University of Groningen Faculty of Economics and Business

University of Groningen

Faculty of Economics and Business

Aukje van der Hout

S1577271

The origins of State Capture in Transition Countries

- An investigation of the Reform Process

Robbert Maseland

Abstract

This paper investigates the mechanisms between state capture and the reform process in transition economies. It stresses that the transformation of political and economic institutions that characterizes the process of transition introduced scope in some nations for powerful interests to influence the structure of state institutions and the formulation and implementation of economic policy to their own advantage. From the investigation of 22 transition countries, it is found that a rapid implementation of reform policies reduces the level of state capture significantly, especially when the effect of reform at the start of transition is regressed to the level of state capture in the second decade of transition. It is also found that the relationship between state capture and reform is shaped an inverted U-shaped pattern, explaining why countries that are slow on bringing about reform have low levels of state capture. In general, political reform is implemented before economic reform, as the institutional framework, especially the rule of law, is needed to build a successful market economy. The success of reform also depends on the initial conditions of a country.

Key words: transition economies, state capture, political reform process.

Table of Contents

Abstract ………2

I List of Figures ………..………...5

II List of Tables ………6

Introduction ………..7

1. The Economics of Transition 1.1 What is meant by ‘transition economies’ ……….8

1.2 The role of the state and quality of the institution………...8

1.3 The reform process………... ………9

2. The Concept of State Capture 2.1 State capture as grand corruption…………..………...10

2.2 Corruption unbundled: administrative corruption, influence, and state capture……..11

2.3 The origins of administrative corruption, influence, and state capture………11

2.4 State capture defined………12

2.5 The social costs to the economy………..12

2.6 State capture and the capacity of the state………...13

2.7 How transition and corruption are connected………..14

2.8 The objective of this paper………..14

3. The Political and Economic Reform Process 3.1 State capture and the reform process………...15

3.2 The J-curve of policy formation………..15

3.3 The paradox of policy formation in transition countries………..15

3.4 The Reform process: Shock Therapy versus Gradualism………....17

3.5 Shock, gradualism, and the distribution of welfare costs………17

3.6 Why have post-communist counties chosen for a Shock or Gradualist approach…...20

3.7 The dynamics of the J-curve………20

3.8 The relationship between state capture and the pace of reform reform..……….21

3.9 The sequencing of political reform and economic reform………..….23

3.10The importance of initial conditions………...25

4. Methodology and Method 4.1 Discussion of data………....26

4.1.1 The state capture index……….26

4.1.3 The measure of initial conditions………..………28

4.1.4 Control variables………...28

4.2 The analytical framework………30

5. Regression Analysis and Results 5.1 Introduction……….33

5.2 Does reform explain variation in the level of state capture?...33

5.3 State capture: following a predetermined path?... 35

5.4 Is political reform important to enhancing the success of economic reform?...35

5.5 Is there a hyperbolic relation between reform and state capture?………...36

5.6 What is the role of initial conditions to the level of state capture?...37

Conclusion………..38

References………..41

I List of Figures

Figure 1: The J-curve

Figure 2: The J-curve with and without the effect of state capture Figure 3: The path of state capture and the various reform strategies

Figure 4: The J-curve of twenty two transition countries, GDP growth over 1991-2005 Figure 5: The inverted U-shape relationship between state capture and economic reform Figures A.1 J-curve: GDP growth over the years1991-2005

Countries are split in their respective speed of reform as grouped in Table 1 Figure A.2 Distribution of countries and their level of state capture

II List of Tables

Table 1. GDP Growth and the Speed of Reform

Table A.1 State Capture Index and its Components for 22 Countries in 1999 Table A.2 Unbundling and Measuring Corruption 1999

Table A.3 Unbundling and Measuring Corruption 2005 Table A.4 Reform Indicators and Reform Groups Table A.6 Regional dummy

Table A.7 Correlation Diagram State Capture and Administrative Corruption for 1999 and 2005 indexes

Table A.8 Correlation Diagram GDPpc Growth and Investment for 1999 and 2005 averages Table A.9 Data definitions and sources

Regression results

Table R.1 Hypothesis 1: State capture 1990-1998 and the speed of reform Table R.2 Hypothesis 1: State capture 1999-2005 and the speed of reform Tables R.3 Hypotheses 1 and 3: The direct impact of reform on state capture

Table R.4 Hypothesis 2: Inverted U-shaped relationship Economic Reform 90-98 and State Capture 90-98

Table R.5 Hypothesis 2: Inverted U-shaped relationship Economic Reform 99-05 and State Capture 99-05

Table R.6 Hypothesis 2: Inverted U-shaped relationship Political Reform 90-98 and State Capture 90-98

Table R.7 Hypothesis 2: Inverted U-shaped relationship Political Reform 99-05 and State Capture 99-05

Introduction

In analyzing the transition experience of the countries in Central and Eastern Europe (CEE) and the Former Soviet Union (FSU), notable differences in the road towards a market economy have been found (Aslund et al. 1996). Some countries, like Poland and Hungary, were able to rapidly reform their political and economic system, whereas other countries, like Ukraine and Azerbijan, encountered political and economic obstacles that stalled reform. Political economy arguments have been at the center of debates and controversies surrounding the strategies of transition from socialism to capitalism (Roland 2000).

The economic transition of the post-communist countries is now entering its third decade. The first wave of theory on the democratization of the transition countries centered on how the over-extended governments, a heritage from the communist period, should be limited. These papers emphasized the importance of privatization and liberalization of previously state-owned enterprises. However, a new stream of research has replaced the fear of the Leviathan state presenting an obstacle in the process of democracy and market building by a fear of the rise of the so-called ‘oligarchs’, in which powerful firms are able to manipulate politicians, shape institutions, and control the media to advance and protect their own empires at the expense of social interest (Omelyanchuk 2001). This type of behaviour is referred to as state capture and is increasingly recognized as the most destructive problem in the political economy of reform (Hellman, Jones, and Kaufman 2000). Important contributions have been made by the scholarly teams of the World Bank (2000a, 2000b, 2000c; Transition Reports), as well by individual authors (Hellman 1998; Bruszt 2000, 2002; Spiller 1990; Stigler 1971, etc.), who have given the phenomenon different perspectives. However, empirical studies focusing on the causes of state capture are scarce (Slinko, Yakovlev, and Zhurasysk 2002), and substantial theoretical gaps call for further theoretical and empirical inquiries (Hellman et al. 2000) into the phenomenon of state capture.

transition economies faced at the start of the transition. This will be followed by an explanation of the concept of state capture as a form of grand corruption. Then I will set out a theory of partial policy formation. This framework asserts that the economic and political policy formation, or the lack thereof, at the start of the transition period is an important explanatory variable for state capture. A set of hypotheses will be developed and tested empirically. The conclusion will summarize the insights.

