metadata: authors: 0: author: Hoff, Karla
1: author: Stiglitz, Joseph E.
count: World
docna: 0: docna: Exiting a lawless state
docty: Policy Research Working Paper
subtopic: Social Policy,Legal Products,Judicial System Reform,Multinational & Corporate Governance,Corporate Governance,Disability,Common Property Resource Development,State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Capital Markets and Capital Flows,Capital Flows,Services & Transfers to Poor,Economic Assistance,Legal Reform,Privatization,Access of Poor to Social Services,Energy Privatization,Legislation,Regulatory Regimes,Civic Participation and Corporate Governance,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Governance,Public Sector Development,Social Protections and Labor,Gender,Finance and Financial Sector Development
abstracts: cdata!: An earlier paper showed that an economy
            could be trapped in an equilibrium state in which the
            absence of the rule of law led to asset-stripping, and the
            prevalence of asset-stripping led to the absence of a demand
            for the rule of law, highlighting a coordination failure.
            This paper looks more carefully at the dynamics of
            transition from a non-rule-of-law state. The paper
            identifies a commitment problem as the critical feature
            inhibiting the transition:  the inability, under a rule of
            law, to forgive theft. This can lead to the perpetuation of
            the non-rule-of-law state, even when it might seem that the
            alternative is Pareto-improving.
repnme: repnme: Exiting a lawless state
display_title: Exiting a lawless state
listing_relative_url: /research/2008/02/9048193/exiting-lawless-state
topicv3: Justice m1326106 840,Personal Property Rights m1326571 1907,Corporate Governance m1326968 417,Social Assistance m1327201 1466,Privatization m1327236 1283
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Governance,Public Sector Development,Social Protections and Labor,Gender,Finance and Financial Sector Development
no_of_pages: 38
author_keys: 0: author_key: NA
1: author_key: NA
model_extractions: WPS4520 Policy ReseaRch WoRking PaPeR 4520 Exiting a Lawless State _Karla Hoff Joseph E. Stiglitz_ The World Bank Development Research Group Macroeconomics and Growth Team February 2008
Policy ReseaRch WoRking PaPeR 4520

# **Abstract**

This paper looks at the dynamics at play in a transition from a no-rule-of-law state to a strong rule-of-law state. The paper identifies a specific commitment problem in a rule of law democracy as the critical feature inhibiting this transition. The commitment problem—forgiveness of theft—makes exiting the rule of law costly to those who have been stripping assets. A simple mechanism is proposed to explain the underlying commitment problem: namely, politicians have incentives to appropriate illegitimately obtained income and to redistribute it to their supporters, whereas they do not have such incentives with respect to legitimately obtained income because to do so would harm investment incentives. Asset stripping in this model is like getting “blood on one’s hands,” in that it makes an individual vulnerable to a loss during the transition to the rule of law. The model does not assume that the blood is never washed away, but rather than only the current period's return from asset stripping is vulnerable to recapture. However, as long as the non-rule of-law state persists, some agents may choose to strip assets, period after period. Because the blood on their hands would be fresh when the rule of law state was created, they would gain from the establishment of the rule of law only after they began to build value—that is, with a time lag. This can delay or even prevent the establishment of the rule of law. The results suggest that elected officials face a thorny coordination problem because the commitment problem is inherent in the rule of law process.

This paper—a product of the Growth and the Macroeconomics Team, Development Research Group—is part of a larger effort in the department to study institutional change. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at khoff@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# EXITING A LAWLESS STATE

Karla Hoff and Joseph E. Stiglitz* <u>JEL codes: D02, K10, K42, P26, P37</u> <u>Key words: commitment, dysfunctional institution, coordination, Russia, transition economy, privatization, rule of law, gradualism, governance</u> _*Hoff: World Bank, Washington DC 20433; Stiglitz: Columbia University, New York, NY 10027. We thank Mayuresh Kshetramade for outstanding research assistance. We benefited from valuable suggestions from two anonymous referees, Kaushik Basu, Avinash Dixit, Phil Keefer, Gary Libecap, Norman Loayza, Branko Milanovic, Andrew Scott, Ken Sokoloff, and participants at seminars at UCBerkeley, Harvard (PIEP), Princeton, Tufts, Stanford, UCLA, and at the Joint World Bank-IMF seminar and the meetings of the American Political Science Association. Hoff thanks the MacArthur Research Network on Inequality and Economic Performance for research support. The findings and interpretations expressed in this paper are those of the authors and do not necessarily represent the views of the World Bank._
Why do dysfunctional institutions persist? It is now well understood that they persist if there are politically powerful losers from reform and no way to credibly promise them compensation. There are two possible lines of attack on this problem. The first investigates whether the problem of commitment can be solved dynamically. The second asks how a society evolves when such commitment is not possible. We are concerned with the second question. The presumption has been that if a reform is “good enough,” then once a society understands the magnitude of its benefits, sufficient demand for the reform will emerge that it will occur. Creating the rule of law is an example of such a reform. The rule of law stops the few from stealing from the many. In this view, one would expect the rule of law to emerge.<sup>1</sup> Even though we believe that the rule of law creates a vast majority of winners, we see that many societies are not moving towards the rule of law. In Russia and many other post-communist countries, little progress towards either forming a strong constituency for the rule of law, or establishing the rule of law, has been made since the privatization of most state enterprises.<sup>2</sup> Figure 1 presents the distribution, for the earliest and latest years available, of World Bank scores of adherence to the rule of law for 27 post-communist 1In this approach, if the rule of law does not emerge, it is because the few people that benefit from the future rents that they receive under the _status quo_ are so strong that they can prevent the reform. Thus, the analysis focuses on political structures that allow narrow political groups to block the reform, at such great social cost. Models of political obstacles to efficiency-enhancing reforms include Besley and Coate (1998), Acemoglu and Robinson (2000), Sonin (2003), Acemoglu, Johnson, and Robinson (2005), and Rajan (2007).

2 See, for example, Pistor (1999) and the symposium on “Demand for Law” in which Pistor (1999) appears, Black _et al_ . (2000), Nagy (2000, p. 88), Sperling (2000, pp. 16-17), Kolodko (2000), and Graham (2002, esp. p. 49). Other scholars have argued that in many countries, the cause of the absence of the rule of law lies on the supply side, for instance, in the inability to finance a market-oriented system; see Johnson, Kaufmann, and Shleifer (1997) and Roland and Verdier (2003). But financial problems reflect decisions of essentially the same kind as the demand side decisions that we analyze here. Russia was giving away at fire-sale prices state assets of value an order of magnitude greater than the cost of administering a rule-oflaw system; see _e.g_ . Kotkin (2001, p. 215).

