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Working Paper 26
Bidding for Success:
Why Direct Auction Privatizations Lead to
Successful Transitions
SCOTT BEAULIER*
* Scott Beaulier is a Mercatus Center Social Change Graduate Fellow, and a PhD student in Economics at
George Mason University.
The ideas presented in this research are the author’s and do not represent official positions of the Mercatus
Center at George Mason University.
WORKING PAPER
Bidding for Success: Why Direct Auction Privatizations Lead to Successful
Transitions
I. Introduction
Historians will look back and describe the 1990s as an era of radical
decentralization of power and opening of markets throughout Eastern Europe and the
former Soviet Union. With the collapse of communism, tremendous amounts of
resources were shifted from the public sector to private ownership. In Czechoslovakia,
for example, government spending as a percentage of gross domestic product (GDP)
accounted for 98% of gross domestic product in 1989; today, government spending as a
percentage of GDP is approximately 20% of GDP.
During this transition period, many different privatization programs were
attempted throughout the former Soviet bloc. When assessing the relative performance
of these transition economies, most of the attention has been focused on the State’s role
in the privatization process. For example, elites in Russia’s oligarchy have been heavily
criticized for failing to appreciate de facto control rights during the privatization process
(Boettke 2001 [1998]), Hoff and Stiglitz 2002). By contrast, former Czech Finance
Minister Vaclav Klaus’s voucher privatization has been widely praised for its role in the
relatively efficient and equitable transition in the Czech Republic (Hazlett 1996, Klaus
1997).
In this chapter, I will argue that far too much emphasis has been placed on the
State’s role in privatization. In addition, post-communist leaders throughout Eastern
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Europe and the former Soviet Union have been far too willing to take credit for their role
in the transition. As Hernando de Soto’s The Other Path makes clear, a far more
important source of economic development is the spontaneous de facto rights being
created and enforced at the local level. According to De Soto, the informal sector plays a
more central role in economic development than the established, formal sector.
In the informal sector, property rights are still emerging. They are not fully
defined, well-enforced, or easily transferable. In some regions of the world, these de
facto rights are considered illegal. Yet, many of these rights actually make use of the
legal process, and some are consistent with the current legal code in their respective
countries.
This paper will suggest that throughout the post-communist transition, more
attention should have been focused on the definition and enforcement of rights that was
taking place at the local level. Unfortunately, when it came to privatization in Eastern
Europe, even the most free market reformers went astray by assuming that central
planning would be a more effective approach to privatization. Reformers and citizens
throughout Eastern Europe would have been better served if they had respected the
decentralized nature of property rights formation and enforcement.
In the next section, I introduce two competing theories of property rights. One
theory of property rights emphasizes decentralization, local knowledge, and the
spontaneous process; the other theory of property rights emphasizes the State’s role in the
definition and enforcement of rights, centralization of rights, and clarification of these
rights. After looking at these two theories of property rights, I will then suggest that,
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throughout most of Eastern Europe, reformers were implicitly formulating policy with the
latter version of property rights in mind.
In Section III, I explain how the legal positivist theory of property rights became
popular across Eastern Europe and the former Soviet Union. In Section IV, I look at post-
communist growth rates and other evidence related to post-communist economic
performance in Eastern Europe; this evidence suggests that countries that relied on the
direct sale of resources clearly outperformed more centralized privatization efforts. In
Section V, I explain why the direct sale of resources was a far more efficient form of
privatization. According to my argument, the direct sale approach did a better job of
incorporating the de facto rights and values of the informal economy into the
privatization process.
II. Common Law vs. Legal Positivist Theories of Property Rights1
A. The Common Law Approach
When examining the privatization process, it is useful to draw a distinction
between a common law interpretation of property rights and the legal positivist
alternative. The common law approach emphasizes the spontaneous nature of property
rights and tends to confirm already developed practices and customs that are in place at
the local level. It is a decidedly evolutionary approach that emphasizes the decentralized
nature of information and the role of knowledge in decision-making. The common law
approach to property rights recognizes that property rights do not originate from the law
or some decree, but, rather, come about as a natural response to resource scarcity. Some
1 In a recent paper, David Prychitko and I draw a distinction between evolutionary and teleological
accounts of property rights. A large portion of this section is based on that earlier work. See Beaulier and
Prychitko (2003).