1. The Economics of Transition

1.1 What is meant by ‘transition’ economies?

Transition has been used to describe the evolution from a planned economy to a well-functioning market economy (EBRD Transition Report 2009). However, the word “transition” can be a misleading one in various ways. It gives the impression that transition is ‘simply’ a short-run policy issue that should take a few years at most. In this line of reasoning, the objective of the government should be to adopt a set of policies that stimulate the process of stabilization, liberalization, and privatization. Then, a few years later, when the countries have transformed into successful capitalists the country will reap the benefits. In reality, nobody can tell how transitional the transition is, or whether the countries engaged in transition will end up as successful capitalist (Roland 2000). It is also a misleading term as it suggest that the outcome is predetermined (Przeworski 1991). Formulating specific objectives for the end point by adopting for example the model of the United States or Germany is no guarantee that such an end point will be reached. Further, the breakdown of an authoritarian regime might be reversed, or it may lead to a new dictatorship: a full democracy is thus only one among the possible outcomes after an authoritarian regime. “Transition” is also not comparable to development, which has the objective of helping underdeveloped economies catch up with industrialized countries, because there already is a coherent set of institutions given as a starting point of the transformation process (Roland 2000).

1.2 The role of the state and the quality of institutions

from a command system to a market mechanism. In this conventional view, emphasis was put on privatizing the state resources and price liberalization. People assumed that the rest would follow. However, it is not simply about reducing the state to a smaller size and leaving production to be arranged in the newly formed markets, it is also about changing how the state influences economic outcomes (Hoen 1998). In an additional critique of the conventional view, Amsden, Kochanowicz, and Taylor (1994) argue that effective transition policies need to be backed by an intervention of a “development state” because the transitional states often lack the strength and quality in their institutions to push through the required pro-market reforms that are needed to promote a market economy. Therefore, steps should be taken to build a strong foundation in the rule of the government. According to Bruszt (2002): “to create markets, one cannot rely on markets (…), to strengthen the market one must first strengthen the state”. Certain state activities should be directed into the creation of a functional legal system that enforces contractual obligations, to the establishment of regulations that deal with incentives problem and external effects, to the broadening of physical and intellectual property right, and to the formation of competition policy in addition to the privatization and stabilization (EBRD Transition Report 1999). Furthermore, the movement from a centrally planned economy to a capitalist market economy is a dynamic process, which also forces us to think of institutions in a non-static way. A successful capitalist system, which has the required formation in the legal market, in competition policy, etc., is a highly complex system and has developed from the interaction of social, political, and economic forces over periods of time (Wagner 1993). The need for building institutional infrastructure has been recognized from the onset of the transition process, but in practice the institutional changes have turned out to be more difficult than anticipated or have not been given proper importance (de Melo, Denizer, and Gelb 1996). The lack of institutional and legal reforms of enforcement has been cited as a major obstacle in the pursuit of market-oriented success. The success of the transition process thus depends on the success of the state to reorient its role -especially concerning its interactions with firms- and on the institutions set in place to support long-term investment and entrepreneurship.

1.3 The reform process

reform process is that reforms are interconnected: they can complement and substitute for each other (McMillan 1995). A reform may thus have little effect if implemented in an isolated setting. The timing of how these policies follow each other is also important. Hence, the reform process does not consist of a single choice of reform programs, but is a sequence of various choices on multiple dimensions over time (Hellman 1998). Again, the quality of institutions plays an important role in the effectiveness of reform policies. States can have similar objectives but have different impacts in terms of effectiveness and burden that state activities impose on the private sector (EBRD Transition Report 2009). Chapter 3 will give further insight on the differences in the reform process among the transition countries and how this affects the level of state capture.

2 The Concept of State Capture

The previous chapter set out the difficulties that the transition countries faced at the start of their transition. The need for simultaneous reform of the state and the market is difficult to organize as it takes a longer time to develop state activities needed to sustain the markets, like the formation of a legal framework and competition policy, than it takes to privatize state assets. Because the state is underdeveloped, strong economic actors are able to interfere with the development of the state and the policies itself. This chapter will give information about state capture and further insight into the cause and consequences of state capture.

2.1 State capture as grand corruption

The efforts carried out by firms to influence the legal, policy, and regulatory environment within which they operate, constitutes a normal and healthy process that is common in all countries. What distinguishes such interactions in the capture economy is exclusion (Hellman et al. 2000). Some firms are influencing the decisions of the state while others are systematically excluded, resulting in state officials setting policies and making choices that bring benefits to those who have impact on state activities and impose high costs on those who are excluded. A distortive relationship between firms and the state is the fundamental aspect underlying state capture.

2.2 Corruption unbundled: administrative corruption, influence, and state capture

The World Bank/EBRD contrasts state capture with influence and administrative corruption, two other types of relationships between the state and firms that can be classified as disruptive.

as a result of private gains to public officials. This form of corruption is associated with the ‘grabbing hand’ of the state: public officials who extract unofficial payments from firms and individuals in order for the firms or individuals to ‘get things done’ (Hellman and Kaufmann 2001; World Bank 2000b). The beneficiaries from administrative corruption are primarily the corrupt officials, and the cost to society is the non-transparent, discriminatory tax that distorts the allocation of resources and impairs efficiency (Sprout 2002).

 State capture refers to the capacity of firms to shape and affect the formation of basic rules of the game through illicit and non-transparent payments to public officials and politicians. It describes activities on part of enterprises and individuals that purchase preferential advantages directly from the state by interfering with the formation of laws, rules, regulations, and decrees. Bribes to parliamentarians to buy their votes on important pieces of legislation, bribes to government officials to enact favourable regulations, or bribes to judges to influence court decisions are examples of how state capture works in practice. In contrast to administrative corruption, the firms and individuals that are influencing the state and shaping the rules are the ones who gain the most from capture.  Influence refers to the same capacity as capture firms to influence state activities but

without the aspect of a bribery payment.

2.3 The origins of administrative corruption, state capture, and influence

to lobby for the establishment of well-working state institutions such as independent courts and efficient bureaucrats. Instead, they seek to increase their political influence and modify the existing state institutions so that resources and wealth are continued to be directed in their advantage (Sonin 2003). State capture is the strategic choice made primarily by the new firms who are trying to compete with the first group. These “captor” firms are thus the result of operating in an environment with weak state institutions: as they do not have the same privileges as the incumbent firms they bribe public officials to get their own set of advantages. The rationale behind state capture is that the existing rules of the game are not fair or clear (Sprout 2002).