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countries and the world as a whole.<sup>3</sup> In 1996, the post-communist countries had on average slightly less adherence to the rule of law than the world as a whole, but showed low dispersion. Between 1996 and 2005, a twin peaks pattern emerged for the postcommunist countries and for the world: Some post-communist countries achieved a good measure of rule of law, while for the majority, scores remained low or deteriorated relative to the world. Holmes (2002) reflects a widely shared view (see _n_ . 2) when he writes that in Russia the central obstacle to the emergence of the rule of law is the lack of demand: No well-organized constituency for a rule-of-law system exists in Russia today. Putin may sincerely want to introduce the rule of law. He may repeatedly announce that he is going to create it. ...These subjective intentions are irrelevant, however. The rule of law is going to emerge only if there are strong constituencies supporting it. (p. 87) One possible explanation for this puzzle is that the rule of law is not such a great thing. Perhaps we have overestimated its ability to increase income or underestimated its distributional consequences, in particular, those that cannot be undone by credible commitments to redistribute. For example, the traditional view of the enclosure of the commons in England was that it created large, dispersed benefits. Yet Weitzman (1974) showed that most people could be worse off under the efficient enclosure than under inefficient free access rights.<sup>4</sup> The establishment of the rule of law in a lawless state is a more compelling example of a reform that should engender widespread support, since it is a movement from the jungle to order. Political philosophers from Hobbes to Nozick clearly viewed this kind of reform as an improvement. Economists have argued that although private, relation-based governance may suffice for a middle-income country, the rule of law is necessary to make the transition to a high-income country (Rodrik, 2003, p. 17; Dixit 2004, p. 82). Yet, as Figure 1 illustrates, many societies do not seem to be moving towards the rule of law.

In this paper we offer an alternative explanation. We assume that the rule of law is an institutional change that permits higher levels of welfare _to everyone_ because of the

> 3http://info.worldbank.org/governance/wgi2007/

> 4 Subsequently, Allen (1982) challenged the view that the enclosure movement enhanced efficiency.

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greater incentives to production. We also assume that individuals are forward-looking, with expectations that are consistent with the properties of the underlying model. But we allow individuals who do not believe that a quick transition to the rule of law will occur to adapt their economic activities accordingly. _Costs of exiting the lawless state arise endogenously from these adaptive behaviors and engender resistance to reform._ We show this in a simple, dynamic model that builds on our earlier static model of coordination.<sup>5</sup> In the earlier model, agents with control rights over enterprises face two choices: one economic, whether to build the value of their assets or strip them; and one political, whether to adopt the rule of law or not. Given the static nature of that model, only those who choose to build the value of their assets benefit from the rule of law. Thus, the probability distribution of the political outcome depends on the fraction of the population that chooses to build value, which itself depends on the probability distribution of the political outcome. We showed that self-fulfilling Pareto-inferior equilbria may exist in which few agents build value and thus few demand the rule of law.<sup>6</sup> In the dynamic setting that we explore here, all individuals obtain a future benefit from the establishment of the rule of law. Therefore, individuals who strip assets in the current period may vote _for_ creating the rule of law. Their choice depends on the trade-off between the loss from the expected recapture of part of their stripping income in the transition to the rule of law, and the gain with respect to future economic activities.

Asset stripping in our model is like getting “blood on one’s hands,” in that it makes an individual vulnerable to a loss in the transition to the rule of law. We do not assume that the blood is never washed away. On the contrary, we make the minimalist assumption that only the current period’s return from asset stripping is vulnerable to recapture. However, as long as the non-rule of-law state persists, some agents may choose to strip assets, period after period. Thus the blood on their hands would be fresh when the rule of law state was created, and so they would gain from the establishment of

> 5 See Hoff and Stiglitz (2004a), which also provides a brief review of the transition from communism in Russia.  For a diagrammatic exposition, see Hoff and Stiglitz (2004b).

> 6For another example of political-economic links with self-fulfilling equilibria, see Chang (2006).

4
the rule of law only after they began to build value—that is, _with a time lag._<sup>7</sup> This can delay the establishment of the rule of law or even lock the society out of it. Our results highlight a coordination problem that an elected policy-maker cannot solve because of a commitment problem inherent in the rule of law.

All that we require to generate endogenously the possibility of losers from institutional reform is that, under the rule of law, society cannot commit itself to zero recapture of income from asset stripping.<sup>8</sup> This commitment problem arises from what scholars take to be key features of any system that provides impartial third party enforcement of property rights and contracts: ( _a_ ) Such a legal system should be viewed as a self-enforcing equilibrium between political officials and citizens, and ( _b_ ) only if the distribution of power is such that conflicting actors seek to resolve their conflicts by recourse to law does law rule. Following from these two properties is a third, namely, ( _c_ ) the contents of the rule of law are subject to interrogation and reform, rather than capable of being frozen at a moment in time.<sup>9</sup> In other words, one cannot simultaneously have the rule of law and fence it in so as to commit a society not to capture illegitimate gains obtained before some time _t._ In Section 4, we sketch a simple mechanism underlying the commitment problem in a rule-of-law governed democracy: Politicians have incentives to appropriate _illegitimately_ obtained income and to redistribute it to their supporters, whereas they do _not_ have such incentives with respect to _legitimately_ obtained income.

As in our earlier static model, we have chosen to develop our points in a specific context—post-communist countries after the privatization of many state enterprises. But the framework of our paper illuminates a very general problem and thus may serve as a basis for integrating the literature: Starting with a society in which theft is allowed but

> 7This result is reminiscent of Adsera and Ray (1998), who assume that, for _all_ agents, the benefits of coordination come with an _exogenous_ delay _._ Our paper explores a mechanism that can generate (for some agents) the delay that Adsera and Ray model as a reduced form.

8 Or, more precisely, that the risk of recapture will not increase under the rule of law.

9 See, _e.g._ on ( _a_ ) Weingast (1997) and Basu (2000) and on ( _b,c_ ), Maravall and Przeworski (2003). Regarding point ( _c_ ), it is worthwhile to quote from the Supreme Court decision in the case of _Nebbia_ vs. _New York_ (1934), where the Court declared that “there is no closed case or category of business affected with the public interest...” (cited in North, 1981, p. 198).

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allowing theft is not in anyone’s self-interest, can we explain the creation of third party enforcement of property rights, which makes it costly for individuals to steal?<sup>10</sup> Our framework shows why _it is difficult to create a demand for the rule of law from scratch, e.g._ without norms that limit theft. Our framework is Markov; _i.e._ current and future outcomes are conditioned only on the current state. If, more realistically, we allow that outcomes also depend on history, then the difficulty of exiting the lawless state after asset-stripping will be greater than our model would suggest, as we show in Section 2. In the conclusion, we suggest additional applications of our framework.