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of the more prominent common law theorists include De Soto (2002 [1989], 2000),
Benson (1990), Anderson and Hill (1983, 1975), and Hayek (1983, 1973). Among the
first to describe the common law approach to property rights were Menger (1994 [1871],
1963 [1883]) and Hume (1985 [1739-40]).
For Menger, “[t]he problem that science must solve is…the explanation of human
behavior that is general and whose motives do not lie clearly upon the surface” (Menger
1994 [1871], 315; emphasis in the original). In order to solve this problem, he
distinguished between two different explanations of the origin of social institutions. The
first is a “pragmatic” explanation:
There are a number of social phenomena which are products of the
agreement of members of society, or of positive legislation, results of the
purposeful common activity of society thought of as a separate active
subject…Here the interpretation appropriate to the real state of affairs is
the pragmatic one—the explanation of the nature and origin of social
phenomena from the intentions, opinions, and available instrumentalities
of human social unions or their rulers. (1963 [1883], 145; emphasis in the
original)
He stresses that the origin of social institutions is not the result of an economic process,
but is rather “the result of human calculation which makes a multiplicity of means serve
one end” (1963 [1883], 132; emphasis in the original). An example of this would be a
“social contract” explanation of the origin of property; establishing property rights, in
that approach, is the goal of the participants.
The emergence of social institutions can also be explained as a product of the
unintended results of historical development, rather than as the result of some common
will. Or, to use Adam Ferguson’s familiar phrase, social institutions are “the result of
human action, but not the execution of any human design” (Ferguson 1966 [1767], 187).
Menger labels these institutions, which arise in this spontaneous fashion, “organic”:
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The social phenomena of “organic” origin are characterized by the fact
that they present themselves to us as the unintended result of individual
efforts of members of society, in other words, of efforts in pursuit of
individual interests…they are, to be sure, the unintended social result of
individually teleological factors. (Menger 1883, 158; emphasis added)
Instead of being part of a deliberate plan serving a single hierarchy of ends, institutions of
“organic” origin are essentially spontaneous or unplanned, serving no single hierarchy of
ends, but, rather, a multiplicity of individual, competing ends.2 That is, the institution
develops gradually over time as a result of unintended consequences of intentionally
acting individuals. In this way, the evolution and the organic, or spontaneous, formation
of an institution are “twin conceptions” (Hayek 1973, 23). Throughout the rest of the
paper I shall call this evolutionary approach the common law approach to property rights,
as opposed to using Menger’s “organic” label.
The common-law theory developed by Menger describes two processes of
institutional evolution (Vanberg 1986, 81). The first is a “process of variation” in which
new social norms are generated by means of separate individual choices. In other words,
new practices are adopted as the result of the self-interest of one person or a few people.
The second process—the “process of selection”—explains how a practice will spread
among society due to (self-interested) individual imitation. That is, along with the
traditional practices come new, competing practices, some of which become
“systematically selected by individual imitation” and will spread, over time, throughout
the society (Alchian 1950, 211-21). As demonstrated by Menger (1994 [1871], 257-62),
2 Note that the distinction between “organic” and “pragmatic” origins does not have to be mutually
exclusive (Vanberg 1986, 79, n. 5). “It allows for ‘intermediate’ cases, combining elements of both kinds
of processes.” As Menger stated:
The present-day system of money and markets, present-day law, the modern state, etc.,
offer just as many examples of institutions which are presented to us as the result of the
combined effectiveness of individually and socially teleological powers, or, in other
words, of “organic” and “positive” origin (1963, 158).
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and commonly agreed upon as a valid explanation by virtually all Austrian economists, a
fine example of an institution of spontaneous, evolutionary origin is money.