2.4 State capture defined

The WB/EBRD literature clearly separates state capture and influence as forms of corruption, due to their differences in origins. Overlap between these two concepts can be expected as both represent efforts to influence the policy formation process to their own advantage, albeit via different methods. However, in the WB analysis, a cross-tabulation of captor firms and influential firms shows only a small overlap (Hellman et al. 2000).1In this paper, I blend the WB/EBRD definition of state capture and influence, and base my definition on the work of Omelyanchuk (2001) and state that:

“State capture is the systematic activity of individuals or groups to influence to their own advantage the activities and principles of state institutions using nominally legal mechanisms and to influence to their advantage the activity of bureaucrats and politicians as the result of illicit and non-transparent provision of public benefit to them.”

2.5 The social costs to the economy as a result of state capture

The very nature of state capture is that it divides the economic system into two segments: those who gain from state capture, and those who lose from state capture. Typically, the gainers are the politically important or simply large firms or whole industries and the bureaucrats that receive favours from those firms. On the losing side, there are small firms who enter the market unable to

1

The World Bank identifies captor firms based on the question: “How often do firms like ours nowadays need to make extra, unofficial payments to public officials the influence the content of new laws, decrees, and regulation?”. Firms responding “sometimes” or “more frequently” are classified as captors. The

buy the same favours. Their firms face lower growth rates compared to captor firms (Hellman et al. 2000). Furthermore, captor firms receive advantages in the provision of basic public goods, such as the already discussed protection of property and contract rights. The WB/EBRD papers (2000, 2001) have shown that captor firms can offset general weakness in the rule of law by purchasing individualized protection of property from the state. In high-capture economies, captor firms are more than five times as likely as other firms to see improvements in their property rights. This comes at a significant social cost: when politicians and bureaucrats can privately sell secure property rights to a few individual firms for private payments, they have little incentive to provide the public at large with open access to these goods. So ultimately, the public interest also loses. Furthermore, new entrepreneurs have strong incentives to invest their talents into capturing the state rather than in developing innovative products or production methods. The capture economy thus rewards connections over competence and is fuelled by private investments in politics that weaken the state and undermine the provision of basic public good (Hellman and Kaufmann 2001). Hence, private investment in the buying of state favours take resources that could be invested in the economy away and creates obstacles to the entry of small and medium-sized enterprises, thereby critically undermining the key sources to sustainable growth and this type of grand corruption contributes to erosion of the rule of law in countries that did not have a strong rule of law to begin with. State capture is thus more intractable and much costlier economy-wide than administrative corruption (Sprout 2002).

2.6 State capture and the capacity of the state

the necessary secure policy environment created uncertainty. This resulted in firms engaging in activities to control the state to eliminate this uncertainty.

2.7 How transition and corruption are connected

The economics of transition became an issue of significance when many centrally planned economies collapsed between 1989 and 1991. Some have argued that when the communist system started to move towards democracy, corruption would decline or disappear (Annus 2004). However, several researchers believe that corruption increased after the collapse of the Soviet Union (Gorham 2000; Varese 1997). There are a few reasons as to why corruption may have increased in the transition countries after the fall. First, the incentive to corrupt is more likely to emerge during periods of regime change due to the uncertainty that follows from that type of change. A large set of literature attributes the causes of corruption in the post-socialist CEE and FSU countries to the breakdown of the communist system (Broadman and Recanatini 2001). Furthermore, the incompleteness of economic reforms greatly enhances the possibilities for corruption as an unreformed economy provides certain groups with advantages to pursue their interests (Japaridze 2003). Moran (2001) states that the nature of the democratic transition can lead to corruption as groups seek to build up resources quickly before ‘it is not possible anymore’. Even though it would be too artificial to analyze transition without reference to their differences in culture, economic development, and pre-communist history, this paper will keep a general analysis as I do not want to become too bogged down in the individual circumstances of the economies of the countries taken into consideration. This approach can be seen as justifiable due to the common recent history of the Soviet states (Annus 2004) that this paper focuses on. Finally, it needs to be noted that corruption measures are somewhat subjective, as what is considered a fully legal lobbying activity or campaign contribution in an OECD country might be thought of as a bribe or outright extortion in a transition country (Sonin 2008).

2.8 The objective of this paper

chapter I am going to discuss the reform process of the transition countries, which will put state capture in a more dynamic setting.

Chapter 3: The Political and Economic Reform Process

3.1 State capture and the reform process

An important contribution to the understanding of state capture in transition countries can be found in the work of Hellman (1998), in which he sets out a theory concerning the politics of partial policy formation. His paper explains how the paths of economic and political reforms that were implemented at the start of the transition developed over the years. Hellman’s theory provides insight into how the political restraints that were present at the start of transition could be responsible for the origin of state capture.

3.2 The J-curve of policy formation

3.3 The paradox of policy formation in transition countries

In the theory of the political economy of economic reform, most research has focused on how the state deals with the pressures of the short-term losers until the reforms are supported by a body of voters powerful enough to sustain them. This political restraint to reform is called an ‘ex-post’ political threat. However, the situation of the post-communist countries presents a paradox. Unlike the traditional J-curve that states that the ex-post losers from policy formation object further reform, Hellman (1998) argues that opposition to further reform may come from ex-post winners who expect to lose their gains if reform progresses further. Hence, it are not the unemployed, workers, and the pensioners who are stalling further economic reform, but the narrow groups of economic and political actors who were the first and biggest winners from the first selection of the (partial) policy reformation: it have been the commercial bankers who have opposed macroeconomic stabilization to preserve their enormously profitable opportunities in distorted financial markets and it have been the local officials who have prevented market entry into their regions to protect their share of local monopoly rents (Hellman 1998). This paradox in the policy formation system results into various questions. First, how come many post-communist countries have chosen a system of partial reform? What are the politcal dynamics driving partial reform? How are the small sets of winners able to preserve the partial reform status quo and advance their interest? And, if we solve the dilemma of the partial reform process, are we able to explain the causes of state capture?