Our paper contributes to the rapidly growing literature on the positive economics of institutional change (see references in _n._ 1). Our departure from the existing work on the problem of credible commitment to compensate losers from reform is that we treat individuals’ economic interests as endogenous, whereas existing work<sup>11</sup> treats them as parametric. That modeling approach is appropriate when economic institutions are stable with regard to the political transitions that the model tries to explain, _e.g_ . the case of the transitions from authoritarianism of Latin America and Southern Europe (O’Donnell _et al._ 1986). What is historically distinct about the post-communist transitions is the possibility of simultaneous deep change in both the economy and the polity. These transitions have been compared to “rebuilding the ship the sea”: “Hardly any of the _institutional_ elements of the old order can be relied upon, _i.e_ ., is considered...worthy of preservation for more than a transitory period or recognized as a worthy legacy” (Elster _et al.,_ 1998, p. 18, emphasis in original). In this context it is appropriate to treat economic interests as endogenous. Our paper focuses on the costs of exiting a lawless state created by two kinds of problems: (1) the coordination of economic and political choices and (2) the constraints that the rule of law imposes on the content of laws.

Our paper also contributes to the literature on privatization. Studies of privatization all over the world have concluded that privatization is unlikely to improve 10 Basu (1997, p. 248) observes that “Since this exercise...has not been done thus far, we do not really know whether the model of the market, abstracted from its social and political moorings, can ever be realized.”

> 11 As Acemoglu and Robinson (2006, p. 316) emphasize.  Acemoglu, Johnson, and Robinson (2005) outline the desiderata for a yet-to-be-built general theory of institutional change.

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performance when corporate governance institutions are weak.<sup>12</sup> While noting in that case the absence of any benefit from privatization, these studies overlook a cost that we emphasize here: by widening the scope for asset stripping, privatization may create political forces opposed to establishing the rule of law. Not surprisingly, scholars have enjoined developing countries before privatizing firms to “embrace a corporate governance perspective...that can constrain the grabbing hands of public and private actors” (Dyck, 2001 p. 59). In Section 3, we extend our model to consider two policies that affect the demand for the rule of law—the sequencing and pacing of the postcommunist transition and macroeconomic policy.

Our framework of binary choices in the economy and the polity is too simple to capture the institutional path of any real post-communist country. In our concluding section, we emphasize the need in future work to incorporate changes over time in the distribution of power.

# **1.  A Dynamic Model of the Demand for the Rule of Law**

# 1.1 _The Agents_

There is a continuum one of forward-looking agents with control rights over enterprises. Time is divided into an infinite number of periods. In every period, each agent has a choice between two economic actions: <u>Building value: Making an irreversible investment to increase the enterprise’s value,</u> or <u>Stripping assets: Stripping the assets of the enterprise by appropriating corporate</u> value for themselves and expropriating minority investors, sometimes also referred to as “tunneling.” The assumption behind this setup is that agents are not constrained by norms, other informal institutions, or corporate institutions such as boards.<sup>13</sup> In choosing their strategies, agents

> 12 See Dyck (2001), Djankov and Murrell (2002), and Megginson (2005).

> 13 For an interesting case study of the institutional vacuum in one Russian firm, see Gray and Hendley (1997).

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look at the entire future stream of returns, where _δ_ ∈ (0,1) is the discount factor.

Agents differ in their ability to strip assets. θ denotes an agent’s type, and a higher value of θ corresponds to a greater ability to strip assets. θ has a continuous distribution _H_ ( θ ) and density function _h_ (.).

# 1.2 _The Political Environment_

There are two possible political institutions. Initially the polity is a “non-rule-of-law state.”<sup>14</sup> The alternative political institution is “the rule of law,” by which we mean welldefined and enforced property rights, broad access to those rights, and predictable rules for resolving rights disputes. The gain from the rule of law is that it makes property rights effective. We assume that for _every_ agent, this _is_ a gain: the profit incentives of a private firm under the rule of law are stronger than the rent-seeking incentives in the nonrule-of-law state (see inequality (4)). The question we address in this paper is whether this assumption is sufficient to ensure a demand for establishing the rule of law.

In each period, individuals have to express a political preference, _e.g._ by voting over policies that would create the rule of law. Voting is a metaphor for the myriad ways, such as lobbying an elected policy maker, that individuals influence the collective choice over institutions. We assume that the probability π _t_ of transition to the rule of law in period _t_ is a decreasing function of the fraction of agents, denoted _xt_ , who vote against the establishment of the rule of law:<sup>15</sup> (1) means that the probability that the rule of law will be established rises from zero to one as the proportion of agents opposed to its establishment falls from 100% to zero.

We also assume that the rule of law is an absorbing state: once it is established,

> 14 A typical characterization of the institutional environment in which the first wave of Russian privatization occurred was a “systemic vacuum...[without] effective regulations and controls” (Kolodko, 2000, p. 196), permitting “a sort of Hobbesian capitalism” (Freeland 2000, p. 21).

> 15 A part of the economy does not have control rights over firms.  A premise of the analysis is that those

> who do are the decisive “voters” over whether to create impartial third-party enforcement of property rights and contracts.

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the society continues in that state forever. Similar results would hold if there was a small probability of reversion to the non-rule-of-law state.<sup>16</sup>

# 1.3 _The Payoffs_

For simplicity, we model the process of building the value of an asset as requiring a given level of investment. An individual who builds value in a period obtains an income flow _f_ per unit asset and makes an investment _I_<sup>_j_</sup> _< f_ per unit asset, where _j_ is the state of the world ( _N_ or _L)_ at the end of the period, and _I_<sup>_N_</sup> > _I_<sup>_L_</sup> .<sup>17</sup> One way to motivate this is to suppose that if _N_ is the end-of-period state, then the firm must invest in the private enforcement of property rights to obtain a return on its investment.

Let _b_<sup>_j_</sup> denote the net flow from building value: Building value increases the asset to a proportion _g_<sup>~</sup> > 1 of its former size. We assume δ _g_ ~ < 1 so that asset values are finite.

The model makes an important simplification that leads to an underestimate of the value of the rule of law—the model abstracts from direct externalities across firms. In the real world, if a large fraction of the economy is engaged in asset stripping, then (as in Russia in the 1990s) overall production suffers. We abstract from these externalities in order to focus on externalities mediated by the political environment.

Consider next the payoff to stripping assets. An agent who strips increases the flow of income per unit asset at the cost of reducing the asset to a proportion ~ _z_ < 1 of its former size. Let s<sup>_j_</sup> denote the payoff per unit asset to an agent of type _θ,_ where _j_ is the state of the world at the end of the period: 16 It would be easy to model such a reversion within our Markovian framework, and it is clear from Figure 1 that reversion occurs. Our assumption of no reversion increases the gains from transition to the rule of law and, thus, makes it more surprising that a strong demand for rule of law may not emerge.

