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PROPERTY RIGHTS
Lecture 10: Property Rights Problems in Eastern Europe and Bulgaria
Authors: Richard L. Stroup and Charles N. Steele
• Soviet Legacy
• Private property rights and liberty
• Private property rights and economic performance
• Privatization: successes and problems
• Bulgaria
Introduction
This lecture, the final in the series, explores some issues surrounding property rights in the former centrally planned economies of central and Eastern Europe. The nine previous lectures surveyed topics in the economics of property rights. This lecture applies some of these lessons to the case of the former centrally planned economies, the transition economies. The experience of transition has confirmed the crucial importance of property rights structures in determining economic outcomes. It has also increased our understanding of the difficulties of institutional reform and changing of the overall system of property rights.
In essence, transition is a shift from one property rights structure to another. Even in the Chinese transition, where the term �private property� has been eschewed, the heart of the transition has been the development of what are, in fact, private property rights (Chai 1997, Cheung 1998). Of course, moving from one property rights structure to another is more than simply transferring property from one owner to another. It involves restructuring all of the institutions and procedures for assigning, defending and making low-cost the trading of property rights to encourage owners to move them to higher-valued uses. Both history and recent experience teach us that the process of replacing old institutions with new ones is generally not smooth, but is fraught with difficulties and errors. It would be impossible to discuss every issue related to property rights and transition, of course � numerous books and hundreds of papers have been written on the subject. We will examine a few selected points of importance in central and Eastern Europe today.
The Soviet legacy
This section briefly discusses the status of property rights at the end of the central planning systems in Europe. Officially, productive property was largely owned by the state. In fact, however, under perestroika increased latitude had been given to managers; a sort of attenuated de facto property rights. Gorbachev's hope was to modernize central planning by giving increased decision making authority to lower levels of managers. However, the system did not provide strong incentives for improving output, nor did it correct the fundamental weakness inherent in central planning � the inability of planners to generate a feasible, economically rational plan. Managers found themselves with increased latitude for control of state assets, with relatively little monitoring of their behavior. Managers lost little time in turning �state� property to their own use, behavior that included asset stripping. Productivity did not increase under these constraints, but continued to fall, helping to bring about the demise of the Soviet Union. Also, during this time private enterprise was permitted to an increased extent in the USSR. These enterprises tended to operate partially in the shadows, due to the schizophrenic attitude of the Gorbachev government, which imposed high tax rates and regulations on them.
At the same time, Gorbachev abandoned the USSR's so-called Brezhnev doctrine, which held that the USSR and Warsaw Pact members had a right to intervene wherever socialism was threatened. The Soviet Union had previously intervened whenever reform appeared to threaten to weaken the Soviet sphere of influence. Their intervention included violent invasions of Hungary in 1956, Czechoslovakia in 1968, and Afghanistan in 1979. Bulgaria was likely an exception among central and eastern European countries, in that Bulgaria's alliance with the Soviet Union appears to have been relatively popular, in part owing to historical friendship with Russia and Soviet economic support.
Once the Soviet Union released its grip on Central and Eastern Europe, the communist regimes began to collapse. Poland was the first to move to democracy and a transition towards a market economy, due in large part to the strong and well-developed opposition to communist rule coming from the Solidarity labor movement and the Catholic Church. Hungary, with perhaps the most liberal of the communist regimes and a history of reform, followed Poland's example. The opening of Hungarian and Polish borders with the west led to massive numbers of East Germans (German Democratic Republic) fleeing to West Germany (Federal German Republic), in turn, leading to the collapse of the East German communist regime. In Bulgaria, Czechoslovakia, and Romania, the collapses of the regimes were rather sudden, and in none of these countries was there a well-established civil society or opposition.
In sum, the Soviet Union bequeathed to the transition countries a system with enormous problems. The transition economies possessed large amounts of state-owned property, over which property rights were in fact not well-defined. Similarly, the state apparatus for enforcing rules was broken down, further leaving property rights undefined. Established patterns of production and trade were unsustainable � they had been developed to satisfy the center, rather than to maximize the net values to citizens of production and income. But at the same time, the transition countries did not have in place alternative systems for decision making and governance. Nor did they have well-developed civil society (societal organizations developed voluntarily by the people, rather than by government) or institutional frameworks which might allow alternative systems to be easily developed, although they differed among each other in this regard. Poland and Hungary entered transition with relatively well-developed civil society, compared with Bulgaria, Ukraine, Russia, and similar countries with little history of reform or opposition to one party rule.
