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Why institutional change shouldbe rapid — A transaction costsperspectiveRasto Ovin aa School of Business and Economics , University of Maribor ,Razlagova 14, p.p. 142, Maribor, 2001, SloveniaPublished online: 13 Dec 2007.

To cite this article: Rasto Ovin (1998) Why institutional change should be rapid — A transactioncosts perspective, Communist Economies and Economic Transformation, 10:1, 63-79, DOI:10.1080/14631379808427906

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Communist Economies & Economic Transformation, Vol. 10, No. 1, 1998 63

Why Institutional Change Should Be Rapid—A Transaction Costs Perspective

RASTO OVIN

One of the most disturbing elements of reforms is uncertainty and unclearness ofevents, which prevent economic agents forming expectations without substantial risk.This then hinders investment and the growth of firms. Development in the institu-tional field, here meaning the supply of institutions and rules by the state, reducesfirms' risk and enables them to concentrate on growth. It is important that we areaware that through this activity they support essential macroeconomic goals.

Owing to the state of affairs in transition theory, it is far from clear which of thetwo reform strategies, gradualism or 'big-bang', can lead to the best outcome in thereform from socialism to a market economy1. This article will try to show that in thecase of institutional change, faster changes offer more advantages than gradualism.

In this article a limited group of transition countries, which we call progressivereform countries, is considered. They are Poland, the Czech Republic, Hungary andSlovenia. We will distinguish them from other European transition countries by theirstarting position with respect to reforms, which is connected with their experiencebefore World War II. In terms of systems it can be summarised as follows:

• They had already experienced the rule of law.• They had followed the pattern of Central European social organisation for a

certain period.• They had experienced a market economy.

The analysis in the article will be based also on the theory of transaction costs, andmore precisely on transaction-specific investment. The hypothesis is that, with fastinstitutional change, firms comply with and support the reform goals, while with thegradual development of institutions their transaction-specific investment is morecostly owing to the higher risks attributable to unclearness and uncertainty. Becauseof a lack of information, which leads to false expectations, this investment activitymay also be incompatible with the actual course of reforms. With a differencebetween the course of reforms and firms' expectations on which their investments arebased, we consequently also have a loss of welfare. It consists of items such as theopportunity costs of wrong (production and transaction-specific) investment, loss ofproduct in the next period due to wrong investment, and higher costs of economicpolicy in the next period. These costs represent costs of coordination and compen-sation when the measures of normalisation must finally be imposed. Owing to the

Professor Rasto Ovin, School of Business and Economics, University of Maribor, Razlagova 14,p.p. 142, 2001 Maribor, Slovenia.

1351-4393/98/010063-17 © 1998 Centre for Research into Post-Communist Economies

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need for integration of progressive reform countries into regional and world trade, wewill consider the course of reforms as an exogenous variable. This also means thatfor progressive reform countries the only possible course of reform is towards aliberal economy,2 no matter what actual current policy is being pursued.

When we accept the necessity for an appropriate institutional setting we must,however, be very conscious that the outcome of such action does not depend just onsupply-side strategies and measures (here meaning the state) but also on responsesand choices of the demand side (here meaning economic agents). They will try toadjust their production and transaction activity by following the mini-max principle.This article stresses their possible response in the field of transaction costs and themeaning of their behaviour for the economic policy of reforms. In this way we arecombining the macroeconomic phenomenon economic policy with microeconomictransaction costs theory. So the emphasis will be on the business firm as agovernance structure rather than a production function (Williamson, 1989, p. 136).

The Role of Institutions in Reforms

We will consider institutions as 'composed of formal rules, informal constraints, andcharacteristics of enforcing those constraints' (North, 1992, p. 477). By consideringthe role of the state, which is to support reforms by the supply of institutions, wefollow the institutional approach, thus considering also (the German) Ordnungs-theorie and Buchanan's constitutional economics. On the other hand we do notoppose the neoclassical view of the role of the state in the market economy forreasons of market efficiency.

Our decision to combine the neoclassical and institutional approaches is based onthe experience of transition in progressive reform countries. It turned out that whereeconomic policy is concerned, neoclassical support is insufficient as it is designed formarket economies which already have developed market institutions. In the reformstates, however, many of the foundations of the inherited institutional network areuseless, and new market institutions must be created.

From the point of view of the following transaction costs analysis, a distinctionbetween institutional environment and institutional arrangement as set up by Davis& North (1971, pp. 6-7) will be considered. The institutional environment representsthe set of political, social and legal rules, while the institutional arrangement meansan institutionalised form of agreement between economic agents. Similar to this is adistinction made by Lachmann (1971, p. 81) between external institutions (aselements of the institutional environment) and internal institutions (which could beunderstood as institutional arrangements). The nature of the external ones is that theyare set exogenously in the form of a legal order, while the internal ones graduallyresult from market processes and other forms of spontaneous individual action.

