By Inge Snip
In the wake of the dissolution of the Soviet Union and the subsequent need for altering the economic model of the former Soviet states, the overall consensus has been that the ‘transition’ from central planning to a market economy would not be without pain, but that within a couple of years the market would have restored itself. Unfortunately, when reviewing the discourse over the past twenty years it seems evident that this was not the case. Although some countries such as Poland and Estonia did manage to come out of the negative spiral, others like Russia and Ukraine are still in much pain, despite recent growth. With regards to Georgia it is an even more interesting discussion, as up until 2004 the economy was extremely volatile — whereas more recently growth has gone up with increasing speed; however, one ought to wonder whether the recent policy implementations that clearly follow a neo-liberal path will eventually benefit Georgia.
When in August 1998 the Russian market collapsed, it became painfully clear that the shock-therapy as proposed within the framework of the Washington Consensus did not seem to have a positive effect on the development toward a market-economy in the former Soviet states. Scholar Douglas C. North argues that the neo-classical theory might explain how markets work, however, does not describe how markets develop. Hence, the failure of transforming central planning to market economy cannot be explained with the standard economic models. Neo-classical theories derived from Adam Smith and David Ricardo’s classical supply and demand equilibrium, the assumption that man acts rational and that man acts out of pure self-interest, have to be re-examined in order to understand the failure of these theories in post Soviet society.
In 1992, Ronald H. Coase won the Nobel price for introducing institutions and transaction costs in the research of mechanisms in the economy in 1937, his thoughts mainly focused on crystallizing the comprehension that rights to perform actions are traded rather than physical possessions themselves. This must be regarded as an important notion since it implies the necessity for a trustworthy legal system ensuring those rights to be protected.
However, it was Douglass North and his perceptions of institutions that have made it possible to come to a more comprehensive understanding of the failure of the implementation of a copy-pasting neo-classical models. According to North, institutions are in place in every society; they consists of human constraints — both informal, such as taboos, customs/traditions, and formal, like laws and property rights. These institutions form the framework of an economy which are often disregarded in explaining economic theory. However, in doing so, the economist tends to fail to notice the flaws that might occur again in the future. Ineffective parts of the institutions result in higher transaction costs, and the higher the transaction costs, the less effective an economy will be.
Therefore, in order to understand how an economic model is being applied in a society, it is of importance to look at which institutions are in place. For example, when there is a lack of trust in the government in ensuring your property rights, as is the case in Georgia, one is more likely to take ones trade to the informal sphere, which does not result in optimal efficiency. Moreover, one is more likely when play by the rules set out by the government to get as much as one can instead of thinking long term investment which would result in higher outcomes for the economy as a whole.
If agreed that a social construction determines institutions, it should be obvious that a region’s history and culture shape the institutions that define a country’s economic path taken. Hence, the mere idea that history does not matter when looking at economic models is a contradiction to the notion that institutions do matter. Moreover, when taking the former Soviet Union as example, institutions do form a foundation in understanding economic development and the cultural and historical legacy have created the economic situation Georgia has experienced after 1992. As the well respected Alan Greenspan realized after years of promoting shock-therapy: “Much of what we took for granted in our free market system and assumed to be human nature was not nature at all, but culture.”
Therefore, when deciding that culture does matter, it is also important to which degree the influence of culture and history ought to be perceived, and whether it is possible to change — or copy-paste — institutions. As mentioned above, a country’s culture and history contribute to its institutions and the economic path taken. However, path-dependency does not necessarily implies determination. As North argues, transactions are culturally shaped but might be altered and path-dependency can be modified, but it is mostly immovable.
Hence comes in the question of evolution or agency, whether the change of these institutions is orchestrated from above (agent) or from within (evolution). It could be argued there are three possible enforcements that shape our behavior: penalties, moral norms and social norms — all of which can be linked back to North’s description of formal and informal institutions. Depending on the time-frame and the will of the government and the population, institutions should be able to be altered, through either agency, in which the government decides to penalize certain behavior, or a slow social process in which the morals and norms evolve.
When taking Russia into account and examining its history, it becomes clear that unlike Western Europe, Russia has always experienced changes from above, which could also be described as institutional choice rather than institutional change. In addition, taking the infamous Mikhail Khodorkovsky case as an example, when there exist a strong hierarchical system as in Russia, there is a fear that if one does not play the rules set forth by the government, it can take away your assets. A strong hierarchical system as such in Russia does not improve entrepreneurship, as the authority needs to enforce its power against people who play the markets outside the rules of their ‘game,’ thus suppressing parts of the market. High transaction costs and low adding to the market result in a large deadweightloss, or a loss of economic efficiency.
However, when looking at Georgia there are definitely some differences that ought to be noted. First of all, after the Rose revolution, Saakashvili has been extremely successful in eradicating the most severe forms of corruption by reforming the police and military. Moreover, the institutional reforms with regards to local governmental divisions, such as the registration office, have highly improved in professional standards (however, sometimes remain bureaucratic pains).
However, with a decline in corruption and clear efforts by the government to clear out informal forms of trade (for instance the street-vendors policy), the desire to trade in the black market should have declined, but remains very much in place. Though the mere existence of these illegal trade-schemes does not necessarily indicate steeply inefficient markets, but in this case they represent larger deadweightlosses than necessary due to prohibitive transactional costs. Also, Georgia’s clan-like society also does not contribute to a maximization of wealth, as jobs and business are offered to friends and family rather than the most efficient and low-cost supplier; and there are more examples like this that contribute to Georgia’s economic situation that have to be taken into consideration when designing economic policies.
To come to a conclusion, the transition from central planning to market economy has not been wholly successful, though it’s arguable that it remains a work in progress. When neo-classical theories were applied through shock-therapy in the early 1990s, the notion that institutions matter was neglected and this has resulted in major stagnation and deflation, which Russia thus far has only been able to overcome due to their natural resources and Georgia by recent extreme anti-corruption reforms and institution-building exercises. Russia’s extreme hierarchical system, institutional change from above, the inability of both Russia and Georgia to efficiently protect property rights, and Georgia’s clan-like society, all have resulted in higher transaction costs and have resulted in/will result in an inability to develop a system in which maximum wealth can be reached. In order to implement future economic policies, it is of importance to take these institutions, both formal and informal, into account.