Exiting a Lawless State

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Exiting a Lawless State Karla Hoff and
Joseph E. Stiglitz
September 20, 2007
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The Question

• Why are dysfunctional institutions persistent?
• Consider
• A situation in which theft is allowed --yet
  allowing theft is not in the self-interest of the
  individuals
• They can vote to create third party enforcement
  that makes it costly for individuals to steal
  (the rule of law)
• Will those with political power embrace the rule
  of law?

Puzzles Post communist transition,
Post-conflict societies, Oil reservoirs with
common ownership
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Lawless Capitalism Grips Russian Business
- The Washington PostNovember 7, 2000
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What does the literature say? It focuses on
obstacles to reform where there are losers from
future economic activities

• Political losers Any change that erodes the
  power of the political elite erodes their ability
  to extract economic rents in the future
  (e.g. Engerman-Sokoloff 1997,
  2005 Acemoglu-Robinson 2000 AJR
  2005)
• Economic losers Some would lose under reform.
  Limited redistributive instruments/information
  to compensate the losers (e.g.
  Fernandez and Rodrik)

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Focus of this paper consequences of a commitment
problem with respect to past activities

• What is this problem?
• Under the rule of law, it is impossible to commit
  to treat illegitimate and legitimate income
  identically
• There is no closed case or category of business
  affected with the public interest
• 
  Statement of the Supreme Court in the
  case of
  Nebbia vs. New York (1934)

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Our key result

• Even if everyone has better future opportunities
  under the rule of law than under a lawless state,
  some may steal in the current period.
• Given the commitment problem, those who have
  stolen in the current period may oppose the
  creation of the rule of law.
• Thus the lawless state may continue, and theft
  may continue, and then the problem of commitment
  continues.

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Fresh blood on ones hands

• Asset stripping in our model is like getting
  blood on ones hands.
• It exposes an agent to a cost in the transition
  to the rule of law.
• We do not assume that the blood is never washed
  away.
• Instead, only the current periods return from
  asset stripping is vulnerable to recapture.
• Our model shows that, as long as the non-rule
  of-law state persists, some may choose to strip
  assets, period after period.
• Thus the blood on their hands is fresh when the
  rule of law state is created, and they gain from
  the establishment of the rule of law only after
  they begin to build valuethat is, with a time
  lag
• This can make the lawless state persistent.

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Modelling innovation of the paper

• Existing work treats economic interests as
  parametric (Acemoglu and Robinson 2006, p. 316)
• We treat economic interests as endogenous.
• We model a joint coordination-commitment problem

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Outline of talk

• 1 A pure coordination problem in a static model
• 2. Individuals intertemporal trade-off problem
  (dynamic model)
• 3. Why rule of law cant commit not to look back
• 4. Policies
• Gradualism vs. big bang privatization,
• Macroeconomic policies
• International sources of coordination

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1. Coordination problem Static model

• Agents have control rights over assets
• They choose to strip assets (steal corporate
  value) or invest,
• Vote for or against
• rule of law (L)
• non-rule of law (N)
• Notation
• x vote against
• 1-x vote for.
• Note Only if you invest do you gain from the
  rule of law otherwise you dont care.

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A political-economic link, with 2 equlibria cc

Strip assets
Build value
? (uniform distribution
on 0,1 of stripping abilities)
Probability distribution of the voting outcome
depends on the fraction of the population that
chooses to build value (1-x), which itself
depends on that distribution. (Other example
Roberto Chang, 2006)
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Rule of law
No rule of law
An agent get payoffs equal to ¼ if he builds
value, or, if he strips, he gets from ¼ to 1,
depending on stripping ability
All agents obtain payoffs 1
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Payoffs
1
1/4
Expected return from building value ¼ ¾
(1-x)2
x
0
1
Increasing support for the rule of law
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2. Dynamic model with imperfect commitment

• Every period, each agent chooses to build value
  or to strip assets, AND to vote for or against
  the creation of the rule of law
• The rule of law is an absorbing state.
• So a path is N N L L L L L L L.

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2. (cont) Technology and payoffs
DEPLETION OR GROWTH OF ASSET
FLOW
STRIP ASSETS
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Two switch lines determine economic and
political decisions
Switch line for economic action
Locus of (x,q) for which an agent is indifferent
between stripping and building value




Switch line for voting
Continuation benefit from no rule-of-law for an
agent who strips today is zero
.
q
lq
-
-
z
)
,
(

x
S
V







0
N
L
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An asset stripper might vote for the rule of law
?
II (strip assets and oppose establishment
of the rule of law)
?p(x?)
III (strip assets and demand the rule of law)
I (build value and demand the rule of law)
?a(x?)
x
0
1
Increasing opposition to the rule of law
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The switch lines, numerical example
?
1.2
?a(x0.3)
II
1
?p(x0.3)
0.8
III
0.6
I
0.4
0.2
0
0
0.2
0.4
0.6
0.8
1
x
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Two stable equilibrium paths of agents
aggregate expected income
2.5
2.0
x 0
1.5
Agents' aggregate expected income
1.0
x 0.75
0.5
0
0
10
20
30
40
50
60
70
80
Time period
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? 0 (no reappropriation of stripping returns)
?
1.2
II
1
?p(x0)
?max
0.8
III
0.6
I
0.4
0.2
?a(x0)
0
0
0.2
0.4
0.6
0.8
1
x
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3. Why the commitment problem?

• Dynamic consistency problem--The security of
  such rights depends on the social consensus that
  underlies them. Not just any distribution of
  property can be protected under the rule of law.
• The consequences of the states seizing
  illegitimately taken property are markedly
  different from the consequences of the states
  taking or redistributing legitimately obtained
  wealth. It is rational for politicians to argue
  for the first (and not the second) and to
  redistribute the wealth to voters.
  Nationalizing stolen wealth does not harm
  investment incentives. On the contrary, it
  improves them.

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4. Policies

• Speed of privatization
• To improve the tradeoff between agency costs
  within
• the public sector, and within the
  private sector, and
• to influence the constituency for
  reform after privatization

• Macro policy and open capital markets
• Policies that affect the relative return to
  stripping vs.
• building value affect constituency
  for reform
• International sources of coordination
• EU (see Elster, Roland and Verdier)

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Future work Co-evolution of institutions and
the inequality of the political power and wealth

Our model abstracts from the development of some
agents into oligarchs Economic history suggests
the high payoff to a thoery that endogenizing
changes in political inequality Engerman-Sokoloff
1997, 2005 Acemoglu-Robinson
2005, AJR 2006
Muckraking Governor Slain By Sniper on Moscow
Street Wall Street Journal, October 19, 2002
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Conclusion Coasian view (what matters is
defining property rights) is misleading, because
it ignores the problem of corporate governance
(the control function in corporations is not
allocated on the basis of property rights) and
the resulting scope for theftWhen theft occurs,
the long run prospects of rule of law are
undermined. Theft changes the political dynamics
that matters for the establishment of the rule of
law.