The State as a Supplier of Institutions

The natural monopoly of the state in enforcing and protecting the rales has beenexplained by game theory when referring to the supply of public goods. Althougheconomic agents are interested in development of the rales, they are not capable ofcontrolling spillovers of these rales of bearing the risk of violation of the rales byother economic agents3. By adopting these assumptions we are in no way attackingneoclassical assumptions. Experience of transition so far convinces us that the

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neoclassical approach should be combined with an institutional one. This experienceseems to require that the consistency of neoclassical analysis be combined with theexplanatory strength of constitutional economics. Here we would agree withKoslowski (1992, p. 674), who, however, stresses the importance of institutionaleconomics. Nor does the fact that institutional environment means institutionsprovided by the state necessarily conflict with neoclassical disregard of the role ofthe state in transition states. As rules are an alternative to permanent discretionarypolicy, institution building actually represents the shortest way to prevent stateinterventionism and to develop towards a free market.

So, following our analysis, we necessarily have a dichotomy in economic policyin progressive transition states. To develop towards a liberal economy in the future,we need intervention now, and as institutions are a public good, state intervention isrequired here. On the other hand, if we persist in extensive liberalisation now(following the neoclassical advice), imperfections of the (hardly existing) institu-tional network will provoke state policy which is suited for market failure situationsin the next stage. This then establishes discretionary economic policies with a strongrole of the state.

However, in transition countries the actual goal is to establish a sustainableliberal economy where the desired state of affairs is markets rather than hierarchies(in the sense of state intervention). Here we must note the difference betweeninstitutional development in market economies and in reform countries. In marketeconomies there were no organised endeavours to promote market institutions; theydeveloped from interests of supply and demand. The rules were set so as to preventunreasonable risk and chaos as well as to serve political interests. In transitioncountries, however, an institutional network should ensure the conditions for marketsto develop. Unlike institutions of the former system, this network is not supposed todetermine economic agents' activities but to regulate free actions of economic agents(Kriisselberg, 1984, p. 189) and to prevent anarchy and chaos in the liberalisationprocess (Newberg, 1994).

Owing to the low level of supply of institutions in reform countries, the effectsof raising the supply are relatively high. In this respect externalities gained from theemergence of an institutional network must also be considered. Network externalitiesarise because of initial set-up costs (emphasis in original), but also as a consequenceof learning effects and coordination effects via contracts among organisationscreating institutional arrangements (North, 1991, p. 109).

Property Rights and Institutional Network

One of the most cited examples showing the importance of the institutional settingis property rights (Comisso, 1991; Williamson, 1991; Koslowski, 1992; Jones, 1983).In the transition states we have the situation of insufficient specification of propertyrights, which was inherited from the former system. For economic policy, as well asfor enforcement of contracts within institutional arrangements, this means morecostly regulation. The institutional setting will thus have positive consequences forthe state as well as for firms, as 'the fuller specification of property rights permits theuse of more economical means of coordination and control' (Jones, 1983, p. 460).

As Slovenian experience shows (Ovin, 1992(a)), absence of property rights at thebeginning of the transition period led to behaviour that is typical for circumstanceswhere property rights are subject to arbitrary policy. When the possibility ofpluralistic property rights (instead of communal and to a certain degree tolerated

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private ownership) was introduced by the last Yugoslav communist government, thefirst reaction of management was to start gaining control over communal property,which was to be just partly privatised. In this way they improved their position in theexpected development of privatisation. The circumstances we experienced at thistime can also be well described by Williamson's (1991, p. 288) observation stressingthat, in the transition period in the reform countries, wealth which was controlled bythe management was reallocated (disguised, deflected, consumed) so as to compen-sate possible disadvantages in the future.4

Although there had been a certain experience with market institutions, in theprogressive transition states they were more or less destroyed by socialist ideologyand replaced by institutions which were to reconcile economic activity with ideologyrather than offering better opportunities for economic activity. Because of this gap intransition countries we now have the situation where organisations depend muchmore on the opportunities provided by the institutional framework (North, 1991,p. 109).

Why is Institution Building Necessary in Reform States?

According to the above considerations, collective action is required to ensure aminimum institutional network in transition states. Such action is also necessarybecause socialist ideology destroyed institutions which have underlain modernWestern society to an extent which obviously has not been realised by neoclassicaladvisers on the one side and by some economists still seeking answers in the idea ofmarket socialism on the other (Ovin, 1992(c)). Although Yugoslav socialism was atolerant one, and Slovenia was a leader in democratisation processes, at the begin-ning of reforms in 1990 the legal system clearly neglected:

• Personal integrity of personality (juridical treatment, freedom of political gath-ering);

• Property rights (in contrast to the view of most Western economists thatprivatisation means transition from state property to private property, it must bestressed that the so-called social property was not defined in the sense ofproperty, but was primarily subject to ideological limitations for those whocontrolled it. So privatisation in reform states called for two steps: to firstintroduce any—even state—property; and then to privatise it);5

• Hard budget constraint (neglected in the fiscal system as well as in the bankingsystem);

• The role of the state (the state was an instrument through which the communistparty exercised control over society, and so the institutions that it controlledwere not designed to support the role of the state in collective action. So thestate was far from representing a sovereign and impersonal bureaucracy gov-erned by the rule of law, which is the Western definition of the state).6