Figure 1: The J-curve

3.4 Reform process: shock therapy versus gradualism

The transition from communism to capitalism has necessitated a scale of reform that is of historic proportions. It involved the change in ownership of assets from state to workers, the development of market mechanisms, and the correction of macroeconomic imbalances inherited from the command economy (Barlow and Radulescue 2005). Along with reform of the economic system, the political system also required transformation: the one-party system was abandoned and replaced – in most countries - by a multi-party democracy. Throughout the 1990s two opposing views were put forward considering the optimal transition strategy for the transformation of the economic and political system (Hoen 1998). This theoretical debate is often put into the framework of ‘shock therapy’ versus ‘gradualism’. The dispute concentrates on the differences with respect to the speed and sequencing of reforms. The shock approach advocated undertaking as much reform as possible to take advantage of the extraordinary political environment in the immediate post-communist period, described as the “window of opportunity” or “period of exceptional politics” (Roland 2001). The supporters of the shock approach like Hellman (1998) and Przeworksi (1991) stress that if the necessary reforms are not implemented in this period of exceptional politics, the short-term winners of the first round of reform will block further reform and the economy will end up in a partial reform equilibrium, in which the output will continuously be suboptimal. Dewatripoint and Roland (1995) and Roland (2001) provide theoretical arguments for the gradualism approach based on the importance of building institutions and the aspect of reversibility and learning due to uncertain outcomes. Advocates of the gradual approach also stress the importance of institutional strength that cannot be reached in short term and argue that a shock treatment will only result in an unnecessary large decline of economic activity (Hoen 1998).

3.5 Shock, gradualism, and the distribution of welfare costs

‘normal’ transition would start to benefit from the reformed system as line number 1 represents, the post-communist countries that have not taken enough comprehensive policies travelled a sub-optimal path characterized with partial reform and state capture, represented by line 2.

Figure 2: J-curve with and without the effect of state capture

Table 1: GDP growth and the speed of reform

GDP growth

Group of Reform Countries 1991 1995 2000 2005

Advanced Poland -7.31 6.88 4.75 3.41 Reformers Slovenia -9.06 3.59 3.92 3.85 Hungary -10.90 1.63 6.28 4.32 Slovakia -14.60 5.52 2.16 5.93 Czech Republic -11.1 6.00 3.75 5.80 Average -10.6 4.73 4.17 4.7

High Intermediate Estonia -7.53 6.42 8.34 10.00

Reformers Bulgaria -7.53 3.29 7.34 6.06 Lithuania -5.83 4.03 4.85 8.14 Latvia -12.3 -0.36 9.20 10.80 Albania -27.5 9.08 7.35 4.91 Romania -12.8 7.40 2.17 4.34 Average -12.25 4.87 6.5 7.4

Low Intermediate Kyrgystan -9.33 -6.45 4.36 -1.58

Reformers Russia -5.26 -4.02 10.00 6.95 Moldova -10.61 -1.13 2.43 7.41 Armenia -10.90 9.08 6.52 14.40 Croatia -11.1 6.00 3.75 5.80 Kazakhstan -11.6 -6.58 10.1 8.74 Average -9.8 -0.52 6.19 6.95 Slow Uzbekistan -2.59 -2.67 2.75 5.76 Reformers Ukraine -8.60 -10,5 6.97 3.40 Belarus -1.50 -10.10 6.12 9.79 Azerbijan -2.23 -12.80 10.20 2.50 Georgia -2.04 4.51 3.00 10.30 Average -3.39 -6.31 5.81 6.35

Source: De Melo et al. (1996) grouped the countries in their respective reform groups based on the Cumulative Liberalization Index (CLI) indicators. At the time the divisions were made, Armenia, Azerbaijan, Georgia, and Croatia were grouped into a section called ‘war’ as during 1989-94 these countries experienced “major and persistent internal conflicts (…) or conflict related blockades”. As I take into account a larger time frame in which these conflicts were resolved, I grouped these countries based on the classification of the WB/EBRD paper by Hellman et al.(2000). The GDP growth estimators are taken from the World Development Indicators 2007.

The political implication of the partial reform model is clear: the ex-ante political threat – the winners from the initial reforms - inhibits further reform as these winners engage in state capture to influence future policies. The best strategy for a country to prevent state capture is to implement reforms fast, and take the transitional costs as a unpreventable loss and given. The first part of this paper will test whether the theory of Hellman is correct and states that countries that have implemented reforms fast are better able to protect their state from capturing firms.

3.6 Why have post-communist countries either chosen a shock or a gradualist approach?

An important question remains: why have certain post-communist countries delayed or failed to implement beneficial reforms where others have implemented them straight away? Even if transition countries are aware of the partial reform equilibrium trap, there may be political restrictions that influence the ultimate strategy of the reform process (Hoen 1998). First, in practice a pure shock therapy may not be feasible because some reforms take time to implement, as is for example the case with setting up a formal legal reform framework (Barlow and Radulescue 2005). Zinnes et al. (2001) have shown that an increase in welfare can only be achieved when the transfer of ownership is accompanied by key institutional reforms. Another political restriction has been briefly touched upon. If the general public is unwilling to adopt a set of comprehensive reforms, politicians face greater ex-post electoral pressures (Hellman 1998). In practice, small-scale reform has proven to be important for gaining support for further, more comprehensive reform. At the beginning of transition, polls in Russia and Ukraine showed that the population opposed the transfer of ownership from state to firms, but were in favour of small-scale privatization (Barlow and Radulesque 2005). Transition governments’ executive turnover and average length of government tenure have been higher and shorter in those countries where the pace of reform has been fast (Hellman 1998; Roland 2001). Hence, post-communist countries have experienced some pressure of electoral backlashes against reforms, which has hindered the reform process exactly how the traditional theory of the J-curve suggests. Politicians fear that they will be punished at the elections if they introduce reforms that are considered too far-reaching. However, despite its logic, it has not been the case that politicians have been forced to reverse reforms in response to high transitional costs (Hellman 1998). Of course, this does not mean that such reform reversal cannot happen in the future, and Przeworski (1991) has expressed concern over the lack of electoral backlashes against reformers. Przeworski stresses that, if voters believe that their votes are not reflected in policy changes, they can lose confidence in the democratic process and be more attracted to authoritarian solutions. He asserts: “democracy is a system in which parties lose.”

3.7 The dynamics of the J-curve

advancing, stumbling, retreating, and advancing again”. Figure 3 shows the development of GDP growth over the years which seems to display this stop-and-go pattern. Appendix A.1 pictures the J-curves of the countries in their respective reform group. Graph 3. and the graphs from appendix A.1 seem to affirm this pattern.

Figure 3: The J-curve of 22 transition countries, GDP growth over 1991-2005

Hence, over time, when the economic reform becomes more comprehensive, the economy performs better, and state capture will decrease. The winners will thus favour the efficiency of well-reformed state institutions: the initial rents that they gained from the partial equilibrium increasingly deplete.

