by Svetozar Pejovich - Texas A&M University (USA)
If you wish to copy, reproduce or
reprint please check our Permissions
Institutional restructuring in West Germany and Eastern Europe
is a consequence of the failure of two major socialist experiments,
National Socialism and Marxism-Leninism. The paper addresses
a number of issues such as: Why was the transition of West
Germany in the 1950s more successful than the institutional
restructuring of Eastern Europe in the 1990s? Why are the
results of institutional changes within the former Soviet
Bloc different from one country to another? Why do we observe
no tendency in former Marxist-Leninist states for more efficient
institutions to replace less efficient ones?
The paper identifies the rule of law, the carriers of institutional
restructuring and informal rules in the community as three
critical factors upon which the results of institutional restructuring
depend. The paper then demonstrates the interaction between
those three factors is a powerful and perhaps necessary method
for analysis of institutional changes and their causes, directions
and consequences. To that end, analysis internalizes the effects
of the interaction between the rule of law, the carriers of
institutional restructuring and informal rules on incentive
structures and the costs of transactions, and the effects
of incentive structures and the costs of transactions on economic
Finally, the paper addresses three issues: Why has the use
of economic policies based on neoclassical economics contributed
to the rising strength of pro-socialist parties? What happens
to the transition from socialism to capitalism when the carriers
of institutional restructuring have comparative advantage
in running a state-centered economy? And finally, the paper
suggests a primer for changes in informal rules.
I would like to thank professors Enrico Colombatto and Victor
Vanberg for useful comments. Jelena Vesovich of the Department
of Economics at Texas A&M University helped with statistical
calculations. I am grateful to the Lynde and Harry Bradley
Foundation for financial support of my research on the effects
of customs and morals on social stability and economic performance.
The basic premise of socialist literature is that the institutions
of socialism are capable of bringing about a "just"
society. This premise has provided both the philosophical
foundation and the political justification for the practitioners
of socialism to replace the rule of law and individual liberties
with the rule of men (hereafter: the arbitrary state) and
a contrived concern for the "people." The term "people,"
a favorite cliché of all socialist leaders, is merely
a façade of words behind which the ruling elite hides
its own private ends.
The twentieth century witnessed the rise and failure of two
major applications of the socialist doctrine: National Socialism
and Marxism-Leninism. Like the competing families of the underworld,
National Socialism and Marxism-Leninism were at war (cold
and hot) with each other as well as with the rest of the world.
And they both failed to deliver on their promises. The Second
World War destroyed Hitler's socialism, while Marxism-Leninism
decayed from within.
National socialists and communists shared many basic political
and economic premises of the socialist doctrine. They both
ran command economies. They made the individual a bare tool
in the achievement of the ends of their ruling elites. National
Socialism and Marxism-Leninism were hostile to the private-property
free-market society, and its corollary, the society of free
and responsible individuals. They favored a large and active
state, created comprehensive welfare programs, and paid no
heed to the rule of law. National Socialism and Marxism-Leninism
were equally unrelenting in the pursuit of their primary targets:
inferior races and the bourgeoisie respectively.
National Socialism and Marxism-Leninism had some fundamental
differences as well. Communists were openly hostile to the
right of ownership, while national socialists were comfortable
with controlling and monitoring the behavior of private owners.
National socialists saw the struggle for racial purity within
national boundaries as the major mechanism for the development
of their brand of socialism. Communists, on the other hand,
saw the class struggle waged by the proletariat across national
boundaries as the vehicle for the development of the Marxist-Leninist
type of socialism. In 1972, Nicolae Ceausescu, the communist
leader of Romania, tried to bridge the gap between nationalism
and internationalism. He wrote:
The dialectical process of bringing together nations presupposes
their strong affirmation
. Between national and international
interests not only is there no contradiction, but, on the
contrary, there is a full dialectical unity.(1)
Institutional restructuring in former socialist states is
a consequence of the failure of socialist experiments. That
much is clear. The objectives of institutional restructuring
are, however, less clear. The leaders of former socialist
states like to talk about liberty, social stability, and sustainable
economic growth. However, those objectives have frequently
turned out to be a façade of words hiding the leaders'
real intentions. But this much is clear--economic reforms
mirror the leaders' preferences, their philosophical premises,
the political and economic constraints on their decision-making
powers, and the incentives under which they operate. Observed
results also incorporate the effects of uncertainties, incomplete
information, and divergence of interests between policy makers
and those who implement policies.
Institutional changes in former socialist states have produced
results that raise some important questions. For example,
why was the transition of West Germany in the 1950s more successful
than the institutional restructuring of the Soviet Union and
Eastern Europe in the 1990s? Why are the results of institutional
restructuring within the former Soviet bloc different from
one country to another? Why do we observe no tendency in former
socialist states for more efficient institutions to replace
less efficient ones?
Analysis in this paper identifies the rule of law, the carriers
of institutional restructuring and the prevailing informal
rules in the community as three critical factors upon which
the results of institutional restructuring depend. The paper
then demonstrates that the interaction between the rule of
law, the carriers of institutional
changes and informal rules (hereafter: the interaction thesis)
is a powerful and perhaps necessary method for analysis of
institutional changes and their causes, directions and consequences.
To that end, analysis internalizes the effects of the interaction
between the rule of law, the carriers of institutional restructuring,
and informal rules on incentive structures and the costs of
transactions, and the effects of incentive structures and
the costs of transactions on economic behavior.
FRAMEWORK FOR ANALYSIS
In private-property, free-market countries, the rate of growth
is a good yardstick for evaluating economic performance. However,
socialist countries calculated their respective gross national
products in state controlled (i.e., non-scarcity) prices.
For that reason, growth rates are not a reliable standard
for measuring economic performance of former socialist states.