> 17 Alternatively, as in Hoff and Stiglitz (2004a), we could model the rule of law as entailing an _increased_ return from the _same_ level of investment – _e.g_ . because it reduces the costs of distribution.  Nothing depends on the choice between these two simplifications.

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In this expression, λ represents the diminution in the ability to strip after the imposition of the rule of law, which circumscribes certain actions used by strippers. λ also measures the expected recapture of current income from stripping if the transition to the rule of law occurs in a given period. Thus, an agent of type θ who is stripping assets suffers a loss θλ in expected value in the transition period. This is his cost of exiting the lawless state.

As discussed above, we assume that for all agents, building value under the rule of law yields a higher lifetime utility than stripping assets under non-rule-of-law, _i.e._ ~ for all θ and with strict inequality for some θ _,_ where _g_ ≡ δ _g_ and _z_ ≡ δ<sup>~</sup> _z_ . _One way to view the rule of law is that it suppresses the inferior, stripping technology—analogous to pulling a ship apart at sea—in favor of the superior, value-creating technology—_ _rebuilding the ship._ Below we consider agents’ choice of economic strategy in the initial state _N—_ that is, in the wreckage of the centrally planned economy.

# 1.4 _The Choice of Economic Strategy_

If the initial state is _N_ , individual economic choices are predicated on the path of aggregate political behavior, _xt_ , _xt_ + 1, _xt_ + 2... . Each agent has an expectation concerning these values, and in the equilibria explored here the expectation is correct. We will investigate a subset of possible equilibrium paths such that, as long as non-rule-of-law state prevails, the fraction of agents opposed to reform remains the same: _xt_ = _xt_ + 1<sup>=</sup> _xt_ + 2 = ... ≡ _x_ . We will derive the _economic switch line_ as those combinations of ( _x,_ θ ) for which the agent is indifferent in state _N_ between building value and stripping assets _._ An agent of type θ has expected income per unit asset of _b_ ( _x_ ) = π ( _x_ ) _b L_ + 1[ − π ( _x_ )] _b N_ if he builds value in a given period, and _~~s~~_ ( _x_ , θ ; λ ) = θ 1[ − π ( _x_ ) λ ] if he strips assets. We write utility recursively. We denote it by _VN_ ( _x_ ) if the _initial_ state is _N_ and the individual chooses to build value, and similarly for _VL_ . Thus, 10
If the initial state is _N,_ then an individual of type θ will choose to build value in every period if and only if The inequality in (6) and (7) is equivalent to the condition, The sign of Δ ( _x,_ θ _;_ λ ), defined in the right-hand side of (8), is positive if and only if the individual is better off building value than stripping assets if the initial state is _N._ Since Δ is strictly decreasing in the agent’s ability to strip, _i.e._ there is a critical value of θ for each value of _x,_ which is denoted by θ _a_ ( _x;_ λ ) and implicitly defined by Agents with θ ≤ θ _a_ build value in every period and have utility equal to (6) or, equivalently, Agents with θ > θ _a_ strip assets until the transition to state _L_ occurs, and have utility<sup>18</sup>

> 18The bracketed terms on the right-hand side of (11) and (12) are the capital gains from transition to the rule of law.

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In Figure 2, the switch line is negatively sloped because an increase in _x_ lowers _b_ and raises _~~s~~_ . Greater constraints on stripping (higher λ ) shift up the switch line because they make stripping less profitable. Formally, we have: The first two terms of (13) are positive by construction. We prove in the Appendix that the final bracketed term is also positive. Part (a) then follows immediately from (9). Similarly we obtain

# 1.5 _Preferences over Political Institutions_

In each period, agents express a political preference, _e.g._ by voting, over the rule of law. Those who build value demand the rule of law, since it would increase their incomes currently and in the future. Those who strip assets face an intertemporal trade-off. Their lifetime income is (1- λ ) θ _+ zVL_ if the transition to the rule of law occurs at the end of the current period, and θ _+ zSN_ ( _x_ , θ _;_ λ ) otherwise.

Let β denote an asset-stripper’s benefit (which could be positive or negative) if state _N_ persists one more period:<sup>19</sup>

> 19 We treat (14) as if it is defined over all θ , but it affects behavior only through equation (17), _i.e_ . it is relevant only to asset-strippers.

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β is a strictly increasing function of θ because those who strip better have a greater cost of exiting the lawless state: and so there exists a switch point, which we denote by θ _p_ , at which β _=_ 0. The switch point has the following properties, as one can easily check:

**Proposition 2.** θ _p_ is decreasing in λ and is invariant to aggregate political behavior, _x_ .

The intuition for (16a) is that since the higher is λ _,_ the greater an asset stripper’s cost of exiting the lawless state, more agents will oppose the establishment of the rule of law ( θ _p_ is decreased). For (16b), the intuition is that when β = 0, individuals are indifferent between states, and so a marginal change in _x_ has a zero first-order effect on an individual’s “vote.” We are now ready to define the _political switch line_ , denoted θ _*_ ( _x;_ λ ), as those combinations of ( _x,_ θ ) for which the individual is indifferent between states _N_ and _L_ : Agents of type θ _≤_ θ _*_ demand legal reform (the rule of law), and agents of type θ _>_ θ _*_ oppose it. Figure 2 depicts an example of a _political switch line._ It coincides with the _economic switch line_ for _θa > θp_ , and otherwise, corresponds to _θp_ . As shown in the figure, some asset-strippers support the rule of law even though its establishment will make them vulnerable to the recapture of illegitimate gains from asset stripping; the longrun benefits from the rule of law exceed the “exit cost” of transition. These agents fall in Region III of the figure, where θ _a <_ θ _<_ θ _p_ .

There are also two possible polar configurations. The first occurs if λ is so high—and thus θ _p_ is so low—that _no_ asset stripper demands the rule of law. The second 13
configuration, depicted in Figure 3, occurs if λ = 0. (In the figure, θ _max_ denotes the maximum ability to strip among agents, which is implicitly defined by writing (4) as a strict equality.) With no risk of recapture of stripping returns, there is no exit cost from the lawless state, and so _all_ asset strippers demand the rule of law. We will argue in Section 4 that the rule of law, _by constraining the content of laws_ , bars setting λ = 0.

