Missed Markets: Implications for Economic Behavior and Institutional Change
WHY GOOD POLICIES FAIL: A SECOND-BEST PERSPECTIVE
Over the last few years, more than two dozen countries worldwide have undergone profound economic and political transformations, aimed at establishing market economies and pluralist democracies. The fact that most of these nations have launched their reforms more or less simultaneously, precipitated first by the erosion of the former Soviet Bloc and later by the collapse of the former Soviet Union, naturally invites comparisons of the results achieved to date. The call for such a comparative analysis is especially compelling as—despite the close proximity, if not coincidence, of both the content and schedules of their reform programs—the outcomes vary dramatically from one country to another.
This paper is concerned with Russia—the largest of the post-communist nations to embark on the transformation of its economy and society. Despite recent signs of economic and political stabilization, few will disagree with the proposition that Russian reform has hardly been a success story. Economic decline has slowed, but only after the country's gross domestic product (GDP) shrank to approximately 50 percent of its prereform level. One independent and credible source estimates that real personal per capita income has fallen to 60-70 percent of its 1990 level (Zaslavskaya, 1995). But per capita measures may be seriously misleading. The reform period has been characterized by dramatically increasing economic inequality, with a few earning extremely high incomes and the vast majority suffering grave losses. Official estimates indicate that 64 percent of the country's population has ''below average" incomes, while approximately 30 percent live in poverty (Goskomstat, 1995).
This record is in striking contrast with that of the post-communist reform front-runners—the Czech Republic, Poland, and Hungary. While such heterogeneity is not necessarily surprising, given the broad differences among post-communist nations, the main challenge is to explain its causes and to identify factors underlying the successes and failures of the various countries.
Explanations and answers abound, reflecting different analytical perspectives and schools of thought, as well as divergent political and ideological platforms. While no one denies the importance of historical, social, political, and economic contingencies, attempts to identify those which may have been of particular relevance have stirred great controversy. Whether there is a universal set of policy prescriptions that, if properly implemented, could ensure a successful post-communist transformation regardless of such contingencies is also actively debated.
Most scholars seem to agree that, no matter what the underlying realities, on the surface reforms are advanced or derailed by concurrent political processes. "The diagnosis usually centers on the political sphere, with dilatoriness, rent seeking, and lack of policy credibility the prime suspects" (Murrell, 1995:164). The dramatic failures (until quite recently) of the Ukrainian reform effort, which in many ways mirrored that of Russia, are ascribed to the actions of powerful blocs that obstruct reforms that would have (1) reduced or eliminated the "rents" they received, and (2) undermined the bases of their political and economic power in the system (Havrylyshyn et al., 1994). As for Russia itself, in the opinion of Sachs (1995:72), "the major weakness came in the conception and execution of reform measures." Although Sachs denies that political or social opposition to reform in Russia played any significant role in blocking change, a position that is scarcely corroborated by the facts, his analysis remains focused on the policy side.
Indeed, Russian policy misconceptions and failures are too obvious for any analyst to question their share in the responsibility for the current crisis. Nevertheless, the puzzle remains of why financial stabilization, economic liberalization, and other indisputably sensible policy prescriptions were implemented relatively easily in some former communist countries, while elsewhere, and particularly in Russia, they met with so much resistance. This chapter examines that question, attempting to bring an analytical perspective to bear not only on the choice and implementation of policy prescriptions, but also on the reasons for their rejection and failure. It argues that major lacunae and deficiencies in the institutional infrastructure of the Russian economy, and in particular the unavailability of functional markets for factors of production, are largely responsible for the lack of progress in the Russian reform enterprise. Policy measures that would have enhanced efficiency if implemented in a completely functioning institutional environment in fact stimulated counterproductive behavior and imposed substantial efficiency losses when they were implemented in what might be termed an "institutional void."
These institutional deficiencies were particularly destructive in Russia as they compounded, and greatly complicated, the task of correcting the economy's profound structural distortions—the legacy of seven decades of central planning. With restructuring stalled, few economic agents could earn adequate returns to the factors of production they did possess in the marketplace. Since these underutilized factors, first and foremost, comprised human resources, economic agents were left to seek redistributional gains by extra-market means, or to resort to inefficient subsistence production.
Classical, evolutionary theories of institutional change suggest that correctives to these institutional deficiencies will emerge spontaneously, in response to market forces. However, given the pervasive structural distortion, the prevalence of distorted incentives, and the narrowness of those pockets within which productive activities are properly rewarded, the missing components of the institutional framework of a fully operational market economy stand little chance of emerging spontaneously in Russia. Russian reformers chose the spontaneous scenario in the first place largely in response to the perception that the weakened central state structures would not be capable of creating the necessary new institutions. These expectations, however, were frustrated as unanticipated behavioral patterns became entrenched as conventions and then themselves became institutionalized, thereby producing a stable low-level equilibrium.
The possibility of abandoning the current "bad" equilibrium and replacing it with a "good" one hinges on the incentives facing, and the resources under the control of, the participants in the process of institutional transformation. The democratic political system, which has been established de jure in Russia, should provide the means to surmount narrow, entrenched interests, as the vast majority of the country's population would benefit from a streamlined institutional environment. This mechanism, however, is precluded from fulfilling its role by the Russian electorate's split into constituencies controlled by the very same interest groups the democratic process was supposed to supplant. This means the choice among multiple possible equilibria is taking shape not on the basis of abstract theory or policy prescriptions, but as the result of distributional conflicts. Unfortunately, the most powerful parties to these conflicts, and the probable victors, are those least interested in departing from the status quo or altering the institutional arrangements on which their power and privileges depend.
