life planning as a continual balancing of obligations within relevant networks through which members minimize transaction costs has important implications for the post-communist transformation. It demonstrates first that formal contractual obligations were prone to failure, and second that industrial managers had to develop an ability to "get things done" on their own even under the prereform Soviet system. A LOW-LEVEL TRAP IN LEARNING Consider a persistent problem of Soviet railroads with the unloading of agricultural fertilizers, which in winter used to freeze solid during rail shipping (Kuznetsov, 1989, 1993). To unload such fertilizers, one must keep the car in a heated space for a number of days, and even after that it must be unloaded manually. The technical solution to the problem was well known: producers needed to switch to granulated fertilizers, which do not freeze. The mechanisms for inducing producers to make such a switch were far less obvious, however. Usually, coordination problems of this type were solved by the interested party's establishing an informal network of individuals, including representatives of the agency that could solve the problem (the producer), representatives of an agency interested in seeing a solution (the consumer), and planning officials who would help negotiate the solution and later make it legitimate through a decree of the Council of Ministers and/or the Central Committee of the Communist Party. To induce the producer to undertake the relevant change, the consumer had to offer some incentive, usually in the form of a transfer of a share of its investment funds, construction capacities, or other scarce resources or services. Thus to solve the problem, one had to establish an institution: an informal network capable of negotiating relevant exchange proportions (how much would be done and for what). This activity had to be based on personal trust for the agreement to endure. To establish such a network, one had to invest a tremendous amount of organizational talent and time; this explains why coordination among various branches of Soviet industry usually failed. In the case of the fertilizers, no one was willing to incur the fixed costs of establishing such a network (although the problem was important, there were more pressing ones), and the solution was found along the lines of incremental learning. The railway agency asked the defense sector to invent a technical device that would enable thawing and unloading of fertilizers that freeze solid during shipping. This device—a cheap and effective one—was invented and

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Transforming Post-Communist Political Economies produced by one of the defense plants. This example shows it is erroneous to assert that a Soviet-type system was innovation-averse. Rather, it catered to special imbalance-driven innovations that (more often than not) represented allocatively inefficient technical change. If this innovation had not appeared, it is likely that mounting pressures from both consumers and transporters of frozen fertilizers would eventually have induced the producer to switch to much more efficient granulated fertilizers that do not freeze. After the technical innovation appeared, however, these pressures abated, and a low-level equilibrium trap, in which a more efficient outcome became permanently locked out, was established. There are many facets of allocative inefficiency in Soviet-type economies, and technical change as a handicap rather than a promoter of socially efficient development is one of the most striking of these. The need to incur fixed start-up costs to establish a network explains why low-level equilibrium traps were so widespread in the Soviet economy. Benefits from relevant innovation (or any change) typically did not justify these costs. The following sections show that the creation of networks (involving nontrivial start-up costs) that facilitate learning and enterprise adjustments remains a central feature of the Russian post-communist transformation. THE PORTFOLIO PRINCIPLE IN LEARNING Learning to adjust can be viewed as the accumulation of competencies and a firm's intangible capital. The latter includes the firm's technical and organizational know-how; its reputation, as embodied, for example, in trademarks; organizational and customer networks; the culture of the firm (e.g., its ability to change); and trade secrets. The accumulation of such intangible capital may be incremental or, when a new institution is being created, involve an investment that implies fixed costs in terms of financial resources and/or the firm's competencies. For instance, firms wishing to attract foreign capital invariably find it necessary to switch to Western-style accounting systems. Doing so requires not only relevant investment in subcontracting with Western accounting firms, but also non-negligible learning on the part of the firm's employees to master the system. In the case of the transition to a new accounting system, the start-up cost of learning can be reduced by resorting to foreign expertise, though this option is not always available. In Russia beginning in 1993, funds for defense procurement were allocated directly to the final producer of weapon systems. This was something entirely new to the Russian defense industry, in which the military-industrial commission routinely allocated funds to every enterprise irrespective of whether it was a subcontractor or final manufacturer. As with the switch to a new accounting system, the expenditure of organizational resources was necessary to make the procurement headed by final producers (rather than by a central authority) function smoothly. Why should the final producer pay on

