Did you Know?  March 11, 1994

                          Did You Know?

The article below was published by the University of Wisconsin-
Madison one year ago; nevertheless, it is entirely germaine to the
current discussion of economic development in Eastern Europe and
the former Soviet Union.  The article is important for its attempt
to redirect the focus of debate.  It emphasizes the necessary
institutional preconditions for a market economy.  Bromley argues
that too much attention has been given to privatization, so much so
that it appears that privatization is sufficient for transition to
a market economy.  This contributes to the misguided notion in
developing countries that laissez faire equals "anything goes."
Insofar as rules and institutions reduce transaction costs by
keeping to a minimum costly negotiation, they serve as the
necessary basis for successfully running market mechanisms.  The
"choice domain," or the set of possible choices open to an economic
agent, is defined by convention, habit and rules governed by the
legal system.  These are the institutional arrangements of the
economy, and they must function within the framework of an
authority system.  The supporting legal structure must offer
flexibility as well as predictability, however, if sustainable
economic transformation is to occur.

March 1993

Number 121


Daniel W. Bromley*

The major economic transformations now underway in eastern Europe
and the former Soviet Union (EE/FSU) provide a convenient
opportunity to assess the profound difficulties in creating market
economies and fostering economic development.  While economists
have devoted considerable attention to development policy in the
agrarian nations of the tropics, difficult times in EE/FSU serve to
remind us of the need to think more creatively about the economic
problems of the post-communist world.

Stories in the popular press suggest that the challenges in EE/FSU
are of a fundamentally different nature than those in, say, South
Asia or sub-Saharan Africa.  In these regions of the world, the
tradition has been to invest in infrastructure, and in agricultural
projects.  It was only recently that macroeconomic conditions
received much attention.  In certain settings, efforts at getting
"prices right" have led to political unrest.

If early evidence from EE/FSU is any indication, the primary
concern there is to get capital and private titles into
the hands of creative entrepreneurs recently liberated from the
heavy hand of centralized planning, administered prices, and
compulsory deliveries of certain products.  From
there it is thought that goods and services will suddenly
materialize, markets will evolve, and general economic conditions
will improve.  Macroeconomic policy is central to this
transformation as well.  Much attention is paid, therefore, to the
exchange rate of dubious currencies, and to other
economy-wide indicators.  While these changes are being debated,
economic and social conditions continue to deteriorate at an
alarming pace.  Inflation is severe--currently 20-30 percent per
month in Russia--undermining not only current incomes, but
destroying the value of assets recently distributed to citizens
in the form of shares in newly privatized firms.  Crime is
increasing and a small class of hustlers-entrepreneurs is emerging
who may, if nothing else, affirm the worst Dickensian propaganda of
the Lenin-Stalin era.

Unfortunately, most of the attention these days focuses on the
standard macroeconomic conditions and prescriptions while the
essential ingredient in the transformation to a market economy
remains undiscussed.  That central idea in economic transformations
is the institutional preconditions for decentralized and autonomous
markets.  These institutional preconditions have been ignored at
great peril in conventional development programs in the agrarian
tropics, and they now stand the risk of being overlooked as
western experts dispense advice concerning the economic trans-
formation problems elsewhere.

The Incentive Problem in Economics

Market Prices as Signals -- An economic system can be thought of as
a set of "ordered relations" among self-interested individuals who,
in pecuniary matters, act alone or as members of firms and
families.  The essential problem of economic organization at the
national level is to design a set of signalling devices (exchange
opportunities)--and hence signals (relative prices)--that will
guide self-interested agents to act in the interest of the larger
community.  In this, the impact of the aggregate of individual
actions will be larger than the mere sum of their parts--a point
popularized in the 18th century by the moral philosopher Adam
Smith.  Markets are signalling mechanisms, but markets cannot
function in a world without structures of one form or another.
Markets, if they are to represent legitimate signalling, must
function so as to hold down: (1) the costs of obtaining information
about possible market opportunities; (2) the costs of negotiating
contracts or bargains among market participants;
and (3) the costs of enforcing bargains or contracts that have been
struck.  We call these costs transaction costs.

The nation-state, if it is to flourish, requires not only a
low-cost economic signalling mechanism, but it must always strive
to keep transaction costs low.  The fragmented and autarchic
economies in Africa are stifled by high transaction costs.
Similarly, the command economies of eastern Europe were burdened
with very high information costs, very high contracting costs, and
very high enforcement costs.  In such circumstances, bad signals
result in poor economic performance.  Indeed, in a command economy,
prices are not meaningful information at all, but rather
disinformation--in a sense, propaganda.

The successful transition to a market economy in EE/FSU--and the
improvement of the market economy in many agrarian
nations--requires that great attention be devoted to the nature and
extent of economic signalling that will emanate from markets.