3.8 The relationship between state capture and the pace of reform

among the low-capture countries, both the most reform-minded and the least reform-minded countries are included. This appears puzzling at first, as state capture is presumed high in an environment of little reform and lacking formal institutions. However, as privatization has been minimal in low-reform countries, important elements of the command system are still in operation and the political regimes highly authoritarian. This renders the capacity of the private sector to capture the state low (Hellman and Kaufmann 2001). In contrast, the most reform-minded countries have made the most progress in liberalizing their economies, strengthening their bureaucratic accountability, and promoting political contestability. These are all developments that might place limits on the capacity of powerful firms to capture the state. It are the intermediate reformers who are worst off in this theory: they have not fully developed the right institutions and implemented the necessary policies to overcome state capture successfully, but neither do they have the remnants of the command system that will enable the state to push through policies. Based on these explanations, it is hypothesized that the relationship between reform and state capture follows an inverted U-shaped pattern. Figure 4. attempts to highlight the relationship between the comprehensiveness of reforms and the level of state capture.

But the story is not yet finished. The political theory of the partial reform process explains that once a country is captured, it will be almost impossible for that country to eliminate state capture. A crucial element in this theory is the amount of reform implemented at the start of the transition process, that creates, as it were, either a vicious or a virtuous circle to state capture. Figure 4. shows the interactions between three different modes of reform and how they relate to the scope of state capture through time. The partial reform curve can be considered to include the high intermediate and the low intermediate reform countries from Table 1. that follow a gradual approach to reform. In these countries, capturing firms have been able to capture the state and stall further reform, allowing for further state capturing activities. Comparing the level of state capture between 1990 and 2010, its level is persistently prominent through time. Slow reforming countries are represented by the no reform curve, having undertaken neither a shock or a gradual approach to reform. Comparing the level of state capture between 1990 and 2010, the level does not vary much over the years.

Figure 4: The path of state capture in the various reform strategies

Hypothesis 2: There is an inverted U-shaped relationship between reform and state capture.

Hypothesis 3: The path of state capture over time depends on the particular reform strategy chosen at the start of transition.

3.9 The sequencing of political reform and economic reform

I have spoken of economic and political reform as if they are automatically implemented together. It is true that the general onset of the CEE and FSU countries was to implement economic and political reform simultaneously. However, there has been a large degree of variation in the approaches to economic liberalization and democratization as there has been in economic performance. While some countries succeeded in implementing important elements of democracy and the market economy, others essentially returned to being autocracies with overwhelming state interference in the economy. In some countries, political liberalization followed only after economic reform was well under way, in other countries economic liberalization is unfolding with little simultaneous democratization (McMillian 1995). The variation of approaches and outcomes raises the question whether a more reformed state facilitates progress in economic liberalization. According to the annual “Nations in Transit 1998” research of the Freedom House the former communist countries which have made the most progress towards political democracy have also enjoyed the most success in economic reform and have experienced the highest rates of economic growth; countries which were most resistant to political and economic change registered a decline in their economic output. They concluded that countries that failed to reform their political system had trouble to further reform their economic system. Furthermore, reforms can only be implemented by a capable state: it must decide, explicitly or implicitly, on the sequence in which to free prices, to privatize enterprises, and to remove trade barriers.

The empirical evidence on the relationship between democracy and successful transition to a market economy is mixed at best – virtually non-existent for transition economies. I assert that political reform is a precondition for the success of economic reform and economic prosperity.

Hypothesis 4: Political reform facilitates economic reform.

3.10 The importance of initial conditions

There has been some debate on the importance of historical circumstances of the individual countries and their divergent experiences in transition. Ellman (1992) has argued that there are “prerequisities” for the success of rapid transition and whether a country has chosen a path of partial or comprehensive reform strategy. Differences in prior economic conditions, location, natural resources, and institutions may have had influence in the economic outcomes, directly, or through their effect on policies (de Melo et al. 1996). Variations in these institutional and economic settings among the transition countries are referred to as ‘initial conditions’. These initial conditions influenced the early choices about the basic structure of the political institutions governing the transition as well as the speed and comprehensiveness of the first moves on economic reform. De Melo et. al (1996) have investigated the matter of initial conditions and found that adverse initial conditions are associated with slower economic liberalization. However, their analysis also include transition countries in Asia. I assert that countries that had more favourable initial conditions are less afflicted with state capture,

Hypothesis 5: Countries that had more favourable initial conditions supporting a democratic system have lower levels of state capture.

Chapter 4: Methodology and Method

reform. Based on the created framework of partial reform of Hellman (1998), and the theory of the firm-state interaction as theorized by Bruszt (2000, 2002), the World Bank (2000, 2001) and Omelyanchuk (2001), a couple of hypotheses were set. In this section, the methodology of the empirical research will be discussed. In the next chapter the results will be examined.

4.1 Discussion of variables

In this section the variables that are of main interest in this paper, as well as some control variables, are discussed.

4.1.1 The state capture index

The first systematic effort to distinguish the causes and consequences of state capture has been performed by the WB/EBRD (2000, 2001). The WB/EBRD research primarily draws on the empirical data collected by the 1999 Business Environment and Enterprise Performance Survey (BEEPS). This survey is commissioned jointly by the WB and EBRD and is a firm-level survey weighed towards small- and medium-sized firms. For the BEEPS of 1999, 4104 interviews were made. The dataset is available at the World Bank website. This state capture measure is an index calculated as the unweighted average of six component indices. Specifically, firms were asked to assess the extent to which six types of activities have had a direct impact on their business: (1) the sale of parliamentary votes on laws to private interests

(2) the sale of presidential decrees to private interests (3) central bank mishandling of funds

(4) the sale of court decisions in criminal cases (5) the sale of court decisions in commercial cases

(6) illicit contributions paid by private interests to political parties and campaigns

2005 myself. The BEEPS survey of 2005 was conducted based on the interviews of 9655 firms. The main problem with this survey compared to the 1999 survey is that the questions have somewhat changed over the years. The benefit of this is that the results of the interview improve, the trouble is that comparison is more difficult. In the BEEPS of 2005 only the impact of the sale of parliamentary votes on laws and to private interests (1) and the sale of presidential decrees to private interests were asked (2). The firms who found a significant influence of state capture on their business were selected and divided over the total respondents. The weighted average of components (1) and (2) in de BEEPS survey represents the state capture index of 2005. Table A.2 and A.3 give an overview of the state capture index of 1999 and 2005. To give an impression of the extent of state capture compared to administrative corruption, I included these numbers in the tables as well. The corruption measures of the WB/EBRD are also compared with the corruption indexes form Transparency International and Freedom House to offer a robustness check of the corruption measures. To simplify the comparisons between the four measures of corruption, the indexes have been grouped into three ordinal categories: low, medium, and high levels of corruption. Comparing the state capture index of 1999 and 2005, it shows that some state capture levels have remained relatively the same (Belarus, Uzbekistan, Czech Republic), others shown an increase in state capture (Albania, Armenia, Lithuania), and some have lower state capture levels (Romania, Georgia, Moldova, Slovakia).