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Transforming Post-Communist Political Economies time? What would happen if it canceled the order after inputs had already been produced? Since such issues cannot be settled in court because in Russia there is no enforceable business code, an organizational network of subcontractors was created to deal with these issues.10 In a few cases, we observed the creation of institutions providing information about potential demand to customers of enterprises undergoing conversion. Thus a defense enterprise in St. Petersburg contributed space for the exhibition of civilian products manufactured in the defense sector. The exhibition has a database of specific outputs required by customers in the St. Petersburg area. It is open to everyone, but in order to join, an enterprise must include in the database the range of its output, along with relevant price and delivery data. The database has proven useful to the extent that a number of matches between customers and suppliers have been accomplished. What is noteworthy in this example is that the database and exhibition have emerged as a cooperative effort of defense enterprises frustrated by the wasteful way they were entering the civilian market,11 rather than the creation of an entrepreneur who perceived and seized the opportunity. There were nonmarginal start-up costs in terms of managerial time for the organizers; as in every cooperative effort, benefits and responsibilities had to be negotiated. New institutions are invariably created when a firm starts exporting. All relevant firms in the sample had to establish (with the help of Western consulting firms) agencies dealing with the preparation of export contracts, and had to set up service and customer networks abroad. Investment was involved, but it was investment in intangible capital rather than fixed assets. The list of examples showing that serious adjustment involves the creation of a new institution requiring start-up costs can easily be extended. At this point it is important to note that, as in every situation involving increasing returns, there is a probability that innovation requiring fixed costs will fail to appear. As usual, there are two basic reasons for this. The first is lack of capital: because of capital market deficiencies, the firm is unable to raise the capital required to undertake the investment. The second is the deficiency of the revenue stream (because of a lack of demand, for instance) for recouping the fixed costs. Although we are concerned here with organizational innovations, these two basic reasons still apply. A lack of intangible capital (the 10   Kuznetsov (1995) shows that such a network implies settlement of business disputes on the basis of personal reputation and the threat of expulsion in case of noncompliance. There are designated individuals within networks—modern equivalents of law merchants—who prepare settlements and make recommendations to top management of enterprises in the network. 11   In the manufacturing of consumer durables, one can clearly observe the phenomenon of waves of excess competition emerging as a result of the lack of information about market demand. For instance, in 1993 the market for refrigerators became profitable, and no fewer than ten defense sector companies were unaware that other firms also doing this had entered the market. The database was created with the modest objective of avoiding such situations.

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Transforming Post-Communist Political Economies company's competencies) is even more serious than a shortage of financial capital, since intangible assets are tacit and difficult to transfer. That is why if a company's initial competencies are below a certain threshold, no amount of Western consulting will help it establish competitive marketing and service and customer networks abroad. Similarly, to recoup investment in the establishment of a new institution, the benefits should be sufficiently high, yet the revenue stream from the (more often than not) outdated fixed assets of Russian industry does not allow this. As a result, adjustment normally proceeds through incremental learning rather than the creation of the new institutions. More accurately, one may envision a portfolio of restructuring options that vary by the amount of start-up costs. Rather than adopting a Western-style accounting system, one can reorganize company accounting by adopting a system of double or rather triple bookkeeping: one level for top management to understand what really happens in the enterprise, one as the standard system, and the third for tax authorities and other outside observers. Another option is to computerize an existing system, thus improving the flow of information. The option with the lowest start-up cost is the one usually chosen. An export orientation has the indirect benefits of a regime change in that options with negligible start-up costs are often not available (to be successful one must establish marketing and customer networks), and thus export-induced learning is necessarily quite intensive. Even if export attempts fail and the relevant fixed costs turn into sunken costs, the learning experience has been gained and can be applied later. Because of these learning-inducing externalities of export activity, there is a rationale for government support of export programs. LEARNING PATTERNS Lessons managers learn in the process of adjustment are wide-ranging and often unexpected. The manager of a mechanical plant in Voronezh was visiting German firms for training in marketing and returned with a resolute belief that his company's intentions to start exporting were futile, that its expectations for exporting should be adjusted downward. Three and a half years after the beginning of adjustment, managers now have a more sober assessment of themselves, their companies, and the economic future. When contemplating diversification three years ago, managers tended to focus on high-tech output, while today the emphasis is on more mundane products that meet market demand. There is a growing awareness among both management and labor that without outside investment, all attempts to turn a company around will be futile, and outside investors are unlikely to appear unless the incumbent managers leave. In one case in the sample, the manager voluntarily stepped down to give way to a strategic investor. Table 6-1 summarizes the major dynamics involved in real adjustment, in the areas of both performance