Privatization:  The Promises and Perils

>From all of the press coverage and discussion about Russia's
efforts at economic transformation, one would think that
privatization were both necessary and sufficient for a market
economy to appear.  However, there is nothing inherently good about
privatization that justifies it as an end in and of itself.
Rather, privatization is a means to some other end.  That
end is better signalling and hence better incentives transmitted to
individuals in their capacity as economic agents.

In fairness, it must be said that even in the face of bad or
missing signals, the command economies of eastern and central
Europe were reasonably effective at providing those goods
and services deemed to be important by the central planners--
science, education, health care, housing, military programs, and
transportation.  Recall that even in a market economy the state
plays an important role in this process--either budgetarily, or
through the law-giving activity of the legislature and
the courts.  In these circumstances, the state provides a "public
good" or a "collective consumption" good.

The institutional arrangements that I call the preconditions of a
market economy constitute the "ordered relations" that reduce
transaction costs and allow markets to arise.  Properly structured
markets emit meaningful signals that reflect marginal values with
some social significance.  Recall that not all prices are of equal
validity in a market economy; those from distorted or imperfect
(monopolized) markets claim scant normative significance.  That is,
privatization of productive assets requires a coherent market
system as a companion institutional component.

The Coherent State as a Foundation for the Market

Markets Embedded in Politics -- The focus on institutional
arrangements underlying a viable market economy serves to remind
us that shared (collective) values of a particular society are the
necessary building blocks of these institutions.  Whose interests
are to count?  How will these interests be articulated through the
political system?  In a word, one cannot establish a meaningful and
functioning economic system unless and until one has a coherent
political entity we call a nation-state.  The sequential primacy of
a nation-state suggests that we must start with some sense of an
ethical consensus regarding the larger purposes of the state.  This
then leads to some sense of the policy interests of the state
looking to the future.  From this one gets an idea about the
desired structure of what we may call operating institutions--
the working rules--that will frame individual domains of economic
choice.  Law is the empirical manifestation of a transformation
from a state of anarchy to a structured civil society.  A civil
society is one in which reason and the rule of law trump emotion
and brute force on the part of some.  A civil society requires the
recognition of an authority system.  Property rights mean nothing
in the absence of an authority to enforce duties on non-owners.

>From Authoritarianism To Anarchy, and Back Again

Here lies the fundamental dilemma confronting a Russia that wants
to become a market economy.  The Russian citizen, having just been
liberated from one authority system, is understandably reluctant to
create and empower another.  However, it is impossible for the
nations of eastern Europe to have a market economy without first
creating an authority system that both establishes and legitimizes
that market.  The necessary authority system can only come from a
meaningful state; there is no middle ground.  Unfortunately, in
many agrarian nations of the tropics, the current state and its
accompanying authority system is seen to squander scarce financial
resources on military equipment and personnel, ostentatious life
styles, and political friends who can offer necessary support and

The authority system will be manifest in terms of the legal
relations it defines and enforces.  As a start, we may regard the
necessary characteristics of a meaningful and coherent legal system
to be:  (1) clear lines of authority and the division of
responsibility among governmental units; (2) clarity and precision
in legal rules; (3) mechanisms and processes for the protection of
property rights; (4) procedures that offer stability and
predictability; (5) a sense of fairness focused on law as process
more than outcome; and (6) accessibility of laws and regulations
to the public.

Recall that the central problem for any nation-state is to create
an institutional structure that will channel self-interest into
socially useful directions.  This requires more than having
government "get out of the way."  It requires a new and prominent
role for government as agents of the political entity we know as
the nation-state.  In the absence of that, one has anarchy in
which aggressive individuals can become very rich by selling what
they most probably do not own.  The economies of EE/FSU and the
agrarian tropics will not flourish until existing political systems
make a commitment to an authority system that seeks to reduce
transaction costs, and that places a premium on productive
efficiency.  In the meantime, low-level anarchy prevails.  The
command economies were characterized by a legal system that
entailed the presumption of prohibition.  That is, if an action was
not expressly written down it was presumed to be prohibited.  As
one can imagine, this presumption of prohibition stifled all
manner of otherwise useful activity.  The Gulag was not just an
artistic creation of Russian novelists in exile.  On the contrary,
a viable economy requires a legal system built on a presumption of
permission in which an action, if not expressly forbidden,
is permitted.  This profound shift in the burden of proof and
liability for action stands as the basic issue in legal structures
for a nation-state.  With the presumption of prohibition, one ends
up with fear of a powerful state and an oppressive government.  In
this circumstance there cannot be a viable economy.  This situation
describes the command economies of eastern Europe.  But the
converse, a presumption of permission, must be seen as part of a
larger consensus about which actions are impermissible.  That is,
a system predicated upon a presumption of permission must still be
embedded in a social fabric that sets general parameters for
acceptable commercial behavior.