At the same time, it should be recognized that a sufficiently strong pro-reform constituency does not exist in Russia. The majority of the population has suffered economically and become disillusioned politically over the course of the last 5 years. Earlier policy measures, including privatization, were based on the premise, derived from laissez-faire, liberal theory, that institutional reform should be kept separate from distributional considerations. However, in Russia's distorted economic environment, and in the absence of
adequate regulatory controls, these measures produced a highly skewed distribution of costs and benefits across society. As a direct consequence, the very sustainability and credibility of the new allocation of property rights and economic roles are called into question, and the reforms are threatened with reversal at the polls. Further, it remains unclear whether forces capable of and interested in providing support for policies aimed at economic stabilization and growth will develop. The emergence of these forces will depend critically on whether the benefits of reform spread across the Russian economy and society and diffuse down to the grass roots. The institutional deficiencies of the Russian market make such an outcome anything but a sure bet.
The remainder of this chapter examines in turn the principal institutional factors that threaten the success of reform in Russia: a weak state and the "organic growth" of institutions, the institutional void in the exchange economy, structural distortions and suppressed input markets, market reallocation versus extra-market redistribution, monetization of the economy and rent seeking, nonpayment as a spontaneously developed institution, evolving patterns of rent seeking, and what is termed the B-o Law."
A WEAK STATE AND THE "ORGANIC GROWTH" OF INSTITUTIONS
Russian radical reform began in earnest in 1992 in the context of the rapid disintegration of the central institutions of the state. By that time, the spectacular failures of Gorbachev's ill-fated perestroika campaign had discredited any socialist alternative to economic liberalism as the desired end state of the transformation process, not only among the political elite, but also among the Russian public generally. Still, the question of whether the transition to such an end state should be hands off (left to the operation of market forces) or guided (controlled by the state) was actively debated.
In the guided, gradualist scenario, a proactive state would create the institutions of the new economy and would lift controls over private economic activities only after the required institutions were already in place. The state also would be actively involved in correcting the inevitable failures of emergent transition markets and, most important, would provide an adequate safety net to cushion economic and social shocks.
Despite the appeal of such a scenario, the opinion that ultimately prevailed was that the choice between gradual and liberal transitions was anything but a purely academic exercise, to be determined on the merits of abstract theories. Since there were no functioning public institutions capable of implementing a program of gradual economic transformation, reform would have to proceed without them. After the demise of the Soviet Union, Russia was faced with the formidable task of (re)creating its state structures virtually from scratch. According to Gaidar (1993:12), "tectonic processes within soci-
ety and the economy" left the reformers with no choice, not only over the end state of the reform, but even over the process by which it would arrive. The laissez-faire scenario for establishing a free market economy was viewed as the only practical option.
As a result, during the early stage of the Russian reform process, the government made no attempt to play a significant role either in establishing new economic institutions or in shaping economic restructuring. Institutional changes occurred primarily as the result of the removal of old mechanisms and structures of governance (which were routinely ignored anyway), with no attempt made to create a new institutional nexus in their place. The only notable exception was the government's pursuit of financial stabilization, a policy aimed at supporting economic freedoms by creating a reliable medium of exchange.
Of the standard LSI (liberalization, stabilization, institutional reform) reform triad (Balcerowicz, 1994), only the first two components were initially on Russia's reform agenda. Economic institution building was consciously postponed until a more propitious time—after the threat of economic and social collapse had been averted, new political institutions were firmly established, and a growing economy was providing sufficient resources to fund the provision of public goods.
It was further expected that by assuming a low-profile role, the government would gain some breathing space and, in particular, would reduce the lobbying pressure that is inevitable when a government is broadly involved in running an economy. More generally, reducing the domain of public decision making was viewed as conducive to political stability as the market, rather than the government, would become the arena for resolving social and economic conflicts.
Operating on these premises, Russia became a gigantic laboratory, testing the "organic growth" model of economic and political institutions. This represented a dramatic break with Russian historical tradition, in which the state almost invariably constituted the key agent in advancing economic development. The state's active role in the economy, both in the tsarist and Soviet periods, and the perpetual failure of reform efforts were traditionally attributed to a lack of grass roots demand or support for institutional, organizational, and technological changes (see, e.g., Gerschenkron, 1962). In sharp contrast, post-Soviet reform was predicated on grass roots demand becoming the locomotive that would propel the process forward.
THE INSTITUTIONAL VOID IN THE EXCHANGE ECONOMY
During its first few months, the liberal reform project fared reasonably well. The initial price shock, along with the release of previously repressed inflation, was largely compensated for by two powerful sources of economic
gain. First, freedom to trade unleashed the no-trade equilibria typical of an economy characterized by controlled prices and barter exchanges. Repressed inflation, which results when prices are kept below their equilibrium levels across the board, blocks trade, even if price ratios happen to be correct (Benassy, 1982), since the oversupplied currency cannot serve as an effective medium of exchange. Barter trade, endemic prior to the reform, similarly could not substitute for stable currency and free prices. Both Russian households and firms had accumulated large inventories of merchandise in the prereform period, and were therefore able to reap broad gains from trade in these stocks immediately after reform began. The blanket liberalization of imports contributed further to the same end.
