From plan to markets

Journal of Economic Behavior & Organization Vol. 34 (1998) 49±68

From plan to markets Gunnar Eliasson* Department of Industrial Economics and Organization, The Royal Inst. of Technology (KTH), 100-44 Stockholm, Sweden Received 8 August 1994; accepted 18 May 1997

Abstract While formerly planned economies lack critical institutions, ailing welfare economies have too many, reducing investment incentives in both. While institutional redesign is urgent in the formerly planned economies, there is no instant concern in the West, where institutional change must be realized through reluctant democratic procedures. Some formerly planned economies, therefore, are likely to improve upon the West in institutional design and experience superior long-run economic growth. They explicitly link investment incentives one way to property rights and the other to investment and growth, to demonstrate how such superior performance can be achieved. # 1998 Elsevier Science B.V. JEL classi®cation: D23; K1; P21 Keywords: Enabling law; Institutional design; Political risk premium; Political lock-in; Property rights; Tradability of ®nancial contracts; Transition economies; Welfare economy

1. Introduction1 Privatizing public sectors in welfare economies and turning formerly planned economies into market economies raise principally the same property rights problems, but call for different remedies. While the formerly planned economies lack critical * Corresponding author. 1 This paper draws together several related ideas of mine on the critical role of financial property rights (Eliasson, 1993a), the difficulties of realizing complex change that few understand and some stand to lose from through democratic procedure (Eliasson, 1986, 1993a, 1994a), and the complex institutional fabric that links property rights through investment incentives and competition to economic growth (Eliasson, 1993c, 1996b, 1994b). The investment growth linkages draw directly on the notion of an experimentally organized economy, as represented in the Swedish micro-to-macro model (Eliasson, 1977, 1991a). 0167-2681/98/$19.00 # 1998 Elsevier Science B.V. All rights reserved PII S 0 1 6 7 - 2 6 8 1 ( 9 7 ) 0 0 0 5 1 - 6

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property rights supporting institutions and suffer from political opportunitism and negative investment incentives, the welfare economies, notably the European ones, have too many institutions restricting efficient market behavior. Such restrictions have often been instituted to enforce political income and wealth distributional ambitions. Transforming a formerly planned economy into a market economy involves three stages: (1) getting the contracts right (`incorporation'), (2) spreading ownership (privatization) and, finally, and most important (3) establishing dynamically competitive markets, or opening up markets to free competitive entry. The first stage gets the institutions right. The second is critical, since it introduces a market for the allocation of resource competence and corporate control (Pelikan, 1989). The last stage is what executes real change and hurts socially during the adjustment. In both the transition and the mature welfare economies there is agreement about the need for incorporating and privatizing state-run production. In the mature welfare economies, returning significant production to market competition may be sufficient, and it also redistributes some ownership back to the market. Consensus on the need to allow and support competition and the `creative destruction' of inferior producers through appropriate institutional change is, however, not at all apparent from privatizing practice. In both cases, furthermore, the needed institutional change cannot be brought about over night, but only through historic evolution. Lack of understanding of the dynamic interaction of institutions, markets and economic growth prevents the explicit design of reliable policy. Two instruments can speed up the needed institutional evolution: enabling law and insurance for local political opportunism. To return ailing welfare economies to a competitive market system organization is most difficult. The formerly planned economies are motivated by urgent circumstances. Even though the Western welfare economies have experienced a gradual decline in productivity and welfare, institutional change there has to be realized through a reluctant democratic procedure, and the adjustment is likely to affect significant parts of the voting population in ways they have great difficulties of understanding. One hypothesis proposed, therefore, is that one or more of the couple of dozen formerly planned economies are likely to improve upon the West in institutional design and in a generation or two become wealthier (per capita) than the average industrial welfare nation. This proposition is no more radical than to have suggested some 15 years ago that the Swedish economy (then the third wealthiest among the OECD economies) because of an inferior institutional design would drop below the OECD average by 1997. This is what has now happened. This paper discusses the links between property rights institutions, market competition and economic growth through the six blocks in Fig. 1. I will proceed in the following order. First, I discuss how property rights are supported by particular clusters of institutions and how these institutions affect investment incentives (left part of Fig. 1). This discussion is particularly concerned with the uncertainty affecting the investment decision, notably political uncertainty. I then (second) go on to establish the right-hand link in terms of four investment categories that constitute the mechanisms of growth. These four investment categories (third) are then linked to the incentives of the previous section that relate back to property rights through the complex of supporting institutions identified (see Table 3). To establish the growth conditions the role of competition has

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Fig. 1. The links between property rights, investment incentives and economic growth.