4.1.2 The measures of economic and political reform

freedom, trade freedom, fiscal freedom, government freedom, government spending, monetary freedom, investment freedom, financial freedom, property rights, freedom from corruption, and labour freedom. Based on the average score of these dimension, a value between 0 and 100 is given. Although both indexes have been used in various articles to represent a measure of economic reform, I favour the EBRD indicator of economic reform. Unfortunately, the EBRD has been unable to construct an indicator for Czech Republic. The Heritage Economic Freedom Index will be used as a robustness check in the analysis. The measure of political reform is constructed by the FeedomHouse, and is an index of civil liberties. The index ranges between 1 and 5.

4.1.3 The measure of initial conditions

This paper also investigates how history matters to the considerable variation in levels of state capture across transition countries. Different institutional and structural legacies with which countries entered the transition may be part of the explanation of how different paths of reforms have occurred. For this reason, an index of initial conditions will be included in the regression analysis. This initial condition variable is created by the WB/EBRD, and is based on a set of measures for the level of development, trade dependence on the Council for Mutual Economic Assistance trading arrangements (CMEA), macroeconomic disequilibria like depressed inflation and black market premium, distance from the EU, natural resource endowment, market memory, and state capacity (Fischer 2004).

4.1.4 Control variables

The first empirical research to investigate state capture has been completed by the WB/EBRD, and has remained one of the few to engage in empirical research surrounding state capture. Their focus of investigation has been on the micro-economic incentives underlying the decision of firms to attempt to capture the state. They investigate the difference in firm performances in terms of sales and investment of firms that have been previously state-owned, privatized, or de novo (new) and the impact that administrative and state capture corruption have on these outcomes. The section of their work that investigates the origin of state capture also keeps a firm-level approach. The size of the firm, its ties with the government2, the level of market power, and the access to public officials have been used to explain state capture by the WB/EBRD. However, those variables are more about showing that state capture exists, and less about explaining why it exists. On the aggregate macro-level, only civil liberties are mentioned as an explanatory variable.

2

Because this research takes an aggregate approach to state capture on both the firm and state side, attention needs to be shifted to different areas to find possible explanatory variables for state capture on the macro-level. As state capture is a form of corruption, it might be valuable to look at corruption explanatory variables. State capture, like administrative corruption, can be seen as a problem of poor economy. Most cross-country regression shows that GDP per capita is one of the most important economic determinants of corruption (Liiv 2004; Paldam 2002). Corruption will decline if the economy develops, and this development is reflected in GDP per capita. The Freedom house (2002) has shown that this is also true for post-communist states as countries that have a higher GDP per capita are shown to have lower levels of corruption. However, this relationship also runs the other way, which makes it unsuitable as an explanatory variable for state capture. If this endogeneity problem indeed exist, a variable like investment as a percentage of GDP could be used, as this also represents development of the economy, but may not be afflicted with endogneity problems. Table A.8 shows the correlation for GDP growth and Investment share, which for the 1990-1998 is shown to be strongly positively correlated and for the 1999-2005 time frame to be negatively related. This means that Investment share is a good replacement for GDP growth for the first time variable, but not so much for the second time segment.

be put in the regression, it represents the initial political strength of the non-communist elite. A region dummy is added to capture potential regional effects, the geographical numerical values Table A.6.

4.2 The analytical framework

This section will set out the analytical framework used for testing the hypotheses outlined in the previous chapter. The first hypothesis goes as follows: “transition countries that implement reforms in a rapid manner are less afflicted with state capture”. The interest of the first hypothesis is to test which of the two approaches to reform, the shock approach and the gradual reform strategy, results in a lower value of state capture. The following equation will be regressed:

(1)

In this regression, Statecapture is the dependent variable, Economicreform and Politicalreform are the exogenous indicators for economic reform and political reform respectively, and several control variables are included. Countries with a high level of state capture are regarded as countries with strong economic actors who are influencing the policies of the state in a direction that benefits them, and are successful in their rent-seeking activities to a great extent. Higher values of political en economic reform translates to more comprehensive policies. These control variables are GDP growth per capita, Investment share of GDP, HDI, (Human Development Indicator, an indicator of human development), ELF (ethnolinguistic fractionalization, a measure of ethnic diversity), an indicator that measures the amount of freedom of press, the amount of years the country has spend under communist rule, and a dummy variable to capture any potential regional effects. Economicfreedom will be used as a robustness check for the Economicreform indicator and a combined indicator PolitEcon is created from the variables Economicreform and Politicalreform. This is done because the political and economic reform indicators are highly correlated with each other. For the 1990-1998 period they have a correlation of 0.78. It is impossible to regress these two reform indicators together in one regression as there is risk of multicollinearity. Hence, PolitEcon attempts to measure economic and political reform as one variable. Regression (1) will be regressed for two time period: for 1990-1998 and for 1999-2005. It might be interesting to see if in the second decade of transition the speed of reform has a different impact on the level of state capture.

 

 

    

 Economicreform Politicalreform Control iables

re

The second hypothesis will test the inverse U-shaped pattern between state capture and reform. An inverted U-shaped relationship between reform and state capture explains why some countries that have achieved little to no reform have low values of state capture as well as countries that implemented comprehensive reform. It reveals also that countries that ended in a partial reform setting are burdened with many rent-seeking and state capturing activities. To establish an inverted U-shape, the reform variables should fit a quadratic expression, like the following regressions:

(2) StateCapture    Econrefrom  Econreform2₃Control variables 2

1 0

(3)

.

The regression variables StateCapture, Econreform, Polreform, and Controlvariables are the same as explained in regression (1) above. These regressions will also be performed for both time periods. By estimating the regressions in this matter, OLS-regression methods can still be applied while capturing a non-linear function. To determine an inverted U-shaped relationship, the regression parameters need to be subsequent to:

0

0









and

0

0









The third hypothesis states that the level of state capture in the second decade depends on the amount of reform introduced in the first decade of transition, implicating the persistence of the reform strategy chosen at the start of transition through time. A country that implemented a gradual approach to reform ended up in a partial reform setting where strong actors were able to capture the state, influencing future policies directed to their advantage. Countries that implemented reforms in a rapid manner avoided this trap. The equation estimated goes as follows:

(4)

In this regression, Statecapture2005 is the averaged level of state capture for the 1999-2005 period (the second decade in transition), Economic reform90/98 and Politicalreform90/98 the averaged value of economic and political reform implemented in the first decade of transition. By

 

 

    

 Economicreform Politicalreform Control iables

re

taking the value of state capture of the second decade and measuring it to the depth and speed of reform at the start of transition, the persistence of state capture through time is captured. The control variables are the same as for equation (1).

