CASE Ukraine case-ukraine.kiev.ua

1. 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 Driving Forces for the Unwanted Reforms: Can the rent seekers curb the rent seeking? The case of UKRAINE 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 www.gdnet.org CASE Ukraine www.case-ukraine.kiev.ua

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

3. CASE Ukraine Understanding reforms in Ukraine The reforms (passive or reactive) occurred nonetheless the state was “captured”, and the rent seeking dominated Stylized facts: The major reforms were undertaken irrelevant to the position of the population, and often even against the dominating vested interests No program of reforms has ever got a public mandate Collective actions were rare and unimportant 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

4. CASE Ukraine The model-based analytical narrative Going to explain: How a rent-seeking society can transform itself? UKRAINE Why did the reforms (particularly the ones of 2000-2001) NEVERTHELESS happen? Why did not these reforms happen earlier? How did they eventually lead to the Orange Revolution?

5. CASE Ukraine Escaping from a “capture” trap 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. Requires a collective action at least within this interest group Historicallywas not the case in Ukraine

6. CASE Ukraine Escaping from a “capture” trap Dixit, Grossman, and Helpman (1997): a government can have sufficient political choice, if: • Itis a common agent of many diverse lobbyists acting as principals • The pool of rent isfixed • A norm for sharing of the rent between principals and agent is uniform andstrictly defined (e.g. by a competitive market) 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

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

8. CASE Ukraine Our contribution: • 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. Main ideas: • 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!

9. CASE Ukraine Rent seeking vs. profit seeking Profit seeking Rent 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 Players can establish certain efficient institutions, primarily, the property rights by a voluntary agreement In many cases players fail to establish the efficient institutions. Sonin (2003), Hoff and Stiglitz (2002, 2004), Polishchuk and Savvateev (2002): 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

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

11. CASE Ukraine Arbiter-clients model: how it works Authoritarian arbiter Distributes the quotas for rent appropriation arbitrarily, and enforces them in order to restrain the devastating competition Rent source Rent source client player player client player player client client … but instead extorts the rent himself, or trades it for loyalty

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

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

14. CASE Ukraine Problem of an authoritarian arbiter Rent seeking CONTRACTS! Rent-seeking sector Profit-seeking sector Similarly to Ronald Coase’s theory of a firm The rent seeking proliferates Systemic reform A residual remains! MORE EFFICIENT UNSUSTAINABLE! EQUILIBRIUM CRISIS Marginal cost of control and coordination Marginal rent A long-term process preceding to reforms Technology SOCIETAL NORMS

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

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

17. 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 1980th, 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 (1995-96 and 2000-2001), each brought about by a crisis As a result, the rent-seeking sector has been contracted so much that made the Orange Revolution possible (???)

18. CASE Ukraine Implications Only valid in a long run! Testable hypotheses: • Democracy should be negatively correlated with rent seeking • 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) UKRAINE • 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 • As a result of Orange Revolution, the rent seeking sector should contract further

19. 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

20. Thanks for your attention!