In analyzing the emergence of social institutions, Hayek has also emphasized the
difference between the rules of intentionally acting individuals and the cultural rules of a
society. The rules governing individual action are innate behavioral regularities all
humans possess (“genetic rules”), while the latter are rules of conduct generally
recognized by specific groups (“cultural rules”).3 For Hayek,
The chief points on which the comparative study of behavior has thrown
such important light on the evolution of law are, first, that it has made
clear that individuals had learned to observe (and enforce) rules of conduct
long before such rules could be expressed in words; and second, that these
rules had evolved because they led to the formation of an order of the
activities of the group as a whole which, although they are the results of
the regularities of the actions of the individuals, must be clearly
distinguished from them, since it is the efficiency of the resulting order of
actions which will determine whether groups whose members observe
certain rules of conduct will prevail (Hayek 1973, 74; emphasis added).
More specifically, with regards to the formation of private property, Hayek writes:
I think the first member of the small group who exchanged something with
an outsider, the first man who pursued his own ends, not approved and
decided by the head, or by the common emotions of the group, the first
man above all who claimed private property for himself, particularly
private property in land, the first man who, instead of giving his surplus
product to his neighbours, traded elsewhere…contributed to the
development of an ethics that made the worldwide exchange society
possible.
All of this developed…in a competition among groups, each imitating
those who adopted a somewhat advanced…system of practices, and in
consequence, increased more rapidly in population, both by procreation
and by attracting people from other groups (Hayek 1983, 31-2).
Hayek stresses that individuals never understood why they accepted the morals of
private property…“[m]an was never intelligent enough to design his own society” (1983,
3 For more on innate rules, see Ridley (1996). For more on “cultural rules,” see Taylor (1982).
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46-7). That is, “private property…was never ‘invented’ in the sense that people foresaw
what its benefits would be,” but spread “because those groups who by accident accepted
them prospered and multiplied more than others” (1983, 47). Hayek calls this a process
of “cultural selection,” which allows certain groups and practices to withstand the
duration of time.
Outside of the Austrian School, David Hume’s (1985 [1739-40]) understanding of
the emergence of property rights was clearly an evolutionary one. For Hume, property
rights are similar to other useful conventions that are adopted spontaneously. For
example, when:
[t]wo men pull the oars of a boat, [they] do it by an agreement or
convention, though they have never given promises to each other. Nor is
the rule concerning the stability of possession the less derived from human
conventions, that it arises gradually, and acquires force by a slow
progression, and by our repeated experience of the inconveniences of
transgressing it…In like manner are languages gradually establish’d by
human conventions without any promise. In like manner do gold and
silver become the common manner of exchange (1985 [1739-40], 542).
More recent evolutionary arguments clearly point to privatization being a process
rather than an outcome. Sugden (1989) offers a game theoretic interpretation of Hume
when he suggests that all that is necessary for a convention to emerge is other individuals
believing that other people are following the same convention. A rule, such as the right
of first possession, can be adopted for no other reason than the fact that it is popular. As
Anderson and Hill (1983, 414) point out, the evolution of property rights in land, water,
timber, and livestock on the American frontier was the result of a messy process
involving homesteaders and other de facto owners of the resources: property rights were
allowed to emerge in the West rather than being imposed by the State. In an oft-cited
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passage, De Soto argues that the de facto property rights are defined by where the dogs
on local farms bark. As De Soto puts it,
If you take a walk through the countryside, from Indonesia to Peru, and
you walk by field after field—in each field a different dog is going to bark
at you. Even dogs know what private property is all about. The only one
who does not know it is the government (2000, 214).
As the common law approach makes clear, the world is filled with different, and often
competing, property rights systems. These rights are the result of ongoing interactions
among the users of scarce resources. The State’s role in the privatization process is
therefore limited to the codification of already existing property rights systems.
