The Creation Of The Rule Of Law And The Legitimacy Of Property Rights: The Political and Economic Consequences of a Corrupt Privatization
| Author | Karla Hoff . Joseph E. Stiglitz |
| Profession | World Bank, Washington DC . Columbia University, New York, NY |
| Pages | WPS3779 |
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Karla Hoff and Joseph E. Stiglitz.Hoff: World Bank, Washington DC 20433; Stiglitz: Columbia University, New York, NY 10027. We thank Mayuresh Kshetramade for outstanding research assistance. We benefited from valuable suggestions from Avinash Dixit, Branko Milanovic, the editor Andrew Scott, Ken Sokoloff, two anonymous referees, and seminar participants at Berkeley, Harvard's center for Political Institutions and Economic Policy(PIEP), Pennsylvania State University, Princeton, UCLA, the World Bank, and meetings of the American Political Science Association. Hoff thanks the MacArthur Research Network on Inequality and Economic Performance for financial support.
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The central issue in this paper are the dynamics of transition to the rule of law-an issue that has become paramount in the debate over the transition from communism to a market economy. There is a long history recognizing that property rights are very important. There has also been a long debate about how the institutions of property rights evolved (e.g., Smith, 1776, Book III, iv; Marx and Engels, 1848; North 1981). In Western European history, in general, they evolved gradually and incrementally. But for transition and developing countries today, policymakers seek to expedite this process. For the countries in transition from communism, the theory was put forward that the process could be expedited by the mass privatization of state enterprises to individuals: Privatization would create a demand for property rights institutions and the rule of law.1 The institutional evolution that was expected to follow would lead to growth-wealth creation and wealth maximization. There was a logic to this theory, but the theory neglected a variety of reasons why rapid privatization might not have the desired effect on institutional change.
Preliminary evidence more than a decade out is that this strategy has not worked in Russia and many other transition countries. The political scientist Stephen Holmes (2002, p. 87) writes that "no well-organized constituency for the rule of law exists in Russia today" and that for lack of one, the rule of law cannot be established. This view is shared by numerous scholars with respect to not only Russia but also many other Page 2 transition countries.2 Figure 1 plots nonparametric estimates of the distribution, in 1996 and 2004, of World Bank scores of adherence to the rule of law for 27 transition countries and the world as a whole.3 The rule of law indicator is scaled so that the values of the world average and median are zero and the standard deviation is one. Higher scores represent greater adherence to the rule of law. In 1996, the transition countries had, on average, slightly less adherence to the rule of law than the world as a whole, but showed a low level of dispersion. Between 1996 and 2004, a twin peaks pattern emerged in the transition countries: Some achieved a good measure of rule of law by world standards, while the majority had scores that remained low or even deteriorated.
When it became clear in Russia's privatization that many individuals were obtaining equity stakes through rigged bids and that controlling shareholders were stripping assets, even then some people argued that businessmen would, sooner or later, settle down to value-building. The following passage attributed in 1996 to the first head of Russia's privatization program (Anatoly Chubais) is suggestive:
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"They steal and steal and steal," Chubais complained of the country's businessmen and their routinely corrupt practices. "They are stealing absolutely everything and it is impossible to stop them. But let them steal and take their property. They will then become owners and decent administrators of this property." (Freeland, 2000, p. 70)
But there was no way to evaluate how long that would take, or what price would be paid in the interim. Many apologists for what was happening in Russia suggested that the theft was nothing more than redistribution-a small price to pay for establishing the rule of law and thereby attaining an efficient economy. In contrast, in this paper, we present a model in which there are social costs attendant to theft.
We argue that the linkage between privatization and the demand for the rule of law has been misinterpreted. A central analytical failure is misunderstanding the difference between an individual's owning an asset and an individual's having control over an organization of which he is not the sole owner.4 Control rights enable one to take others' assets. In the absence of the rule of law, control rights undermine more general property rights because they make it easy to steal. Privatization without institutions to enforce good corporate governance may vitiate private property rights and give those with control rights an interest in the persistence of a weak, corrupt state that would not interfere with their theft.
The paper is organized as follows. In Section 1, we present an infinite period Page 4 model in which forward-looking agents who control assets choose an economic strategy- to build value or strip assets-and express in each period, e.g., by voting, a political preference for or against establishing the rule of law. The probability of transition to the rule of law depends on the size of the constituency that demands it, and an agent's optimal economic strategy depends on his beliefs about when the transition to the rule of law will occur. If he believes that this constituency is large, so that the probability of transition is high, then the relative expected returns to building value and to supporting the rule of law will both be high. This is the scenario predicted by supporters of rapid privatization. If, however, the agent believes that the constituency for the rule of law is small, then the expected return to building value (relative to stripping assets) will be low and he may choose to strip assets. Asset stripping may in turn give him a preference for postponing the establishment of the rule of law because stripping gives him a stake in the existing system that does not interfere with his theft. We assume that the individual votes his self-interest.
This means that he compares the long-run gain from a more efficient society under the rule of law to his short-run foregone ability to strip. He naturally ignores any effect of his behavior on how others invest and vote. We show that even if only those who have control rights determine the outcome of the political process (i.e., those who under the nave theory would support the rule of law), the outcome of the interactions of many actors may be very inefficient because the political environment is a public good (or public bad). We show that a weak constituency for the rule of law may be self-perpetuating.
In Section 2, we solve the model for a numerical example and illustrate the stark implications that the mechanism studied in the paper can have for growth. Economists are well attuned to analyzing group behavior that is inconsistent with what would be in Page 5 the interests of each and all if they could act cooperatively. We provide a setting of interactions between economic and political decisions that illustrates this failure dramatically. We thus show that the argument that mass privatization always leads to a demand for a wealth-maximizing legal regime is not correct.5
In Sections 3 and 4, we consider the assumptions of our model in more detail and use the model to address three policy questions One concerns the sequencing of privatization of large state enterprises and regulation of corporate governance. We show that whether or not privatization first, as rapidly as possible, is superior to the strategy of regulation of corporate governance first depends on the magnitude of certain behavioral parameters. As a second example, we consider macroeconomic stabilization policy to address the inflation that accompanied price decontrol. We ask: what is the effect of high interest rates on the size of the constituency for the rule of law? We show that at high interest rates, the relative returns to stripping assets and opposing the establishment of the rule of law may both rise; thus, a too stringent macroeconomic policy can undermine the constituency for legal reform. As a third example, we consider the liberalization of international capital flows. When capital flight is easier, the relative return to stripping assets will rise and the constituency for the rule of law will fall. In the concluding section of the paper, we consider the problem highlighted in our Page 6 model in a broader context. The issue is how, when the legitimacy of the distribution of property rights is contested, a society can establish a foundation for building the rule of law. The various forms that privatization took represented alternative ways of assigning private property rights at the beginning of the...
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