The fourth hypothesis will test whether political reform reinforces economic reform. From the theory presented in the previous chapters it is asserted that there is a strong correlation between economic reform and institutional capacity. From this relationship it can be implied that the shape and nature of political institutions determine the shape and nature of economic reform policies: a democratic political institution that is build on the concepts of accountability and transparency will produce economic reform policies with a great deal of accountability and transparency too. The following calculation will be performed to test whether political reform facilitates economic reform:

(5) Economic Reform >

1

Political Reform <

When the equation is larger than 1, political reform is followed by economic reform, rendering the conclusion that countries put effort in reforming their political institutions before economic reform is implemented to increase the success of these economic reform policies. The calculation will be done for both time periods.

The fifth hypothesis focuses on the importance of the starting point from which transition took off and its influence on subsequent development. It is asserted that countries that had a more favourable initial setting have begun the transition with an advantage, thereby being more successful in transition. These advantages are shown in countries with legal and institutional traditions that emphasized the rule of law. Moreover, previous exposure to market-oriented institutions in countries that had adopted variants of market socialism may have shaped the receptiveness to reform as well. However, economies with a high level of natural resources are more likely to generate powerful interests seeking to capture states and lay claim to the concentrated gains stemming from such resources. Therefore, the impact of initial settings on state capture is ambiguous. Regression analysis in the shape of the following equation will shed more insight:

In this regression, Statecapture is the dependent variable measuring het level of state capture, Initialcondition is the exogenous index taking into account the set of initial indicators that benefits transition. The Control variables used in this regressions are the same as used in regression (1). The regression will be executed for both time frames.

Chapter 5: Regression analysis and Results

5.1 Introduction

Why has transition been marked by state capture as a persistent and destructive form of corruption, hindering economic and political development? How can the considerable variation in the levels of state capture across transition countries be explained by the pace and comprehensiveness of reform? These are the main questions of interest in this research. From the theoretical discussion on the interaction between state capture and reform in the previous chapters, a couple of hypotheses have been set. This chapter will discuss the results of the regression outcomes that will reject or fail to reject the hypotheses. All of the regressions have been performed with simple OLS- regression methods. For the variable GDPgrowth and StateCapture a Hausman test has been performed to assess endogeneity. The results show that such a relationship does not exists for both the 1990-1998 time period and the 1999-2005 period. In the analysis, the variables StateCapture, EconomicReform, PoliticalReform, PolitReform, EconFreedom,, GDPgrowth, Investmentshare, Initialconditions, HDI and Press are an averaged value for the time periods 1990-1998 and 1999-2005, whereas the variables ELF, Communism, and the Region dummy are based on one value in both time periods, as they do not vary over the years. The reason for the lack of change over the years is obvious for the length of time the countries have been ruled under communism and the region dummy, for the ELF it is that the variable does not change over the years for transition economies. A total of 22 countries are used in the regression analysis. Where data is missing from a certain variable, all variables of that country are excluded from the analysis.

5.2 Does reform explain variation in the level of state capture?

measures of reform into the analysis. Regressions (OLS6)-(OLS12) are robustness checks that check whether conclusions can be drawn from the parameters found in (OLS2)-(OLS5). Comparing the R2between (OLS1) and (OLS2)-(OLS5), it is found that including a measure for reform, whether it is political, economic, or a combination of the two, improves the equation: the R2increases from 0.23 to 0.76. Unfortunately, the measures of reform are in some regressions not significant, which makes it difficult to make finite conclusions. The relation between reform and state capture is negative, which means that for higher values of reform state capture is lower. This is consistent with the theory that I have set out in this paper: the more comprehensive the reform implemented, the lower the ability of firms to capture the state and the higher the capacity of the state to deter capturing firms. Interestingly, when the measure of economic reform is replaced by a measure of economic freedom, the variable turns out to have a positive effect on the level of state capture. Economic freedom seems to be explaining something else than economic reform, as its effect on state capture is so different in all regression performed in this paper. However, as economic freedom is in this regression not significant, no conclusions can be drawn from it.

For what the control variables are concerned, most are behaving in a way that fits previous theoretical discussions. It appears form Table R.1 that a more ethnically diverse society has higher values of state capture and a country that has more freedom of press has less state capture. The analysis also finds that the human development indicator is positively related to state capture, in some regressions quite strongly and significant. This seems to go against general theory. The effect of the number of years a country has been ruled by communism and regional effects are in all regressions small, albeit significantly positive. When these two variables are excluded from the regression, as shown in (OLS6), the R2 is small, which seems to show that, at least for this time period, the number of communist years and the area in which the countries are located matter a lot for the amount of state capture.

transition countries were under communistic rule matters less as time continues. The same can be said about regional effects.

In Table R.3 the direct impact of the various reform measures presented in this paper are regressed with the level of state capture as its depend variable. The results show that reform explains only a small aspect of state capture – with an R2 ranging from 0.03 to 0.23 – and in general the effect is smaller in the second time period.

5.3 Is there an inverted U-shaped relationship between state capture and reform?

Table R.4 and R.5 show the test results of equation (2), measuring the presumed inverted U-shaped relationship of economic reform and state capture for the 1990-1998 time period and the 1999-2005 time period, respectively. Table B.6 and B.7 show the regression results of equation (3), measuring the inverted U-shaped pattern between political reform and state capture for both time periods. To determine an inverted U-shape pattern between reform and state capture, the regression parameters need to be subsequent to:

0

0









and

0

0









In all regressions the coefficients meet the conditions, verifying that an inverted U-shape pattern between reform and state capture exists. This is an important finding, as it explains how it is possible for both high reform countries and low reform countries to have low values of state capture, and for intermediate reform countries to have the high levels of state capture. Interestingly, the regressions are overall significant in the second time period, for both economic and political reform, where it is only significant in a few regressions of the first decade of transition. This can be explained by the persistent nature of state capture: once a country suffers from rent-seeking activities, the process becomes self-enforcing, and the differences between the slow, intermediate, and fast reforming countries in terms of their level of state capture become more pronounced as time progresses.