In some respects the Soviet legacy was the tragedy of the commons, applied to an entire set of economies. While this is a great simplification that overlooks many details, the broad characterization helps to explain much of what happened. In the Soviet system, the state was the official owner of the bulk of productive property � in effect, all of this property formed a commons. So long as those who ran the state were able to enforce their will, they were able to largely control this commons. However, the basic contradictions of central planning led to economic crisis, and a weakening of political control � further exacerbated by popular frustration with totalitarianism and poor economic performance. In the Soviet Union, it came to be seen as a good thing to steal from or cheat the government. Cynicism became widespread, and with it corruption and a willingness to plunder the commons.
When the old regimes collapsed, the constraints on this behavior were further reduced. In addition, explicit programs of reform began, including recognition of private property, privatization, and development of markets and market prices. The ensuing decade plus has been characterized by enormous change, much of it best characterized as captures and transfers of property rights and wealth. Property rights analysis is one of the most useful tools for understanding these phenomena.
Private property rights and liberty
The economic literature on transition widely recognizes the importance of establishing well-defined property rights in economic reform. Even vocal critics of the Russian privatization and the rapid �big bang� reform strategy, such as Joseph Stiglitz, agree that establishing 3D property rights improves the economic performance of a country. The analysis in the previous nine lectures helps to explain why. But there is another role of property rights that perhaps receives insufficient attention. The structure and form of property rights is an important determinant of the extent to which a country's citizens are free, with their so-called �human rights� respected.
The most important point can be stated simply: well-defined and defended private property rights, enforced impartially, are a prerequisite for the protection of individual rights. Some aspects of this should be obvious. If the state � or anyone else � can seize one's property arbitrarily, or deprive one of one's livelihood, or deny access to the means to act (i.e. property) then one is not free � one is at the mercy of those with this power. Similarly, in a state where most productive property is state-owned, one is again at the mercy of those in government. In either case, if an individual undertakes an act which is not favored by those with power, those in power can retaliate. Also, possession of secure property rights permits one freedom to act, speak, write and publish, etc. Only when the state is constrained is there real freedom.
The important point here is that property rights are first of all constraints. Property rights are not so much licenses, as is sometimes supposed, but limits that define and govern every person's conduct (Alchian, [1965], 1977). It is not so much that property rights give a person freedom to act, as that they restrict every person's actions. They define the boundaries over which exclusion is to be enforced. Within these boundaries, every member of society has liberty.
To see this more clearly, consider the original doctrine of property rights, as developed by thinkers in the Western European Enlightenment, most notably the Englishman John Locke. This tradition poses a simple argument concerning property rights, one which sees all property rights as stemming from a single original principle: each individual's self-ownership, i.e. his inherent property right to himself. Given this ownership, subsidiary property rights follow. These include (but are perhaps not limited to) the right to one's own labor, or actions. From this right stem both what we typically think of as human rights, and property rights. Freedom of thought and expression are thought of as rights implied by self-ownership. Similarly, property rights are seen as stemming from the right to self-ownership. By �mixing one's labor� with previously unclaimed assets and making them productive, one establishes a property right in them. Given these original rights, further rights over property can be established by mutually agreeable trades among parties. It is this, of course, that is the link between the liberal society and the market economy. Furthermore, in this view, human rights are just a subset of property rights.
A political system is designed to enforce the boundaries defined in Lockean thinking, that system will limit the power of all parties, governmental and private, to arbitrarily act in disregard of these boundaries. It is this limit on power that defines the liberal society. In short, the first function of private property rights is that they are the basis of the liberal society.
It is important to note that this says more than simply �establish private property rights markets.� The transition from a centrally planned economy to a modern market economy is not simply a matter of reassigning property rights and establishing markets � it is redefining the entire relationship between the individual and the state. It is move from a totalitarian system, in which the state was the ultimate authority in almost all spheres of life, to a system in which people choose for themselves, and in which they may organize themselves as they see fit, in order to build the life and society they wish. Private property rights, as understood here, enforced equally for all citizens , are absolutely crucial for this fundamental change in systems.
Private property rights and performance
Previous lectures in this series have emphasized the importance of 3D private property rights in economic performance. Under transition, private property rights have been established, but countries differ in the security of private property rights, as well as in the extent to which property rights remain in the hands of the state. What does the evidence say about the relationship between the structure of property rights and performance?
Following the collapse of the central planning system, the initial years of transition saw a continued decline in GDP in the transition countries. In part, this was because the production patterns of the old economy made little economic sense. It produced enormous amounts of military equipment, industrial machinery for producing more industrial machinery for producing more industrial machinery with no ultimate usefulness, poor quality consumer goods, and similar things that no one would buy given a choice. To have a new economy, capable of producing value, it would be necessary to restructure. The theory we've developed implies that the firms, and countries, with better developed private property rights will be more responsive. How has economic restructuring been influenced by property rights?