Another source of efficiency gains was the elimination of wasteful non-monetary equilibrating mechanisms. Price controls led to the expenditure of valuable resources other than money to ration limited supplies of goods. Most frequently this resource was time—spent in lines, in search of goods in short supply, or in attempts to make connections with those having access to goods. Price liberalization rendered these nonproductive expenditures unnecessary, and thus increased aggregate consumer welfare.
Although the distribution of these gains was frequently inequitable, it was sufficiently dispersed to provide the majority of the population with some offsetting relief to the many-fold increase in the consumer price index. According to household surveys, in the first few months after the blanket decontrol of prices, the population was satisfied by and large with the available level of consumption (Gorin, 1995). The reformers were also able to rely for a limited time on a "credit" of broad social support, based in part on widespread expectations of improving social and economic conditions, and in part on disarray among the potential opponents to reform (Balcerowicz, 1994). The fact that Russian reform initially met little resistance and that protests and signs of discontent were few and far between allowed monetary policy to be kept under tight control, thereby preventing the one-time dramatic price increase from triggering an ongoing inflation.
It should be stressed, however, that this initial success was accomplished within what was essentially a simple exchange economy, where institutional lacunae and deficiencies were less damaging than they would be in a full-scale trading economy with production and distribution based on market mechanisms. It was when the gains from trade in initially held endowments and inventories had been exhausted, and it was time to produce new commodities, earn returns on the contributed factors of production, secure ownership over these factors, and arrange for their reallocation to meet market demand that Russian reform ran into trouble. "Exchange in modem economies consisting of many variable attributes extending over long periods of time necessitates institutional reliability, which has only gradually emerged in Western economies" (North, 1990:34). This desideratum was—and largely remains—absent
in Russia. As a result, the Russian economy developed an acute imbalance between its capital stock and technological potential, on the one hand, and the available institutional environment on the other (Rapaczynski, 1996).
STRUCTURAL DISTORTIONS AND SUPPRESSED INPUT MARKETS
All the post-communist economies were characterized by profound structural distortions at the beginning of their reform processes. Since allocation decisions under central planning were based largely on the political preferences of the ruling communist elites, cost structures, output mixes, and inter-sectoral proportions were divorced from market demand, rendering them unsustainable in the new economic environment.
Few analysts were surprised that institutional restructuring featured prominently on reform agendas across the former Soviet Bloc. What was not always properly appreciated, however, was the degree of variation in the depth of these structural distortions from one country to another. While structural (dis)proportions are usually listed among the relevant "initial conditions" affecting the progress of reform (see, e.g., Balcerowicz, 1994), macroeconomic indicators, such as monetary and fiscal imbalances and foreign debt, received most of the attention in cross-country comparative studies. It was not generally recognized that policies (or the lack thereof) targeted at the micro level of the economy, particularly those designed to reallocate economic resources in order to compensate for or correct inherited mismatches, would underpin the success or provoke the failure of macroeconomic stabilization, and thereby the entire reform effort.
The extent and nature of prereform structural distortions in the post-communist countries depended on a number of factors, including the duration of centralized control over the economy, the political and economic role of the country in the former Soviet Bloc, and the scope of the tolerated nonstate sector. In Poland, agriculture and many services remained private throughout the period of communist control, and the economic system remained relatively less centralized than those of its neighbors. A substantial degree of decentralization was also characteristic of the Hungarian economy, which had been drifting away from communist economic orthodoxy and experimenting with reform for 20 years. The Czech Republic entered its period of communist rule with an advanced industrialized economy, shaped by market forces, already in place. The industrial structure of that economy displayed a great deal of inertia and was more or less preserved under the facade of central planning.
It is also important to recognize that within the framework of Comecon, all three of these countries specialized in the production of consumer goods. This meant that although none of the three completely escaped the structural "birthmarks" of central planning (e.g., an outsized heavy industrial sector, an
overconcentration of production in a few regions, the maintenance of large stocks of redundant labor), the inherited distortions were not as dramatic as they were in other former Eastern Bloc members. As a direct result, the scope of restructuring was much less daunting.
Others suffered from far more severe "birth defects." Romania, for example, had to cope with the legacy of Ceausescu's drive for economic autarky, predicated on the hyperdevelopment of heavy industry. As a result, it faces much more formidable problems in attempting to implement structural corrections than did any of Central Europe's reform front-runners, and not surprisingly ranks far behind them on any scale measuring reform success. Slovakia, the disproportionately agrarian sector of the former Czechoslovakia, experienced the impact of Soviet-style industrialization to a much greater extent than did the neighboring Czech Republic, and consequently took longer to embark on a path of economic growth.
Russia found itself in a particularly disadvantageous position at the start of its reform effort. The country's economic profile had been shaped for over seven decades by political leaders seeking global dominance and strategic superiority. Even more perniciously, the backbone of the Soviet Union's, and the entire Soviet Bloc's, military-industrial complex was located on Russian territory. This "division of labor" meant that heavy industry, and military industry in particular, experienced hypertropic development in Russia at the direct expense of industries producing for consumer needs.