As institutional restructuring unfolded in former socialist
states, scarcity prices began to replace accounting prices
in measuring the value of gross national products. A smaller
gross national product valued in scarcity prices could be
worth more to citizens of former socialist states than a larger
gross national product calculated in accounting prices. That
is, slower and even negative growth rates during the process
of transition do not necessarily signal economic retardation.(2)
A Nobel Laureate James Buchanan wrote:
Economic performance can only be conceived in values; but
how are values determined? By prices, and prices emerge only
in markets. They have no meaning in a non-market context...
where the choice-influenced opportunity costs are ignored.(3)
The Rule of Law
An implication is that the evaluation of institutional restructuring,
while the process is going on, requires a proxy for feasible
economic growth. Such a proxy has to be a strong predictor
of both social stability and post-transition economic growth.
Academic research and empirical evidence have identified the
rule of law to be such a factor.(4)
The rule of law means the absence of arbitrary power on the
part of the ruling group, subjection of all citizens to the
same laws, stable and credible rules, and an independent judiciary.
By eliminating the time horizon problem and creating a sense
of social stability, stable rules provide incentives for individuals
in the community to maximize the extent of voluntary interactions.
James Buchanan captures the critical importance of stable
and credible rules:
[In a capitalist society] there is an explicit prejudice
in favor of previously existing rules, not because change
itself is undesirable, but for the much more elementary
reason that only such a prejudice offers incentives for
the emergence of voluntary negotiated settlements among
the parties themselves. Indirectly, therefore, this prejudice
guarantees that resort to the authority of the state is
While democracy is about the process of selecting a government,
the rule of law is about the limitation of government's power.(6)
It protects individual rights against the majority rule. That
is why in a society of free and responsible individuals, the
word constitution must come before the word democracy. Cass
[The rule of law] creates a wall of protection around citizens,
giving a guarantee of immunity and ensuring that they may
engage in productive activity without fear of the state.
And by creating this wall of protection, the guarantee creates
the kind of security and independence that are prerequisites
for the role of a citizen in a democracy.(7)
Robert Barro summarized his empirical research on the importance
of the rule of law vis-à-vis democracy as follows:
The overall effects of expanded democracy are ambiguous
Madeleine Albright once [said that] democracy was a prerequisite
for economic growth. This response sounds pleasant but is
. For a country that starts with
democracy and little law [like Hitler's Germany and the
former Soviet bloc] an increase in democracy is less important
than an expansion of the rule of law as a stimulus for economic
. If there is a limited amount of energy that
can be used to accomplish institutional reforms, then it
is much better spent
by attempting to implement the
rule of law-or, more generally, property rights and free
Obviously, on the strict interpretation of the rule of law,
no country would qualify. However, the concept of the rule
of law provides an ideal yardstick for comparison of alternative
institutions and their economic, political and social consequences.
The farther a country travels away from the rule of law, the
greater is the power of the ruling group to pursue its own
The Carriers of Institutional Restructuring
Decisions made by governments, parliaments, corporations and
other organizations are, in effect, decisions made by individuals.
Individuals conceive ideas, invest time and effort in formulating
policies, push others into accepting their innovations, and
bear the risk of failures. Thus, the individual is the unit
of economic analysis. Armen Alchian and William Allen wrote:
Groups, organizations, communities, nations, and societies
are institutions whose operations can best be understood
when we focus attention on the action and choices of constituent
members. When we speak of the goals and actions of the United
States, we are really referring to the goals and actions
of the individuals in the United States.(9)
To understand the direction of institutional restructuring
in former socialist states, analysis must identify decision-makers,
the method of choosing them, the incentives under which they
operate, and the constraints on their decision-making powers.
The Old Ethos
Informal rules are traditions, customs, moral values, religious
beliefs, and all other norms of behavior that have passed
the test of time. In this paper the terms informal rules and
the old ethos are used interchangeably, although the latter
is a somewhat broader concept. The ethos defines the pattern
of behavior in the community that emerges from the interaction
between informal rules and a current set of values.
Institutional restructuring in former socialist states means
that new formal rules are coming into force. Those rules have
to interact with the prevailing customs, traditions, and moral
beliefs of the community. The results of institutional restructuring
then actualize the response of informal rules to those new
formal rules. A harmonious interaction of new formal rules
and the old ethos reduces the transaction costs in the economy
and frees some resources for the production of wealth. However,
when new formal rules are in conflict with the old ethos,
the transaction costs of making exchanges and enforcing new
the rules of the game will reduce the production of wealth
in the community.(10) An implication is that a community in
which rule- makers have incentives to enact formal rules that
are in tune with the old ethos should be both stable and growing.
Anglo-American common law stands out as an example of such
a system of incentives. Henry Manne wrote:
Anglo-American common law was primarily local, tribal,
or customary law, and, probably for this reason, common
law judges have always had a predilection to subsume local
customs into decision rules.(11)
TRANSITION IN WEST GERMANY
The Rule of Law
Several factors contributed to the acceptance of the rule
of law in West Germany within a decade after the Second World
War ended. First, before the First World War, Germany was
a liberal autocracy--that is, the country was low on democracy
but high on law and order.(12) Second, national socialists
stayed in power for about twelve years. Hence the period of
their rule was not long enough to erase or seriously impair
memories of law and order. Next, the end of national socialism
in 1945 placed West Germany into the hands of three Allied
Occupation Powers, all of them rule of law countries. The
Allied Occupation Powers imposed a number of rules, which
were not meant to foster democracy but to create law and order.
And the German tradition of law and order helped to reduce
the transaction costs of accepting, maintaining and enforcing
The Allied Occupation Powers, with the assistance of the
West German judiciary, carried out denazification of the country.
The national socialist party and its various organizations
were outlawed, and party bosses were sent to prison or to
the gallows. Lesser functionaries were barred from important
positions in public life. Of course, the transaction costs
of denazification had to be high. When the cold war created
a market for German scientists, business experts and former
intelligence officers, the costs of denazification got to
be even higher.