A further example showing the necessity of an appropriate institutional setting isprovided by new small firms. Empirical data show that, since reforms started, thenumber of new private enterprises in Eastern Europe has risen sharply. They are asa rule small firms with small investment.7 So we have positive consequences ofliberalisation and negative consequences of arrears in the field of institutionaldevelopment. The growth of their number must be also considered as a consequenceof the deteriorating economic position and the closing of big state or communalfirms. To a great extent these small firms are owned by experienced management

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from the former state sector who were mobile and courageous enough to start theirown business, despite the fact that they are legally weakly protected and that they aresubject to punitive taxation when employing labour. They started businesses so as tosave their economic position from the destiny of their less capable and less mobilecolleagues in state firms. The positive side of liberalisation is that they coulddevelop. However, owing to the institutional arrears they now remain small,8 andwait for normal legal conditions, when they will reconsider the direction of theireconomic activity.9

The Strategy of Institutional Change Matters

Evolutionism or Constructivism?

Regarding institutional change in progressive reform countries, two possible optionsare relevant. On one side there is an evolutionary approach (Hayek) and on the otherside a constructivist approach (Buchanan).10

The most often cited argument for evolutionary liberalism seems to be Hayek'sdefinition according to which it would be impossible to develop the contemporarystructure and complexity of market economies through planned action (Hayek, 1969,pp. 35, 41). The evolutionist party argues (Rapaczynski, 1996, p. 88) that thedevelopment of the legal-regulatory system, much as the development of othereconomic institutions, is not an outcome of a fully rational choice of 'optimal'solutions but rather a gradual, incremental and evolutionary process.

However, we must not exclude one possibility when at a certain moment itbecomes clear that our knowledge about institutions and their efficiency is inadvance of the present institutional environment. That means that if we are sure wehave the means to improve the institutional setting, we should undertake this action.Buchanan is sceptical towards Hayek's enthusiasm for evolutionary development ofrules, as all institutions are potentially improvable (Buchanan, 1977, p. 38). Besides,institutions as they developed in the history of a legal system are not necessarily thebest, and they too can be changed and improved (Buchanan, 1977, p. 31). Also, inhis 'Limits of Liberty' he has in mind the construction of new rules, as he states thatthe existing legal system can face a situation when it loses even minimal efficiencyand has to be replaced by a more efficient one (Buchanan, 1975, p. 168).

Another possibility for collective action has been addressed by Hayek himself inhis article 'The Role of Knowledge in Society' (1945), although he was convincedthat these conditions were not fulfilled.11 However, if we consider that evolutionaryinstitutional development in progressive reform countries was interrupted in arevolutionary way, and the fact that other (neighbouring) countries developed aninstitutional framework which suits the requirements of the market economy betterthan the system that these states had at the beginning of the 1990s, we tend not toshare Hayek's scepticism.

From the point of view of the strategy of institutional change it is interesting toremember that in recent decades market economies underwent considerable institu-tional change, which could hardly be considered evolutionary. There were severalmarket functions which have been institutionalised by transferring some regulatoryfunctions of the state to new institutions and agencies in the USA (such as theSecurities and Exchange Commission, the Federal Deposit Insurance Corporation,unemployment insurance—Koslowski, 1992, p. 689) along with recent debates onsocial insurance. This means the revitalisation of some economic policy schemes

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which have been known for a considerable time. Here we mean Eucken's (1952,1968) constitutive (apart from regulatory) principles of economic policy as well asKirschen's distinction of groups of economic policy instruments (1964). Apart fromex-post global instruments of fiscal and monetary policy and instruments of directcontrol, he considers measures involving change in the institutional environment.And in this direction the attitude of neoclassical economics towards the role of thestate in transition will obviously have to be rethought.

Through their trial-and-error learning principle economic processes are evol-utionary. We do not oppose the position that in history this was how the developmentof institutions, which subsequently adapted to the needs of economic practice as wellas of society, took place. In this way they adapted to each level of development offactors of production. In the socialist period productive forces in progressive reformstates were subject to a polity which proved to be a failure in every respect. On theother hand, they were, however, indirectly and partially exposed to (foreign) marketsthrough trade with the West (Zizmond, 1994). This influence of Western technologyin the reform states must also be considered by institutional development strategy.

Here we come to the point where two options are possible if we follow theevolutionist strategy of institutional development. The first possibility is evolutionaryupgrading of institutions which were introduced in the socialist period. But how cana democratic market economy be developed by upgrading institutions which arebased on norms of civilisation which are alien to the European norms whichinfluenced these countries before the socialist project? Going further, we may expectthat a pure evolutionist view would assume that the socialist foundation of institu-tions would be abandoned and on their ruins, according to the needs of economic andsocial development, new institutions would gradually develop, which would then bethe second possibility. From the costs perspective such a policy is no doubtinappropriate. The first option would introduce a long intermediate transition periodand would prevent integration of reform countries into the world economy. Thesecond option is risky, as liberalisation without institutional support is causing theinstitutional environment to be replaced by private arrangements which are carriedout according to economic power in a revolutionary development of the privatesector. This reminds us of 19th century capitalism, which can hardly find devoteesat the end of the 20th century. Rules developed in such a way could not preventchaos and development of mistrust in the market economy (Newberg, 1994). We canend our discussion here by concluding that the chances for such development are sopoor that we could use them as an additional argument for a policy of rapidinstitutional change.

