Law, tradition, and the transition in Eastern Europe.

• Author: Pejovich, Svetozar

The end of communist rule in Eastern Europe and the former Soviet Union (hereafter jointly termed Eastern Europe) created an institutional vacuum in the region. New leaders faced two critical issues: what new institutions to choose, and how fast to substitute the new institutions for the old ones. After several decades of ideological brainwashing and intellectual isolation, East Europeans were ill prepared to quickly identify alternative institutional arrangements and evaluate their expected consequences. At the same time, intellectual and political leaders in the West interpreted the end of socialism in Eastern Europe as a vote for capitalism. Westerners provided public and private funding for the transition from socialism to capitalism. Eastern Europe was quickly flooded with a large variety of transition models, transition experts, and scholars who appreciated a new source of research grants.

Neoclassical economics provided the general framework for the transition debate in the early 1990s. The basic neoclassical model became a foundation for the development of transition strategies in most East European countries as well as a yardstick for evaluating economic outcomes. According to the tenets of neoclassical economics, the transition required macrostabilization, privatization, market prices, free international trade (including convertible currency), and a balanced government budget. East Europeans were assumed to be rational utility maximizers who would quickly and costlessly perceive new opportunities, evaluate their consequences, and make the utility-maximizing choices. Privatized assets, regardless of their initial ownership, would quickly move into their highest-valued uses. In this scenario, it seemed appropriate to encourage the new leaders in Eastern Europe to use the strong hand of the state to build capitalism.

Many property-rights and public-choice scholars regard neoclassical economics as ill suited for informing the institutional restructuring in Eastern Europe, largely because of its lack of appreciation for the importance of transaction costs in a world of uncertainty and incomplete knowledge. Transaction costs are the costs of all resources required to transfer property rights from one economic agent to another. They include the costs of making an exchange (e.g., discovering exchange opportunities, negotiating exchanges, monitoring, and enforcement) and the costs of maintaining and protecting the institutional structure (e.g., judiciary, police, and armed forces). Academic research and empirical evidence have established that different institutional structures generate different transaction costs.

Enrico Colombatto and Jonathan Macey (1997) have commented as follows on the neoclassical model in the analysis of the transition process:

The virtues of this stercotype in a frictionless, zero-transaction

costs world are beyond dispute. Nirvana economics always work, by

definition. It [was] indeed acknowledged that the adjustment

process involves some costs and that, as a consequence, national

income may drop in the short run. But this [was] usually

considered an affordable price to pay in order to achieve

"optimality." In other words, transaction costs [were] not looked

upon as part of the transition problems, but rather as an unpleasant

by-product.

Most transition models paid little attention to transaction costs. They failed to identify, and therefore to reduce, some inevitable types of transaction costs specific to the post-1989 adjustment process in Eastern Europe: the costs of convincing East Europeans that the legal system could be stable and credible; the costs of training new judges and lawyers; and the costs of helping ordinary people understand the requirements of institutional restructuring. Moreover, the transition entailed transaction costs that could have been avoided: frequent changes of rules, insecure property rights, and restrictions on the tradability of privatized assets.

An important aspect of the transition debate in the early 1990s involved the comparison of alternative stabilization models. The debate, initiated by Jeffrey Sachs, gave rise to a number of impeccable technical proposals for solving economic problems such as inflation, unemployment, and trade and budget deficits. But the proposals ignored the effects on transaction costs of frequent adjustments in the rules. Evidence shows that uncertainty about the rules had major effects on stabilization programs in the early 1990s (Bossak 1993, 15-17; Cuckovich and Sirotich 1994, 87-90; Madzar 1995, 223-63).

The privatization debate focused on the costs of alternative privatization techniques and their fairness (e.g., spontaneous privatization, preferential treatment of the employees of business firms, and restitution). With a few exceptions, such as Jan Winiecki (1991) and Ljubo Madzar (1994, 7-66), analysts failed to focus on the effects of various privatization rules on the incentives of owners to seek the most valued uses of their assets.

Finally, from the standpoint of ordinary people in Eastern Europe, the transition process forced upon them institutional changes alien to beliefs and behaviors embedded in the fabric of community life (the more so, the farther to the east). They experienced the switch of one set of institutions for another, neither of which they chose for themselves. In most East European countries, privatization programs ultimately favored former nomenklaturists, the Czech Republic being perhaps the only exception.

By the mid-1990s, procollectivist parties (socialists, social democrats, communists, nationalists, and other anti-free-market parties) were gaining ground in many East European countries. For example, Hungary and Poland elected socialist governments even though their economies were performing fairly well. Analysis and evidence suggest that the transition models of the early 1990s bear a major responsibility for reenergizing procollectivist parties in the mid-1990s. According to Zoltan Krasznai and Jan Winiecki (1995), "The number of confused people, convinced that all our economic problems started in 1989... seems to be quite large" (246). Zbigniev Janaz (1991), a leader of the old solidarity coalition in Poland, said: "The laissezfaire theory has not proven right. We have got to have the state intervention. The question is how deep it should be" (28).

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