Exiting a Lawless State Karla Hoff and Joseph E. Stiglitz September 20, 2007

The Question Why are dysfunctional institutions persistent? Consider: A situation in which theft is allowed --yet allowing theft is not in the self-interest of the individuals They can vote to create third party enforcement that makes it costly for individuals to steal and rob (the “rule of law”) Will those with political power embrace the rule of law? Puzzles: Post communist transition, Post-conflict societies, Oil reservoirs with common ownership

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

What does the literature say What does the literature say? - It focuses on obstacles to reform where there are losers from future economic activities—which by assumption do not exist in the scenario we will consider Political losers: Any change that erodes the power of the political elite erodes their ability to extract economic rents in the future (e.g. Engerman-Sokoloff 1997, 2005 Acemoglu-Robinson 2000; AJR 2005) Economic losers: Some would lose under reform. Limited redistributive instruments/information to compensate the losers (e.g. Fernandez and Rodrik)

Focus of this paper: consequences of a commitment problem with respect to past activities What is this problem? Under the rule of law, it is impossible to commit to treat illegitimate and legitimate income identically “There is no closed case or category of business affected with the public interest” Statement of the Supreme Court in the case of Nebbia vs. New York (1934)

Our key result Everyone has better future opportunities under the rule of law than under a lawless state, but given the commitment problem, those who have stolen in the current period may oppose the creation of the rule of law

“Fresh blood on one’s hands” Asset stripping in our model is like getting “blood on one’s hands.” It exposes an agent to a cost in the transition to the rule of law. We do not assume that the blood is never washed away. Instead, only the current period’s return from asset stripping is vulnerable to recapture. Our model shows that, as long as the non-rule of-law state persists, some may choose to strip assets, period after period. Thus the blood on their hands is fresh when the rule of law state is created, and they gain from the establishment of the rule of law only after they begin to build value—that is, with a time lag This can make the lawless state persistent.

Modelling innovation of the paper Existing work treats economic interests as parametric (Acemoglu and Robinson 2006, p. 316) We treat economic interests as endogenous.

Outline of talk 1 A pure coordination problem in a static model 2. Individuals’ intertemporal trade-off problem (dynamic model) 3. Why rule of law can’t commit not to look back 4. Policies: Gradualism vs. big bang privatization, Macroeconomic policies International sources of coordination

1. Coordination problem: Static model Agents have control rights over assets They choose to strip assets (steal corporate value) or invest, & Vote for or against rule of law (L) non-rule of law (N) Notation: x vote against 1-x vote for. Note: Only if you invest do you gain from the rule of law; otherwise you don’t care.

A political-economic link, with 2 equlibria [cc] Strip assets Build value Political environment Rule of law 1  (uniform distribution on [0,1] of stripping abilities) No rule of law 1/4 Probability distribution of the voting outcome depends on the fraction of the population that chooses to build value (1-x), which itself depends on that distribution. (Other example: Roberto Chang, 2006)

All agents obtain payoffs = 1 Rule of law No rule of law An agent get payoffs equal to ¼ if he builds value, or, if he strips, he gets from ¼ to 1, depending on stripping ability All agents obtain payoffs = 1

Unique stable equilibrium, probability of rule of law = 1/9th Stripping ability curve: x = 1 -  Payoffs 1 1/4 Expected return from building value = ¼ + ¾ (1-x)2 x 1 Increasing support for the rule of law

2. Dynamic model with imperfect commitment Every period, each agent chooses to build value or to strip assets, AND to vote for or against the creation of the rule of law The rule of law is an absorbing state. So a path is: N N L L L L L L L….

2. (cont) Technology and payoffs FLOW DEPLETION OR GROWTH OF ASSET STRIP ASSETS BUILD VALUE f – I j

Switch line for economic action: Two switch lines determine economic and political decisions Switch line for economic action: Locus of (x,q) for which an agent is indifferent between stripping and building value Switch line for voting Continuation benefit from no rule-of-law for an agent who strips today is zero . lq - z [ V - S ( x , q )] = 0 L N

An asset stripper might vote for the rule of law θ II (strip assets and oppose establishment of the rule of law) θp(x;λ) III (strip assets and demand the rule of law) I (build value and demand the rule of law) θa(x;λ) x 1 Increasing opposition to the rule of law

The switch lines, numerical example θ 1.2 θa(x;0.3) II 1 θp(x;0.3) 0.8 0.6 III 0.4 I 0.2 0.2 0.4 0.6 0.8 1 x

Two stable equilibrium paths of agents’ aggregate expected income 2.5 2.0 x* = 0 1.5 Agents' aggregate expected income 1.0 x* = 0.75 0.5 10 20 30 40 50 60 70 80 Time period

λ = 0 (no reappropriation of stripping returns) θ 1.2 II 1 θmax θp(x;0) 0.8 III 0.6 I 0.4 0.2 θa(x;0) 0.2 0.4 0.6 0.8 1 x

3. Why the commitment problem? 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. The consequences of the state’s seizing illegitimately taken property are markedly different from the consequences of the state’s taking or redistributing legitimately obtained wealth. It is rational for politicians to argue for the first (and not the second) and redistributing the wealth to voters. Nationalizing stolen wealth does not harm investment incentives. On the contrary, it improves them.

4. Policies Speed of privatization: To improve the tradeoff between agency costs within the public sector, and within the private sector, and to influence the constituency for reform after privatization Macro policy and open capital markets Policies that affect the relative return to stripping vs. building value affect constituency for reform

Muckraking Governor Slain By Sniper on Moscow Street Future work: Co-evolution of institutions and the inequality of the political power and wealth Our model abstracts from the development of some agents into oligarchs Economic history suggests the high payoff to a thoery that endogenizing changes in political inequality Engerman-Sokoloff 1997, 2005 Acemoglu-Robinson 2005, AJR 2006 Muckraking Governor Slain By Sniper on Moscow Street Wall Street Journal, October 19, 2002

Conclusion Coasian view (what matters is defining property rights) is misleading, because it ignores the problem of corporate governance (the control function in corporations is not allocated on the basis of property rights) and the resulting scope for theft When theft occurs, the long run prospects of rule of law are undermined. Theft changes the political dynamics that matters for the establishment of the rule of law.