Russia also suffered distortions in other critical areas. The share of the labor force employed in industry in Russia was double that in Western industrialized economies, while employment in services was, proportionately, less than 50 percent of Western levels. Russian firms frequently consumed several times the quantity of inputs characteristic of similar enterprises in market-driven economies. Almost every enterprise featured formidable levels of overemployment.
The endemic "value subtraction" that was a salient characteristic of production in the Soviet-era Russian economy made restructuring not just one of the highest priorities of reform, but a necessary precondition for the successful introduction of a market economy. Unless market returns could be gained from the utilization of the nation's factors of production—particularly labor—continued stagnation and decline were inevitable. But market returns were impossible unless restructuring freed factors of production to move among firms, industries, and regions on an unprecedented scale. Unfortunately, the embryonic state of the input markets, particularly the labor market, meant that such movement was scarcely possible.
While input markets in all the reforming economies were characterized by serious deficiencies, the barriers to the movement of factors of production in Russia were particularly high. Although geography played a role, this was primarily the result of institutional deficiencies and lacunae. Unfortunately,
the urgent need to correct the endemic misallocation of factors of production coincided in Russia with particularly dire conditions in input markets.
The development of a vitally necessary Russia-wide labor market was stifled by the deep territorial segmentation of real estate markets, the persistence of administrative barriers to population movement, and the absence of a universally available safety net and publicly provided services.
As the central government has abdicated its role as the provider of a safety net and basic social services, industrial firms and, to a lesser extent, regional authorities have emerged as their almost exclusive source (see, e.g., Gorin, 1995). The nonwage benefits traditionally provided by employers have become vital lifelines supporting workers and their families through the throes of transition. This "lifeline," however, compels workers to remain with their current employers despite nonpayment of wages and regardless of market conditions. Paltry and poorly administered unemployment benefits, as well as the loss of employer-provided housing, child care, and health benefits, make the decision to quit a job an extremely hazardous endeavor. As a result, "workers [are] retaining state jobs, where feasible, as basic insurance" (Commander et al., 1995:163).
Whatever labor mobility does occur is largely within the confines of particular cities and metropolitan areas. While some of the obstacles to interregional migration are the result of policies imposed by local authorities, the deep differentiation in the cost of housing plays a greater and more pervasive role. With mortgages practically unavailable until recently (because of inflation) and without established standards for secured lending, housing costs must be paid in full and in advance. Not only do these costs vary widely across the country, but they are also positively correlated with economic opportunities. This makes it almost impossible for workers from depressed regions to move to areas with better labor market conditions. As a result, the spatial disproportions of population and labor created by decades of decisions based on nonmarket principles continue to be sustained during the transition. In short, "the Russian labor market remains characterized by low interregional labor mobility, significant inefficiencies in labor allocation, and a large employment overhang" (Commander et al., 1995:148).
To assess fully the opportunity costs imposed by these barriers to labor mobility, one must first recognize that, as a result of Soviet policies imposing unified standards on education and broad aspects of social and economic life, Russian society is characterized by unusually high levels of social homogeneity, and hence "potentially high professional and territorial mobility. . . [that would allow for] prompt economic adjustment" (Naishul, 1996:4). Regrettably, these potentially advantageous social prerequisites for rapid restructuring are foreclosed by the institutional roadblocks discussed above.
The Russian capital market remains underdeveloped and heavily depressed for a number of reasons, including inadequate protection of property
rights, poor enforcement of contracts, profoundly asymmetric information, low liquidity constraints on up-and-coming entrepreneurs, and overall political and economic instability. In addition, corporate governance is dominated by insiders, and, for reasons discussed below, the market for corporate control fails to function properly.
Most of the structural change that has taken place to date in the Russian economy has occurred through attrition. Loss-generating firms and industries have withered away (in terms of output, if not yet in terms of labor stocks), but the major investments needed to ensure that new businesses will take their place are not being made (see Kommersant, 1995). In addition, the link between the financial and "real" sectors of the Russian economy has been undermined, first by high inflation, and later, after inflation was brought under some measure of control, by political instability and the failure of the government to provide adequate safeguards for property rights and enforcement of contracts. As a result, the fairly substantial pool of private savings that does exist in Russia is prevented from being transformed into investment capital.
Blocked channels for the reallocation of economic resources, in combination with the deep structural distortions that pervade the Russian economy, have produced vast efficiency losses and, perhaps even more critically, had a profoundly distorting impact on the patterns of economic behavior emerging in transitional Russia. In addition, some of the main benefits of a market economy—as a source of efficiency-enhancing incentives and information—have been missed, and "when some markets are missing . . . markets need not clear in equilibrium, prices do not uniquely summarize opportunity costs and can even misinform, externalities result from most individual actions, information is often asymmetric, market power is ubiquitous, and 'rents' abound" (Przeworski, in this volume).
MARKET REALLOCATION VERSUS EXTRA-MARKET REDISTRIBUTION
Production in modern economies requires that human resources, such as labor, entrepreneurship, and human capital, be properly combined with complementary factors of production (e.g., physical and financial capital, workplaces, land). Because prereform structural distortions did not provide for such combinations, there is a need for massive reallocation of factors of production through the input markets—in other words, for broad restructuring.