# 1.6 _The Stripping Ability Curve_

To analyze the equilibrium demand ( _x_ ) for the rule of law, one additional curve is needed that reflects the distribution of types in the population. We denote by the _stripping ability curve_ the function _x_ ( θ ) _=_ 1 _-H_ ( θ ). For each value of θ _,_ the stripping ability curve gives the fraction of agents whose ability to strip is greater than or equal to that value. If the distribution of θ is approximately normal, then the stripping ability curve will have the shape of the dotted line in Figure 4 (another example is in Figure 5A).

# 1.7 _Equilibrium Paths_

An equilibrium path in the lawless state depends on the fraction of agents _x_ * who oppose the establishment of the rule of law, where _x*_ solves An interior equilibrium is a pair of values ( _x_ , θ ) that satisfy the _political switch line_ and the _stripping ability curve_ . Since both curves are downward sloping, they can have more than one intersection. Figure 4 depicts the case of two stable values of _x_ * (at 0 and _x_ ′′ ).

The figure also depicts an unstable equilibrium, at _x_ ′ . At that point, the _political switch line_ is steeper than the _stripping ability curve._ This means that the response along the political switch line to a perturbation in _x_ will be greater than the perturbation itself. So if there is a perturbation at _x_ ′ _,_ the “switched” agents do not wish to switch back. The perturbation changes the way agents believe the system will evolve, which lowers θ _a_ by so much that some agents change their economic strategy and, having done that, face sufficiently high exit costs that _their preference ordering over political institutions changes._ Thus the path along which a fraction _x_ ′ opposes the establishment of a rule of law in each period is unstable.

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The model could have two corner solutions: _x_ * = 0 is always an equilibrium (though it need not be stable), since at _x =_ 0 the _political switch line_ lies above, or is coincident with, the _stripping ability curve. x*_ = 1 is also an equilibrium if the _political switch line_ lies below the _stripping ability curve_ at _x_ = 1. If this point is an equilibrium, then the society is trapped in the non-rule-of-law state.<sup>20</sup> The model clarifies the effect of changes in the expected recapture fraction, λ .<sup>21</sup> A decrease in λ makes asset stripping more attractive (the _economic switch line_ shifts down), but also increases the demand for rule of law by asset strippers (the _political switch line_ shifts up). The net effect on support for the establishment of the rule of law thus depends on the nature of the original equilibrium. Starting from a stable equilibrium in which the marginal “voter” is a wealth-creator,<sup>22</sup> a reduction in λ _increases the opposition_ to the establishment of the rule of law, since it increases the fraction of agents who strip assets. However, starting from a stable equilibrium in which the marginal “voter” is an asset stripper, the effect is the opposite: a reduction in λ _increases the demand for_ the rule of law, since it lowers exit costs from a lawless state.

# 1.8. _A Numerical Example_

In the standard model of “political and economic losers” who block reform (see references in _n._ 1), dysfunctional institutions serve the interests of narrow groups at the expense of everyone else. In our model, in contrast, _the victims of the dysfunctional_ 20 As emphasized by Greif (1994), culture is an equilibrium selection device, and so it is interesting to consider within this model the role that culture might have played in Russia. Two facts suggest that the “good” corner equilibrium, with _x*_ = 0, would not be a focal point: (a) managers commonly engaged in asset stripping well before the mass privatization of 1992-94 (see Grigoriev 1992), and (b) most beneficiaries of the mass privatization of large state enterprises in Russia were the managers. For instance, Varese (2001, Appendix B), finds in his survey of one Russian city that 51 percent of the 92 full-time officials of the Communist Party in 1988 were top managers of economic enterprises in 1993.

21 We discuss other comparative statics results in Hoff and Stiglitz (2004a).

> 22 Or, more accurately, if the intersection of θ _*(x;_ λ _)_ and the _stripping ability curve_ lies along θ _a_ , not θ _p._

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_institutions include those who choose them._ To illustrate this, we present a numerical example. In the example, we assume: (a) a transition probability equal to the squared demand for the rule of law: π ( _x_ ) = (1- _x_ )<sup>2</sup> , (b) a set of values of the parameters,<sup>23</sup> and (c) a distribution of stripping abilities in which two-thirds of the agents have θ = θ _max_ and among the remainder, θ is uniformly distributed on [0.65, θ _max_ ].

Figure 5A shows that the stable equilibria of _x_ * are 0 and 0.75. In the first case, no one opposes the establishment of the rule of law, and reform occurs in period 1. In the second case, three-fourths of the agents oppose the rule of law, and reform is delayed on average for 16 periods.<sup>24</sup> Figure 5B depicts the growth paths of agents’ expected aggregate lifetime income in these two cases.<sup>25</sup> Expected aggregate income is 20 percent lower along the path of delayed reform. Every agent is strictly worse off.

# **2.  Sources of Historical Dependence**

In the Markovian model we have constructed, actions do not depend on history. In this section, we consider sources of historical dependence.

# 2.1 _History-dependent Payoffs_

An important example of history dependence are endogenous shifts in the distribution of types _H_ ( θ ). Consider a set of societies with initially similar distributions of types among which, for some reason, one subset began with an initially high level of asset stripping and another subset with an initially low level. If stripping assets was characterized by learning-by-doing, then behavior would be self-reinforcing. The distribution of types would diverge over time, as would the degree of support for the rule of law. As Holmes (2003, pp. 20-21) states,

> 23 _f =_ 0.05, _IL_ = 0.01, _IN_ = 0.0475, _g_<sup>~</sup> = 1.05, ~ _z_ = 0.9, λ = 0.3, and δ = 0.945.  Using (4), these values imply θ _max_ = 0.8.  The excel program is available at <u>www.econ.worldbank.org/staff/khoff.</u> 24 One can show by standard methods that given a transition probability π per period, the expected number of periods before reform is 1/ π .   If _x*_ = 0.75, then π ( _x*_ ) _=_ 0.0625, and the expected delay is 16 periods.

25 When _x_ * = 0.75, 87% of agents build value (the marginal asset-stripper demands the rule of law). To compute aggregate income, we assume that each agent has control rights over an equal share of aggregate assets. This implies that the fraction of _agents_ who strip assets equals the fraction of _assets_ that are stripped.

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Bullies and plunderers—who could never flourish if the rules of the game were crystal clear and reliably enforced—cannot be expected to promote or enforce a system that will radically devalue the rude skills of acquisition and domination they have perfected in the state of nature.

Efficiency in stripping may also increase as it becomes more institutionalized (and similarly, the ability to engage in growth-enhancing investments may increase with use, or atrophy without it).

An offsetting factor would be that as the stock of assets goes down, the returns from further stripping decline. When assets to strip run out, everyone would support the rule of law. However, in natural resource-rich economies, such as Russia’s, this would not happen quickly.

A further source of history dependence are labor adjustment costs if hired labor is specialized to either stripping assets or building value, _e.g._ mobsters _vs_ . engineers. A formal model is Krugman (1991).