also to be identified. I then (fourth) discuss the critical institutions that influence investment incentives negatively in the formerly planned economies, namely, political uncertainty (opportunism) associated with the credibility of institutions. This analysis is supported by case descriptions. To minimize such uncertainty credible rules have to be designed to convert political uncertainty into risks tradable in specialist markets for risks and/or the political uncertainty has to be carried by a third party. Finally (fifth), I draw a parallel to similar institutional problems among the rich welfare economies of Europe, notably Sweden. Altogether, the analysis demonstrates the formidable complexity that faces any group of politicians attempting to force a radical change through a democratic political procedure in a formal and informal rule system that has evolved historically, to establish the needed institutional links that integrate the blocks in Fig. 1. The invisible hands of evolution have to be called in. I discuss these solutions in terms of enabling law and political insurance. 2. The institutions supporting growth of a market economy Tradability in markets requires that ownership to the commodities traded can be ascertained. The importance of well-defined property rights for the functioning of a market economy was observed and discussed in great detail already by John Commons (1893),Commons (1934). North and Thomas (1970),North and Thomas (1973),North (1990) describe how the minimal property rights institutions necessary for viable market transactions had been more or less established in Europe and North America by the early eighteenth century to support the market-based industrial revolution. North and Thomas also demonstrated that the establishment of these institutions was not done overnight through quick legislative action, but rather took place through an experience-based evolution. The rule system that makes up these institutions, furthermore, is much more than formal rules. What matters are the interpretative structure of legal rules, conventions, market ethics and the means of enforcement of voluntary contracts. From this historical experience can be inferred the essential institutional pre-requisites for a decentralized market economy based on private voluntary exchange and enterprise. 2.1. The critical role of trade in financial contracts Economic growth is realized through investment. Investment incentives are all embodied in the present value of resource commitments today. The most difficult

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commodity for which to establish well-defined property rights and tradability, therefore, is the ownership to future profits from a resource commitment today. Such property rights are the foundation of financial markets, notably the stock market, but also patents and copyrights belong to this category. Financial markets are based on more complex property rights than tangible goods and, therefore, took much longer to be established. Such markets have become fully operational only in the last few decades, notably in international financial markets and North America. The establishment of financial markets has traditionally been seen as a means of pooling large amounts of resources for concentrated uses to fund large-scale investment projects. Ashton (1948), therefore, gave the early rudimentary forms of stockmarkets an important explanatory role in the industrial revolution. But finance is much more than cash flow. The price has to be right, and capital contributions without embodied supplementary competence contributions are of limited importance as incentives for investment. As pointed out by Pelikan (1989), financial markets also serve the important long-term role in advanced industrial economies of allocating competence by affecting the appropriability of future rents from innovative activity. This allocation, hence, depends on the long-term confidence in the rule system, and the conditions for establishing tradability in the risks that influence the trade values of the property rights (the risk premium). The risk premium (we will show) depends on the credibility of the institutions supporting property rights. 2.2. The optimal minimal set of rules We observe that the formerly planned economies of the former Soviet Union lack essential elements of the property rights that are necessary for the functioning of a market economy. On the other hand, we also observe that most Western so-called market economies have far too many institutions that restrict the existing property rights and limit the efficiency of the market institutions supporting trade, notably associated with the ambitions of the welfare state to redistribute income and wealth. This allows us to make three conclusions. First, there exists an optimal, minimal set of institutions that directs the evolution of explicit and implicit rules that support the long-term `maximization' of sustainable economic growth. A critical task of the politicians of the formerly planned economies is to establish such a minimal set as quickly as possible. But there is also (second) a large brushwood of institutions established in the Western market economies that reduces the maximum sustainable growth rate. Some of them are mandatory rules, instituted to thwart market allocation to serve other political ends than economic growth, that agents would not voluntarily support, notably distributional goals. Because of the complexity of the policy problem, and the lack of reliable guidance from economic theory a large part of these mandatory rules may not even support distributional goals, but nevertheless reduce growth and often redistribute income in not intended ways (interest groups, privileges). An important task of Western politicians, therefore, is to understand the workings of this institutional machinery and find ways of reducing redundant institutions with negative economic and social effects. We argue that this second pruning of institutions to increase efficiency is more difficult than to develop the required minimum set of institutions. Interest groups block radical and rational change through the

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Table 1 Institutions supporting property rights Right to 1. Manage

Institutions supporting ± Existence of the firm ± Reorganization of the firm ± Operation of the firm

2. Access profits

± Third person rights ± Market conditions ± Exchange regulations

3. Trade

± ± ± ±

Credibility of rules Identification of property right Court recognition Enforcement

Source: Modified version of Table 1 in Eliasson (1996b).

democratic process, very much as Bloc (1966) observed in his study of the organization of agricultural production on the high plateau in medieval Spain. Therefore (third) some of the formerly planned economies are likely to develop a significantly better set of institutions than Western market economies have developed, that will allow them to experience superior (to the mature welfare economies) long-run growth performance. 2.3. Property: a set of identifiable, recognized and enforceable rights Property is defined by the rights to control the use of a commodity or an asset. There are three fundamental rights (Table 1): the right to manage, to access the rent from, and to trade in the assets. The presentation to follow will be equally valid for goods and assets, but it will be carried on in terms that relate to assets and asset markets. Each of these rights are supported by a set of institutions, a rough grouping of which is shown in Table 1. A first cluster of rules establish and support the right of the firm to exist in the financial market as an autonomous decision entity. This right (second) is restricted by the rules of the markets for control, and controlled (managed) by the owners that govern the reorganization of the firm. The third set of operations rules delimits the operational latitude of firm management. Operations control obviously applies to the labor market and employment rules etc., even though we do not discuss this further here. Such autonomy in the market was at variance with the resource assignment methods of the centrally planned economy and consequently did not exist in the former Soviet Union, except as not active legal rudiments of the pre-Soviet era. Access to rents is determined by three factors: third person access rights, market conditions and exchange restrictions. Three sets of legal provisions determine those rights: tax law, bankruptcy rules and exchange controls influencing transactions across different currency regions (see Table 3). Trade and tradability of assets critically depend on the rules and conventions supporting the other rights, plus rules that directly regulate trade in assets. Such rights can be generally expressed in terms of identification, recognition and enforcement.

