AFTER SOCIALISM: WHERE HOPE FOR INDIVIDUAL

LIBERTY LIES

By
SVETOZAR PEJOVICH
Professor of Economics
Texas A&M University, College Station, and
Imadec University, Vienna
and
Senior Fellow
International Centre for Economic Research
Torino, Italy

ABSTRACT

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
 1

effects of incentive structures and the costs of transactions on economic

behavior.

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.
 2

INTRODUCTION
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
 3

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
 4

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
 5

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:
 6

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
 7

themselves. Indirectly, therefore, this prejudice guarantees that

resort to the authority of the state is effectively minimized.5

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 Sunstein wrote:

[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 simply false…. For a country that starts with
…little 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
 8

for economic growth…. 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 markets.8

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 ends.

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
 9

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
 10

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
 11

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 new rules.

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 well-
positioned 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.
 12

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 as follows:

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
 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
 14

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

Codetermination. 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
 15

employees of a firm join shareholders of that firm on the board of

directors and take an active role in decision making.21

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 to innovate.
 16

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 other.

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
 17

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
 18

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, or both.

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
 19

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, black-
market 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 3.3 respectively.

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

 20

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 Repub. 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

 21

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
 22

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 free-
market 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
 23

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.
 24

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
 25

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 Europe33

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
 26

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. Why?

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
 27

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
 28

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
institutional alternatives.36

The maximization paradigm of neoclassical economics translates the

desire for more—an observable trait of human behavior since the
 29

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 wrote:

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
 30

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.

Transition Industry
 31

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 rent-
seekers, 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.
 32

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
 33

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
 34

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
 35

self-determination. These small enterprises are the engine of a slow

and genuine reconciliation between the region’s old ethos and the
culture of capitalism.

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.
 36

ENDNOTES

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., p. 47.
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
 37

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, 1993.
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, 1951, p.93
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.”
 38

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, 60, 1987.

23. 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 1.80.
 39

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/cpi2000.html.
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 Publishers, 1998.
34
Svetozar Pejovich, Economic Analysis of Institutions and Systems, Dordrecht:
Kluwer Academic Publishers, 1998, p. 14.
 40

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.