“Lawless Capitalism Grips Russian Business” - The Washington Post November 7, 2000

After the Big Bang? Obstacles to the Emergence of the Rule of Law in Post-Communist Societies Karla Hoff and Joseph E. Stiglitz PIEP May 2003

The Hope “Privatization offers an enormous political benefit for the creation of institutions supporting private property because it creates the very private owners who then begin lobbying the government...for institutions that support property rights.” Murphy-Shleifer-Vishny 1998

Broad private ownership [didn’t create] a constituency for strengthening and enforcing [the new Civil and Commercial Codes]. Instead, company managers and kleptocrats opposed efforts to strengthen or enforce the capital market laws. They didn’t want a strong Securities Commission or tighter rules on self-dealing transactions. And what they didn’t want, they didn’t get. Black et al The Result in Russia

Property rights insecurity in 20 transition economies Index of insecurity of property and contract rights (BEEPS) GDP 2000/GDP 1989 R 2 = BLR UKR ARM GEO AZE UZB RUSSIA KAZ KGZ LTU POL BGR ROM HRV EST CZE SVK HUN SVN MDA The index of insecurity is the fraction of respondents who disagreed with the statement: “I am confident that the legal system will uphold my contract and property rights in business disputes.”

“Corruption in the organs of government and administration is literally corroding the state body of Russia from top to bottom.” Speech by President Yeltsin, 1993 “Russia is the only country we know where…even retail businesses often operate from behind unlabeled doors Black et al., 2000 The “no-rule-of-law state”

Question: Could individuals choose the “wrong” rules of the game? In choosing his economic action, each individual ignores the effect of his economic decision on how other people believe the system will evolve and, thus, how others invest and vote.. Each individual votes for the regime that enhances his own welfare—and stripping may give him an interest in prolonging the absence of the rule of law.

The controller’s dilemma: Strip assets or build value Strip assets s (  ) = f +  Controller Build value Rule of law V L = f + g - I L Political environment No rule of law V N = f + g - I N

Example  Stripping returns uniformly distributed on [0,1] g – I L = 1 g – I N = ¼  = (1-x) 2 Probability of rule of law = demand “squared”

Illustration of example Payoffs from ¼ to 1 depending on stripping ability No rule of law Rule of law Payoffs: 1

Switch line:  *= ¼ + ¾ (1- x ) 2 Unique stable equilibrium, probability of rule of law = 1/9 01 x Increasing support for the rule of law Stripping ability curve: x = 1 -  2/32/3 1 1/41/4 Payoffs

01 x Increasing support for the rule of law 1 1/41/4 A shift up in distribution of ability to asset-strip Initial conditions: Criminal networks Natural resource abundance Civic virtue Policy: Capital account convertibility Payoffs

Natural resource abundance, growth, and property rights insecurity Fuel and mineral exports/ total exports 2000 GDP/ 1989 GDP Percent who believe legal system will not “uphold my contract and property rights in business disputes” Wall Street Journal Rule of Law index (10 = best, 0 = worst) Average for countries with less than 10% natural resource exports 6.81% 89% 40% 7.5 score Average: % 15.22%84%42%6.9 score Average: greater than 20% 41.88% 66% 68% 4.2 score Russia 53.15% (1996) 63%73%3.7 score

Legal Transition as a Markov Process Probability of transition to rule of law depends on votes in the current period x t vote against 1-x t vote for. We explore a subset of possible equilibria where, as long as the no-rule-of-law prevails, the demand is the same every period. The rule of law is an absorbing state.

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

. Economic and political behavior are linked Switch line for building value vs. stripping

Why can’t society “grandfather” the control rights of the asset strippers? Dynamic consistency problem-- The security of such rights depends on the social consensus that underlies them. Not just any distribution of property can be protected under the rule of law.

Dynamic model θ I (build value and support the rule of law) θaθa θpθp Increasing support for the rule of law 01 x III Strip assets and oppose the rule of law II Strip assets and support the rule of law

Multiple equilibrium levels of demand for rule of law Stripping ability curves Political switch line, θ* θ 01 Increasing support for the rule of law x High demand for the rule of law Low demand for the rule of law

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

To sum up: (1) Functionalist arguments may be misleading ii vote jj 1. The political environment is a public good 2. Actions have spillover effects on the political environment

And (2) the tortoise may beat the hare If V N < S N, there may exist an equilibrium where many strip and so many wish to prolong the no-rule-of-law state. Big Bang privatization may thus put in place forces that delay the rule of law.

Caveats: The process of legal regime transition may not be Markov 1. History affects norms “Vladimir Rushaylo has flatly denied the allegations that 70 per cent of all Russian officials are corrupted … ‘Only those who have links with the organized criminal gangs can be regarded as corrupted officials. Do not mistake bribe-taking for corruption,’ the Russian Interior Minister stressed. (BBC, March 13, 2001)

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

We made 3 very special assumptions: No individual agent exercises power Only 2 possible legal regimes: one good for investment, the other bad A fixed set of agents (no new entry) We relax these assumptions in on-going work, where our focus is the conflict between “rules for all” (rule of law) and rules biased in favor of the powerful Rule of law Oligarchy Security of returns to building value Biasedness Future Work