GAAMA Governance.

Introduction

Implicit in the private sector success of commercially viable economies is a reflexive relationship between markets and firms. Markets provide multiples and liquidity that incentivize firms. Firms reciprocate by providing transparency and governance to comply with market commands. The end-condition of this process creates wealth. What self-respecting capital market consultant would deposit money in a zero interest savings account? Yet, this is what we asked the post-Soviet enterprises to do. The preceding papers of the symposium described "what," "where," "who," "when," and "how" to develop transitioning economies. GAAMA Governance focuses on the incentives of "why."

Joseph Stiglitz (1999) maintains that the "Washington Consensus" doctrine of transition failed in their understanding of the core elements of a market economy:

"Standard neoclassical theory argues that for a market economy to work well (to be Pareto efficient), there must be both competition and private property (the "Siamese twins" of efficient wealth creation). Both are required, ... The issue however, concerns choices: if one cannot have both, should one proceed with privatization alone? ... After all, it is easy to simply give away state assets ... Indeed, if privatization is conducted in ways that are widely viewed as illegitimate and in an environment that lacks the necessary institutional infrastructure, the longer-run prospects of a market economy may actually be undermined."

Markets want firms to state their corporate mission, disclose the results of their operation, and equitably apportion the residual commercial benefit to the corporate stakeholders. Markets also want to know that sound judgment exists relative to the custody of corporate assets that were entrusted to management and that these assets were deployed in a socially responsible manner. Firms, on the other hand, want to be rewarded for successful operations. They want to leverage their effort through debt and/or equity valuation multiples. Thereafter, at a time of their choosing, firm stakeholders want to be able to convert into cash any portion of the results of their operations through the orderly liquidation of their securities.

Path Dependence

Whenever any component of this reflexive relationship is missing, the relationship degenerates into a false construct that produces unintended consequences. Too often the capital markets of the post-Soviet successor states lacked valuation multiples and/or liquidity that resulted in the "Field of Dreams" fallacy--build it and they will come. This realization begs several questions. Were mistakes made relative to the initial condition of transitioning economies? Does the economy "lock-in" to these incorrect choices notwithstanding existing knowledge that these choices were incorrect? Path dependence argues that these lock-ins and errors occur, even in a world characterized by voluntary decisions and individually maximizing behavior.

In their paper entitled, "Path Dependence, Lock-In and History", S. J. Liebowitz and Stephen E. Margolis (1997) define three specific types of path dependence. They correctly warn that the three discrete forms of path dependence are often conflated in the literature. When different things are grouped together and treated as things that are similar, error is assured.

"There are three possible efficiency outcomes where a dynamic process exhibits sensitive dependence on initial conditions. First-degree path dependence are instances in which sensitivity to starting points exists, but with no implied inefficiency ... In second-degree path dependence, sensitive dependence on initial conditions leads to outcomes that are regrettable and costly to change. They are not, however, inefficient in any meaningful sense, given the assumed limitations on knowledge.... In third-degree path dependence, sensitive dependence on initial conditions leads to an outcome that is inefficient--but in this case the outcome is also "remediable." That is, there exists some feasible arrangement for recognizing and achieving a preferred outcome, but that outcome has not as yet been obtained."

Using the Liebowitz-Margolis model, the misdiagnosis of the Former Soviet Union as an "inefficient market" illustrates first-degree path dependence. Mistakes were made, but the deliverables will eventually prove fully functional. The misdiagnosis of the initial condition resulted in a suboptimal path, but with no implication of inefficiency.

Second-degree path dependency was exhibited from the establishment of false constructs and their related unintended consequences since they have resulted in higher costs. The false construct establishing self-sustainability versus commercial viability as a desired-end condition had the unintended consequence of subsidizing shadow-economy activity. Firms in emerging economies share a common challenge as to whether they can evolve beyond self-sustainability (rewarding the enterprise's employees and management) to commercial viability (rewarding the enterprise's employees, management, and risk-capital contributors). By lowering expectations from commercial viability to self-sustainability, donor agencies may be inadvertently reinforcing many of the biases of the past that encouraged the appropriation of surplus capital before it could be distributed to enterprise stakeholders.

This false construct also acts to retard the development of market entrepreneurs. In "Myth of the Robber Barons," Burton Folsom (1996) describes an evolution of entrepreneurs. Folsom distinguishes early adapters, "political" entrepreneurs who take advantage of new licenses and/or legal opportunities, from later-stage, "market" entrepreneurs who provide cheaper and/or better goods and services. Initially, political entrepreneurs employ "state subsidies" in the form of directed order flow to benefit themselves, political apparatchiks, and oligarchs. Thereafter, market entrepreneurs use "best practices" to produce cheaper and/or better goods and services. Using the standard of self-sustainability (vs. commercial viability) delays the entrepreneurial evolution because it subsidizes political entrepreneurs with capital surpluses.

The second false construct was choosing to develop the post-Soviet successor states through mass privatization programs in the absence of capital formation. Unlike the US capital market that was "need-driven" in pursuit of capital formation, the post-Soviet capital markets have been primarily "event-driven" in response to mass privatization. The US capital market evolved from a series of initial public offerings to underwrite the needs of American industry. A secondary market was developed to provide aftermarket liquidity. "Best practice" capital formation was codified in the 1933 Securities Act and best practice secondary trading was codified in the 1934 Securities Exchange. The post-Soviet experience has reversed this sequence. Privatization was undifferentiated. It had the unintended consequence of aiding FDIs acquire promising enterprises at bargain prices that resulted in these enterprises being securitized and colonized.

GAAMA Governance illustrates third-degree path dependence. It is sensitive to and dependent on the initial conditions of economic reform. It has lead to an outcome that while inefficient--is also "remediable." GAAMA Governance provides a practitioner's perspective that relies upon both incentives and commands. It holds that the command-to-incentive ratio in relation to a given level of commercial activity is what determines an enterprise's effectiveness. The bottom-line for corporate governance is to...