Simeon Djankov and Peter Murrell (2000) examined over 100 studies done by economists on enterprise restructuring in the transition countries. The evidence is fairly clear. Privatized firms are far more likely to engage in substantial restructuring associated with higher productivity than are state firms. Furthermore, the kind of privatization seems to matter. Some state firms were privatized in so-called �insider� privatization, in which shares went primarily to managers and workers (most often to managers). Others were privatized in �outsider� privatizations, in which people from outside the enterprise � sometimes foreigners � could obtain ownership. These outsider privatizations are more likely to be transparent, i.e. the details open and with less attendant corruption. In general, the foreign owned firms engaged in the most restructuring. Next in ranking of restructuring are the firms with relatively concentrated management � manager owned firms, followed by firms with outsider ownership. Less likely to restructure were firms with diffuse ownership, such as firms privatized to managers and workers, or firms with many individual owners. Restructuring is, of course, correlated with subsequent productivity increases.
These results should not be surprising. Private property rights and an end to the soft budget constraint create both the room for action and the incentive to restructure. The more concentrated the rights, the stronger the incentive and the ability to influence the course of action. That the least restructuring is associated with state enterprises is also not surprising. However, another finding is that enterprises in which the state holds a partial share do have effective restructuring. These firms can be thought of as �commercialized,� and quite unlike the old state enterprises. They do not have a soft budget constraint, and still must compete in markets to earn profits. 1
But the research of Djankov and Murrell also noted that the effects of privatization were stronger in Central and Eastern Europe than among the CIS (Commonwealth of Independent States) members. Restructuring and productivity gains were not as great in the former Soviet Union. It has also been noted that the former Soviet countries have generally fared less well in transition than countries such as Poland and Hungary, in terms of output growth. What might property rights analysis say about this?
A study by Simon Johnson, John McMillan, and Christopher Woodruff (1999) looked at differences in the willingness of private firms in transition countries to make investments to increase their productivity and profitability. In the time period considered by the study, owners of firms in Russia and Ukraine tended to invest less in their firms than did owners in Poland, Hungary and Romania. Why? The evidence suggested that owners in Russia and Ukraine had similar access to investment funds as owners elsewhere � often in the form of the firm's retained earnings and cash reserves. Thus it was not a problem of a poorly developed financial system or constraints on credit and cash. Instead, the evidence was that Russian and Ukrainian owners feared that their ownership was insecure, especially from official corruption. Hence owners were less willing to invest than were their Central European counterparts. Again, such a finding supports the lessons of previous lectures. More secure property rights provide more incentives to invest. Less secure rights reduce that incentive, as people put more effort into protecting what they have.
Privatizations: successes and problems
Under Gorbachev, asset stripping (unofficial, �spontaneous� privatization) grew. This asset stripping increased with the demise of the USSR. One major component of transition was official privatization of state assets. There were numerous approaches to privatization, some of them transparent and straightforward, some opaque, some quite corrupt. Some of the privatizations were insider privatizations, with enterprise ownership going primarily to the managers and token shares to workers. There were also sales to politically connected bidders at �fire sale� prices (e.g. the Russian �loans for shares� privatizations of the middle 1990's), and mass privatizations with shares distributed among the public. European countries such as Poland, Czechoslovakia, and Hungary used a variety of methods as well, including mass privatizations and auctions.
It is beyond the scope of this lecture to analyze privatization methods or the history of privatizations. A good source for such information is Anders Åslund's excellent book, Building Capitalism (2002). Instead, we will look at a few issues surrounding privatization. While many of the privatizations were fraught with corruption, the more important point is that private property rights were established, and the incentive structure for firms changed, largely for the better (as discussed above). For a contrast, consider Russia's moribund agricultural sector, where privatization of the primary asset � land � has not yet occurred at any appreciable level. Neither has restructuring.
Boycko, Shleifer, and Vishny (1995) � economists who helped develop the initial Russian privatization programs � argue that one of their crucial concerns was to push reform as quickly as possible while the opportunity existed, i.e. before communist politicians could organize effective opposition. The initial privatizations were designed to remove productive property from political control, i.e. from the hands of the state, and thus to fundamentally change the relations between the state and the citizen, and the role of the state in the economy. The program was undoubtedly successful in this. Some critics, as we will see shortly, have argued that it would have been advisable to move gradually, to first establish institutions such as commercial law, means of impartially enforcing contracts, etc. While in principle this might be so, it was not a realistic possibility for reformers.