Up to now in this article we have stressed the efficiency and ideological reasonsfor an active policy of institutional change in progressive reform countries. Apartfrom these there is also the cultural reason, which supports the constructivist view ofinstitutional change.

It is often stressed that institutions should rest on norms and values that havedeveloped in the society (Rapaczynski, 1996). However, in the case of progressivereform countries here we have a similar problem as with the question of evolutionaryversus constructivist development of rules. It is very difficult to answer the question,which norms and values are to be counted upon. If we take as an example the CzechRepublic, we must answer the following question. Is it better to construct aninstitutional setting considering the fact that this country was one of the leadingindustrial states in Europe before World War II, and developed until then onevolutionary principles? Or should they stick to the evolutionary concept and wait till

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market institutions develop from the norms and values of bureaucratic collectivismwhich had been ideologically imposed after World War II until 1989? We do not seemany arguments for the evolutionary concept here.

As already stressed above, progressive East and Central European states experi-enced a market economy before they were overwhelmed by the Soviet model ofsocialism. This was not just an attempt to implement another system or even just adifferent option of industrial development; here a non-European model was toreplace the European model which had developed over centuries in this area.12 Thismeans that at a certain stage the development of market and democratic institutionswas interrupted and replaced by means of revolution with an institutional setting thatwas without any doubt inferior to the setting that had developed at that time. Whenthis inappropriate institutional framework is abandoned in the progressive reformstates, we therefore have to answer the question, what should be the path ofdevelopment of institutions in these countries.

The Policy Issue

When reform policy is discussed, norms and values must be addressed once more.We must beware the fact that the effect of institutional changes does not depend juston their design and implementation but also on the way they correspond to and arefollowed by informal constraints, which, however, are based on norms and values.While formal rules can be changed overnight by the polity, informal constraintschange very slowly (North, 1992, p. 477). This means that, so as to avoid excessivecosts, institutional changes should not be designed independently of informal con-straints. However, in the progressive transition countries we have an exceptionalsituation. Their trade relations to Western countries enabled management to havesome knowledge about the market principles which were followed by their Westernpartners. So they are now aware that informal constraints which developed insocialism will be replaced by market economy constraints. However, they are readyto accept just the constraints that they understand. So in progressive reform countriesinformal constraints are subject to a learning process, which then introduces new andmodified informal constraints to replace the ones which were part of real businesspolicy in the socialist system.

So, owing to the consequences of socialism, the laws must first be introduced andthen they will be subject to changes with democratic instruments and in this processthey will no doubt approach the values which will survive the adjustment process.The reform strategy which seems appropriate for progressive reform states is toreplace direct supervision to monitor behaviour by the use of rules and proceduresin the first instance and then, subsequently, by unobtrusive controls such as sharednorms and values (Jones, 1983, p. 460).

Further argument for active reform policy in the field of the institutional settingis on the issue of risk and information. A consistent gradualist policy requires alonger period of time. Here the gradualist approach ignores the fact that this requiresinformation on (future) developments and that no significant change of reformparameters should occur. Complementary to these expectations is the requirementthat there should also be no essential change of political structure carrying out thereforms. Contemporary market processes, as well as democratic developments, donot sustain such expectations, thus actually reducing the chances for a gradualistpolicy. The fact that we cannot be absolutely sure about the future sequencing of

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reforms then speaks against gradual changes and in favour of rapid action (Winiecki,1992).

What is then called gradualism is often uncoordinated improvisation and harmsreform policy itself. Here we have additional costs, as fields which reform has eludedreduce the effects in fields where reforms have been carried out.

An example here would be the dichotomy between reforms of the monetarysystem and policy on one side and privatisation and fiscal reforms in Slovenia on theother. Thanks to a corresponding institutional setting, monetary policy is in aposition to pursue stabilisation goals to a sustainable extent (the growth of basemoney in 1995 was 16.8% while GDP growth was 3.5% and inflation was 8.5%). Onthe other hand, privatisation and income policy reforms are developing only moder-ately. As a consequence of delays in privatisation, firms are still rather inefficient andsuffer from high costs. This is connected to the incomes policy, which is still not ina position to adjust the wage level to tradeable production. This then nurturesalternate demonstration effects between the economy and the public service sector,thus exposing fiscal policy to pressures (19.7% of public expenditure went on wagepayments in 1994; the level of tensions depends on the wage level in the economy).In the former system inefficient production and high (public) expenditure wasmaintained also by creating losses in the banking system and by adjustments to theexchange rate. As expectations of continuation of such a policy are to a certain extentstill present, the conflict between monetary and income (plus fiscal) policies has beentransferred to the relationship between the central bank and the economy. Since thecentral bank is not willing to compensate labour costs pressure through cheapermoney and adjustment of the exchange rate, firms are facing problems of insolvency,while exporters are losing their competitiveness in world markets. In order to helpthe exporters' position and to support stabilisation, the government in 1995 promisedto partly compensate the losses of exporters 'due to a passive exchange rate policy'through the budget. Such a 'fire brigade' policy not only raises the costs of reformsbut also supports wrong expectations and makes wrong (transaction-specific) invest-ment decisions more likely.