B. The Legal Positivist Alternative
The legal positivist theory of property rights places far greater emphasis on
deliberative action and planning. Unlike the common law approach, the legal positivist
approach views legal practices and customs as artifacts of the State. The legal positivist
approach recognizes a significant role for the State in the privatization process: in most
cases, the State is given the exclusive authority to define and enforce property rights. As
Lipton and Sachs (1990, 294) describe it, “Privatization means creating anew the basic
institutions of a market financial system, including corporate governance of managers,
equity ownership, stock exchanges, and a variety of financial intermediaries…” The
emphasis is, therefore, on creating something new rather than attempting to recognize the
existing bundles of rights. In fact, that existing set of customs and rules is often thought
to be so perverted that a “Big Bang” is necessary to bring about the necessary economic
reforms. Some of the more prominent legal positivists include Dworkin (1980), Tribe
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(1985), Lipton and Sachs (1990), Riker (1991), Holmes and Sunstein (1999), and Murphy
and Nagel (2002).
The legal positivist approach is ultimately grounded in a strong form of
rationalism, so it is not surprising to discover that Thomas Hobbes (1991 [1651]) offers
us one of the earliest legal positivist theories of property rights. In Hobbes’s state of
nature, there is no property. According to Hobbes, property rights were the result of the
commonwealth. Since the commonwealth exists only through the civil laws granted by
the sovereign, property rights are a vacuous concept in the absence of the State or
sovereign authority.
Many contemporary legal theorists and political philosophers have followed
Hobbes in claming that private property does not exist in the absence of the State. For
example, Holmes and Sunstein (1999) argue that since property rights involve public
costs, property rights are not going to be well-protected unless there is a large State to
pay for the public costs of the rights. Murphy and Nagel (2002) go so far as to suggest
that property rights do not even exist in the absence of taxation.
Contemporary economists and political scientists also emphasize the State’s role
in creating, defining, and enforcing property rights. In an examination of Ghana’s
economic performance, Firmin-Sellers (1995) argues that Ghana’s central government
“lacked sufficient coercive authority.” In the absence of a strong state, the informal
rights in Ghana failed to inspire investment and growth. McFaul (1995) makes a similar
point when examining Russia’s difficult transition: without a strong State defining and
enforcing property rights, Russia’s privatization programs were destined to fail.
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The legal positivist approach to privatization has difficulty recognizing property
rights in the absence of the State. According to the legal positivist interpretation, the
State is necessary for the enforcement of rights. Without the State, rights would be
severely fragmented. As legal positivists see it, without some kind of centralized
authority, rights will be scattered and there will be a permanent war of all against all over
these undefined rights.
III. Legal Positivism in Eastern Europe
The common law versus legal positivist dichotomy is an important one when we
turn our attention to Eastern Europe and the former Soviet Union. If reformers are
promoting a common law approach to privatization, power tends to be decentralized and
decisions flow from the bottom up. By contrast, if reformers are promoting a legal
positivist approach, the organizational structure is highly centralized; power is
concentrated in the hands of a few (or one), and decisions flow from the top down.
While this distinction is admittedly simplistic, it serves a useful purpose in that it
helps us understand how much information is embedded in different property rights
arrangements. According to the common law interpretation (Anderson and Hill 1975,
Demsetz 1967), the allocation of property rights is like any other scarce good: scarcity
determines the quantity and quality of property rights. As Harold Demsetz put it in his
seminal article on the emergence of property rights among Montagnais Indians of the
Labrador Peninsula,
property rights develop to internalize externalities when the gains of
internalization become larger than the cost of internalization. Increased
internalization…results from changes in economic values, changes which
stem from the development of new technology and the opening of new
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markets, changes to which old property rights are poorly attuned. (1967,
350)
When beavers in the Labrador Peninsula became relatively scarce, property rights
became more well-defined. The efficient allocation of property rights is, thus, a result
of resource scarcity, and it cannot be easily determined in advance.
When we seek to make sense out of the transition economies of Eastern Europe
and the former Soviet Union, it is important that we first understand the common law
versus legal positivist interpretation of property rights. If property rights are, indeed, like
other goods and services, granting the State the exclusive right to privatization can
seriously hamper the quality and quantity of rights. If, by contrast, property rights are a
scarce good that emerges from the market process, then policymakers should be less
concerned with how to allocate rights and more concerned with how to encourage an
environment conducive to the emergence of rights.