Yet, denazification had two critical consequences for the
transition of West Germany to capitalism. By outlawing the
national socialist party, denazification helped to absolve
the German people of the crimes committed by national socialists.
BY making it more difficult for memebrs of the Party to remain
in public life, denazification also eliminated from the process
of transition a large group of wellpositioned people, whose
comparative advantage was in running an arbitrary state. An
implication is that denazification reduced the transaction
costs of transforming West Germany into a rule of law country.
The Carriers of Institutional Restructuring
The process of institutional restructuring of West Germany
began in the late 1940s. Ludwig Erhard, Minister for Economic
Affairs in the government of Konrad Adenauer, was the architect
of West Germany's transition from socialism to capitalism.
Erhard wanted an economy based on credible private property
rights, freedom of contract, scarcity (competitive) prices,
and stable monetary and fiscal policy. To this end, he was
assisted by a group of free-market scholars centered at the
University of Freiburg.
Erhard had to sell his reforms to the Allied Occupation Powers,
which held the ultimate veto power on institutional changes
in West Germany. Erhard's problem was that the attitude of
the Allied Occupation Powers reflected the mood of the era.
It favored easy credit policy, public investments, and direct
governmental regulation of business. John Kenneth Galbraith,
then economic advisor to the American Military Government,
expressed the pro-planning bias of the Allied Occupation Powers
The question is not whether there must be planning-the
assignment of priorities to industries for reconstruction
and rehabilitation, the allocation of materials and manpower,
the supplying of incentive goods and all the rest-but whether
that planning has been forthright and effective.(13)
However, Erhard played the game right.(14) When the Allied
Occupation Powers approved the new currency (Deutschemark),
he saw a chance to remove price control, to implement non-expansionary
monetary and fiscal policies, and to provide credible protection
for private property rights. Erhard acted without approval,
hoping that the Allied Occupation Powers would go along with
his reforms once they proved successful. And he was right.
"West Germany's performance in industrial output and
exports was phenomenal, and by the 1960s the country was on
top of the European economic league."(15)
The Old Ethos in Germany
The prevailing informal rules in Germany have a strong bias
toward communalism; that is, limited government and methodological
individualism are not part of the old ethos. I conjecture
that the role of the state and codetermination are two important
consequences of the conflict between German tradition and
the culture of capitalism.
The Role of the State
The Anglo-American tradition considers the state to be a predator
requiring a constitution to tame it. German tradition, on
the other hand, sees the state as a partner in the social
and economic life of the community. Even free-market economists,
who provided Erhard with theoretical arguments and academic
imprimatur for the transition to capitalism, did not believe
that capitalism is a self-generating, self-equilibrating,
and self-correcting system.(16) The market is great, they
claimed, but some of its consequences are not. Thus, the state
must step in to take care of market failures.(17)
Consequently, the government acquired a number of responsibilities.
Initially the state was expected to focus on the so-called
market failures. However, making the government an active
player in the economy created incentives, which in turn produced
"unintended" consequences. Before long, rent-seeking
coalitions learnt how to use the state to obtain favorable
regulations, while legislators and bureaucrats perfected the
art of giving or denying favors via redistributive policies.
The trend toward an ever-increasing role for the state in
the economy accelerated in the 1970s, when Chancellor Willy
Brandt introduced his concept of "rational planning."
According to Christian Watrin, a leading German economist,
the rate of growth subsequently declined to become negative
in 1975. (18)
The Anglo-American tradition sees the community as a voluntary
association of individuals who interact in the pursuit of
their own private ends and, in doing so, create both order
and unintended outcomes. German tradition, on the other hand,
considers the community as an organic whole in which members
cooperate with one another in the pursuit of a common purpose.(19)
Codeterminaton is a consequence of that tradition.(20) Codetermination
means that the employees of a firm join shareholders of that
firm on the board of directors and take an active role in
The codetermining firm per se is neither an anti- nor a pro-capitalist
organization. It represents one of many types of business
firms we observe in capitalist countries, such as corporations,
partnerships, proprietorships, and cooperatives. However,
the law that mandates this specific type of contractual arrangement
and protects it from competition by other types of business
firms is both an anti-capitalist and an anti-freedom rule.(22)
The fact that the German government had to mandate the codetermining
firm and protect it from competition by other types of firms
is the best evidence of its inefficiency.(23)
Summary on Institutional Restructuring in West Germany
The rule of law and Ludwig Erhard were two key factors in
the successful transition of West Germany from socialism to
capitalism in the post-World War II years. However, informal
rules in West Germany were in conflict with the capitalist
concepts of a limited state and of individualism. The result
of that conflict is the social
market economy, which is a German variant of capitalism. The
main features of the social market economy today are large
subsidies, costly welfare programs, a myriad of rules regulating
business activities, large nonwage costs, and weak incentives
The 2000 Index of Economic Freedom identifies the consequences
of the German brand of capitalism.(24) The book uses a scale
of 1 to 5 for comparison of economic freedoms in 161 states.(25)
With a score of score of 2.20, Germany is ranked as the 22nd
freest country in the world.(26) However, the Index gives
Germany the best possible score 1 for the protection of private
property rights, and the worst possible score 5 for fiscal
burden. The latter, I conjecture, reflects the costs of the
compromise between the old German ethos on the one hand and
classical liberalism and methodological individualism on the
TRANSITION IN EASTERN EUROPE AND RUSSIA
The Rule of Law
In the following observations more than thirty years ago,
G. Warren Nutter captured the essence of what Marxists-Leninists
thought of the rule of law:
It was Lenin's genius to recognize the importance of embellishing
the Soviet system with all the trappings of democracy. If
the people want a constitution, give them one, and even
include the bill of rights. If they want a parliament give
them that, too. And a system of courts. If they want a federal
system, create that myth as well. Above all, let them have
elections, for the act of voting is what the common man
most clearly associates with democracy. Give them all these,
but make sure they have no effect on how things are run.(27)
The development of the rule of law in the former Soviet bloc
countries has been spotty and generally disappointing. While
many factors might have contributed to the patchy development
of the rule of law in the region after 1989, two are likely
to have played major roles. First, the majority of the former
socialist states in Eastern Europe had no memory of the rule
of law. For centuries, benevolent and not-so-benevolent czars,
local despots and foreign invaders ran those countries. A
few countries in the region belonged to the Austro-Hungarian
Empire, which was almost the classic example of liberal autocracy.