In this respect the arguments of Winiecki (1992) against Rosati's (1992) claimthat the Balcerowicz stabilisation programme in Poland caused too high social costswith only moderate stabilisation effects are relevant. Winiecki stresses the undevel-oped institutional network which prevented enterprises responding logically tostabilisation policy measures.

The development of property rights in Slovenia may serve as a further exampleof the importance of institutional setting on the one side and the evolutionarycharacter of the economic process on the other. In 1991 and 1992 in Slovenia therewas a lively discussion on the law on privatisation. Some economists argued forpostponement of the legislation so as to achieve the best technical solution13. Theauthor argued that this view missed two important facts mentioned above (Ovin,1992/c):

• The state of affairs in the field of property rights required prompt action so asto establish consistent property rights.

• The nature of economic processes is evolutionary. So definition of propertyrights will only start the operation of property markets and only after a certainperiod will a comparable (to a market economy) property structure arise(private, state and mixed property). This can then differ greatly from today'sexpectations.

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So here political interests (fairness) and economic interests (a capable user) shouldbe pursued and combined in prompt action.

The policy of institutional change is a very demanding one. It does not dependjust on a massive professional and technical endeavour. Its outcome depends also onthe confidence that this policy gains with firms. For the best results this policy willhave to be carried out in the same manner over a comparatively long period or (asthis is not possible in reform states) through credible (not easily reversible) reorgan-isation of policy (Williamson, 1991, p. 289).

Where (progressive) reform countries are concerned, it must also be appreciatedthat the shape of their governments and bureaucracy confirms the criticism that theycould hardly be in a position to carry out the demanding action that completesystemic change represents. In this field we must not forget international conditions,which should stimulate institutional change in reform countries. These includeinternational initiatives to assist reform states14 with these changes, and processes ofharmonisation of European institutions which are rather transparent. But still theempirical evidence proves that, in spite of the almost unanimous conviction ofreform economists that institutional change should be a foundation rather than aconsequence of reforms (Falk & Funke, 1993), governments in reform countries arereluctant to ensure a faster pace of these reforms. As the Slovene example shows,this is the consequence of lack of political will for changes; in most developedtransition states political readiness for changes represents a huge challenge for newgovernments.

Since governments are faced with choice in the political market, it is logical thatthey should prefer to ensure their political position in the future through underliningthe sustainability of their reforms. On the other hand they do not trust much in thepossibility that victory in hard political struggle for reform goals could leave themin power in the future. This is why governments in reform countries prefer todiscount the pluses and minuses of different transition strategies to the present.

The desired approach here would be to concentrate on establishing appropriatestructures (preferably incorporated in reform tasks) with a strong political will anda readiness to take risks. The strategy of reform measures must show that they aredecisive and credible. At the same time, however, governments must be aware thatafter conditions are normalised their role will be reduced. Then 'the heroes from thereform period will be replaced by Schumpeterian innovative entrepreneurs' (Klaus,1994). According to the role which the state is assigned by constitutional economics,its task will then be reduced radically and will be limited to protection of institutions.

Transaction Costs in Reform Countries

By the term transaction costs we shall understand the costs of negotiating, monitor-ing and enforcing exchange between team members (Jones, 1983, p. 456). These arecosts which do not emerge through production but through the transfer of activityfrom one economic agent to another. They represent costs of concrete carrying outof transactions and should be distinguished from costs of information (Vahlens,1993, p. 2101). Transferring goods and especially rights causes costs, which meansthat it ties up scarce resources (Schiiller & Kriisselberg, 1992, p. 104). So theproblem facing the team is to economise on these costs in order to achieve the gainsfrom team production (Jones, 1983, p. 456). Firms will reduce their transaction coststhrough adjustment of organisational form, negotiations with their partners and

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transaction-specific investment. Transaction-specific investment takes place in acertain time period and is, like every investment, future-oriented and risk-con-ditioned. So it will be carried out in response to present rules and future expectations.

In the reform countries we have a situation where additional transaction costsappear. They may be divided as follows (compare with Krug, 1991, p. 107):

• Costs of uncertainty and risks in finding new trade relations;• Costs of negotiations and enforcing of contracts which occur due to undevel-

oped legislation in this field in socialism;• Costs of uncertainty of the course of reforms.

So it is logical that in transition countries the transition-specific investment differsfrom such investment in a stable market economy. The reasons for this are theabove-mentioned additional transaction costs.

As we speak about structural systemic change in reform countries, one other typeof specific investment in reduction of transaction costs is relevant. Reforms add anew dimension to Williamson's possible transaction-specific investment15. This issystem-specific investment. It becomes such when the system changes radically overa relatively short period of time, which is the case in the progressive reformcountries.

Since state-owned enterprises in Yugoslavia, Poland and Hungary enjoyed acertain independence, apart from exercising some business functions, they alsocarried out a kind of transaction-specific investment.

However, this investment was to a great extent undertaken in conditions where'the value of state enterprises was largely a function of the network of informalconnections of managers and local party bosses with their counterparts in other firmsand localities' (Koslowski, 1992, p. 683). Such business methods then spread also onthe concrete business practice level, where extensive maintaining of personal con-tacts was essential.

