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Transforming Post-Communist Political Economies
specialization requires low costs of impersonal exchange across space and time. If this is to be achieved, a fundamental determinant of these costs—the state's commitment not to interfere arbitrarily in the functioning of the economy—must be credible.
When macroeconomic policy rules lack credibility, the resulting uncertainties about taxes, deficits, and inflation raise the costs of entering and enforcing contracts. Individuals respond on many margins, such as lending to the government only for short periods of time at high rates of interest, or investing and trading primarily in personalized contexts within the informal sector. During hyperinflation, time horizons shrink dramatically, and trade may be reduced to barter.
At the microeconomic level, a lack of credible rules concerning contract enforcement, property rights, or regulations raises the costs of exchange.14 Without low-cost impersonal exchange, the gains from specialization are lost.15 At the extreme, trade will be limited to spot-market exchange and personalized trade with self-enforcing mechanisms. As official third-party sources of contract enforcement become less certain, the comparative advantage of organizations such as the Mafia increases (Gambetta, 1993).
The significance of credibility in contract enforcement can be illustrated by the fall in interest rates following the Glorious Revolution of 1688 in England (North and Weingast, 1989). During the 10 years after the revolution, the interest rate the English Crown had to pay to obtain long-term loans fell from 14 to 7 percent. Over the next four decades, this rate continued to fall by more than half, to 3 percent. This was an extraordinary development that had profound implications for the subsequent prosperity of England.
How did this happen? North and Weingast argue that the revolution credibly constrained the ability of the Crown to manipulate the rules to the advantage of itself and its favored constituents. Prior to the revolution, the Crown had repeatedly reneged on previously agreed-upon terms. It had sold grants of monopoly that expropriated the value of existing investments and reduced the expected returns on all investments. Titles had been sold with promises of a fixed maximum number of sales, promises that were soon broken. Assets stored in the Tower of London for safety had been seized by the Crown. The Crown had paid judges' salaries and openly fired those who disagreed with it. All executive,
For a discussion of the role of political authority in originating property rights, see Riker and Sened (1991).
North and Weingast (1989:831) make the following observation: "We are convinced from the widespread contemporary Third World and historical evidence that one necessary condition for the creation of modern economies dependent on specialization and division of labor (and hence impersonal exchange) is the ability to engage in secure contracting across time and space. That entails low transaction costs per exchange."