The general consensus among economists regarding the privatization process in
Eastern Europe is that the privatization programs have failed because bureaucrats have
been in charge of the privatization process. For economists, this result is not that
surprising. As McChesney (1990, 298) points out,
…there is no guarantee that government actors will choose the optimal
system of ownership in privatizing some common resource; government
officials will prefer an inefficient private-rights assignment if it is
beneficial to them personally.
For example, McChesney suggests that land privatization for Indians was halted when the
budget of the Bureau of Indian affairs began to shrink.
Citizens in Eastern Europe and the former Soviet Union had a similar experience.
After the first two waves of privatization in the Czech Republic, the National Property
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Fund failed to follow through on promised privatizations of banking and other heavy
industry. As one Czech citizen put it,
The National Property Fund is the “National Property Fraud.” According
to their original mission, they should not even exist today. Yet, they still
hold 15-20% of Czech assets. What would happen to their jobs if they
privatized their remaining assets?4
Individuals on the street in the Czech Republic seem to realize the crucial point in
McChesney’s model: why would a leader or bureaucrat acquiesce to the privatization of
resources if privatization promised a reduction in wealth and power for that official?5
The degree to which bureaucrats and government officials cling to power depends
largely on the structure of the privatization process. If the privatization process is going
to be determined by private citizens who are able to bid on resources, the resources will
be allocated and used more efficiently. If, instead, ill-informed bureaucrats—without
much to gain if they do a good job—guide the privatization process, less efficient
property systems are likely to result.
In the next section, I will suggest that the legal positivist approach to privatization
was actually the main reason for why the privatization process failed in so many
transition economies. Economists from the West exported the legal positivist notion of
property rights to Eastern Europe. As we will see, those countries that whole-heartedly
attempted to design property rights systems anew are the countries that have performed
most poorly since the collapse of communism. By contrast, those countries that relied on
4 Interview with a Czech cab driver while en route to my interview with Pavel Kuta of the National
Property Fund on July 17, 2003.
5 Of course, this begs the question as to why any amount of privatization would take place. In addition to
the bureaucracy’s wealth and power, there also must have been some concern over legitimacy. Had
institutions like the National Property Fund held onto all or most of the Czech assets, it’s safe to assume
that they wouldn’t have held onto power for very long.
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a direct sale method of privatization—a method more consistent with the common law
approach—have fared much better in their transitions.
IV. Evidence from Transition Economies
At this point, the careful reader might be asking: weren’t the transitions in the
Czech Republic, Estonia, Hungary, and Poland cases where top-down planning worked?
Moreover, when we look at other successful transitions in places like Chile, Ireland, and
New Zealand, high degrees of centralized authority also went hand-in-hand with these
reforms. If top-down planning and legal positivism go hand in hand, then recent history
suggests that legal positivism works! After all, this is the conclusion that Sachs and
Warner (1995b, 61) reach when they point out that, “…all of the strong trade reformers
[of Eastern Europe] achieved positive economic growth by 1994, while none of the other
countries had done so.”
While this explanation might be appealing, careful central planning cannot be the
whole story behind these successes. As Marcouiller and Young (1995, 630-31) point out,
in places like Nicaragua, the Philippines, and Zaire, decisive and powerful leaders have
been predatory and “squeeze[d] the formal sector without pity and without limit.” Early
on in the Eastern European privatization process, just about every transition economy had
a high degree of centralization with significant power vested in the hands of a few key
reformers. If leaders in Eastern Europe had chosen to abuse their power, we could have
seen results similar to those of Nicaragua, the Philippines, and Zaire. Furthermore, if
concentration of power and authoritative (if not authoritarian) leadership were all it took
to be successful, then every Eastern European country should have done reasonably well.
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Part of the problem for the post-communist countries in their transitions has been
that they all have relied on specialized government bureaus to direct the privatization
process, leading them to ignore the de facto property rights that were already in existence.