It remains to answer the question what kind of transaction-specific investmentcan be expected in the transition period. Here we have to remember that the ratherunformed institutional environment by itself already makes such investment ratherrisky. However, following from our previous discussion, we would like to stress that,owing to insufficient information on the institutional environment, we can expect thisinvestment to go in the wrong direction. The following Slovene example shows onepossible background for inefficient transaction-specific investment in the transitionperiod.

Owing to its large cultural and economic differences, the keeping of Yugoslaviatogether was only possible through a rather tolerant type of socialism. This resultedalso in loose property rights, which was realised by some representatives ofmanagement, who used communal assets in a very liberal way and could thereforeextract considerable profits. With the beginning of transition in Slovenia, thegovernment misunderstood the actual background of the prosperity of some enter-prises. So it applied rather liberal economic policy supposing that in the last yearsof socialism Slovene management had already been able to gain experience of amarket economy and that there was no need for decisive institutional measureswithin the reforms. Here it obviously overlooked the fact that a great part of the'good' performance should be assigned to the abnormal institutional environment inthe last years of Yugoslavia and that this was changing under market conditions16.Transaction-specific investment could thus hardly be expected to be complementaryto the reform goals.

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Institutional Change and Transaction Costs 73

The Interaction between Institutional Reforms and Transaction Costs

Transaction Costs and Reforms

When institutional change is extensive enough to influence firms' organisation, inaddition to Hayek's central problem of adaptation to price changes (Hayek, 1945),in transition we also have the problem of adaptation to new rules of the game, nomatter how they were imposed.

The institutional setting has consequences for firms' organisational structure.Institutional arrangements between firms influence their organisational structure(Jones, 1983, p. 454), which means endogenous influence. In this sense an exogenousinfluence from the institutional setting created by the state will have an effect on theorganisational structure of firms too. Let us translate this relationship into thelanguage of transition: the institutional setting will determine the reorganisation offirms previously adjusted to socialism towards a market economy. From the point ofview of transaction costs, with big structural changes in reform countries not onlydoes choice between trade partners change but so does choice between hierarchiesand markets. For firms this is a very complex decision and depends on many factorsthat determine costs of (production and) transaction.

The kind and value of the transaction-specific investment are determined byexpectations. If we use the example of property rights, in a market economy too,increasing specification of property rights will enable team members to (re)formexpectations, thus changing the value of exchange (between them) and their orien-tation to one another (Jones, 1983, p. 460). Their smooth functioning is necessary forthe reproduction of exchange (Koslowski, 1992, p. 681). As that reproduction ofexchange becomes routine, we have a lowering of risk and thus of the costs oftransaction-specific investment.

Unlike Western privatisation, where just the relationship between private andpublic ownership is being changed, in transition countries establishing of newproperty rights means a fundamental shift from one concept to another. We musttherefore be aware of the consequences of system-specific investment which weintroduced above and which will alter the specificities as presented by Williamson.It is no wonder that replacing property rights, abandoning the soft budget constraint,opening the economy and introducing responsible contracting represent a newdimension to the specificities concerned. New property rights will change theeconomic calculus and require reconsidering of the size of capacities and almostcertainly lead to restructuring. This will influence all types of transaction-specificinvestment. The same thing will happen when even state-owned enterprises have toface a hard budget constraint, which again sometimes leads to radical reshaping oftheir capacities, thus reducing or even destroying the efficiency of asset-specificinvestment. The opening of the economy will again expose domestic capacities tointernational competition and the same will happen to all kinds of transaction-specific investment. Introducing responsible contracting has shown that under newconditions for acquiring bank loans, many partners in such relationships were nolonger capable of maintaining their level of production, which practically destroyedan important part of the system-specific investment they and their partners had madepreviously.

Just like business methods and responsibilities, institutional arrangements willalso have to be subject to considerable development so as to make transactingprofitable. Especially when the latter is concerned, it is useful to remember that asa consequence of totalitarian rule, post-totalitarian societies lack many of the habits

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and skills of independent association (Koslowski, 1992, p. 694; see also above), afact which can be attributed to the ideological constraint in the political field.

Relation-specific investment is the criterion when firms will 'make longer ex-antecommitments to the terms of future trade, and rely less on repeated negotiations overtime' (Joskow, 1987, p. 168). We know that firms continually check the choicebetween using institutions (in the form of laws and prescriptions) and carrying outnegotiations with their partners. Here the relationship-specific investment will bemore important, 'the longer will be the period of time (or number of discretetransactions) over which the parties will establish the terms of trade ex ante bycontract' (Joskow, 1987, p. 169).

This is, however, also applicable to system-specific investment. The firmer thesystem (or the bigger the number of transactions carried out in this system), thegreater the importance of system-specific investment to reduce transaction costs willbe.

Transaction Cost Saving and Costs of Reforms

Here the thesis is that with a functioning institutional network in progressivetransition countries transaction cost saving (in the sense of transaction-specificinvestment) will reduce costs of reforms.