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Table 2 The four mechanisms of economic growth 1. 2. 3. 4.

Entry Reorganization Rationalization Exit (shut down)

Source: Eliasson (1993b), (1994b).

3. Competition and the mechanisms of economic growth The ultimate objective of this analysis is to establish a connection between property rights, via incentives to invest, and economic growth. This section links investment to economic growth and introduces competition through innovative entry as a critical moving force. 3.1. The four investment mechanisms of economic growth Economic growth can be shown (Eliasson, 1994b, 1996a, p. 45) to occur through four investment mechanisms (Table 2): entry, reorganization, rationalization and exit.2 This simplification does not explicitly recognize that reorganization of firms (item 2 in Table 2) also occurs across firm boundaries, through entry and exit in the markets for control, bits and pieces of firms reconfiguring to form a new firm. For our explanatory purposes the above simplification will, however, serve as a satisfactory approximation. Innovative business solutions are the mover of the growth process. For these to occur the competence and incentives to engineer them will have to be present. Incentives are, in turn, defined by the possibilities of capturing the rents from innovative activity, which is a property rights problem. An extreme case is the prohibition of free innovative entry, which was universally the case in pre-industrial societies under, for instance, the craft system. It is still the case in many underdeveloped economies, and in the public sectors of Western welfare economies which in many cases employ as much as one-third of the labor force, and control or regulate a much larger share of total resource flows, in Sweden almost 70 percent. This is why a formerly planned economy and a European welfare economy share a common principal `transition problem' even though the solutions have to be different. Economic growth cannot, however, take place in a closed system where free innovative activity, notably through the establishment of new firms, is not permitted and/or the possibilities of capturing the rents from the same innovative activities are severely restricted.

2 This taxonomy builds on the existence of stable decision units (`firms'), including not yet existing ones (entry) as elementary `particles' of economic growth, as is the case in the Swedish micro-to-macro model. It can be demonstrated (with this model) that differences in the empirical specification of the four investment mechanisms (signifying differences in market dynamics) are capable of generating very large differences in historic growth patterns of the same order of magnitude as those by which long-term growth rates between industrial economies have differed in the past (Eliasson, 1991a).

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3.2. Free competitive entry forces change on incumbent actors If any actor is free to enter the market and compete with incumbents through entry, reorganization or rationalization no incumbent actor will ever be safe. Superior actors threaten inferior actors, but superior actors have to reckon with the possibility that inferior actors will leapfrog and challenge them through innovation. The capitalist market regime, making it a virtue to kill your inferior neighbor economically is an unusual social order that requires very sophisticated institutions to support. So formulated the growth mechanisms of the economy are set in motion through innovative, competitive activity under items 1 (in particular), 2 and 3 in Table 2 that exert competitive pressure on incumbent firms to improve through reorganization or rationalization (items 2 and 3) or to exit (item 4). Hence, without competition, moved by innovative activity, there will be no economic growth. One of the big problems of the formerly planned economies, besides the lack of critical institutions, is the existence of a large group of incumbent producers, incompetent by Western standards, that will be rapidly forced out of business if markets are opened up for free competitive entry. The political system in any country has difficulties accepting such `creative destruction.' While innovative entry generates macroeconomic effects in the long run and requires low discount rates to be viable, reorganization and rationalization represent fast responses to competitive pressure. Economic growth will, therefore, involve the entire economy. Reallocation of resources will force reorganization of production structures and affect income and wealth distributions. Such change is already radical and rapid in the formerly planned economies, and will be in Western European economies, whenever their planned or regulated (read protected) sectors are opened up. Change is then likely to be resisted by those who will not benefit or do not understand that they will benefit. 4. Institutions, the structure of political risks, investment incentives and growth Next, we link the various dimensions of property rights via the necessary institutions to the four growth mechanisms of Table 2. This is the most difficult part of analysis. Many rules support more than one of the rights defining property, and thus influence incentives operating on more than one investment category. 4.1. Property rights and investment incentives Table 3 sorts the elements of the rule system to establish links between property rights, on the one hand, and investment incentives or the four growth mechanisms (Table 2), on the other. The table highlights the complexity of the linkages and also brings home the main thrust of the analysis; one further step in detailing the rule system ± which legislators frequently take ± and the policy maker will be at a loss about what he is doing. Complexity is such that no one can claim to have even the semblance of intellectual control of all the relationships that integrate the boxes of Fig. 1 from the very left to the very right. Manipulating the details of the rule system in order to achieve certain end policy goals should be expected to worsen the situation more frequently than to improve it. The development of such rules, to serve the end purpose well, will thus have to be slow

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Table 3 Linking property rights through invested incentives to economic growth Property rights Right to 1. Manage