This means we can expect collective memory in those countries
to be low on political democracy but strong on civic and economic
freedoms. However, almost five decades of socialist oppression
had to make a dent in those memories as well.
Second, unlike West Germans in the late 1940s, East Europeans
didn't have a "colonial master" to teach them that
formal rules could be stable and credible, and that an independent
judiciary could be relied upon to enforce those rules. New
leaders had to take care of developing legal systems in their
respective countries themselves. Unfortunately for their citizens,
these leaders had to bear the costs of replacing the region's
tradition of arbitrary states (and much discretionary power
for the leaders) with the rule of law. Thus, they had little
incentive to pursue the rule of law. Predictably, the development
of the rule of law in former socialist states has been slow,
uneven and spotty. And the farther eastward we move, the spottier
the rule of law gets to be.
The 2000 Index of Economic Freedom shows just how spotty
the development of the rule of law has been in the East. Of
the ten factors the index uses to measure economic freedom
in 161 countries, two are used here as proxies for progress
in developing the rule of law. Those factors are private property
rights, and prices and wages.
The private property factor measures the stability and credibility
of property rights, which constitutes a good proxy for the
stability of the legal system. A score of 1 means that the
government and independent judiciary have made property rights
fully secure, stable and credible, while a score of 5 means
that private property is either outlawed or un-protected,
The prices and wages factor measures the freedom (and enforcement)
of contracts, a cornerstone of the private-property free-market
economy. A score of 1 means that wages and prices are determined
in competitive markets, and a score of 5 means government
dirigisme. For reference, Denmark, the United States, and
Iraq received the scores of 1, 1.5 and 5 respectively. The
average of those two factors in column 2 shows the extent
of the rule of law in former socialist states after a decade
of institutional restructuring. Sliding down the table changes
the mix of law and arbitrariness in favor of the latter. Those
changes should, in turn, spell out mean more corruption, blackmarket
activities, and government regulation.(28)
The 2000 Corruption Perception Index in column 3 of table
1 "ranks countries in terms of the degree to which corruption
is perceived to exist among public officials and politicians.
The 2000 CPI is a composite index, drawing on 16 surveys from
8 independent institutions. The surveys embrace the perceptions
of business people, the general public and country analysts."(29)
The Corruption Perceptions Index, clearly a very subjective
index, includes 90 countries. Scores range from 10 (highly
clean) to 1 (highly corrupt). For reference, Finland, the
United States and Mexico received the scores of 10, 7.8 and
TABLE 1: The Rule of Law, Corruption, and Black
Markets in Former Soviet Block Countries
Country - Rule of Law - CPI - BM&Reg
Czech Republic - 2 - 4.3 - 2.5
Estonia - 2 - 5.7 - 2
Hungary - 2 - 5.2 - 2.5
Latvia - 2.5 - 3.4 - 3.5
Poland - 2.5 - 4.1 - 3
Slovenia - 2.5 - 5.5 - 3
Bulgaria - 3 - 3.5 - 3.5
Lithuania - 3 - 4.1 - 3.5
Moldova - 3 - 2.6 - 3.5
Romania - 3 - 2.9 - 3.5
Russia - 3 - 2.1 - 4
Slovak Republic - 3 - 3.5 - 3
Albania - 3.5 - Not rated - 4
Ukraine - 3.5 - 1.5 - 4
Belarus - 4 - 4.1 - 4.5
Croatia - 4 - 3.7 - 3.5
Yugoslavia - Not rated - 1.3 - Not rated
Bosnia - 4.5 - Not rated - 5
Sources, 2000 Index of Economic Freedom, and 2000 Corruption
Perception Index, (see endnotes 23 and 28).
Column 4 shows the average score for black market activities
and government regulation. Higher scores indicate more regulations
and black market activities. Relationships between columns
2 and 3 and between columns 2 and 4 are statistically significant
at the 5% level. That is, changes in the mix of law and arbitrariness
in favor of the latter create more black market activities,
government regulations, and corruption.
The Carriers of Institutional Restructuring
Decommunization did not happen in Eastern Europe. With only
a few exceptions, communist parties in the former Soviet bloc
were not outlawed, and party members were not brought to justice.
Some decommunization did occur in the former East Germany.
In a few places, like the Czech republic, former leaders and
members of secret services were excluded, or were supposed
to be excluded, from decision-making jobs in government. In
a number of countries, the communist party merely changed
its name and continued to function. In this paper all attempts
on the part of communists to hide the past and/or signal newborn
beliefs are ignored.
The fact that decommunization did not happen in most East
European countries has had significant consequences. In 1989,
communists held most of the important jobs in all branches
of government as well as in business. They also had a well-established
"old boys" network. Thus, communists were in much
better position than other citizens to become or join the
carriers of institutional restructuring. And, looking back,
that is precisely what happened in many East European states.
Once they along with others became the carriers of institutional
restructuring, the behavior of communists, like that of everyone
else, depended on the incentives under which they had to operate.