However, if the markets for production inputs, and in particular for labor and capital, are not functional, such restructuring is forestalled. As a result, human resources are not properly matched with complementary inputs and earn poor market returns. In this case, extra-market redistribution, where
economic resources are spent for the appropriation of what has been produced by others, rather than for market production proper, presents an attractive alternative. Extra-market redistribution also demands far fewer complementary inputs than does production, enabling it to provide an income stream whether other factors of production are available or not.
Whether a rational individual seeks economic gains by productive or nonproductive means will depend less on his/her innate preferences or merits than on prevailing institutions, available opportunities, and anticipated payoffs (see, e.g., Buchanan, 1980). The inability to utilize complementary inputs effectively makes socially inefficient and/or nonproductive activities preferable to market production by rational agents. Therefore, as I have argued elsewhere (Polishchuk, 1996), sustained structural distortions promote widespread redistributional activities and subsistence production at the expense of the productive use of human resources.
A substantial body of empirical evidence, including household surveys, corroborates these conclusions. Gorin (1995) notes that once the gains from trade in previously stockpiled commodities had been exhausted, human resources sought a different extra-market cushion against the shocks of economic liberalization rather than shifting into productive channels. Government subsidies, channeled through industrial enterprises, were used to ''open up umbrellas of social protection" (Gorin, 1995). As was also anticipated above, human resources continued to be engaged in harvesting small private plots of land, almost entirely for consumption within the household.
Nonfunctional input markets inflict three kinds of damage on an economy. First, there are the direct efficiency losses due to the persistent misallocation of factors of production, and it should be recognized that this harm goes well beyond simple mismatches between inelastically supplied human resources and other production inputs. Second, there is the diminishing aggregate supply of human resources available for productive use, as these resources are broadly absorbed in nonproductive and subsistence activities. Third, even those who have access to the required combinations of human resources and complementary inputs confront reduced incentives to produce. This follows from the threats of extra-market expropriation of facilities and output (by governments, corrupt competitors, or theft), as well as the pressure to join the redistributional "rat race." Many are vigorously involved in redistributional activities for what they foresee as the limited transition period. Since these lucrative opportunities will be lost once the uncertainties of the transition period are past, a "make hay while the sun shines" mentality is in the ascendant.
Because input markets remain undeveloped or dysfunctional, the lion's share of the country's GDP is being produced by a few export-oriented industries, concentrated in the extraction of natural resources and frequently utiliz-
ing environmentally hazardous technologies (Kommersant, 1995). Apart from these industries, only trade, finance, and a few other services are doing well in Russia. As only a relatively small fraction of the country's population is employed by or otherwise directly benefits from these sectors, and there are few market channels to spread the earnings of these sectors throughout the rest of the economy, the social and economic benefits from these pockets of prosperity have been limited. Subsistence production, where available, is providing minimal levels of nourishment for many in the short term, but it is incapable of maintaining acceptable living standards in a post-industrial society. The resort to these extra-market mechanisms by a large contingent of the Russian labor force should be recognized not simply as a matter of rational choice based on a cost-benefit analysis of alternative activities, but as a requisite for economic survival.
To summarize the argument to this point, the institutional void in the Russian economy is responsible for the fact that massive extra-market redistribution of the national product is taking place instead of the badly needed market reallocation of factors of production.
This redistribution, or rent seeking, is typically accomplished in Russia by either criminal or political means, and the two are closely intertwined. The result has been widespread concern about "mafias" gaining control of the country. While many fear that a tidal wave of organized crime is flooding the Russian economy, criminal methods of obtaining extra-market redistributional gains remain secondary to, and often feed upon, political mechanisms. Ironically the state, which reformers anticipated would withdraw from the economy, and in particular would refrain from making allocative decisions to the maximum extent possible, has reasserted itself and become the hub of what Russians term the "bureaucratic market" (see, e.g., Leontiev, 1994). Russian state structures have taken on roles that directly contradict Posner's (1987:28) ideal: "the optimal government for economic growth [is] strong enough to maintain law and order, but too weak to . . . engage in extensive redistribution." State structures and agencies have emerged as the only alternative to spot market trading. Private long-term contracting, a fundamental requisite of economic growth, requires the impartial enforcement of contracts and property rights (Williamson, 1995; Hedlund and Sundström, 1995), an impossibility in conditions of an institutional vacuum.
The "currency" of the "bureaucratic market" is lobbying and corruption. Both were widespread in the prereform Soviet economy and hinged on informal bargaining arrangements between different units of the state and economic bureaucracies. Reform, however, has unexpectedly provided a major boost to lobbying activities. That came as a surprise to many, as common wisdom suggested the opposite: lifting administrative controls over the economy would make bargaining between private parties explicit, and would
transfer the settlement of distributional conflicts from the government to the marketplace.
MONETIZATION OF THE ECONOMY AND RENT SEEKING
The first significant bout of lobbying in postreform Russia occurred shortly after the initiation of the 1992 reform program, prompted by the monetization of the economy. While the government surrendered any role in directly allocating economic resources in kind, it was still available as a source of subsidies and cash bailouts. For several reasons (discussed below), the switch from distribution in kind to cash payments enhanced incentives for capturing redistributional gains, and at the same time made it much more difficult for the government to withstand pressure from the lobbies.