Supporting institutions

Influencing; (see Table 2)

Existence of firm ± Establishment law ± Company law

Entry

Reorganization of firm ± Corporate governance reorganization ± Takeovers, mergers ± Acquisitions Operations ± Monitoring and control ± Labor relations ± Environment rationalization ± Liability and tort law ± Allocating and auditing law ± Reporting 2. Access profits

Reorganization

Rationalization

Market conditions ± Competition (antitrust etc.) ± Patents ± Price controls ± Credit controls Third person access ± Tax law ± Inheritance conditions Exchange controls ± Insider trading ± Bankruptcy law

3. Trade

Guarantee of law ± Constitutional property rights

Exit/Entry

Identification of rights ± Registration ± Rules for identification with person Court recognition of voluntary contracts ± Procedures ± Choice of jurisprudence Enforcement of contracts ± Procedure ± Litigation ± Resolution of conflict Restrictions of trade

and experimental, and be corrected along the way. Above all, it is not an intellectually explicit process. The evolution followed will mean an institutional and political lock-in on a path that the economy can normally only leave through further evolution. It is

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therefore critical for the formerly planned economies to organize the institutions that determine their institutional evolution right. Since the formerly planned economies are willing to scrap their existing institutional system entirely, they have a unique opportunity to organize themselves for a successful future, that mature democracies do not have, locked, as they are, into an historically determined system that can only be changed through explicit democratic procedure. I will discuss this initial core of rules below in terms of enabling law. Before, I discuss the political uncertainties that have to be reduced for sufficient incentives to invest to be created. The case descriptions to follow in the next section will illustrate. 4.2. How to make risks3 tradable? The elimination of political uncertainty, or its conversion into tradable, subjectively calculable risks is necessary for the intermediation of long-term financial commitments and the possibilities for owners to credibly believe that they can appropriate expected future rents. We can talk about institutions that remove political uncertainty from the risk premium and institutions that transform business uncertainty into tradable risk. This is not only a problem with the formerly planned economies but also with Western market economies. The institutions necessary to support long-term futures markets are not in place, and most democracies are incredible institutions when it comes to guaranteeing property rights, since incumbent politicians cannot bind future politicians to contractual commitments. Market actors take no longer risks than they expect policy makers to honor their institutional commitments. This is the critical problem in the formerly planned economies, but it is no minor problem in the West. Table 4 and the discussion in Section 6 explain why. Table 4 The risk hierarchy Political uncertainty 1. Force majeure ± referring to non-economic events (military intervention etc.) 2. Macro economic ± referring to uncontrollable macro development (run away inflation, collapse of monetary system etc.) 3. Opportunistic political behavior Business risks 4. Private opportunistic behavior of competitors 5. Pure business risks Source: Eliasson, Rybczynski, Wihlborg (1994).

3 We have a terminology problem here. Frank Knight's (1921) distinction between risk and uncertainty has been abandoned by `modern' economists, but it is necessary to understand the incentive problems facing investments in the formerly planned economies. By doing away with that distinction static general equilibrium theory and financial economics have managed to reduce uncertainty to calculable risks by assumption. This can only be done in the static world of complete markets, including the vacuous future markets of Debreu (1959), and of ex ante subjective probabilities of Arrow (1965). In a context like this and in most interesting applications of financial economics such abstractions do not make sense.

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Table 4 distinguishes between two types of risks. Even though the border lines are not clear, market actors constantly have to decide whether they are facing true, unpredictable uncertainty associated with political risks or a calculable business risk. The diversity of attitudes and competencies of the business community means that the borderline will be floating. Many firm managers think they can assess also political risks and factor them in under their risk premium in the discount rate they use to decide on investment projects. But it must be obvious that if business managers spend too much time learning to cope with political risks or, worse, if they earn their profits from such activities, the economy cannot be very efficiently organized. Force majeure factors usually freeze long-time commitments in any economy. Macroeconomic uncertainties do the same if there are no ways to hedge. Even though they are very important we do not discuss these matters here. Our focus is on opportunistic political behavior (item 3 in Table 4), and on how the business uncertainties associated with such behavior can be removed or transformed to calculable business risks. This analysis can be directly conducted in terms of the institutions of Table 3.

5. From plan to market ± implications for the formerly planned economies The formerly planned economies lacked, and still lack critical property rights, notably making opportunistic political behavior possible. The consequent political uncertainty generally reduces incentives to invest long term. I clarify the nature of this uncertainty, illustrate with cases and then discuss how political uncertainty can be reduced and private incentives to invest long term increased. 5.1. Institutional inconsistencies and complexity A number of inconsistencies and lack of relevant institutions make the formerly planned economy a judicial nightmare. The complexities involved can be sorted out in terms of Table 3. First, the institutional rule system of Table 3, governing management access to profits and the conditions for asset trading in the formerly planned economy, consists of a mixture of old rules, designed for a different, planned economic organization, the absence of fundamental rules and newly introduced rules. These different rule systems often conflict (as both cases from the formerly planned economies will illustrate) and uncertainty arises as to which combination of rules that will determine the legal outcome. Second, the complex of explicit and implicit code (law and conventions) that coordinates a market economy is immense. Only a fraction of the needed rules can be formulated explicitly. The rest has to develop through precedent `in the market.' Even if Western law is adopted the legal expertise to implement it may be lacking. Hence, it is impossible for an East European country to institute it all in the short time needed to get the economy moving. In addition, old rules still in force work against the desired objectives.