Leaving aside the morality of their "conversion,"
and given their knowledge of and skills in dirigisme, the
survival trait for communists was to favor economic policies
based on more government and more public spending.(30) The
bottom line is that the failure to outlaw communist parties
and to prevent their members from becoming the carriers of
institutional restructuring has raised the transaction costs
of transforming former socialist states in Eastern Europe
into freemarket private-property economies.(31)
The Old Ethos in Eastern Europe
Informal rules in Eastern Europe are not homogenous, but they
do have some common traits, such as a strong bias toward collectivism,
egalitarianism, and the extended family. Although countries
that belonged to the Austro-Hungarian Empire have a more Western
tradition than do other East European countries, classical
liberalism and methodological individualism, which are part
of that tradition, do not have deep roots in the region.
Many communities in the region have developed customs and
common values along ethnic lines. Frequently a person's ethnic
origin predicts that person's religion--usually Islamic, Roman
Catholic, or Eastern Orthodox--reinforcing the differences
in customs and values among ethnic groups. Interactions within
any specific ethnic group are then subject to rules of behavior
that do not necessarily hold or that may not hold in exchanges
across the ethnic lines. Most unfortunately, the tradition
in Eastern Europe is a repository of the old unsettled scores
among the region's ethnic groups.
The old ethos, however, served East Europeans well under
socialist rule. With its emphasis on ethnicity, the extended
family and shared values, the old ethos gave East Europeans
a fortress: behind its walls they could hide and survive socialist
rule without having to accept it.
It is clear that capitalism and the old ethos in Eastern
Europe do not mesh together well. The accumulation of private
wealth in Eastern Europe is suspect, the more so the farther
east one travels. Gains from trade are seen as a redistribution
of wealth rather than as rewards that individuals receive
for creating new value. The intellectual heritage in the East
supports an activist state.
Given the ethos of the region and several decades of isolation
from the rest of the world, East Europeans couldn't see capitalism
as a way of life based on (1) the constitutional guarantees
of individual rights, (2) credible and stable private property
rights, (3) the freedom of contract, (4) the exchange culture
in which each and every individual bears the value consequences
of his/her decisions, and (5) the behavioral principles of
self-interest, self-determination and self-responsibility.
Summary on Institutional Restructuring in Eastern Europe
The interaction of the rule of law, the carriers of institutional
restructuring, and the old ethos suggests that the future
of capitalism in Eastern Europe might be, at best, hanging
in balance. With a few exceptions, East European countries
are still short on the rule of law. The fact that privatization
programs have made them rich is the best evidence that communists
have been playing a major role in the institutional restructuring
of Eastern Europe. The old ethos in Eastern Europe is not
in tune with a way of life that rewards performance, promotes
individual liberties, and places high value on self-interest,
self-responsibility and self-determination.
IN LIEU OF CONCLUSIONS
The rule of law, the carriers of institutional restructuring,
and the old ethos are three powerful and perhaps necessary
factors for analysis of the causes, directions and consequences
of institutional restructuring. Economic theories and policies
that pay attention to the interaction thesis are likely to
have fewer unintended consequences than those theories and
models that do not. The analysis in this paper has shown us
why the transition in West Germany was a success, and why
it does not make sense to force East Europeans to accept capitalism
until their leaders give them credible and stable legal systems
and East Europeans become comfortable with capitalist culture.
Before leaving the interaction thesis and its as yet inevitably
incomplete trajectory, it is worth briefly addressing three
issues that have been playing important roles in the institutional
restructuring of former socialist states. Those issues are:
Why has the use of economic policies based on neoclassical
economics produced the rising strength of pro-socialist parties?(32)
What happens to the transition to capitalism when the carriers
of institutional restructuring have comparative advantage
in running state-centered economies? And finally, the paper
suggests a primer for changes in the old ethos.
Neoclassical Economics and the Transition In Eastern Europe(33)
Neoclassical economics became a basis for the development
of transition strategies as well as a yardstick for evaluating
economic outcomes in former socialist states. While the intention
here is not to denigrate an approach to economic inquiry that
has made important contributions to the stock of scientific
knowledge, the point has to be made that neoclassical economics
falls short of explaining a wide range of real world events,
including the causes and consequences of institutional changes.
It is important to understand how and why economic policies
based on neoclassical economics have produced a host of unintended
political and social consequences culminating in the rising
strength of pro-socialist parties in the region.
I conjecture that neoclassical economics is ill-suited for
informing the institutional restructuring in Eastern Europe,
largely for its lack of appreciation for the importance of
institutions and the assumptions of unbounded rationality,
stable preferences, maximizing behavior, and market equilibrium.
Neoclassical economics ignores the fact that alternative
institutions have their own ethical roots, so that it can
claim to be value-free. By ignoring the incentive effects
of alternative institutions on transaction costs, neoclassical
economics gave us erroneous evaluations of the state of socialist
economies in the 1980.
Robert Heilbroner and Lester Thurow wrote: "Can economic
command significantly compress and accelerate the growth
process? The remarkable performance of the Soviet Union
suggests that it can. In 1920 Russia was but a minor figure
in the economic councils of the world. Today it is a country
whose economic achievements bear comparison with those of
the United States." Paul Samuelson said: "It is
a vulgar mistake to think that most people in Eastern Europe
are miserable... The gap between Western and Eastern living
standard may narrow in the future." Seweryn Bialer
and Joan Afferica wrote: "The Soviet Union is not now
nor will it be during the next decade in the throes of a
true systemic crisis, for it boasts enormous unused reserves
of political and social stability that suffice to endure
the deepest difficulties." And John Kenneth Galbraith
on his return from Russia in 1984 claimed that the Soviet
economy had made great national progress in recent years.(34)
Then, in the early 1990s, neoclassical economics demonstrated
a complete lack of understanding of the true nature of institutional
restructuring in Eastern Europe. In a recent paper, professor
Enrico Colombatto wrote that the process of transition is
not aimed at starting some kind of a mechanical catch-up process;
but rather at reducing transaction costs and providing better
opportunities to meet individual objectives. Institutional
restructuring, Colombatto said, is a cultural issue, rather
than a mere technical one.(35)
Unbounded rationality exists only in frictionless blackboard
models, which rule out positive transaction costs. However,
ours is the world of bounded rationality in which individuals
have different subjective perceptions of real events and different
abilities to process new knowledge. Among the consequences
of bounded rationality, then, are positive and variable transaction
costs, information asymmetries, and opportunistic behavior.