# 2.2. _History-dependent Beliefs_

The experience of the transition may reinforce one or another view of man; one can learn to trust, or not to. A history of corruption may influence a social group’s norms in ways that would make it harder to achieve a rule of law state (Fisman and Miguel 2006). The following response of a Russian minister to allegations of corruption illustrates that the abuse of power can come to be publicly perceived as legitimate: Vladimir Rushaylo has flatly denied the allegations that 70 per cent of all Russian officials are corrupted ... “Only those who have links with the organized criminal gangs can be regarded as corrupted officials. Do not mistake bribe-taking for corruption,” the Russian Interior Minister stressed.

(RIA news agency, Moscow, March 13, 2001/BBC Monitoring © BBC)

# 2.3 _Cumulative Exit Costs_

We assumed that only those assets stripped in the transition period were subject to recapture, whereas assets stripped in earlier periods were “grandfathered”—time had gained them 17
legitimacy. In reality, it is the cumulative stock of asset stripping that is at risk of recapture. As the stock increases over time, the costs of exiting the non-rule-of-law state also increase. This effect would be even larger if, as the amounts taken mount, demands that more of the assets be recaptured increase, _i.e._ λ increases.

Recapture may not be the only exit cost. Asset strippers who have engaged in criminal activity may also face a risk of retroactive criminal prosecution. Recognizing the huge cost associated with the transition to the rule of law, they may “invest” a great deal in the maintenance of the non-rule-of-law state, including murdering those who work to establish the rule of law. Not only are some individuals locked in by their pasts, but others who might wish to support the rule of law may incur tremendous risks in doing so.<sup>26</sup>

# **3.  Policies that Change the Political/Economic Dynamics**

A better understanding of barriers to institutional reform can serve as a guide to what conditions might be changed in order to achieve success. We will consider first the sequencing and pacing of reform, and then macroeconomic policy.<sup>27</sup>

# 3.1. _The Sequencing and Pacing of Reform_

The model in Section 1 analyzed how, _after_ privatization, asset-stripping affects the demand for the rule of law. Here we develop a very simple model that links what happens _before and during_ formal privatization—and what happens _after._ The extended model captures aspects of the debate in the 1990s between advocates of “gradualist policies” and proponents of a “Big Bang” approach to privatization. (In the end, only Russia and the Czech Republic followed the latter approach.) A gradualist approach 26 The assassination in 2002 of V. Golovlyov, a member of the Duma, is one of a long list of assassinations, nearly all unsolved, of Russian public officials. It was believed that “Mr. Golovlyov was killed by former cronies because he had jumped [from a criminal past] to the side of the law helping the investigators.” (Michael Wines, _New York Times,_ August 24, 2002).

27 On the uses of political-economic models for posing normative questions with regard to aspects of policy that are treated as exogenous, see Rodrik (1993). Besides the two policies considered in this section, another key influence on the demand for rule of law are controls on international capital inflows; see _e.g._ Qian 1999, Hoff and Stiglitz 2004a, and Braguinsky and Myerson 2007.

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postpones privatization until corporate governance institutions are in place, whereas a Big Bang, sometimes called “shock therapy,” privatizes as rapidly as possible.<sup>28</sup> At the outset of the transition from communism, a central rationale for rapid privatization was to avoid the diminution of wealth within the state from asset stripping and inefficiency. Let _YG_ denote output per period from the initial stock of assets in the public sector. If wastage reduces the assets each period to a proportion μ of their former size, and if the assets are privatized at time _T_ , then the assets will have diminished by a factor μ<sup>_T_</sup> .

Gradualism entails creating corporate governance mechanisms that reduce the ability of an agent to strip assets after privatization. Such mechanisms shift down the _stripping ability curve_ .<sup>29</sup> We parameterize the shift by a function ω (.). The faster the privatization, the weaker is corporate governance.

Let _W_ [ _x*_ ( ω _, λ_ ) _,_ ω ( _T_ ), λ( _T_ )] denote the maximized value of expected future income _as of time T_ . The model of Section 1 maps into this function. _W_ (.) depends on the constituency against the rule of law, _x*_ ( ω _, λ_ ), and also depends directly on the extent of corporate governance mechanisms ω and on λ through their influence on stripping.

The value of expected future income _at time zero_ can be written as (19) captures several effects of delaying privatization. First, delay means greater dissipation of value while assets remain in the public sector. But transferring property to 28 This policy choice also has implications, which we do not discuss here, for the manner of privatization (its perceived legality and the ability to transfer state enterprises to outsider, not insider, owners, with large consequences for privatization’s success) and also for employment losses and fiscal costs; see Roland (1994), Dewatripont and Roland (1995), and Frydman _et al_ . (1999). An engaging overview of the debate is McMillan (2002, ch. 15).

29 One measure of this is in Atanasov et al. (2007), which shows that following a change in Bulgarian securities law to restrict the scope for financial tunnelling, share prices jumped in a high-risk-of-tunnelling group of firms relative to share prices in a low-risk control group.

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the private sector does not eliminate agency problems.<sup>30</sup> Strengthening corporate governance institutions increases the value of the assets in the hands of the private sector. A third set of effects relates to the political dynamics _._ Creating better corporate governance institutions before privatizing large state enterprises reduces the incentives and scope for asset stripping, and so influences the constituency for reform.

Thus, if one plots social welfare in (19) as a function of the speed of privatization, it may be that some delay in official privatization trades off optimally the agency costs of state ownership with the agency costs and political risks (given weak corporate governance) of private ownership. Figure 6 depicts this case.

But whether a comparison of gradualism and the Big Bang is a relevant comparison for Russia is contentious. In one view, no reform-minded government existed to “engineer” the transition. As the Russia historian Stephen Kotkin (2001) writes: The idea that the collapse suddenly ended in December 1991 and that a handful of new ‘democrats’ or ‘radical reformers’ had come to power, was silly. (p. 7) ... _[W]ho_ was supposed to have implemented [the critics’] suggested state-led ‘gradualist’ policies—the millions of officials who had betrayed the Soviet state and enriched themselves in the bargain? No Russian leadership, rising to power by virtue of the spiraling collapse of central (Soviet) state institutions, could have prevented the ensuing total appropriation of bank accounts and property that ...were in the hands of unrestrained actors. (p. 116, emphasis in original) A second perspective is that Yeltsin enjoyed enormous authority in the fall and winter of 1991-92. That authority gave him the opportunity to _change the political forces in place before implementing privatization._ Had he made those changes, he could have 30 In both the public and the private sectors, deadweight losses arise because information is asymmetric, incentives are not aligned, and controllers take distortionary actions to divert assets and income from the “true” owner (the state or the corporation) to themselves (Stiglitz 2000). Two recent developments shed light on the importance of agency costs in privatized firms in Russia: (a) A study finds that oligarchs who controlled _state_ enterprises reported twice as much income as those who controlled _private_ enterprises, “presumably because it was more difficult to hide incomes in those businesses” (Braguinsky, 2007). The less income that is hidden, the less income that is likely diverted, with consequent deadweight losses. (b) One can interpret actions of Putin to limit the ability of privatized Russian firms to sell reserves of natural resources as reflecting his belief that this will reduce the diversion of assets (see _The Russia Journal,_ “Kremlin eyes Russia’s natural resources,” Aug. 2-8, 2002 repr. in Johnson’s Russia List).