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All Western legislative practice rests on a vast structure of procedures relating to the implementation, interpretation and enforcement of coded law and precedent. Investors in transition economies face political risks even when written law exists, because predictable interpretation and enforcement practices have not had time to develop. In addition, law tends to be changed frequently, sometimes from day to day. An important source of political uncertainty refers to unclear definitions of what is allowed and not allowed. The legal system of Western market economies is normally negative. What is not explicitly forbidden in law is permitted. In the socialist economies prohibition was instead general. Economic actions not explicitly listed in law should be thought of as forbidden. Under the new regime the situation has been turned upside down. `Anything is allowed' creates a different type of uncertainty. Another source of business uncertainty in the formerly planned economies is that the socialist legal system has not been generally abolished. Old laws are often allowed to remain in effect until new laws have been explicitly introduced, and longer. Similarly, administrative procedures granting licenses have remained. Thus, vested interests have been able to prevent new ventures by means of, for example, permit-requirements. New and old law may also be conflicting. The first thing a Western observer learns when looking into the East European economic problem concerns the institutional design of his own so-called market economy, above all the tangle of rules, regulations and legal code, that does not appear to serve any desired, pronounced or imaginable purpose, and the fact that much of such redundant code may hinder economic growth. Observing this at home, one should be very cautious when advising the formerly planned economies on the design of the necessary market institutions, especially about the danger of overly detailed mandatory law, increasing the probability of faulty specification and the rigidity of institutions, once legislated, hindering their necessary, constant adaptation to new circumstances through interpretation and evolution. The case of Grand Hotel Europe in St. Petersburg illustrates the complex problems involved, and how arbitrary choices of law by Russian courts wiped out access to generated profits and reduced tradability, turning the business into a loss investment for the foreign investors. 5.2. CASE 1: Grand Hotel Europe, St. Petersburg4 In 1988 a group headed by Reso International Hotels and SIAB, both of Sweden, teamed up to restore the old Hotel Europeijskaja in St. Petersburg to a luxury hotel of international standards. 600 million SEK ($85 million) were invested and the hotel began to operate in December 1991 about the time the Soviet Union collapsed as a centralized political system. The first year was a success with 92 percent capacity utilization, very high by any standard. During the first year, the hotel had a problem with managing its cash flow. There was no banking service in St. Petersburg and the hotel was granted informal permission from Moscow to run its accounts through Nordbanken in Stockholm. In March 1993 banking service had been established in St. Petersburg and the hotel moved its banking services 4

Sources are Dagens Industri, Sept. 15, 1993, p. 17, Aug. 17, 1994, p. 12, and interviews.

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back to St. Petersburg. The same year (1993) in June, however, the new tax police in Russia was created. It claimed that it had been illegal to use a foreign bank and ordered the hotel to pay $24 million on the transactions accumulated through the Stockholm account. This case was still pending at the time this account was written. If the hotel is ordered by court to pay, it will go bankrupt and the investors will lose their money on account of an arbitrary (opportunistic) reinterpretation of rules. Since the case has not been cleared the value and ownership of assets cannot be determined. Thus, the Swedish investors have had difficulties selling their assets and recapturing their investment.5 Expecting such legal trouble is synonymous to eliminating the private incentives to invest. Problems like those of Grand Hotel Europe are compounded by the almost daily change of laws in the former Soviet Union, the uninhibited use of retroactive taxation, unclear rules of who should pay and which institution should receive payment, and the infighting between local and federal tax authorities on who should receive the tax payments.6 Under such risky circumstances any investment evaluation will heavily discount future profits, rendering most long-term investments unprofitable. The second case of Talleks, an Estonian producer of small trucks and earth moving equipment, illustrates another side of opportunistic interpretation of conflicting legal code; a legal process by interest groups that ran absolutely counter to the longterm interests of Estonia. The Talleks case was eventually resolved in a constructive way, but by recourse to special law that cleared the privatization as originally intended; a legal procedure that was not ideal by Western democratic procedural standards, which could have been avoided by cleverly drafted enabling law as elaborated in the next section. 5.3. CASE 2: Talleks, Estonia7 In December 1991, the President of the Supreme Court in Estonia allowed the Government to privatize seven industrial enterprises. Talleks, a producer of small trucks and earth-moving equipment, was one of them. Two joint stock companies made bids on Talleks, both representing employees of Talleks. The group presenting the most modern business plan won the bid and began negotiating with the State Property Department (SPD) about how to realize the privatization. The other group, however, led by the former managing director filed a protest with the Prime Minister. It did so despite the fact that it had only offered one-tenth of the winning bid for Talleks and had tried all kinds of backstage political maneuvering to win the case. The Prime Minister decided that the decision of the SPD had been correct. The new owner group began to invest in the firm. The earlier managing director, however, sued both the SPD and the Ministry of Industry, arguing that both the procedure and the implementation of the principles of the 5 After a drawn-out period of negotiations the 30 percent share in the hotel held by Reso and SIAB was acquired in September 1995 by Dresdner Bank and the Kempinski Hotel chain. The price for the 30 percent share was SEK 26 million (Dagens Industri, Sept. 18, 1995, p. 12). 6 One example was (The Wall Street Journal, April 20, 1994, p. A16) a suggested tax law that would allow tax inspectors to levy a tax of up to 23 percent on foreign loans to enterprises in Russia. 7 From Kukk (1993).