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Transforming Post-Communist Political Economies TABLE 6-1 Enterprise Learning Dynamics, 1992-1995 Strategies Learning in the Incentive Sense (How well can I [the manager] perform a task? Should I start doing it?) Learning by Doing Export orientation Growing awareness of sunken costs related to entry into the export market. More pessimistic attitude toward export promotion. Accumulation of expertise in preparing export contracts, making an enterprise more transparent for foreign partners. Foreign consultant firms are used extensively. Diversification to meet internal demand Growing attention to ''mundane" output, including services and diversification into agriculture. Ability to carve up viable parts of the enterprise and create wage differentials to induce the separation of unwanted labor. Downsizing with the preservation of major production lines Awareness that without an outside investor, such a strategy is often doomed. Readiness to step down from the top management position to clear the way for outside investors. Marginal learning related to cooperation with banks and searching for inputs from new suppliers. Downsizing on the way to closure; managing enterprise as a social protection unit (the most widespread strategy) Result of repeated failures in the past. No matter what I do, I am going to fail because of the unfavorable economic environment. Marginal learning related to private rent seeking (asset stripping) and traditional rent seeking (lobbying the government). Splitting of the enterprise into different parts More permissive attitude toward the spin-off because of the presumed ability to retain some control over the spin-offs Learning to create new organizational forms, such as business groups and other networks of firms. improvement (learning by doing) and learning in the incentive sense (How capable am I? Would I be able to respond to this or that challenge?). In addition to these two facets of learning, there is another, often overlooked aspect—learning to deal with inherited personal and social networks. The personal networks of industrial managers were of vital importance in the times of extreme uncertainty following the shock of 1992. Network capitalone of the components of intangible capital discussed earlier—still facilitates

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Transforming Post-Communist Political Economies input/output decisions, as well as contract enforcement. There is a growing realization, however, that many inherited personal and social networks are becoming increasingly unreliable and an impediment to adjustment. For instance, the general director of a large radio-electronic plant in St. Petersburg was skeptical that he could dramatically restructure the management structure of his company. "Because of implicit obligations to my deputies and to other staff, it is difficult for me. Someone from the outside must do it." The same manager allowed certain units of his enterprise to spin off while using the parent company's infrastructure and research and development capability. One of the spin-off companies had attractive assets, so the parent company management obtained a loan to acquire a controlling share of its stock during the share auction. There was an agreement—based on personal trust—that the spin-off company would not redistribute shares without consulting the parent enterprise. The spin-off company subsequently broke the agreement, and the management of the parent company lost control, as well as a share of its investment. Ex-post, this was probably an efficient outcome, but had the managers of the parent company predicted it, they would never have allowed it to happen in the first place. One of the functions of a network is the provision of information and the diffusion of learning experience. The failure of the "engineered spin-off" became known to other enterprises and formed their attitude toward similar actions. Some enterprises with strong charismatic leaders are now choosing to separate themselves from any networks and to be free of the associated implicit and explicit obligations. The prevailing attitude, however, is to carve out new networks combining viable elements of the old ones and to seek closer associations with banks, trading companies, and other agents of the nascent private sector. Associations of graduates of elite Moscow colleges such as Moscow Physics-Technical Institute, University imeni Bayman, and the Aviation Institute play an active role in the process. Once the major source of human capital for the defense industry, these institutions have now become major suppliers of skilled labor for the banking and trade spheres. Graduate associations, some of which are quite active, provide a cross-fertilization of expertise between reform-oriented directors and the new banking elite. New networks are being formed, the major function of which is the provision and distribution of information. Through such networks, for instance, banks obtain information about which assets are potentially competitive and thus worth including in emerging business groups. There is also a process that parallels the carving out of a restructuring-oriented network: the formation of rent-seeking networks, a phenomenon that is particularly pronounced at the regional level. Managers of defense enterprises, many of which are the only employers in their respective communities, have always been considered "shadow" local governments with an authority exceeding that of the real government. Faced with the imminent collapse of