First, once the economy became monetized, endowments also acquired monetary values. Cash subsidies, however, produced inflation, which eroded the value of these endowments. In their competition for subsidies, economic agents were not simply attempting to capture part of the economic surplus, but to compensate for inflation-induced losses in the value of their endowments. This rendered rent seeking much more vigorous than it would have been if subsidies were dispensed in kind.
Second, in a monetized economy, lobbyists' claims are made in nominal terms, allowing the government to buy time by trading off today's political pressure for tomorrow's inflation. As both parties to the exchange recognize, the government always has the option of fulfilling monetary claims, either in part or in full, by running a budget deficit. When the government's "budget constraints" were hard, that is, determined by limited stocks of contested resources, so was its ability to appease the lobbyists. Given the short tenure of reformist governments and the several months' time lag between an increase in the money supply and the ensuing rise in inflation, this exchange may look particularly attractive to those in power. Until rent seekers develop rational expectations about the "real," i.e., inflation-discounted, value of the subsidies they are obtaining, they will continue to be under the monetary illusion that their lobbying efforts are obtaining greater rewards in the monetized economy than they did when subsidies were distributed in kind.
Third, in the prereform, administratively controlled economy, the lobbyists' primary goal was to increase the amount of resources allocated to the firm. In so doing, lobbyists competed directly for access to scarce commodities. As a result, the contested rent was often dissipated, and the resources invested in rent seeking were partly absorbed within the community of lobbyists, with little impact on the government. When the Russian economy was monetized, however, rent seeking, while still to some extent retaining the characteristics of a competitive activity, developed features of collective ac-
tion. This meant that all lobbyists were in effect pursuing a common goal: derailing the government's policy of financial austerity.
Given the large number of actors and the well-known difficulties of collective action involving many agents, analysts would expect such collusion to be difficult to achieve (Olson, 1965). However, two factors eased the problem of collective action for Russian firms seeking government subsidies. First, these firms historically were organized into sectoral groups (formerly controlled by branch ministries), and it is usually these groups, rather than individual producers, that are represented by lobbies. Second, and most important, in the absence of conventional corporate control and functional input markets, the Russian economy has spontaneously switched to an alternative institutional arrangement, one that promotes collusion rather than competition. This institutional arrangement is based on mutual nonpayment.
NONPAYMENT AS A SPONTANEOUSLY DEVELOPED INSTITUTION
Apart from achieving price stability, one of the main rationales for introducing tight monetary policy was to eliminate the notoriously "soft" budget constraints faced by Russian firms, thereby compelling them to become cost conscious and profit oriented. "Hard" budget constraints would make producers sensitive to market signals and thus promote restructuring. This restructuring could take the form of shedding redundant labor, reducing nonlabor production costs, replacing obsolete equipment, switching to new product lines, or—should none of these options prove viable—going out of business through bankruptcy and liquidation.
As was detailed above, the inadequacy of input markets greatly impeded restructuring, but at least as important a role was played by the lack of a clearly defined and enforceable ownership structure for productive assets. With de jure property rights in limbo and de facto under the control of the firms' prereform management and labor representatives, there was little internal pressure on firms to engage in bona fide restructuring. Instead, faced with dwindling cash flows and unable to devise alternative strategies for securing income either through the market or (initially) through the government, firms resorted to the next available option: they ceased paying each other's bills.
When nonpayment became a universal modus operandi, insolvency was no longer an unequivocal indicator that a firm was nonviable. It could just as easily be an innocent victim of its nonpaying customers. The impossibility of assessing the economic health of enterprises on the basis of their books further undermined the prospects for restructuring in general. As a result, the economic signals required to guide the correction of inherited structural distortions were absent (Ickes and Ryterman, 1993), along with the input markets
needed to reallocate the factors of production and economic agents with incentives to engage in such reallocation.
This snowballing of obstacles to restructuring indicates that when there is a gap in the standard set of institutions of a market economy, it will not necessarily be filled spontaneously by the missing component. On the contrary, an institutional gap may cause the economy to move further away from the desired set of interdependent institutions, causing it to slide toward a "bad" equilibrium. In this new equilibrium setting, additional sources of efficiency losses will emerge from the grass roots. In other words, the second-best dictum has both static and dynamic aspects: an incomplete set of market institutions will not only stimulate counterproductive behavior on the part of individual agents, but also give rise to alternative institutional arrangements of a collective nature that further undermine economic efficiency. Mutual arrears are an example of such an arrangement: they have become institutionalized as a stable convention, so that "the members of the community come to treat this rule as the appropriate and just form of behavior" (Knight, 1992:6)—in short, as an institution. Four years after its emergence, this institution not only shows no sign of withering away, but in fact has become "the most urgent problem of today's Russian economy" (Segodnia, February 28, 1995).
Nonpayment should also be viewed as a form of collective action on the part of the participating firms, based on their mutually held expectation of mass bailouts through either the resumption of subsidies or the cancellation of arrears. This expectation proved to be self-fulfilling. For the reasons stated above, the government was unable to distinguish the firms that should have been eliminated from those that were the victims of others' nonpayment. It also recognized that any attempt to enforce payments would have brought the entire economy to a standstill. In Russia, it took less than 6 months for the government to yield to this collective pressure, and as a result, financial stabilization gave way to an unprecedented inflation that brought the country to the brink of hyperinflation.