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Property Reform Act had been violated. A new Government was now in charge. The parliament had amended the contested paragraph of the implementation act. It was also revealed that the former director of Talleks was backed by influential circles of Estonian Society not willing to lose their positions during privatization. Government, however, explained to the court that the privatization of Talleks was according to law. The Tallin City Court, nevertheless, (in September 1992) declared the purchase invalid. The new owner then appealed to the Supreme Court, which supported the Tallin City Court. This whole outcome rested on inconsistencies in the new law, even if the practice was in accordance with Government intentions. Seven other privatization cases were, therefore, also at stake, and several companies had made significant investments on the basis of the granted privatization. Important principles were at stake. Then, the Vice Chairman of the Supreme Court demanded that the President of the Supreme Court consider the case again. In January 1993, the President declared that the privatization had been legally correct. The former director now turned to the Chairman of the New Constitutional Highest Court, the National Court and protested the privatization deal, this time citing formal inaccuracies of procedure contradicting civil code. The privatization of Talleks was once again declared illegal on May 12, 1993, this time by the National Court. This time (on May 14, 1993), however, the Prime Minister acted, accusing the former nomenclature of hindering privatization efforts, and proceeded to initiate a special law to privatize Talleks as already decided. Parliament approved the law on June 16, 1993, and decided that in determining the final price for acquiring Talleks the costs and losses associated with the long law suit would be taken into account. 5.4. The need to minimize political uncertainty The picture that emerges from the previous analysis and the two cases is that the institutional foundation of a market economy is an immensely complicated and historically determined heritage over which no one has more than partial intellectual control. To organize the incentives necessary to stimulate long-term investment, the formerly planned economies need a new complex of institutions that minimizes the political uncertainties associated with lack of, or arbitrary interpretation of rules. This is synonymous to removing these uncertainties or establishing conditions to make such risks predictable, calculable and tradable. We have demonstrated that the complications associated with that task are overwhelming. The design of the new system is beyond intellectual control from anyone central point. And social science offers no reliable guidance. All actors in the economy, including government advisors and policy makers facing such a task are boundedly rational. Any considered change, furthermore, will be fraught with inconsistent vested interests that will push for, or resist particular change. With little hope that informed politicians will come up with a satisfactory institutional fix by way of democratic procedure, the desired institutional solution will have to evolve endogenously. The capacity of the political system both to wait and design the initial, minimal seed rules to direct the evolutionary process becomes crucial. If the political and social patience to sustain this wait is lacking, there is cause for concern. The economy may never make the transformation.

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From that basically pessimistic standpoint I discuss two ways of speeding up the evolutionary development of necessary institutions: enabling law (Wihlborg, 1996) and political insurance. The insurance solution has been formulated (Eliasson, 1993d) in recognition of the fact that the formerly planned economies may never make the transformation within a socially acceptable time without the support of large-scale, longterm foreign investments (Eliasson et al., 1994), and that it is in the interest of the rich Western nations to support an orderly such transformation. 5.5. Enabling law Excepting a full-scale implementation of an already existing institutional system, including all legal code, regulations, interpretations and enforcement practices (as in Eastern Germany), a complete institutional system on the mode of a Western industrial economy cannot be instituted within the timeframe allowed in the formerly planned economies. Some new intermediate institutional device is needed. One option is enabling law (Eliasson et al., 1994, Wihlborg, 1996), designed to direct a speeded-up evolution of an informal and formal common law. Enabling law has two dimensions: a constitutional part that specifies a few dominant and mandatory principles, by which voluntarily contracted agreements are interpreted (in case of disagreement) and precedent developed and the legal latitude for customized, voluntary agreements (as distinct from mandatory law) allowed. Enabling law, therefore, follows the central idea of the US constitution where Government can only exercise powers explicitly stated, and everything else is the free right of the individual. It should be noted that the opposite situation ruled in the former Soviet Union, where everything not explicitly listed as free was in principle forbidden for the individual. European legal tradition has ranged in between, some countries, for instance Sweden, showing tendencies to develop a judicial tradition of `unlimited Government political discretion.' In our particular case, I will see enabling law as a provisional set of explicit and implicit code to make the market economy workable until the needed institutional framework has developed through precedent. Very little explicit constitutional and dominant code may be needed. The foundation is a bill of rights8 that frees a business activity from restrictions and enables law and precedent needed to stimulate growth to develop rapidly. All law, especially pre-existing law that contradicts this bill of rights, excluding specially listed exceptions are considered inapplicable. Exceptions should also be limited by dominant principles. For example, doing harm to a third person should be limited in certain well-defined ways, but these limitations have to exclude economic damage to third parties and their indirect effects on individuals caused by competition. Competition (by definition) means causing economic damage to competitors. On the other hand, collusion among private agents to limit competition is also harmful to other competitors and consumers. Such private opportunistic behavior should of course be ruled out (see Table 4). Enabling law has the advantage of speeding up the legal process, and preventing bureaucratic use of old law to slow it down. If old law that contradicts the new enabling 8 An example would be the unlimited right to start a company, provided it is registered, excepting a small number of explicitly listed exceptions where particular licenses are required, for example, in surgery.