In the Czech Republic, for example, the National Property Fund ran Klaus’s voucher
privatization programs. Under Section 5 of the Privatisation Act, the National Property
Fund has the sole authority to define and create property rights:
(1) The Government of the Czech Republic (hereafter ”Government”) shall
make decisions concerning the selection of State property and capital
interests in other legal entities suitable for privatisation [sic].
(2) The transfer of property under this Act shall be realised [sic] based on the
decision to privatise [sic] a company or its part, or based on the decision
to privatise the capital interests of the State in other legal entities
(hereafter “privatisation decision”), issued on the basis of a privatisation
project proposal.
In Section 6, the scope of the National Property Fund’s power is clearly defined:
(1) The Company Privatisation Project is a sum total of economic, technological,
asset, time and other data that contains:
a) the designation of the company and definition of the assets intended for
privatisation in compliance with this project (hereafter ”privatised
assets”),
b) information concerning how the State acquired the privatised assets,
c) definition of the parts of the concerned assets that cannot be used to
business purposes (for example, bad debts, inapplicable fixed assets and
stocks of materials),
d) valuation (assessment) of the privatised assets,
e) method of transfer of the privatised assets including the settlement of
the claims of the entitled subjects,
f) in the case of establishment of a commercial company, designation of
its legal form,
g) in the case of establishment of a joint stock company, state the method
for distribution of the shares, their stakes in company, as the case may be,
the types, as well as information concerning whether and to what extent
the investment vouchers would be applied,
h) in the case of sale, the method of sale, determination of price, payment
and other conditions,
i) method for the transfer of industrial or other intangible rights agreed
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with the Industrial Rights Office, if such rights are the property of the
company.
As Sections 5 and 6 of the Privatisation Act make clear, even the Czech Republic, a
country whose post-communist transition was fairly successful, was unable to avoid the
tendency towards central planning in the privatization process; in essence, they used
central planning in an attempt to decentralize their resources.
The Czech Republic is not the exception to the rule. A similar agency, the
Estonia Privatization Agency, directed Estonia’s privatization. In Poland, the Ministry of
Ownership Transformation was responsible for the Polish privatization. Similarly, the
State Committee for the Management of State Property (GKI) controlled Russia’s
privatization, and, in 1991, the generally pro-market Anatoli Chubais became its
chairman. Throughout Eastern Europe and the former Soviet Union, the collapse of
communism meant the collapse of central planning in the market for goods and services;
yet, at the same time, the increased opening of markets did not lead to a decentralization
of the allocation of property rights.
In 1998, the European Bank for Reconstruction and Development (EBRD)
sponsored a project that classified the methods of privatization in post-communist
countries. The EBRD’s classification system, while imperfect, indicates the level of
centralization in the privatization process. The EBRD first classified a country’s primary
method of privatization as one of the following: voucher, management-employee buyouts
(MEBOs), or direct sales. The EBRD also listed a secondary method of privatization. To
illustrate the EBRD’s classification system: Albania’s primary method of privatization
was a MEBO privatization, and their secondary method of privatization was a voucher
privatization.
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The EBRD classification system is clearly an imperfect measure of the
privatization process. For instance, Russia’s voucher privatization was far more
extensive than Moldova’s. Yet, the EBRD classification system puts the two into the
same discrete group. Despite these imperfections, the EBRD’s classification system does
provide us with a more concrete indicator of the degree of centralization in the
privatization process.
In Figure 1 and Figure 2, I look at the method of privatization and the economic
performance of post-communist countries from 1990-2002. The data for economic
growth rates was taken from the World Development Indicators, 2003. As these tables
indicate, the method of privatization is highly correlated with economic performance. In
countries that relied heavily on voucher privatization, the average rate of post-communist
growth has been approximately –3% per year. Countries that relied primarily on
management-employee buyouts have, on average, experienced a –1.5% average rate of
economic growth from 1990-2002. By contrast, post-communist countries that relied
primarily on direct sales of assets have experienced 0.4% economic growth per year since
the collapse of communism.