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implemented gradualism. He chose not to do this and to focus instead on economic reforms first.<sup>31</sup> A third view is that while gradualism was not politically feasible in Russia because it would have expropriated powerful stakeholders, Big Bang privatization was both feasible and also favorable to the progress of Russia towards a free market economy because it would _change the interests of the key political players._ Fast privatization, moreover, would constrain the policy options of future governments that might oppose capitalism (Boycko _et al._ 1995, Shleifer and Treisman 2000).<sup>32</sup> History cannot readily resolve counterfactual questions. However, Poland provides an example where advocates of Big Bang privatization had argued that gradualism was not politically feasible, but privatization was delayed, and wealth within the state was preserved (the rate of wastage μ was low). Given Poland’s success in preserving wealth and in moving towards the rule of law,<sup>33</sup> there is a strong presumption that Big Bang privatization would have been inferior to the gradual privatization strategy _that Poland adopted_ . It is also plausible that Russia could have preserved a large fraction of its principal assets, natural resources, within the public sector: In extractive industries, one can at worst steal the flow. If the right to sell assets does not exist, no one can steal the capital value.

# 3.2 _Macroeconomic Policy_

Macroeconomic policy can also change the political/economic dynamics that we investigate in this paper. In post-communist countries, rapid price liberalization led to high inflation, which led to tight monetary policy to dampen the inflation. We will slightly modify the model of Section 1 to capture a link between macroeconomic policy and institutional change.

We relax our assumption in (1) about the probability π (.) of transition to the rule of law. We assume here that a particular type θ<sup>ˆ</sup> is decisive, as in the case of a median voter

> 31 This view is held with various nuances by Fish (1994), McFaul (1995, pp. 225-27), Dewatripont and Roland (1995), Black _et al._ (2000), Reddaway and Glinski (2001), and Goldman (2003).,

> 32 Biais and Perroti (2002) and Hoff (2003) discuss the limits of the strategic use of privatization.

> 33 See Belka _et al_ . (1993) and Grzymala-Busse (2003).

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model,<sup>34</sup> so that we can direct attention at how policy affects him. We also assume that θ<sup>ˆ</sup> is sufficiently high that if an individual of type θ<sup>ˆ</sup> strips, he will oppose the establishment of the rule of law in the current period, _i.e_ . θ<sup>ˆ</sup> > θ _p._ Thus, if he strips, π = 0 and his utility is _N N N S_ ( θ<sup>ˆ</sup> , _r_ ) = _s_ ( θ<sup>ˆ</sup> , _r_ ) + _zS_ ( θ<sup>ˆ</sup> , _r_ ) , where _r_ denotes the interest rate. If he builds value, _L L_ then π = 1 and his utility is _V_<sup>_L_</sup> ( _r_ ) = _b_ ( _r_ ) + _gV_ ( _r_ ) . Under plausible circumstances, raising _r_ lowers the relative return to building value: At a higher value of _r_ , the cost of capital is higher, the likelihood of credit rationing is greater, and future profits obtained from current investments are more heavily discounted.35 Government chooses a level of public spending, _G,_ and through monetary policy influences the level of the interest rate.<sup>36</sup> The rule of law will be established if ˆ Equating the two sides of (20) implicitly defines a critical value _r ._ Only if the interest rate is below it will the rule of law be established.

Suppose that social welfare depends on growth, the level of social expenditures, and inflation and, in turn, these three variables depend on _r_ and _G_ . In any given state ( _N_ or _L_ ), welfare is an indirect function of these two government policies. In Figure 7, in the traditional approach, the social optimum is at point _P_ . That approach takes the political institutions as given, but in this paper we have emphasized their endogeneity.

Suppose that social welfare under the rule of law is so much higher than under no rule of law that under any policy, the rule-of-law state provides greater welfare than the non-ruleof-law state. Then { _r,G_ } should be chosen so that the rule of law emerges as part of the

> 34 Suppose that the establishment of the rule of law depends on a majority voting rule: π = 0 if _x >_ 1⁄2 and ˆ otherwise π = 1.  The “tipping point” at which the rule of law is established is a population fraction _x =_ 1⁄2.

> Associated with the tipping point is a critical value of stripping ability, which we denote by θ<sup>ˆ</sup> , such that half of the population has a stripping ability above the critical value and half below it.

35 This result can be derived by positing in (4) and (10) that the discount factor is a function of _r._

> 36 For simplicity, suppose that the level of _G_ does not affect the relative return to building value.

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ˆ political equilibrium, _i.e. r_ ≤ _r_ . The iso-welfare curves are dashed in the policy region where the rule of law is unattainable. Maximum social welfare is obtained at point _P_ ′ _,_ not _P._

# **4.  Is it Possible to Have Secure but Illegitimate Rights to Income?**

All that we require to generate the possibility of losers from reform is that society cannot commit to λ = 0. Some defenders of Big Bang privatization have argued that the reason for the failures is the fear of renationalization, and that all that is required to turn defeat into victory is to guarantee that there will be no recapture of assets even from those who have engaged in stripping of corporate value or in other respects defrauded investors or the state. In this section, we explain why it may be neither desirable, nor feasible, to provide such a guarantee.

It may actually be functional for society that some recapture of past theft is expected **.** A key limit on the extent of opportunistic behavior in a lawless state is that such behaviors are punished under a future regime. If self-interested individuals perceived λ to be zero, then until the moment of the establishment of the rule of law, each would be trying to steal as much as he could. On such grounds, Adam Smith (1759, Part II, ii, 3.3) argued that justice was necessary to the existence of society.

The _sina qua non_ of the rule of law or any rule-governed state is the effective restriction on arbitrary power. Our paper focuses on a limited range of theft—that of corporate assets. It is difficult to see how a society could commit itself to totally forgiving corporate theft (if its costs were viewed as high), while not doing so for other forms of theft. And the latter, both theory and history suggest a rule-governed state cannot do.<sup>37</sup> Instead of reviewing this vast literature, we suggest one mechanism that would make such a commitment impossible in a democracy.