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laws supports particular regulations or protects interest groups, parties who want to see them remain in force or secure exemptions have to explicitly argue their case, following democratic procedure. This means that restrictive rules have to be explicitly passed through the political process to be valid. One further advantage is that enabling law can be made effective before the exceptions. Another advantage of enabling law is that it allows stakeholders in corporations to develop arrangements as circumstances change. Mandatory rules, on the other hand, imply one `standard form contract' as mandatory. All rules can be classified on a scale between the extremes, since even highly flexible, enabling rules must have some mandatory component. Enabling law should, hence, be seen as a set of guidelines designed to facilitate the interpretation of remaining old law9 and new minimal code in the interest, for instance, of economic growth. Such enabling law will then automatically (through its guided interpretation) make existing law that is detrimental to economic growth inapplicable, and enabling law could be explicitly written to achieve that result. This particular design may sound outrageous to the traditional legal expert of the West. It represents, however, a convenient, speedy and democratic way to achieve the desired results. And this opportunity not only avoids the risk of writing (however carefully done and however long it takes) redundant and inflexible code that will soon tie down growth promoting market activity. It also creates an opportunity for the East to significantly improve upon the West in institutional design. Clearly the Talleks case would not have arisen under an appropriate set of enabling legal code. 5.6. Insurance for political opportunism Since it would not be possible, in general, to implant an entirely new legal system to protect property rights the solution will have to combine (1) a Western financial insurance coverage for political uncertainties (opportunistic political behavior) taken on by firms with (2) strong incentives, directly linked to this support to allow the necessary legal framework to develop. Enabling law is one vehicle to achieve this. An insurance arrangement (as that suggested in Eliasson, 1993d) based on Western government aid to the formerly planned economies is another. Such aid could be in the form of a guaranteed insurance against their own opportunistic political behavior, covering the investing Western companies, in particular, but also new incumbent investors. The total political uncertainty in each country is calculated, and Western governments underwrite that uncertainty against arbitrary political violations of the basic property rights, notably risks identified as group 3 in Table 4. The capital needed to cover these risks is made available and invested in foreign markets. It can only be used to reimburse private investors for political risks. Whatever remains after a very long period (say 50 years) should be

9 A similar suggestion was made for Sweden in Andersson et al., 1993, arguing that it would be politically impossible to remove the tangle of legal structure, inserted all over that hinders innovative competitive entry and small business. A general instruction about how existing legal structures should be interpreted and not interpreted would be a faster solution.

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guaranteed (by contract) to be made available to the formerly planned economy. The incentive will then be strong to move fast in creating an efficient property rights system. The problem will be to define operationally the limiting line between business risks in Table 3 to be covered by the firm and the political uncertainty for which Western governments extend aid to the formerly planned economies. To do this ahead of the development of rules and conventions through enabling law, an extensive and imaginative interview study of the experiences of firms in similar circumstances would have to be carried out. It is not necessary to restrict oneself to the recent experience in formerly planned economies. A large reservoir of similar experience exists in the developing countries and most of the heavily regulated parts of Western industrial nations. Such an inquiry would, in fact, be very valuable to the Western industrial world. Both the Grand Hotel Europe and the Talleks cases could have been handled by such an insurance arrangement. 6. Returning to the market ± Implications for market reforms in mature welfare economies Compared to the problems of formerly planned economies the difficulties of institutional reform in the West appears small. But this is a problem in itself, since the lack of urgency may reduce the political will to enact change which causes unpredictable distributional consequences. One reason is that a majority of the voting population in some mature welfare economies, in one way or the other relies on the state for significant parts of its livelihood. To understand the lack of investment incentives in the mature and political welfare economies one has to look at other parts of Table 3. Three areas in particular stand out: (1) restrictions in property rights enacted to achieve income and wealth redistribution, (2) legislation and practices that favor large business and other organizations (notably unions) compared to small businesses, self-employed and individuals, typical of socialist economies, and (3) attempts to socialize production through direct legislation or union controlled wage earners' funds. 6.1. Egalitarian ambitions restrict property rights A well-organized market economy would probably to some extent support limited income and wealth redistribution in favor of the poor, since people would be willing to pay as they do not want to see the worst excesses of poverty in their neighborhoods. Charity is one case, and voluntary arrangements in work places another. Many European economies, however, have moved far beyond this voluntary acceptance of redistributional arrangements in two ways. They have (1) redefined what people pay for voluntarily as a `right' and enacted that right as mandatory law and (2) pushed political ambitions beyond what people would voluntarily pay for. To achieve that mandatory law is needed and encroaches on property rights. Tax law (see Table 3) is the most well-known example, but law regulating labor relations include many mandatory provisions that were enacted to enforce income redistribution goals. Very high tax rates, asymmetric taxes and taxes and rules restricting the management and tradability of assets have long been recognized as