Since then, each attempt to restore financial stability has invariably been followed by a new surge of nonpayments and a financial crisis, although of gradually diminishing magnitude. While fiscal and monetary discipline was expected to reduce the scope of rent seeking by raising the transaction cost of bargaining with the government (Shleifer and Vishny, 1994), in fact it provoked a powerful response among rent seekers, who joined ranks de facto to offset this threat to their interests.
Nonpayment has become so deeply entrenched an economic convention that the government itself, in its struggle to gain control over the budget, has had recourse to the same mechanism. When the government routinely defaults on its obligations, firms quite naturally reciprocate, and overdue taxes
currently dominate the payment arrears. Inadequate tax collections, in their turn, have produced an acute fiscal crisis (Segodnia, February 28, 1995).
EVOLVING PATTERNS OF RENT SEEKING
Despite strong opposition, the government has not renounced its pursuit of financial stabilization. In an attempt to ensure fiscal discipline, a "double key" system was instituted: if a motion to increase spending is initiated by the President's office, it must be endorsed by the Cabinet, and vice versa. Thus the division of power is being used to create a credible commitment to budgetary austerity, and, if nothing else, to increase the cost of seeking subsidies and handouts.
As the tendency toward reduced inflation became clear, direct financial subsidies began to lose some of their attraction for rent seekers, both as too costly and as unsustainable in the long run. At the same time, the government intensified its efforts to develop the legal and regulatory framework that had been missing during the earlier stages of reform.
Since opportunities to do well in the marketplace remain heavily suppressed, these changes have not restrained the growth of extra-market redistributional activities. With extra-market redistribution continuing to offer greater rewards than productive activities, the main factor promoting the vigorous pursuit of rents remains intact. The nature of rent seeking, however, has evolved, reflecting shifts in government policy.
Responding to these changes, lobbyists have focused their efforts on the legislative and regulatory processes. The government's new emphasis on the rule of law and secure property rights has presented the managers of firms with opportunities to occupy and maintain advantageous economic niches and to gain control over streams of rent with potentially high capitalized value, not just to obtain one-time handouts. Preferential tax regimes, access to regulated activities, de jure control over resources, and advantages in privatization have become the targets of choice.
On the one hand, this is undoubtedly an encouraging sign, as it indicates that Russia's economic agents expect the rule of law to prevail ultimately in the Russian economy and society. On the other hand, it shows that Russia's various interest groups have discovered new incentives and opportunities for lobbying and that their competition has further intensified. To secure influence over public policymaking, the lobbies are no longer approaching the government as supplicants, requesting favors. Rather, they are attempting to gain direct representation within the government. In the opinion of one well-informed observer, Russia has a "unique quasi-state, all the elements and components of which are pursuing only private or group interests" (Leontiev, 1994:159). In such a "quasi-state," private and group interests become intertwined, and the well-being of each
will depend on the political maneuvering and the leverage of their patrons in the government (Glinski, 1996).
In their attempts to secure a foothold within the institutions of the state, the lobbies are exploiting various natural divides—between different ministries in the cabinet, between the executive and legislative branches, and between federal and regional authorities. This process, which is known in Russia as the "privatization" of the government, goes well beyond developing close relationships with existing segments of the state apparatus. Those who have come late to the game are trying to establish new structural components within the bureaucracy or to expand existing agencies beyond their narrowly defined functional roles to create greater access.
The same factors help explain the excessive fragmentation of the Russian political scene and the proliferation of liberal and conservative political groupings, incapable of creating stable alliances despite shared platforms and values. Ideological differences are frequently of secondary importance, since the main reason for creating a new political movement is yet another interest group's perceived need to gain direct access to public policymaking.
"THE B-o LAW"
Evidence from various sources indicates a strong correlation between the propensity to seek redistributional gains and an inability to function effectively in the marketplace. "One can formulate a statistically proven 'B-o Law' [the abbreviated name of a Russian political entrepreneur who allegedly exemplifies the phenomenon], according to which high political activity correlates with low liquidity" (Leontiev, 1995:2). Thus, a group's lack of productive assets with real market value may prove advantageous when it competes for political benefits, since it is less likely to be splitting its energies and resources between market production and extra-market redistributive activities and is fully investing in the latter (Glaziev, 1995).
The same logic explains the strong priority Russian managers place on preserving their firms' labor teams. According to various surveys and polls (e.g., Belianova, 1995), this task dominates managers' agendas, usually ranking higher than profit maximization. While this phenomenon is certainly symptomatic of a lack of corporate control, the incentives motivating labor teams, as well as managers, require further explanation.
As was mentioned above, workers view their continuing employment as a vital substitute for an otherwise unavailable safety net and therefore are willing to stay on despite meager wages, part-time employment, involuntary leaves without pay, chronic delays in salary payment, and other features typical of suppressed unemployment (see, e.g., Commander et al., 1995). But for exactly the same reasons, workers wield very limited bargaining power. "Managers appear to have high discretionary powers with respect to wages and
employment, but they evidently choose not to exert them to enforce large employment separation or restructuring" (Commander et al., 1995:178). The fact that managers are not engaged in large-scale labor shedding, despite the weakness of labor's bargaining position, indicates that their self-interest is somehow served by retaining a large, though currently unproductive, labor force.