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Transforming Post-Communist Political Economies these enterprises and the need to maintain them as social protection units, local governments first resist any attempts to declare bankruptcy, then seek subsidies for the plants (which are actually subsidies for the plants' social infrastructure) through their own channels. To illustrate, the manager of a large tank plant in Siberia that had not been receiving any defense orders had been begging the federal government to close the plant. He obtained some personal rents from its assets and wanted a safe retirement. It was the local government which threatened that if the manager stopped "fulfilling his social obligations" (i.e., maintaining the social infrastructure), it would engineer a comprehensive audit of the plant, with the objective of revealing abuses of managerial authority. This is an example of forced managerial entrenchment that illustrates the rapidly forming rent-seeking alliance between local government and enterprise management that is unable to adjust. At this point it is worth carrying a step further the argument of Krueger (1974), who emphasizes that rent-seeking activity does not emerge out of nowhere: in addition to the distortions imposed by rent seeking, there is associated deadweight loss.12 Rent seeking is just one option in an enterprise's portfolio of adjustment responses. When performed outside the lobbying group/rent-seeking network, it is not even particularly efficient. Our case studies show that more learning-intensive options are often preferred. Once chosen, each adjustment often goes through a process of being perfected and improved and becomes self-reinforcing. As the formation of rent-seeking networks advances, the switch to restructuring options becomes increasingly unattractive: rent seeking crowds out restructuring. On the other hand, once restructuring options have been mastered, rent seeking becomes unattractive: learning-intensive restructuring crowds out rent seeking. Because of the cumulative nature of learning, early choices determine long-term outcomes. Two policy implications follow from this analysis. First, until substantial progress in learning-intensive restructuring is made,13 the federal government should abstain from discretionary sectoral policies that are particularly prone to rent seeking. Such policies would encourage an early choice of restructuring options (which is likely to perpetuate itself) from a portfolio of adjustment responses. Second, the federal government should allot more specific and transparent subsidies to social infrastructure, thereby discouraging alliances between antireform enterprise managers and local authorities. The distinction between rent-seeking and restructuring-oriented networks once again underlines the differences between rudimentary learning with little 12   Anyone seeking rent will be willing to commit resources (which is a deadweight loss for society) up to the amount of the rent. 13   One criterion of such maturity is the presence of competitive enterprises that became viable without government subsidies.