The consequences of the state’s seizing illegitimately taken property are markedly

> 37 See _n._ 9 and Elster (2004), who finds that attempts to design institutions to protect once politically powerful groups from justice under successor regimes have never succeeded.  Such protection was denied not only to past elites, but even to ordinary people who “[a]lthough not wrongdoers... were the beneficiaries of wrongdoing” (Elster, p. 39).

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different from the consequences of the state’s taking or redistributing legitimately obtained wealth. It is rational for politicians seeking to increase their share of the electorate to argue for the first and not the second and for redistributing the illegitimately obtained wealth to voters. Nationalizing stolen wealth does not harm investment incentives. On the contrary, it improves them.

In contrast, in a democratic society, what stops nationalization of legitimate wealth and its distribution to voters by politicians is that doing that would discourage investment, which would leave most citizens worse off. By the same token, what may stop nationalization of illegitimately taken wealth is that beliefs about its unfairness change, or that the new owners are more efficient than the old owners and so better able to command power and to benefit society.<sup>38</sup> Myths have a role to play in changing a political consensus, but inventing myths takes time. In Russia, there is evidence that rights holders have some but limited ability—through investing in the firms and providing public goods—to change the perceived legitimacy of their property rights (see Frye 2006).

It is at times of transition that new myths and beliefs are created. At the beginning of the transition, not everyone believed that privatization and the creation of a market economy would, at least by themselves, improve the well-being of most citizens. Support for the Coasian position that, in the absence of transaction costs, _any_ distribution of property rights under a rule of law is efficient, and therefore should be respected, depends on the fact that it actually does lead to efficient outcomes. There is an equilibrium in which this is not believed, and justifiably so, because it does not produce the promised results if it is not believed. Distrust in this proposition undermines the legitimacy of rights directly and, indirectly, weakens property rights through the mechanism outlined in our model, by undermining the demand for the rule of law. Our paper has investigated this type of coordination failure and the “exit costs” from a nonrule-of-law state to which the coordination failure gives rise.

# **5.  Avenues for Future Research**

> 38For historical examples, see Rajan and Zingales (2003, ch. 6).

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Our model leaves open a wide range of problems for future work.

# 5.1 _The Evolution of Inequality_

As is well-known, in Russia many of the asset-strippers evolved into oligarchs, and the loans-for-shares program in 1995-97 consolidated the oligarchic structure of power. The dysfunctional institutions in Russia led to a vast increase in inequality of wealth and power (an interesting discussion is Colloudon, 2002). This development lies completely outside our model. Moreover, as economic historians have established, high inequality is itself a key factor in the creation and persistence of dysfunctional institutions (see _e.g_ . Engerman and Sokoloff 1997, 2003; Acemoglu, Johnson and Robinson 2002). An important problem for future research is thus to incorporate the modelling of changes in inequality with that of changes in institutions. This should shed further light on why attempts to jumpstart capitalist institutions are hazardous.

# 5.2 _Bayesian Dynamics_

Not only do we see that the distribution of power coevolves with institutions. A similar process occurs with respect to beliefs. In the post-communist countries, individuals update their beliefs about whether privatization leads to efficiency on the basis of the economic outcomes of the privatization and also the incentives of the advocates of particular positions. The fact that short-run outcomes were so poor in many of the postcommunist economies, and that those advocating rapid privatization enriched themselves by it so greatly,<sup>39</sup> would increase doubts about the validity of the view that a market economy is broadly beneficial (see Denisova _et al_ . 2007). An analysis of the Bayesian dynamics, in which agents update their beliefs about the truth of the Coasian view, might help explain differences across countries in the paths of institutional development.

39 Of the 296 businessmen in Russia ranked by experts as most influential in 1995-1999, one-third either came from the ranks of former reformist politicians or their close personal assistants, or became elected politicians or office-holders at some point after becoming wealthy. The Russian media in 1999 named virtually all of these 296 as warranting criminal investigation for asset stripping (Braguinsky 2007).

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# 5.3. _International Policy as a Coordination Device_

We have explored the role of _national_ policies ( _e.g._ macroeconomic policy) in limiting the economic behaviors that can reinforce bad institutions. What role can _international_ organizations, such as the World Trade Organization, play in facilitating coordination? In the case of the Eastern European countries, the opportunity to join the European Union made a particular set of rules focal and led individuals to anticipate large rewards from coordinating on them, which helps to explain the successful transitions in those economies (see Elster _et al_ ., 1998 and Roland and Verdier 2003).

# 5.4. _Other Applications of the Model_

We have focused on the transition from communism, but our analysis has three other applications. Without change, the model can be applied to the problem of post-conflict states in which economic and political structures have collapsed. A second application is _-_ to post colonial countries in which the legitimacy of inherited law is contested. To those currently in possession of assets, there is a risk that another claimant to the property will appear and have the backing of law. This lowers the relative return to investing (relative to asset stripping). Stripping affects the political dynamics. It creates an additional obstacle to the movement towards the rule of law based on any conceivable criteria of legitimacy of property rights.

A third application is to oil field unitization. Imagine that a number of individuals own an oil reservoir in common; that is, none has the right to exclude any of the others. Overexploitation makes extraction inefficient for each individual by prematurely depleting subsurface pressure. But because no one pays for the use of the field, no one takes this cost fully into account in deciding how to exploit the field. The problem disappears if one individual owns the whole field and charges each individual for his use (see Libecap 1989). However, anticipation of delay in unitization leads to individual drilling. Imagine that every period of individual drilling gives a lease-holder private information about the value of his lease. Then he may gain from a delay in unitization if his private information is favorable. Delay, by making the information public and so increasing his rental share under unitization, offsets the impact on him of the damage to the reservoir. This can lead to opposition to unitization, period after period.

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We hope that some of these issues will be pursued in future research.

# **Appendix**

We use the following property of the _economic switch line_ in the proof of Proposition 1. **Lemma.** ( _g_ − _z_ ) _V L_ − _g_ _~~s~~_ ( _x_ , θ _a_ ; λ ) + _zb_ ( _x_ ) ≥ 0

**Proof of lemma.** Rearranging terms in (8) and using (10) gives

> By substituting for ( _g_ − _z_ ) _V L_ from (8 ′ ) and rearranging terms, we can write the left-hand side of the lemma as

where the last expression is obtained by substituting for _b_ 1 − _g_ from (11) and for _~~s~~_ 1 − _z_ from (12) and by recognizing that _VN_ ( _x_ ) ≡ _S N_ ( _x_ , θ _a_ ; λ ). Since _g > z_ and _V L_ ≥ _V N_ ( _x_ ), the lemma is proved.

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