Considering transaction costs in the reform process is relevant also from the pointof view of the costs of reforms themselves. Here the distinction between costs ofinstitutional development at different levels should be made. While costs for theinitial set-up are borne by the state, the costs for negotiation and transaction-specificinvestment between firms are borne by them. In this respect two arguments for rapidreforms arise, offering better information to firms in the reform state:

• Thanks to greater understanding and certainty regarding the institutional en-vironment, costs for the initial set-up and its protection, together with costs forcontracting and transaction-specific investment, will be considerably smallerwith prompt and credible institutional change than with gradual and half-heartedreforms. The latter impose higher costs borne by the state (for continualintervention for protection of some economic order), and higher firms' costs ofnegotiation (uncertainty and unclearness). Such a policy also does not stimulatetransaction-specific investment or provoke wrong investment as a consequenceof wrong information which may survive due to inappropriate policy.

• When institutional development is supported with appropriate information,firms will try to economise within the expected network. In this sense negotia-tions, as well as transaction-specific investment, will follow such expectations.Here the consequence of reforms for economic policy will be that the costs ofadaptation will be partly borne by participants in the market, which will thenreduce their requirements for compensation.

The issue that economic reforms policy faces in respect of system-specific invest-ment concerns investment made under the former system. Here investors are tryingto protect their investment from reforms. The Slovene example shows that manage-ment requires economic policy measures which will actually help them to preservecapacities in spite of changes which are unavoidable. The consequence for economicpolicy, and indirectly for its costs, is that, in order to enforce their requirements, theywill seek political programmes which promise continuity, here meaning unclearproperty rights, a soft budget constraint and a closed economy.

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Institutional Change and Transaction Costs 15

And at present there are still some facts which maintain such expectations inreform states. In the absence of credible action in the field of institutional develop-ment, government measures for restructuring the economy and preventing too highunemployment often preserve hope that the story of abandoning the soft budgetconstraint will not be taken too seriously. Misunderstanding of what a marketeconomy (which can only be an open economy) is and short-term political interestsunderpin the hope that for patriotic reasons there will be a continuation of protection-ism similar to that of the former system. All this of course maintains transaction-specific investment which is far from being adjusted to the institutional environmentthat the reform countries will have to adopt in the future. Then economic policy canexpect higher costs of reforms.

Considering its influence on transaction-specific investment, creating an appro-priate institutional setting will have positive effects on reform goals. It is importantthat here part of the task is actually financed by firms. It is a fact that throughstabilisation of relationships between government and firms (less discretionarypolicy) and among them (credible enforcement of new rules prevents any participantflouting them), new relationship-specific investment will take place. Founded oncredible policy, we shall have activity of private economic agents which will be inthe same direction as indicated through reforms. In this way firms (following theireconomic interest, of course) will support the desired direction and pace of reforms.Here the exchange has economic and political effects. The government is offering thepublic good (institutions which are a consequence of the changing political system)while companies are offering economic effect. This effect supports the politicalchange and promises fruits of this change to companies which act according to thenew rules.

What is also relevant for economic policy is the fact that cooperation amongeconomic agents (through transaction-specific investment) ensures the irreversibilityof the transition process. There are still some demanding tests which even progress-ive reform countries will have to go through (entering the European Union, adjust-ment of wages in Slovenia to tradeable production, rationalisation of labour in theCzech Republic) and there the support of the pro-reform facts in the form oftransaction-specific investment might be of use.

Concluding Remarks

In view of the needs in progressive transition economies, the above definition of twokinds of rules will imply that formal rules should undergo (designed) change(through collective action), while formal constraints (that will be offset in institu-tional arrangements) will in principle develop gradually. However, especially at thebeginning of reforms, the latter process will have to be given impetus by designedinstitutional change. Its function is not only to be the catalyst of the process but alsoto be a credible basis for the development of expectations which are complementaryto the market economy by firms.

The nature of economic policy also emerges from different strategies of institu-tional change. Gradualist and often half-hearted reform policy leads to discretionaryeconomic policy of etatist allocation of resources and income distribution whichreminds us more of the practice of the former system than of the liberal economicpolicy which is the only possible destination of economic control in reform states(Ovin, 1995).

Although we count ourselves among the free market devotees, for reasons

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stressed in this article, we argue that for such an environment a minimal institutionalsetting must be assured and that the state, with its natural monopoly on introducingand protecting rules, should do the initial job. This is a necessary condition but stillnot a sufficient condition. The productive, entrepreneurial and adaptive strength ofthe population, as part of their values and norms, will in the end determine howsuccessful the joining of these nations to the European and world democratic marketeconomies will be.

So we believe that, despite criticism of what Hayek calls 'constructivist rational-ism', it is worth reconsidering where progressive transition states are concerned. Thisdoes not necessarily run counter to the spontaneous generation of institutionsunderlying Western civilisation.

Notes

This article forms part of a research project on 'Price Mechanisms of Transitional Economies'(J5-7774) financed by the Ministry of Science and Technology.

1. For an interesting analysis of this question see Dewatripont & Roland (1996).2. Here we mean an economy where market pricing of factors, a hard budget constraint and

openness to world markets prevail. Such an orientation of progressive transitioncountries is plausible, considering European integration, cost reduction in the field oftradeables, and the need for what is sometimes called fresh capital in the form of foreigndirect investment.