Neoclassical economics is ill equipped to deal with those
consequences of bounded rationality.
The rational expectation theory and the principal-agent model
are two best, but still inadequate, attempts by neoclassical
economists to address the consequences of bounded rationality.
The rational expectation theory considers the process of adaptation
to an optimal solution as a steady trial-and-error process
in which the participants are not acquiring new knowledge.
With uncertainty and incomplete knowledge, the resolution
of contingencies between the principal and the agent cannot
depend on a contract but hinges upon the incentive effects
of the prevailing rules. Herbert Simon wrote:
[New economic theories] are not focused upon, or even much
concerned with, how variables are equated at the margin,
or how equilibrium is altered by marginal shifts in conditions.
Rather they are focused on qualitative and structural questions,
typically, on the choice among a small number of discrete
The maximization paradigm of neoclassical economics translates
the desire for more-an observable trait of human behavior
since the fiasco in the Garden of Eden-into the search for
a single solution based on marginal equivalencies. However,
in a world of bounded rationality, the transaction costs of
identifying marginal equivalencies are positive and not invariant
with respect to alternative institutional arrangements. A
Nobel Laureate Coase wrote:
The reason why economists went wrong was that their theoretical
system did not take into account a factor that is essential
if one wishes to analyze the effect of a change in the law
on the allocation of resources. This missing factor is the
existence of transaction costs.(37)
Market equilibriums are conjectures about what the end
results of human interactions would have been if relative
prices were able to inform utility maximizing individuals
of the best strategy to be pursued in each different situation.
However, in a world of bounded rationality scarcity prices
cannot transmit the information necessary to identify marginal
equivalencies. Neoclassical economics is silent about the
effects of alternative rules on the agents' costs of acquiring
the knowledge needed to make optimal choices as well as about
the effects of new knowledge on prevailing rules. Ronald Coase
If [neoclassical] proposals were carried out, which they
cannot be, the allocation of resources would be optimal.
This I have never denied. My point is that such policies
are the stuff that dreams are made of. In my youth it was
said that what was too silly to be said may be sung. In
modern economics it may be put into mathematics.(38)
The knowledge-creating process continuously changes our
preferences. That is, preferences are neither stable nor
entirely exogenous. Thus, assumptions such as given prices
and given preferences are misleading. Those variables do not
exist independently from the action-choosing process through
which they are generated. The presence of endogenous preferences
and their mutability cast serious doubts on the concept of
efficiency in neoclassical economics, which is based on the
results. The so-called Lange-Mises controversy is a good example
of an impeccable technical discussion that wasted lots of
resources on the wrong issue.
An alternative concept of efficiency, which is preferred
by growing number of scholars associated with the Austrian
School, Public Choice School, Evolutionary Economics and New
Institutional Economics is that efficiency is to be judged
by the process through which transactions are carried out.
The critical policy issue then becomes: what set of institutions
provides incentives for transaction costs to be reduced by
those who can do it at a lower cost, and how and why the observed
patterns of behavior emerge.
The carriers of institutional restructuring in former socialist
states include a rent-seeking coalition that I call the transition
industry. The transition industry, which has no geographical
borders, is an umbrella for the latter-day socialists, social
engineers, bureaucrats, reformed and nonreformed communists,
university professors from the West and the East, policy makers
from the Wold Bank and IMF, and others.(39) The common denominator
of this diverse group of rentseekers, who prefer public policy
to spontaneous institutional changes and favor restricting
the right of ownership, is the culture of collectivism. And
their survival trait is to use the strong hand of the state
to "build" capitalism in Eastern Europe and the
former Soviet Union.
I conjecture that the World Bank and the International Monetary
Fund are two most offending members of the transition industry.
Since their activities do not have to pass the market test,
the discretionary power of decision-makers in these two organizations
is substantial. We observe that these two organizations primarily
serve governments that all the various indexes of economic
freedom classify as mostly unfree, and repressive. It appears
that the more corrupt the country is, the better its chance
of getting support from the World Banks and IMF. While the
Czech republic and Slovenia could live without the World Bank
and IMF, Russia and Ukraine can not.
Obviously, decision-makers in the World Bank and IMF have
incentives to help corrupt governments, and in doing so they
have been creating moral and economic problems. Their activities
are immoral because they reduce the costs of keeping corrupt
governments in power. And their activities are inefficient
because they reduce the costs of maintaining inefficient property
rights in arbitrary states. The so-called international financial
crises are the consequences of internal problems created by
corrupt governments. Yet, the World Bank, IMF have been helping
corrupt governments to shift the costs of bailouts to the
taxpayers of non-corrupt states. The same goes for loans to
East European states. More often than not those loans are
used to either subsidize large enterprises with no chance
of surviving in competitive markets, or to enrich new ruling
elite, or to pay off the loans that should not have been granted,
or all of the above.
A landmark study on WB and IMF, which is usually referred
to as Meltzer Report addressed the issue of incentives and
institutional change as follows:
The development banks cannot succeed in their mission unless
the countries choose institutions and government policies
that support growth. Developing country governments must
be willing to make institutional changes that promote improved
social conditions, reward domestic innovation and saving,
and attract foreign capital. To foster an environment conducive
to economic growth, the development banks must change
their internal incentives and the incentives they offer
developing countries (italics mine).(40)
A Primer for Changes in the Old Ethos
The essence of my argument in this paper is that the transition
from socialism to capitalism is a cultural issue. Since the
old ethos in Eastern Europe is not in tune with the culture
of capitalism, the critical issue is who and how can reconcile
the prevailing ethos with the culture of capitalism. Informal
rules are not a policy variable. Thus, the state cannot reconcile
the conflict between the old ethos and capitalism by fiat.