5.4 State capture: following a predetermined path?

output, and an increase in firms trying to capture the state – as those firms fear that they will lose their momentum if they wait for the policies to work out. But the reforms will pay off in a decrease in unemployment, a rise in output and the disappearance of state capture in the long run. The partial reform curve explains how it could be possible for countries to get trapped in a vicious circle, in which partial political and economic reforms become self-enforcing. Limited reforms enable private interests to shape policymaking to their political advantage, which in turn reduces the likelihood of further structural reforms. Economies trapped in this vicious circle suffer devastating economic consequences. I assert that the level of state capture in the second decade depends on reforms implemented at the start of transition. This is tested by regressing the level of state capture in 2005 by the extent of economic and political reform executed in the 1990-1998 period. From the regression analysis it is found that the economic reform executed at the start of transition, as tested in regression (OLS1) and (OLS5)-(OLS8), is very significantly negatively related to level of state capture in the latter period. The same can be said about political reform, as shown in (OLS2) and (OLS9)-(OLS10). The R2 for all regressions are at a satisfactory level. The pace and comprehensiveness of reform policies introduced in the early start of the transition period explains a great deal of the variation in the level of state capture present today. Therefore, the hypothesis cannot be rejected.

5.5 Is political reform important to enhancing the success of economic reform?

Over the course of this paper, various political impacts on economic reforms have been specified. First, the effectiveness of economic policies depends on the willingness of the state to reform. An authoritarian regime might find it easier to push through reform policies, but their willingness to do so is probably small; a more democratic state might me more willing to implement reforms but they are unable to do so due to electoral pressures. Second, the success of economic reforms lies in the ability of the state to sustain reforms. Implementation of reforms will give rise to complicated issues. The political system must have the capacity to face such crisis and deliver measures for correction. The ability of the political system to timely evaluate and properly upgrade the reforms measures also play an important role in the success of economic reforms. Because a state is better able to achieve such progress when its institutional framework, in terms of an effective rule of law in contract enforcement, competition policy, and intellectual property rights, I have asserted that political reform facilitates economic reform.

Economic Reform > 1 Political Reform

The results are:

For both time periods the equation is larger than one, so the hypothesis is not rejected. Furthermore, the effect seems to be bigger in the second time period than in the first, rendering the conclusion that the further along the transition path, the more important the capability of the state to uphold policies becomes. The sequence of reforms in transition countries are roughly in line with what the prediction of political economy theory suggests: democratic reforms preceded economic reforms. Certain political reforms and other institutional changes are relatively uncontroversial and can thus be decided at an early stage of reform. This goes in line with general political economy theory suggesting that reforms expected to be more popular are implemented first. Furthermore, this also shows the importance of the right reform implemented at the right time. It shows how momentum for reform is created, how institutions can evolve, but also how momentum can be lost and how one can get stuck in inefficient institutions and bad policies.

5.6 What is the role of initial conditions to explaining the level of state capture?

Initial legacies and other initial conditions could have a strong influence on the “first moves” of the transition process, such as choices about the structure of political institutions and the pace and comprehensiveness of economic reform. The choices set in motion unique transition paths that favour particular economic and social groups and shape incentives for further reforms. Table R.9 and R.10 show the regressions results of the hypothesis that countries with more favourable initial conditions have lower values of state capture. (OLS1) measures the direct impact of initial conditions on state capture, (OLS2)-(OLS3) includes various control variables. Neither of the variables included in the regressions are significant for the first time period. The initial indicator in the regressions of the second time period are significantly negative, albeit small. The sign of the coefficient seems to indicate that countries with better initial settings have less state capture. Remarkably, the coeffficient of the initial indicator is not large in the first period, as I had assumed that the effect would have been more pronounced in the first decade of transition, going with theory that over time, the initial settings of the transition economies matters less to the success of the reform process. This cannot be concluded from these regression estimates.

1990-1998 Average 1999-2005 Average

Conclusion

When people think of corruption, they think of a bureaucrat extorting bribes from powerless individuals and firms whose payment will enable them to continue with their business. In this situation, it is the state that is extracting rents from the economy, the sole beneficiaries are the politicians and bureaucrats who abuse their power, and the cost to society is the non-transparent, discriminatory tax that distorts the allocation of resources and hurts economic performance. The way scholars have measured and analyzed corruption is heavily drawn on this view, and policy recommendations to relieve corruption have focused on reducing the power of the state and public officials by setting constitutional checks In some of the weak states of transition economies corruption has taken a new form: that of the so-called oligarchs who manipulate the formation of new policies and are shaping rules of the game to their own gain. Although this concept of state capture conjures up the image of powerful oligarchs, the WB/EBRD working paper of Hellman et al. (1998) has shown that captor firms come in a wide range of sizes and sectors. It is also shown that state capture is profitable: capture firms have higher sales and bettter growth prospects.

Certainly, corruption in and on itself is not a new concept, it has deep roots and existed in these countries already long before transition started. However, this new form of corruption is fundamentally different from administrative corruption in terms of who extract rents from the economy and the burden that it poses to society. Political economy researchers have stated that state capture is the most destructive problem in pushing transition forward. The aim of this research was to contribute to the advancing of the theoretical and empirical knowledge of state capture. Specifically, the questions were: what are the causes of state capture? How does it relate to the speed and comprehensiveness of political and economic reform that were introduced during transition?

economy changed and macroeconomic stability was established, and that, after that period, countries would begin to grow more rapidly than the advanced countries, towards whose level of income they would eventually converge. In reality, transition has not been this straightforward. Remnants of the command economy with its highly centralized industry and political power, the absence of an effective rule of law, and lacking accountable institutional systems led to rent seeking activities and corruption in the shape of state capture.

The reform experience has produced a number of puzzles and interesting patterns. First, countries that adopted a rapid program of reform and took a so-called ‘shock therapy’ approach to reform, as opposed to a gradualist one, appear to have recovered faster after the initial decline in output and experienced higher subsequent growth. Second, in the post-communist economies a limited number of people have gained greatly from rent seeking. The partial reform theory explains that actors in these countries have had little inclination to invest in the formal sectors of the economy as they do not want to give up the arbitrage opportunities that have resulted between the reformed and unreformed sectors. The partial equilibrium generates rent-seeking opportunities arising from differentials between the liberalized sectors of the economy and those still coordinated by nonmarket mechanisms: price liberalization without the subsequent progress in market entry created opportunities for producers to earn monopoly rents, privatization without reform of the credit mechanism allowed managers to divert subsidized state credits.

From a broad point of view, this paper sought answer to the central question of how successful capitalism can emerge from a starting point of socialism. I would like to end this research with a quote from Robert Solow about the nature of transition:

“There is not some glorious theoretical synthesis of capitalism that you can write down in a book and follow. You have to grope your way.”3