Russian privatization has been criticized by some, both in Russia and in the west, because of the corruption and favoritism accompanying some of it. Certainly private property rights that are not regarded as legitimate by a majority of the populace are unlikely to be secure, since there will be pressure to redistribute the ill-gotten gains. However, some have gone farther than this, and argued that privatization was economically harmful, that it accelerated asset stripping and capital flight. This in turn has hurt overall economic productivity, something attributed to the rise of the so-called oligarchs, businessmen who profited from nontransparent privatizations (see, for example, Stiglitz 1999, Hoff and Stiglitz 2002).
However, the evidence is otherwise. Andrei Shleifer and Daniel Treisman (2003) point out that while �oligarchs� indeed profited from the privatization process, and did strip assets from state enterprises, they have used their newly acquired property rights just as our theory predicts. Investment and assets of oligarch-owned companies has increased substantially, as has productivity. Even though the legitimacy of some privatizations might be questioned, the result of establishing private property rights is to encourage productive use of those assets. It is true that the recovery to economic growth was not instantaneous; it required a painful period of restructuring and additional reform as well. Still, the Russian economy has exhibited economic growth and rising income.
Furthermore, even though some of the privatizations were conducted in dubious fashion, the future of reforms based on them may still be good. As mentioned in Lecture 8, Anders Åslund argues that the longer run prospects for wealth-creating reform are promising. In the initial institutional vacuum following the collapse of the Soviet Union, it was relatively easy for bold, aggressive entrepreneurs to grab assets. But today the easy targets, Soviet state property, have been taken. A market system has developed to replace central planning, and Russia is, in the words of Shleifer and Treisman, �a normal middle-income country.�
Anders Åslund (2002) suggests that privatization � even corrupt privatization � may help foster democracy in a transition country, by dividing property (and power) among competing groups, such as various oligarchs. He cites Russia and Bulgaria as examples. While democracy may be flawed in these countries, the decentralization of power resulting from privatization has helped to give it a foothold. He contrasts Russia with former Soviet republics that began from a similar starting point, Ukraine and Belarus. Ukraine (a relatively slow reformer with partial privatization) has weaker democracy and less individual liberty � the power of the government, particularly the president, is extensive. In Belarus, with essentially no reform, the government has returned to a totalitarian model. Economic performance is worse in these countries as well.
Åslund identifies the greatest threat to reform as coming from rent-seeking groups with an interest in the old system. If a �shock therapy� approach such as rapid privatization is possible, it is the surest way to prevent anti-reformers from blocking transition. For all the difficulties of a faster transition, a slower one appears even worse.
Lessons for Bulgaria
If the objective is to build a modern, well-functioning economy, and a political system with individual rights and democratic government, the recent privatizations in Bulgaria are steps in the right direction. As discussed in the previous sections, moving property rights from the state to private ownership is associated with political freedom, improvement in economic performance, and perhaps even democracy. However, it is also clear that simply privatizing property is not enough. The critics of privatization (such as Hoff and Stiglitz, cited above) are correct in pointing out that placing property in private control is not the same as establishing well-defended property rights and functioning markets. How well are property rights protected? And in particular, how well are contractual property rights � rights over mutually agreed upon transfers � enforced?
We have already seen in the previous nine lectures that with lower costs of transacting � easier transferability � rights will be assigned and assets used so as to maximize total wealth and minimize harms. The beneficial social order built on mutual gains from trade requires that it be relatively easy to make trades. In this sphere, Bulgaria has much room to improve. For example, a World Bank survey of business conditions around the world identified slow and unreliable court enforcement of contract disputes as a problem for Bulgaria (World Bank, 2004). This is corroborated by similar studies that find insufficient protection for contracts and property rights in general (e.g. Gwartney and Lawson, 2003, and Heritage Foundation, 2004). This problem is in part due to excessive bureaucracy and unnecessary and complex regulation. Such �red tape� (excessive and burdensome regulation) does not reduce costs of transacting, but raises it, reducing the potential for creating wealth. Furthermore, in such a non-transparent environment, it is easier for rent-seekers in the bureaucracy to extract bribes. Corruption further reduces security of property rights, and depresses economic performance. The Heritage study cites one source as suggesting that corruption is a particular problem for Bulgaria's judicial system. Instead of protecting rights and reducing transaction costs, the courts weaken rights and increase costs�exactly the reverse of their proper function.
The World Bank study offers a number of general reforms that can improve effectiveness of contract enforcement, including simplifying regulations and judicial procedures. One example of such an improvement cited in the study is from Bulgaria. Until recently, court proceedings in commercial cases could not begin until the court notified the defendant in person of the case. Hence, a defendant could block court enforcement of a contract by simply making himself unavailable. These judicial procedures were revised in 2000, to permit cases to proceed after a single attempt at notification and a public announcement.