The answer depends on who the carriers of institutional restructuring
are and on their incentives.
Suppose a new idea hits a community. An important economic
consequence of the idea would be to enlarge the set of opportunity
choices for human interactions. However, if new exchange opportunities
were not in tune with the prevailing ethos, the community
would consider the behavior of those exploiting the opportunities
as submarginal. But if operating below the margin of accepted
behavior provided a differential return, the success of those
individuals doing so would attract competition from others.
If the returns were substantial enough to generate and sustain
a large number of repeated interactions relative to the enforcement
costs of informal rules (expulsion from the community, ostracism
by friends and neighbors, loss of reputation, etc.), the prevailing
ethos would slowly change to embrace the novelty. The essential
requirement here is that the state does not interfere (one
way or another) with the freedom of individuals to choose
whether or not to bear the prevailing costs of violating informal
rules. It is also important that the costs of institutional
change are borne by those who capture the benefits.
The process outlined above is taking place in Eastern Europe.
Thousands of small private enterprises have spontaneously
sprung up in Eastern Europe, even though private property
rights do not yet enjoy credible legal guarantees. Those enterprises
are small stands lining the streets of East European cities
or are conducted from the backseats of cars, and out of small
rooms. Many have failed or will fail, but enough have survived
and will grow.
Spontaneous enterprises represent an insignificant percentage
of gross national products in their respective economies.
However, they are performing the most critical function that
huge and inefficient enterprises, privatized or not, cannot
perform. The small enterprises are the breeding ground for
entrepreneurs, a work ethic, and a capitalist exchange culture.
They educate ordinary people to appreciate a way of life that
rewards performance, promotes individual liberties, and places
high value on self-responsibility and self-determination.
These small enterprises are the engine of a slow and genuine
reconciliation between the region's old ethos and the culture
Indeed, small entrepreneurs have begun to make contributions
to both social stability and economic performance in Eastern
Europe, especially in Poland, Hungary and the Czech Republic.(41)
And in the process, ordinary people are learning about the
costs and benefits of keeping promises, the rule of law, competitive
markets and methodological individualism.
1 Nicolae Ceausescu, Scinteia, July 20, 1972, p.8, quoted
in Isaiah Berlin, "The Bent Twig," in (Henry Hardy,
ed.) The Crooked Timber of Humanity, pp.253-4.
2 The same reasoning applies to the rise of unemployment in
former socialist states, which is an unavoidable consequence
of moving from a planned economy to competitive markets. Given
the positive transaction costs of institutional restructuring,
the emerging labor markets couldn't have reduced unemployment
with the speed of neoclassical models.
3 James Buchanan, "General Implications of Subjectivism
in Economics," paper presented at the conference on Subjectivism
in Economics, Dallas, Texas, December 1976.
4 Robert Barro, Determinants of Economic Growth: A Cross Country
Empirical Study, Cambridge: MIT Press, 1997; Fareed Zakaria,
"The Rise of Illiberal Democracy," Foreign Affairs,
76, December 1997, pp.22-43; Alejandro Chafuen and Eugenio
Guzman, "Economic Freedom and Corruption," in (Gerald
O'Driscoll, Jr., Kim Nolmes and Melanie Kirkpatrick, eds.)
2000 Index of Economic Freedom, Washington D.C.: Heritage
Foundation, pp. 51-63.
5 James Buchanan, "Policy, Property and the Law,"
Journal of Law and Economics, 16, 1972, pp.
6 See the pioneering work by Bruno Leoni, Freedom and the
Law, Princeton: Van Nostrand Co, 1961.
7 Cass Sunstein, "On Property and Constitutionalism,"
Cardozo Law Review, 14, No 3-4, 1993, p. 923.
8 Robert Barro, "Rule of law, Democracy, and Economic
Performance," in 2000 Index of Economic Freedom, op.cit.,
9 Armen Alchian and William Allen, University Economics, Belmont:
Wadsworth Publishing, 1964, p.12.
10 We can think of many examples of the effects of the interaction
of formal and informal rules. The formal rule that limited
the maximum speed on American highways to 55 miles per hour
was in conflict with the driving culture of most American
motorists and raised enforcement costs. Prohibition laws in
the United States were in conflict with the country's prevailing
tradition of social drinking. The
high transaction costs of maintaining and enforcing prohibition
laws opened up the market for the Mafia and eventually convinced
the government to eliminate the conflict between formal and
informal rules concerning the consumption of liquor. The interaction
of formal and informal rules explains the costs of resources
that were required to maintain and enforce the old regimes
in Eastern Europe. It explains the differences in the costs
of enforcing the right to life in religious and less religious
communities. The rise of "ghettos" in American cities
reflected a tendency on the part of various ethnic, racial,
and religious groups (groups living under the same set of
formal rules) to stay together with those individuals whose
behavior they could predict.
11 Henry Manne, "The Judiciary and Free Markets,"
Harvard Journal of Law and Public Policy, 21, fall 1997, p.21.
12 Fareed Zakaria, "The Rise of Illiberal Democracy,"
Journal of Foreign Affairs, 76, December 1997, pp. 22-43.
13 John Kenneth Galbraith, "The German Economy,"
in (ed. S. E. Harris), Foreign Economic Policy for the United
States, Cambridge: Harvard University Press, p. 94.
14 See an excellent paper by Norman Barry, The Social Market
Economy, Bowling Green: Social Philosophy and Policy Foundation,
15 Ibid., p.9.
16 Two free-market economists and strong supporters of Erhard,
Wilhelm Roepke and Walter Eucken, wrote: "Like pure democracy,
undiluted capitalism is intolerable" (W. Roepke, Social
Crisis of Our Time, London: Thames and Hudson, 1958, p. 119);
and "The economic system cannot be left to organize itself"
(W. Eucken, The Unsuccessful Age, Edinburgh: William Hodges,
17 In a private communication to the author of this paper,
professor Victor Vanberg of the University of Freiburg wrote:
"There was a systematic difference between Roepke and
Eucken. Eucken's main argument was that the institutional
framework that constitutes a well-functioning market cannot
be expected to arise 'naturally' but is a matter of adequate
political constitutional choice. Roepke was much more concerned
with 'undesirable social consequences' of the pure market
mechanism, despite his general pro-market attitude."