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Transforming Post-Communist Political Economies investment in the enterprise's intangible capital and the learning of new skills. One can also draw a distinction among (1) rudimentary learning; (2) fragile learning, when restructuring depends on the abilities of one (usually the top) manager; and (3) sustained learning, when a managerial team with extensive organizational capabilities is created to respond to and manage change. Mapping this three-pronged distinction to the network dimension of learning (either networks are active or they are not), one derives a taxonomy of learning patterns (Table 6-2). We were unable to fit all enterprises of the sample to this taxonomy. It is noteworthy that half of the enterprises that could be fit fell into the category of fragile adjustment driven by the top manager, who does not seek the benefits and obligations of network participation. This observation can be interpreted in three ways. First, we might say that reform-oriented managers prefer a competitive industrial structure with no room for enterprise alliances and associations. Second, we might say that mistrust of institutionalized (formally through a business group, or informally through implicit contracts) inter-enterprise obligations is a peculiar consequence of the Soviet type of planning in which such networks were typical of the manager's way of life. Having "tasted freedom," the manager maximizes decision-making authority, a propensity that will subside as time elapses. Third, we might say that the process of carving out old networks has just begun. In the future, reform-oriented networks are likely to become bank-led business groups, while rent-seeking networks will become corporate sectoral associations and lobbying groups. One should wait for the institutionalization of nascent tendencies. TABLE 6-2 Learning Styles of Management Type of Network Rudimentary Learning: Incremental Improvement of Rent-Seeking Skills Individual Learning: Investment of Top Managers' Time and Company's Resources to Master Market Routines Creation of Sustained Organizational Capabilities: Investment in Managerial Team External networks are small "Fly-by-night" manager (2) Entrepreneur—a business loner (7) Profit-oriented management (1) Networks are extensive and growing Lobbying group, cronyism (1) Charismatic leader with established reputation and extensive informal networks (3) Growth-oriented management, often acting as a catalyst for business group creation (2) NOTE: The number of enterprises from the sample of 24 firms belonging to the respective category is shown in parentheses.

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Transforming Post-Communist Political Economies CONCLUSIONS The burgeoning literature on incomplete contracts emphasizes the importance of trust and self-enforcement (enforcement by convention) of incomplete contracts. A contract is said to be highly incomplete if major contingencies remain outside its scope, leaving open the possibility of its breach or ex-post (after the contingency has occurred) bargaining. This chapter has examined the transition to a market economy in Russia as a learning-enhancing transformation of personal networks-which in the planned economy were minimizing transaction costs-to profit-oriented congealed personal networks. This perspective emphasizes the following features. Discontinuity vs. Path Dependency The perspective expounded in this chapter suggests that the discontinuity of the transition from a planned to a market economy is not as large as is commonly believed. Personal trust inherited from the days of a planned economy provides strong path dependency in institutional formation. Trust inherited from past relationships and thus acting as a barrier to entry gradually evolves into an instrument for reducing barriers to entry. This is the most remarkable feature of the newly emerging mechanism of economic selection. Multiple Equilibria and Institutional Lock-in This chapter has emphasized the role of individual and institutional learning in reducing the transaction costs of doing business in new and unfamiliar ways and with unknown economic agents. Since such learning involves increasing returns to scale (with the increase in the number of transactions, the marginal transaction cost decreases), the currently fluid Russian institutional structure may evolve into a number of (rather than just one) equilibrium institutional configurations. As the likely outcome, one can think of a society with a large informal economy and private (and extremely violent) contract enforcement (the Colombian trajectory), or of the industrial structure of most countries of South America and Southeast Asia, with a few highly diversified economic groups that are economic agents at the mezo rather than the micro level. Both outcomes represent a so-called institutional lock-in, in which a rather inefficient institutional structure based on networks perpetuating extensive entry barriers rather than contestable markets becomes the stable equilibrium. Social Construction of the Equilibrium Institutional Configuration Even though the economic policy of the government is potentially capable of escaping the outcome of networks with high entry barriers, its