Simpler and more equitable rules reduce opportunities for corruption. The problem, of course, is that excessive rules can be in the interests of those who enforce them. However, when it is realized that these depress economic performance and harm the public in general, it can be possible to build a coalition strong enough to push for reform. One of the authors of this lecture series spoke with American officials from USAID about a program in Ukraine that did this at a local level. In Ukraine, the general regulations were set at the national level, and attempts at reform were weak. However, some Ukrainian cities appeared to have reasonably good economic growth while others did not. The reason? It appears that regulations are often enforced at the city level � and enforcement differed widely in degrees of fairness and corruption. Reform-minded mayors were generally able to reduce the negative effects of regulation. Competition among cities (or other units of government) for investors who will build a tax base along with productive capacity and output, can itself improve the climate of property rights.
Building on this idea, USAID officials made presentations to mayors in other, lower growth, cities and towns, explaining how a given set of regulations might be enforced in a more transparent manner. For example, to reduce corruption by fire inspectors or other regulators, mayors could enforce rules on inspection processes. Regulatory inspections might be made only with fair notice to owners, alleged violations documented in writing, and fines, if any, paid not to inspectors but at a single city office. Since mayors benefit from economic growth in their communities, and tend to have the ability to affect the way city bureaucracy functions, a process of reform was politically feasible. In cities where this approach was tried, registrations of official businesses increased rapidly, as small businesses left the shadow economy. This in turn increased government revenue, as license fees and tax receipts increased. Although the sphere of reform was small, the example shows how change in the political realm can generate net gains � an example of wealth-creating political entrepreneurship.
It may be that reform depends on the passage of time. It takes time for old ways of thinking and behaving to die, and time for entrenched supporters of the status quo to age and be replaced. But successful reform � based on respect for 3D property rights � raises the total value of wealth in an economy, raises overall incomes, reduces environmental problems and similar frictions. It replaces the loss-creating conflict of rent-seeking for the wealth-creating forces of co-operation, competition, and voluntary exchange. If these lessons are widely understood, political entrepreneurship can take advantage of this understanding. The most important lesson for Bulgarians, or anyone desiring a prosperous, peaceful, sustainable future, is to understand the crucial importance of protecting and defending the rights � property rights � of everyone.
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REFERENCES
Alchian, A. [1965] 1977. � Some Economics of Property Rights.� Economic Forces at Work: Selected Works by Armen Alchian . Indianapolis: LibertyPress, pp. 127-149.
Åslund, A. 2002. Building Capitalism: The Transformation of the Former Soviet Bloc . Cambridge University Press.
Boycko, M., A. Shleifer, and R. Vishny. 1995. Privatizing Russia . MIT Press.
Chai, J. 1997. China: Transition to a Market Economy . Oxford University Press.
Cheung, S. 1998. �Deng Xiaoping's Great Transformation.� Contemporary Economic Policy 16(2) pp.125-135
Djankov, S. and P. Murrell. 2000. �Enterprise Restructuring in Transition: A Quantitative Survey.� University of Maryland, Center for Institutional Reform and the Informal Sector. Working paper 244.
Gwartney, J. and R. Lawson. 2003. Economic Freedom of the World: 2003 Annual Report . The Fraser Institute, Vancouver Canada.
Heritage Foundation. 2004. 2004 Index of Economic Freedom . The Heritage Foundation, Washington DC.
Hoff, K. and J. Stiglitz. 2002. �After the Big Bang? Obstacles to the Emergence of the Rule of Law in Post-Communist Societies.� National Bureau of Economic Research. Working paper 9282. Available at http://www.nber.org/papers/w9282. Accessed 19 Feb. 2004.
Johnson, S., J. McMillan, and C. Woodruff. 1999. �Property Rights, Finance, and Entreprenuership.� Stockholm Institute for Transition Economics. Available at http://web.hhs.se/site/Publications/workingpapers/No152web.pdf. Accessed 19 Feb. 2004.
Shleifer, A. and D. Treisman. 2003. �A Normal Country.� National Bureau of Economic Research. Working paper 10057. Available at http://www.nber.org/papers/w10057. Accessed 19 Feb. 2004.
Stiglitz, J. 1998. �Whither Reform? Ten Years of Transition.� Address to Annual Bank Conference on Development Economics, World Bank. Available at http://www.worldbank.org/research/abcde/pdfs/stiglitz.pdf. Accessed 20 Feb. 2004.
World Bank. 2004. Doing Business in 2004: Understanding Regulation . World Bank, Washington DC.
1 This form of ownership has been relatively common in China, for example.