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-6
-5
-4
-3
-2
-1
0
1
2
3
4
0123
Method of Privatization (1=voucher, 2=MEBO, 3=direct sale)
Source: EBRD and World Development Indicators, 2003
Rate of Growth
Figure 1: Privatization Methods and Post-Communist Growth Rates (1990-2002)
-6
-5
-4
-3
-2
-1
0
1
2
3
4
0123
Method of Privatization (1=voucher, 2=MEBO, 3=direct sale)
Source: EBRD and World Development Indicators, 2003
Rate of Growth
Figure 2: Privatization Methods and Post-Communist Growth Rates (1990-2002)
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The EBRD classification system also allows us to look at the effect of
privatization on economic performance when both the primary and secondary methods of
privatization are taken into account. In Figure 3 and Figure 4, we can see that the same
general relationship described in Figure 1 and Figure 2 holds even when we factor in
secondary privatization methods. Voucher privatization, when used as the primary
method, is still the worst performing method. Management-employee buyout is still in
the middle, and direct sale is still the best performing method of privatization.
-6
-5
-4
-3
-2
-1
0
1
2
3
4
0123456
Method of Privatization (1=voucher & MEBO, 2=voucher &
direct sale, 3=MEBO & direct sale, 4=MEBO & voucher,
5=direct sale & voucher, 6=direct sale & MEBO)
Source: EBRD and World Development Indicators, 2003
Rate of Growth
Figure 3: Method of Primary and Secondary Privatization and Economic
Growth in Post-Communist Countries (1990-2002)
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-6
-5
-4
-3
-2
-1
0
1
2
3
4
0123456
Method of Privatization (1=voucher & MEBO, 2=voucher &
direct sale, 3=MEBO & direct sale, 4=MEBO & voucher,
5=direct sale & voucher, 6=direct sale & MEBO)
Source: EBRD and World Development Indicators, 2003
Rate of Growth
Figure 4: Method of Primary and Secondary Privatization and Economic Growth in
Post-Communist Countries (1990-2002)
The relative superiority of direct sales privatization over the other two methods
isn’t that surprising: when resources are auctioned, they tend to be allocated towards their
highest valued use. Moreover, the specification problems inherent in voucher
privatizations are reduced through direct sales because any ambiguities about the
property rights are embedded in the market value of the resource.
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Unlike the direct auctioning of resources, voucher privatizations went about
valuing resources without the knowledge necessary to place appropriate values on those
resources. As Peter Boettke (2001 [1994], 192) notes,
The problem with the conventional privatization package, however, is that
one cannot value assets without a market, but a reliable market cannot
exist without private property. The whole point of the privatization
schemes of vouchers or public auction is to create private ownership. But
how is the value of assets to be determined without a market in the first
place?
While Boettke correctly summarizes the problem of conventional privatization programs,
it is important that we recognize that some privatization programs are better than others
when it comes to incorporating local knowledge.
Under the voucher schemes, centralized bureaus fixed the value of the goods and
services, and the vouchers were only effective in determining who had majority control
of different companies. The voucher schemes didn’t produce anything close to an
efficient outcome. Instead, in places like Russia, well-informed insiders quickly acquired
the vouchers, and this thwarted any kind of competitive bidding for the resources.
Furthermore, poorly defined ownership rights under voucher schemes did not lead to a
lower market value for the resources being privatized.
The direct sale of resources was also superior to management-employee buyouts.
Under direct sales, management-employee groups could enter as one of the bidders. If
they were the highest valued bidder, resources were allocated efficiently. However, if
resources were simply promised to the management-employee groups, potential owners
who placed a higher value on the resources were kept out of the market. In addition, case
studies of management-employee groups suggest that these firms were run as job-saving
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firms with little concern for the efficient use of resources (see, for example, Frydman et
al. 1993a, 1993b).