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Transforming Post-Communist Political Economies freedom of action is constrained by common law—the implicit norms and beliefs established within existing networks. An exploration of the resilience of societal norms and beliefs in the face of repeated development failure appears to be a promising avenue of research. It could help us discern nonviolent cooperative solutions for the persistent challenges (such as poverty alleviation and correction of income inequality) of economic development. ANNEX 6-1 THE SAMPLE Although the sampled companies include enterprises from all branches of the defense sector and all major regions of Russia, the group is biased in at least three ways. First, half of the sample comprises the radio, communications, and electronics branch, which is less asset-specific compared with, for instance, tank manufacturing, and thus possesses more favorable conditions for conversion and diversification. Second, almost half of the sample is located in Moscow, St. Petersburg, or their metropolitan areas. Third, and most important, the sample represents a more active (but not necessarily more successful) adjustment than appears to be the case in industry as a whole. More energetic enterprises appear to be more amenable and open to study and provide more interesting and challenging information. In addition, many of the enterprises in the sample were selected as a result of a personal connection with their managers, who happened to be dynamic. Information on non-adjustment cases was collected through regional administrations. These interviews were less detailed and did not cover the range of issues included in the case studies. REFERENCES Antal, L. 1985 Planification centrale et Plotique Sociale: Experiences Hongroises. Reflets et Persectives de la Vie Economique (Belgium) 24(March):87-103. Blanchard, O., K. Froot, and J. Sachs, eds. 1994 The Transition in Eastern Europe. Vol I and 2. Chicago: University of Chicago Press. Comes, R., and Sandler, T. 1986 The Theory of Externalities, Public Goods, and Club Goods. Cambridge, England: Cambridge University Press. Gaidar, Y. 1990 Ekonomicheskie reformi i ierarchicheskie struktury [Economic reforms and hierarchical structures] Moscow, Russia: Nauka. Glaziev, S. 1990 Ekonomicheskya Teoria Technicheskogo Rasvitiya [The Theory of Technological Development] Moscow, Russia: Nauka.

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Transforming Post-Communist Political Economies Ickes, B., and R. Ryterman 1994 From enterprise to firm: Notes for a theory of the enterprise in transition. Pp. 83-104 in The Postcommunist Economic Transformation, R.W. Campbell, ed. Boulder, CO: Westview Press. Kindleberger, C. 1978 Manias, Panics and Crashes: A History of Financial Crises. New York: Basic Books. Kornai, J. 1980 Economics of Shortage. New York: North Holland. Krueger, A. 1974 The political economy of rent-seeking society. American Economic Review 64(3):291-303. Kuznetsov, Y. 1989 Fantasies for central authorities. Socialisticheskya Industria (June 18). 1993 How can an economy adjust to simultaneous market and government failures? Lessons from the former Soviet Union, contemporary Russia and countries of late-late industrialization. Communist Economies: Economics of Transformation 5(4):473-498. 1995 Grafting Market Institutions in the Transition Economies: The Case of Russia. Washington, DC: The Brookings Institution. Laky, T. 1985 Enterprise business, work partnership and enterprise interest. Acta Oeconomica 34(1 2):27-49. Lavrovski, I. 1988 Kaphagen should be destroyed. Socialisticheskya Industria (August 7). Medvedev, P. 1982 Ekonomiko-Matematiskeskye Metody i Realnyi Khoziastvennyi Mekhanizm [Mathematical Methods in Economics and Real-life Economic Mechanisms] Moscow, Russia: Moscow University Press. Meeks, F., and K. Bohner Lewis 1995 Blue chips in your own backyard. Forbes 155(9):166-172. Murrell, P. 1992 Evolutionary and radical approaches to economic reform. Economics of Planning 25:79-95. 1993 What is shock therapy? What it did in Poland and Russia. Post-Soviet Affairs 9/2:11 140. Naishul, V. 1992 The country needs stability. Nezavisimya Gazeta (February 7). North, D. 1990 Institutions, Institutional Change and Economic Performance. Cambridge, England: Cambridge University Press. Rassokhin, V. 1985 Mechanizm Vnedrenia Dostizhenii Nauki. Moscow, Russia: Nauka. Schumpeter, J. 1934 The Theory of Economic Development. Cambridge, MA: Harvard University Press. Shironin, V.M., and P.O. Aven 1987 Reforma khoziastvennogo mekhanisma: Realnost namechannykh preobrasovanii. Izvestia SO AN SSSR, Seria Econ., Novosibirsk, 13:32-38. Stark, D. 1992 Path dependence and privatization strategies in East Central Europe. East European Politics and Society 6(1):17-35.

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Transforming Post-Communist Political Economies 1994 Recombinant Property in East European Capitalism. Paper presented at the Joint Conference of the World Bank and the Central European University Privatization Project, December 15-16, Washington, DC. 1996 Heterarchy: Asset Ambiguity, Organizational Innovation, and the Postsocialist Firm. Working paper, Department of Sociology, Cornell University.