18 See Hans Wllgerodt, op. cit., p.79.
19 In the second half of 19th century, Germany became the
very first modern welfare state.
20 Codetermination in Germany has a long tradition. As early
as 1835, Robert Von Mohl, Wilhelm Roscher and Bruno Hildebrand,
all university professors, proposed to create "workers'
committees" in business firms. The most recent law on
codetermination was enacted in 1976. It applies to all business
firms that have more than 2,000 employees. The supervisory
council (i.e., the board of directors) for such firms has
twelve members, of whom six are representatives of the shareholders
and six are representatives of the employees. At least three
members representing employees are appointed by labor unions.
The chairman of the supervisory council is elected by the
shareholders and holds the deciding vote in case of a deadlock.
21 Whatever the facade of words, terms such as "stakeholders"
and "labor participation" are code words for inefficient
(non-contractual) transfers of wealth.
22 American labor unions have refused to embrace codetermination.
The president of the Machinists Union said: "We have
no interest in replacing free enterprise with a Utopian system....
And we believe workers can receive a better share of free
enterprise at the bargaining table than in board rooms."
Whatever their motives might have been, American labor leaders
saved the country from political pressures to implement contractual
agreements that wouldn't emerge spontaneously.
23 See C. Watrin, "The Case of Codetermination in Germany,"
in (S. Pejovich, ed.) Socialism: Institutional, Philosophical
and Economic Issues, Dordrecht: Kluwer Academic Publishers,
1987, pp277-314; and G. Benelli, C. Loderer, and T.Lys, "Labor
participation in Corporate Policy Making Decisions: West Germany's
Experience with Codetermination," Journal of Business,
24 Gerald O'Driscoll, Jr., Kim Novak and Melanie Kirkpatrick,
2000 Index of Economic Freedom, Washington D.C.: The Heritage
Foundation and the Wall Street Journal, 2000, pp. 229-230.
25 Scores 1-1.95 are "free" countries; 2-2.95 are
"mostly free" countries; 3-3.95 are "mostly
unfree" countries; and 4-5 are repressed. The United
States was ranked the 4th freest country with the score of
26 This index is based on ten factors: Trade policy, fiscal
burden, government intervention, monetary policy, foreign
investment, banking, wages and prices, property rights, regulation,
and black market.
27 G. Warren Nutter, The Strange World of Ivan Ivanov, New
York: The World Publishing Co, 1969, p.39.
28 The extent of government regulation of economic activities
in the country is a much better indicator of the restrictions
on private property rights and contractual freedom than, for
example, the level of government spending.
29 "2000 Corruption Perception Index," Transparency
International, Berlin, September 13, 2000, p.1. The Index
and information on methodology are available at www.transparency.de/documents/
30 In multiethnic states, these leaders encouraged the perception
of an external threat to their respective ethnic groups. In
countries like Belarus and Ukraine, communists quickly learned
that political democracy obliges them neither to respect nor
to enforce civic and economic freedoms. In Russia, communists
are in the process of re-creating the state-centered system.
On the other hand, the influence of right wing parties led
by free-market individuals helped the Czech republic, Hungary
and Poland virtually to complete the transition to capitalism.
31 Many educated and skilled people in former socialist states
had joined the communist party in order to enhance their careers.
The argument that those people warrant a different treatment
from true communists is plain wrong. First, the transaction
costs of separating "true" communists from "careerists"
are significant. Second, giving aid and comfort to criminals
is a crime.
32 See Svetozar Pejovich, "The Market for Institutions
Vs. Capitalism by Fiat," Kyklos, 47, No. 4, 1994, pp.
519-529; and "Law, Tradition, and the Transition in Eastern
Europe," The Independent Review, 2, September 1997, pp.
33 This section of the paper is based on Timothy Roth, Ethics,
Economics and Freedom, Aldershot: Ashgate, 1999 (errors in
interpreting the book are mine); and Svetozar Pejovich, Economic
Analysis of Institutions and Systems, Dordrecht: Kluwer Academic
34 Svetozar Pejovich, Economic Analysis of Institutions and
Systems, Dordrecht: Kluwer Academic Publishers, 1998, p. 14.
35 Enrico Colombatto, "On the Concept of Transition,"
ICER Working Paper, November 2000.
36 H. Simon, "Rationality as a Process and as a Product
of Thought," American Economic Review 68 (1978), p. 6.
37 Ronald Coase, The Firm, the Market, and the Law, Chicago:
University of Chicago Press, 1988, p.175.
38 Ibid., p.179. This endnote compresses and generalizes Coase's
original text. However, I believe that I have not changed
the thrust of Coase's argument.
39 In 1989, Western scholars associated with Russian centers,
East European centers and various associations for comparative
studies found, practically overnight, that the value of their
human capital was gone with the wind. East European scholars
had a different problem. After decades of teaching and writing
about "scientific socialism" they had to do a complete
turnaround (what a moral bunch of educators) and switch to
lecturing about the benefits of competitive markets.
40 See Report of the International Financial Institution Advisory
Commission (Meltzer Report), Washington D.C.: Government Printing
Office, March 9, 2000, p.11.
41 See Adrian Karatnycky, "Eastern Europe Rejects Communism-Again,"
Wall Street Journal, November 25, 1996, p. A16.
the Article in PDF Format
If you do not have the required "Adobe
Reader" you can download it for free from the Adobe.com
website by clicking on the following icon: