CASE Ukraine Driving Forces for the Unwanted Reforms: Can the rent seekers curb the rent seeking? Vladimir Dubrovskiy joint work with Janusz Szyrmer, and William Graves III as a part of the country study within the Global Research Project of Understanding Reforms arranged and funded by GDN Prepared for the Ronald Coase Institute's Workshop in Institutional Analysis Barcelona, Spain, September 2005 amended with use of the comments and feedback from faculty and participants The case of UKRAINE

“Standard” approach: “ mandated ” reforms, based on the political support of a resulting political force CASE Ukraine Reforms in transitionThere may be a “bad” equilibrium, in which prevailing rent-seeking becomes self-supporting Sonin (2003), Hoff and Stiglitz (2002, 2004), Polishchuk and Savvateev (2002); Initial (naïve) approach: benevolent government SHOULD pursue the reforms How to minimize the cost of reforms? How to get a political support for the reforms (make them popular)? A state “captured” with rent- seeking vested interests is not supposed to complete the reforms at all Hellman (1998), Hellman, Jones, and Kaufmann (2000)

A majority was always against privatization of the large enterprises, and so were their directors that dominated in politics those times Monetary stabilization was started without any mandate and continued despite the political defeat of its initiators. Paternalism towards the enterprises was contracted despite the growing public sentiment in its support, and against vested interests of all major players CASE Ukraine Understanding reforms in Ukraine No program of reforms has ever got a public mandate and often even against the dominating vested interests The major reforms were undertaken irrelevant to the position of the population, Collective actions were rare and unimportant The reforms (passive or reactive) occurred nonetheless the state was “captured”, and the rent seeking dominated Stylized facts:

CASE Ukraine The model-based analytical narrative Going to explain: Why did the reforms (particularly the ones of ) NEVERTHELESS happen? Why did not these reforms happen earlier? How did they eventually lead to the Orange Revolution? How a rent-seeking society can transform itself? UKRAINE UKRAINE

CASE Ukraine Tornell (1998): a “reform from within”, when the rent seekers themselves restrain the rent seeking, can occur under the threat of a crisis, if such a reform is a “second best” for at least one of the interest groups. Escaping from a “capture” trap Requires a collective action at least within this interest group Historically was not the case in Ukraine

CASE Ukraine Dixit, Grossman, and Helpman (1997): a government can have sufficient political choice, if: The pool of rent is fixed A norm for sharing of the rent between principals and agent is uniform and strictly defined (e.g. by a competitive market) Escaping from a “capture” trap It is a common agent of many diverse lobbyists acting as principals Olson (1980); Olson and McGuire (1997): a rational encompassing rent seeking ruler (or group) has vested interest in efficient institutions, hence curbing the rent seeking

CASE Ukraine Main questions: Why, despite these convincing reasons, the rent-seeking societies exist at all? Why and how they finally transform themselves?

CASE Ukraine Explaining in which way the evolution of societal norms and technologies eventually can break a “bad” equilibrium, thus drive a country out of the “capture trap” through altering the balance between rent seeking and profit-seeking activities. The rent seeking requires control and coordination to prevent from “the tragedy of the commons” Increase in transaction costs of control and coordination brought about by technological and societal evolution eventually drives the contraction in rent seeking – regardless to the special interests! Our contribution: Main ideas:

In many cases players fail to establish the efficient institutions. CASE Ukraine Rent seeking vs. profit seeking Profit seeking Creation of the value voluntary apprised by competitive market Appropriation of already existing value, e.g. created by others A positive-sum game (“cooking a pie”) increases the public wealth A zero- or negative-sum game (“cutting a pie”) usually decreases the public wealth Rent seeking Players can establish certain efficient institutions, primarily, the property rights by a voluntary agreement A coercive force is required to arrange appropriation while preventing the overappropriation Rent seeking requires FORCED coordination and control that can only be arranged by AUTHORITARIAN POWER Sonin (2003), Hoff and Stiglitz (2002, 2004), Polishchuk and Savvateev (2002):

Departures from Dixit, Grossman, and Helpman (1997): CASE Ukraine Multi-agent instead of multi-principal Abilities of extracting the rent from it’s source Coercive force Clients Abilities of extracting the rent from it’s source Coercive force Arbiter Pool of rent: no more fixed, but a common resource vulnerable to overappropriation Proportion of rent sharing is subject to bargaining State budget, renewable natural resources, poorly controlled state-owned enterprises, monopoly rent A model of the rent-seeking society of Ukraine

player client Rent source CASE Ukraine player player Arbiter-clients model: how it works Authoritaria n arbiter D i s t r i b u t e s t h e q u o t a s f o r r e n t a p p r o p r i a t i o n a aa a r b i t r a r i l y, a n d e n f o r c e s t h e m i n o r d e r t o r e s t r a i n t h e d e v a s t a t i n g c o m p e t i t i o n client … but instead extorts the rent himself, or trades it for loyalty Rent source

CASE Ukraine An arbiter: CASE Ukraine Has an incentive to extract the rent (share the players’ rents) Looks as “captured” with vested interests Asymmetry: The players can motivate their arbiter with a “carrot”, but not threaten to him  irresponsibility players are clients of their arbiter In effect, “owns” a source of rent Interested in using his discretionary power for further weakening the clients’ residual rights of control Arbiters and clients form a hierarchy Crowds out and suppresses any other ways of preventing the overappropriation Rent-maximizing Power-maximizingtotalitarian authoritarian, plutocratic Arbiters: ≡ ≡

Profit seeking (competitive) sector Rent seeking sector Monopoly rent CASE Ukraine player In Increase in the social wealth De Decrease in the social wealth Effects of authoritarian rule Paternalism (clietnelism) and corruption Firms earn their incomes mostly as rents depending primarily on the arbiter’s discretion client

Technology SOCIETAL NORMS CASE Ukraine The rent seeking proliferates EQUILIBRIUM Profit-seeking sector Rent-seeking sector A residual remains! Marginal rent Marginal cost of control and coordination Rent seeking CONTRACTS! MORE EFFICIENT S i m i l a r l y t o R o n a l d C o a s e ’ s t h e o r y o f a f i r m Problem of an authoritarian arbiter Systemic reform A l o n g - t e r m p r o c e s s p r e c e d i n g t o r e f o r m s CRISIS UNSUSTAINABLE!

CASE Ukraine TOTAL TOTAL cost of control and coordination Problem of a totalitarian arbiter Profit-seeking sector Rent-seeking sector SMALLER residual TOTALitarian arbiter TOTAL rent Technology SOCIETAL NORMS EQUILIBRIUM

Profit-seeking sector Rent-seeking sector Technology SOCIETAL NORMS CASE UkraineREVOLUTION? Rent-seeking sector Profit-seeking sector “Standard” approach applies Transition from a rent-seeking society: Evolution and REvolution? Politically responsible government

CASE Ukraine In the case of Ukraine: Totalitarian power based on societal norms determined by Communist ideology have been eroding during several decades after Stalin’s death The systemic crisis hit in the end of 1980 th, because the whole system of control and coordination became unaffordable and crashed Adjustments were done by authoritarian arbiter (President Kuchma) in two main waves of reforms ( and ), each brought about by a crisis As a result, the rent-seeking sector has been contracted so much that made the Orange Revolution possible (???)

CASE Ukraine Implications Only valid in a long run! Testable hypotheses: Long-term reversals in modernization should be rarely observable, unless induced by increase in the rent flows Reforms are often brought about by crises of overappropriation (Drazen and Easterly, 2001) As a result of Orange Revolution, the rent seeking sector should contract further The Orange Revolution was mostly driven by the interest groups representing the profit-seeking sector Political support of Kuchma/Yanukovich stem mostly from the rent-seeking sector Democracy should be negatively correlated with rent seeking UKRAINE

CASE Ukraine Prescriptions: Standard approach and respective policy prescriptions are productive when the profit sector already dominates and a politically responsible government is in place. Otherwise they can be counterproductive! Before this moment, the aid strategy should be focused on educating of the population and stimulating of profit-seeking sector. Assistance in improving of control and coordination rather harms than helps. In any case, abstain from providing the potentially rent seeking authoritarian and quasi-authoritarian regimes with rents, even for the sake of preventing of crises

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