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distorting the market information system through `tax wedges,' and the allocation of capital with negative growth consequences (see e.g. Jorgenson and Landau, 1993). 6.2. Legal standardization to prevent the exploitation of individual opportunities Mandatory standardization of contracts is a method to achieve not only economies of scale in certain types of production, but also a sophisticated means of reducing the potential gains from individual opportunistic behavior. If mandatory law favors people with standard employment contracts, union practices and power benefit and those industries that fit this standard employment benefit as well. On the other hand, such law and legal practices reduce the gains to be captured from small scale and individual entrepreneurship. Instead of making it illegal, as in the former Soviet Union, some Western welfare economies have formulated laws to (Table 3) make incorporation and new establishment and operations difficult and expensive, reduced access to profits through tax laws and limited rights to trade such that small-scale voluntary contracting outside the standard contract designed for the large corporations becomes excessively risky and costly to get recognized in case of disagreement. Political/legal discrimination in favor of large corporations to achieve soft control was practiced in Sweden throughout the 1950s and the 1960s and probably has contributed to an excessive concentration of Swedish manufacturing industry to large firms in traditional mechanical engineering industry (Glete, 1996), with probable negative consequences in the future. Bray (1982) has discussed such industrial policy making through large firms in positive terms, and the idea of central planning in France, as theoretically presented by Malinvaud (1967) can only be approximated through a small group of very large firms. British nationalization and denationalization policies that moved firms in and out of public management for decades in the post-war period could only have negative consequences for the economy. 6.3. The wage earners' funds The worst stab at the critical core of the capitalist economic machinery, however, was the wage earners' funds pushed by the unions in many Western countries during the 1970s, that was for sometime even accepted as socially and politically inevitable by a large part of the Swedish population. Sweden was the only advanced industrial nation that pushed wage earners' funds as a means to assume power through ownership in the large firms. While other countries restricted their ambitions to public or union representation on the boards, or profit sharing arrangements, the Swedish attempt was to tax profits in the large firms, to transfer the money to wage earners' funds, controlled by the unions that were then to buy shares in the large firms. This socialization scheme came dangerously close to being enacted as planned by law (Meyersson, 1985). The wage earners' funds in Sweden were deliberately conceived as a legal device, democratically decided as mandatory law, to socialize production through the market and confer a dominant power to unions. To fully comprehend the danger to the market system of such an arrangement an analysis of the kind presented here was necessary. Unfortunately, the very few economists who touched upon a subject matter of this kind during the 1970s were not read by economists at large and rarely surfaced in the political

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economic debate.10 For contrast, it is illustrative to discuss the market alternative to the union controlled wage earners' funds, a device that instead confers discretionary political power back to the individuals, namely, the Citizens' Wealth Accounts (see Andersson et al., 1993, and Eliasson, 1976, Eliasson, 1994c, Rehn, 1983). All welfare economies provide their citizens with a range of welfare services. Those welfare services are a mixture of distributional benefits (horizontal redistribution) and a return to socialized saving (vertical redistribution). The bulk has to do with redistribution of saving and insurance promises over the life cycle of the individual. The Government pays when you study (you do not have to borrow) and provides you with health, employment and other forms of insurance when you work, and a pension when you retire. You allow the Government to take responsibility for your most basic private and family responsibilities and to charge a high tax on your income for the services provided. In addition, central and local Government take control over a large part of the total resource flow in the economy, in Sweden currently some 70 percent of the total. However, in Sweden only some 10 percent, and at most 20 percent of taxes, are effectively devoted to redistributing lifetime disposable income horizontally. The rest is clear insurance and personal saving that can alternatively be left to the individual or the market to administer, especially if done through a system of citizens' wealth accounts. There is only one rational reason for not putting the entire life time reshuffling of wealth into an individualized insurance and savings arrangement, namely, the central power the current system confers to the central political system. Most of the tax wedges and the negative incentive effects would be removed if a voluntary system of individual wealth accounts were substituted for the current mandatory high tax system in most European countries. It would probably affect the distribution of income and wealth in an equalitarian way since economic growth would be stimulated and more wealth would be accumulated in the wealth accounts of ordinary individuals, rather than in the public sector. 7. Political lock-in ± a summary view Eastern European transformation has turned out to be a challenging intellectual problem in the intersection of economics and political, and legal science. The Western professions have also been fast to give advice on how transformation problems should be solved. These attempts, however, while probably not helping the formerly planned economies much, have carried the realization in the West that changing the Western welfare economies into competitive market economies, organized to cope with future market challenges is principally the same problem as that for the formerly planned economies, and far more difficult because the urgency to enact radical institutional change is lacking. The moral dilemma is how the advice prone Western professions could have silently witnessed how many of their own economies were gradually and politically 10 Pelikan (1986) has argued that the centralism embodied in the Walras±Arrow±Debreu model that all graduate students in economics in the West have had to exercise backwards and forwards in the post-war period has contributed to a centralist mind set of the economics profession, the bureaucracy and the politicians of the West, that made the elite unaware of the danger involved and close to accepting the wage earners' funds in Sweden.

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locked into a system of institutions that not only have negatively affected microeconomic performance, but also ± for many countries ± may be almost impossible to break out of.

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