Managers' incentives to retain large labor stocks apparently have strong political underpinnings. While excessive labor is a liability in the market domain, it represents a valuable asset in the political marketplace, where managers can claim to represent sizable and politically vocal constituencies. When economic losses are weighed against political gains, the latter clearly prevail. This provides additional empirical evidence for our argument that actors gain higher payoffs from redistributional activities than from productive ones. The foregone profit can also be viewed as a political investment that is expected to render rewards in the future.
These examples and arguments confirm the view that productive assets in post-communist economies have both political and economic values, and that these values are negatively correlated (Frydman and Rapaczynski, 1994). A large, unrestructurable firm that is the single employer for an entire community may have a low market value, but it will have strong political clout with the government. As a result it will be well positioned to participate in extra-market redistribution. Another firm with modern technologies and a market for its products may do well in the marketplace, but it will have both weaker incentives and narrower opportunities to participate in rent seeking.
The primary distinction between these two firms is the extent to which labor is properly matched with other factors of production. Where there are widespread and profound structural distortions, a large portion of the labor force will be employed by firms with the "wrong" production assets. This will create powerful motivations for rent seeking, capable of destabilizing not only the economy, but the country's political life as well. "In effect, as long as the capital stock contains too much that is economically worthless, so that its improvement involves serious social costs, the government is always subject to being held up for ransom by the holders of economically worthless assets. Only when the winnowing out of the bad assets is a marginal, rather than the normal, economic problem, can the political system effectively resist pressures for large-scale redistribution" (Leontiev, 1994:193).
The analysis and evidence presented above suggest that Russian economic reform is trapped in the following vicious circle. Restructuring requires publicly provided and maintained institutions that support the creation and effective functioning of input markets, corporate control, and social safety
nets. The absence of these institutions during the early stages of the reform both forestalled restructuring and promoted broad redistributional activities based on extra-market means and the creation of socially counterproductive surrogates for missing institutions. Widespread rent seeking spawned interest groups, provided them with the means to pursue their antisocial interests by political means, and opened new opportunities for corruption within the government. As a result, the government has been incapacitated and is incapable of filling the institutional void in a positive way. This places further obstacles in the path of restructuring and continues to produce incentives for counterproductive activities.
These arguments explain why Russian reform has slid into a trap. Both "good" and "bad" institutional frameworks can provide stable equilibria. While the first is based on a full set of competitive markets and effective enforcement of contracts and property rights, in the second the necessary markets are underdeveloped, and property rights are poorly protected—a situation that stimulates broad extra-market redistribution. Both equilibria are based on a numerical externality (presented in different versions in Murphy et al., 1993; Sachs, 1995; and Acemoglu, 1995), which can be summarized as follows. Where "good" (productive, law-abiding) behavior predominates, the structure of social incentives favors such behavior, productive efforts are institutionally feasible, and the benefits that accrue from such efforts are properly secured. In addition, any opportunistic deviations can reliably be expected to be punished by a government that has both the necessary resources and public support ''to enforce [the law] effectively and relatively cheaply against the few individuals who break it" (Rapaczynski, 1996:88). On the other hand, where "bad" (counterproductive, opportunistic) behavior is widespread, the structure of incentives is such that rational individuals are encouraged to join the majority and engage in such behavior, particularly since productive alternatives are few and far between and unprotected against rampant redistribution.
The stability of these equilibria over time indicates that they have a "gravitational zone," capable of capturing and trapping the processes of institutional change. This means initial conditions will be highly important. Where structural distortions in a yet-to-be-reformed post-communist economy are modest, rent seeking should be relatively contained and subject to being overridden, if not suppressed, by emerging market-based interests. In such a case the government usually will not meet much resistance in implementing its reform program. If, however, the initial distortions are pervasive and deeply seated, market interests will be overridden and suppressed by rent seeking, and the government will be confronted with entrenched antireform opposition.
As one might expect, the more distorted the prereform economy, the more difficult it will be to accomplish the required restructuring. What may not be anticipated, however, is that such an economy is also less capable of developing the institutions required for the task. A similar conclusion is reached by
Acemoglu (1995:27): "reversing the adverse effects of misallocation is difficult because such a misallocation also leads to an unfavorable . . . reward structure" (see also Hedlund and Sundström, 1995). While Acemoglu focuses on the misallocation of human resources and does not endogenize the selection of a "bad" equilibrium (except for references to unspecified initial conditions and nonpecuniary rewards), our analysis ascribes the nonproductive use of human resources to the initial misallocation of complementary productive inputs. The causal links adduced above also explain why misallocation is sustained. According to this analysis, countries like Russia are in double jeopardy: not only is the scope of the necessary structural corrections extraordinarily broad, but precisely because it is so broad, it will be all the more difficult to create the tools required to bridge the gap.
The same argument, applied in reverse, serves to explain the success stories of economic reform. Where the initial structural distortion was limited, the amount of resources directed to rent seeking will be relatively modest, and the process of institution building will not be delayed by the actions of self-aggrandizing lobbies. Once the new, or reformed, institutions are in place, restructuring and growth follow promptly.
Politics is revealed as the linchpin of this process, and it should come as no surprise that opportunistic politicians and faulty policy measures are widely cited as the prime culprits for the failures of Russian reform. While our analysis corroborates this conclusion, it goes further by making the propensity for "bad" politics endogenous to the system, and by relating it to the unfavorable conditions extant at the initiation of the reform process.
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