V. Direct Sales as Common Law Privatization
Relative to voucher privatization and management-employee buyouts, the direct
sale method of privatization is much more consistent with the common law notion of
property rights mentioned earlier. The direct sale approach isn’t about “privatizing,
privatizing, and privatizing” (Friedman 1991) in the same kind of technocratic manner as
the alternative approaches. Instead, the direct sale approach allows the market to
determine the efficient quantity and quality of privatization. The very nature of the direct
sale approach is much more bottom-up in its orientation: leaders and property funds are
not asked to be specific about the value of resources. Instead, this important element of
the privatization process is left to the market.
As I have already mentioned, direct auctions allow those who most value a
particular resource to bid and obtain that resource. We would expect that, in many cases,
the individuals who value the resource most highly are those who have secured informal
rights to it. Since these individuals have local knowledge regarding the true value of the
privatized resources, they can easily determine whether the going market price of the
auction is a reasonable one.
In The Other Path, Hernando de Soto describes the informal networks of street
vendors in Peru. According to De Soto, these street vendors gather together to form
small markets. If, suddenly, some of these small markets were up for grabs in an auction,
we would expect these vendors to be among the first to bid on the rights. Why? Since
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they incurred the cost of establishing the small markets in the first place, street vendors
have already demonstrated that they place a high value on the resource. The same logic
operating in De Soto’s story of informal markets in Latin America seems to apply in
Eastern Europe.
Direct sales were the most effective method of privatization because they were,
by far, the approach that was most consistent with the common law theory of property.
Among others, Vernon Smith (2003) has drawn a distinction between policymakers as
farmers versus policymakers as engineers. According to Smith,
Rules emerge as a spontaneous order—they are found—not deliberately
designed by one calculating mind. Initially constructivist institutions
undergo evolutionary change adapting beyond the circumstances that gave
them birth. What emerges is a “social mind” that solves complex
organization problems without conscious cognition (2003, 502).
Given the choice between voucher, MEBO, and direct sale privatizations, the
policymakers who relied primarily on a direct sales approach were behaving much more
as farmers and less like engineers. By relying on direct auctions of state-owned
resources, the direct sales approach let the market handle the insurmountable epistemic
constraints of the privatization process.
VI. Conclusion
Hernando de Soto’s (2002 [1989]), 2000) argument is that the unofficial economy
is at the heart of the development problem. As De Soto puts it,
…most people’s resources are commercially and financially invisible.
Nobody really knows who owns what or where, who is accountable for the
performance of obligations, who is responsible for losses and fraud, or
what mechanisms are available to enforce payment for services and goods
delivered. Consequently, most potential assets in these countries have not
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been identified or realized; there is little accessible capital, and the
exchange economy is constrained and sluggish (2000, 32).
While De Soto focuses primarily on the informal rights of Latin America, this paper has
argued that the evolving rights of the unofficial economy in Eastern Europe were the key
variable in post-communist transitions.
Countries that relied primarily on the direct auctioning of resources have
outperformed other methods of privatization because direct auctions are more effective at
bringing the invisible knowledge described by De Soto to the surface. This result is
important for reforming countries: when given a menu of privatization options, more
decentralized approaches promise higher economic growth.
Moreover, the evidence provided in this chapter forces us to see the role of
leadership in a new light. At best, post-communist leaders can serve a useful purpose in
codifying de facto rights and giving the unofficial economy space to grow and evolve.
Reformers should not be involved in the creation or micro-management of property
rights. Unless they are extremely lucky, legal positivist reformers will be disappointed
by the results of their privatization efforts.
The most successful privatizations are those that are not only hands off in their
policy rhetoric, but also hands off when it comes to the definition and allocation of rights.
As I have shown in this chapter, the common law approach to privatization has a rich
history that extends back to Hume. It is unfortunate that most post-communist leaders
did not pick up on the common law notion of property rights. By choosing the legal
positivist alternative to privatization, many Eastern European reform attempts have lost
their legitimacy. We can only hope that, in the future, transition economies will look at
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some of the successful Eastern European transitions. If they look closely, they will
discover that direct auctions and a common law approach is the best option available for
their own privatization programs.
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