3. For the constitutional analysis of this issue see Brennan & Buchanan, 1985, pp. 60-64.4. This was also possible thanks to the inconsistent Yugoslav privatisation legislation.

Despite warnings from the Slovene Privatisation agency at that time, the first democrat-ically elected Slovene government in 1990 did not suspend articles of privatisationlegislation which enabled privatisation by management. The consequence of such apolicy is considerable damage to community property. Public pressure resulted in amassive auditing process which encompassed 1100 public enterprises (representingalmost 75% of all at that time socially owned enterprises). The findings of the Payment,Auditing and Information Agency were that at the time when the Slovene Privatisationlaw was passed (December 1992) the communal property had already been damaged inabout 50% of the enterprises inspected. The damage amounted to almost one billionUS$. From 447 cases of suspected mismanagement 375 refer to illegal private extractingof profit from privatisation (Večer, 1996). The supervisory and juridical processes whichfollowed now represent a considerable hindrance to the progress of privatisation andforeign investment in Slovenia.

5. There are a number of aspects of the treatment of property in reform states which shouldbe considered when discussing privatisation and reasons for very high transaction costsin these countries. First, private and public property in the West and communal propertyin the East should be distinguished sharply. Here legal gaps in property rights explainthe essential difference in the nature of efficiency problems between East and West. Foran interesting analysis see Comisso (1991) and Pejovich (1992). The different treatmentof property in reform states today derives also from the influence that the Asiatic modeof production had through Soviet dominance (Melotti, 1978). There the collective typeof fixed property served to bind people to the land and to isolated communities. Theactual owner was the despot, who delegated inconsistent property rights to the peopleand controlled them through this arrangement. Elements of bazaar trading (North, 1991,pp. 103-104) were felt in Yugoslav business practice as a consequence of experience ofSerbia's centuries of Turkish rule.

6. The consequence of such relations between the state and the ruling communist party wasthat even the state had insufficient title to its assets. So the party officials were in aposition to interfere and dispose of them (Comisso, 1991, pp. 168-9).

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Institutional Change and Transaction Costs 11

7. In 1994 the shares of private enterprises in Slovenia were as follows: number ofenterprises—88% of all enterprises, employment—15.9%, GDP in industry—24.4%,fixed assets—6.8%. The average number employed was 2.8 workers per firm (ZMAR,1995, p. 6). The experience in Poland is very similar (Koslowski, 1992, p. 694).

8. The latest empirical studies show that in this respect the situation in Slovenia isdeveloping (Bartlett et al., 1996), although at a modest pace.

9. Arrears in institutional development here seem to be felt differently by the new privateand public sectors. The advantage of the new private sector is that they are lesshampered by imperfect definition and enforcement (Rapaczynski, 1996, p. 102) inthe field of property rights than the public sector. However, the situation in fulfil-ling contracts is almost the opposite. Here, owing to underdeveloped contractuallegislation, small firms are often damaged by bigger firms' failure to pay forshipments.

10. As a possible opposite to Hayek's viewpoints W. Eucken and his constitutionalprinciples of economic policy should also be considered (Eucken, 1952, 1968).

11. In the article Hayek reduces the possibilities for conscious action to conditions where:i) we possess relevant information on the state of affairs we want to achieve, ii) we knowthe preferences, and iii) we have the required knowledge and instruments for such action(Hayek, 1945, p. 519).

12. An interesting analysis is given by Melotti in his article 'Marx and the Third World'(1980), denoting the Soviet type of socialism as a 'bureaucratic collectivism' with rootstaken over from an Asiatic mode of production. Considering this thesis we gain adifferent perspective on developments in pre-revolutionary Russia and the Soviet Union,as well as a different view of the prospects for the CIS.

13. These postponements (the law was passed only at the end of 1992) did not result in abetter professional quality of law as they aroused the interest of all possible interestgroups (Ovin, 1992(b)). The outcome is that the Slovene privatisation law includespractically all possible privatisation methods and is rather insider-oriented.

14. Here we mean different papers by international organisations stressing the importanceand the need for assistance with institutional change. Some titles are: Commission of theEuropean Communities (1993, p. 9), International Chamber of Commerce in Starr(1993, p. 4), European Council (1993, p. 2), EBRD (1993, p. 2), OECD (1993, p. 3).

15. They are derived from the four types of asset specificity that he introduces: 1. Sitespecificity, where partners' capacities are located near to one another and can economiseon inventory and transport expenses, 2. Physical asset specificity, where partners investin assets which can be of use to both of them, 3. Human asset specificity, where theycombine working experience on both sides, and 4. Dedicated asset specificity, where oneof the partners invests in capacities which will more or less produce for a known buyer(the other partner). Later Williamson extended this distinction, such as to brand namecapital (1989, p. 143) and later on temporal specificity, as a consequence of technologi-cal non-separability of assets (1991, p. 281).

16. A striking example here is the decline of the gold and jewellery factory in Celje at theend of 1995. In 1993 the general manager of this factory (at that time still one of thebiggest producers of gold products and jewellery in Europe) was praised by the Sloveneassociation of managers as the manager of the year.

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