Evidence to date would seem to suggest that the naive and
simplistic acceptance of the notion of the "magic of the market"
has beguiled the Russians into the pernicious idea that a market
economy is one without laws.  They seem to imagine that laissez
faire translates into "anything goes."  On this tack, yet more
chaos is practically assured.  If this low-level anarchy is allowed
to continue, can a new authoritarianism be far behind?  What should
the nation-state do? 1/

The Role of the State

There are two fundamental roles for the state in economic matters:
(1) to establish an institutional structure that will encourage
industry on the part of individual economic agents; and (2) to
create the means and opportunities for that institutional structure
to be modified through time as social and economic conditions
warrant.  A viable economy is determined by the extent to which
institutional arrangements can be fashioned to preclude equilibria
at inefficient outcomes.

To think of the state as an authority system may serve to remind us
that there must be a coercive force in any social setting.  By
"coercive force" I do not mean repression or totalitarianism.  I
mean that entitlements--rights and duties--cannot exist, indeed
they have no meaning, in the absence of an enforcement structure to
which one can turn to have their claim given protection.  We must
recognize that the nation-state is an authority system whose
purpose is to give meaning to all transactions.  For instance, the
state is the sole entity to print and control the currency.
Similarly, the state is the final arbiter of rights and duties
among individuals.  When one has rights it means that the state
will come to a citizen's defense in a dispute with others.  To have
clear contractual rights in exchange means that the state stands
ready to enforce agreements surrounding that exchange.  In this way
the state is a party to every transaction.  The compelling question
then becomes, how shall the state act in its capacity to influence
the nature and content of market transactions?

Institutions and Economic Development

Rules and Markets -- Economic transformation (or economic
development) results from conscious actions that cause economic
growth to occur today as well as into the future.  Notice that
development is a causal factor rather than being a final product of
a process of economic growth.  I refer to this as a process of
getting the rules right.  Rules--institutions--permit us to carry
on our daily lives with a minimum of repetitive and costly
negotiation.  Institutions reduce transaction costs. John R.
Commons defined institutions as the "working rules of going
concerns."  It is through the establishment of institutions that
societies create markets.  Indeed, markets can only exist within a
legal system that has consciously set out to create ordered domains
of exchange.  Market activity is a process whereby
ownership of, and control over, future income streams is
transferred among participants.  Markets are concerned with changes
in ownership and control of future streams of benefits and costs.
The essence of a market is the exchange of both information and
ownership with an eye to the future.  Markets are arenas of
information about the terms of trade, about future expectations,
and about future control over income streams.  A market without
rules about transactions is a contradiction in terms.

Realistic notions of markets, therefore, require that we imagine
the existence of a large number of buyers and sellers separated
across time and space, all acting to exchange items which, upon
completion, will leave both parties better off.  Such notions of
exchange require a legal environment in which willing buyers and
sellers can negotiate trades.  The requirements of any market are
therefore, at minimum, ownership of the things to be exchanged, and
information about exchange opportunities.  The essence of the
legal foundations of an economy is to provide a predictable
structure within which exchange activity can flourish.  This legal
foundation is required whether the economy is organized along lines
that give the government a dominant role, or whether it is
organized so that the private sector is the dominant active

Rigidity and Flexibility

The difficulty comes when we realize that no economic system,
whether market oriented or command oriented, can thrive if locked
into an inflexible structure that does not recognize the exigencies
of new technology, new scarcities, or new preferences on the part
of buyers.  Indeed, this flexibility is said to represent one of
the main benefits of market processes as opposed to command
processes.  It is, however, a mistake to attribute this flexibility
to the existence of markets rather than to the real cause, which is
a legal environment that recognizes new
opportunities, and that functions to capitalize on those
opportunities.  Markets do not cause adaptation to new conditions.
Rather, markets allow responses to those situations as permitted by
the legal foundations of the economy.

The social problem is, therefore, to craft a legal structure that
offers both predictability yet flexibility; a structure that
establishes order, yet allows for change.  We are concerned,
therefore, with rules about transactions as well as with rules for
changing rules about transactions.  It is important to understand
that predictability of institutional arrangements is not the
same thing as inflexibility.  Institutions:  (1) define the choice
domain of independent economic actors; (2) define the relationships
among individuals; and (3) indicate who may do what to whom--and
how much it will cost.  It is the aggregate of institutional
arrangements that determine, at a particular moment, economic
conditions.  That is, there is a prevailing structure of norms,
conventions, rules, practices, and laws that shape or define the
choice domains individuals and groups in an economy.  In a
centrally planned economy these are the quotas of inputs, the
production plans, the accounting prices, the shipping schedules,
the supply of dwellings, the availability of jobs, and the like.
These institutional arrangements define the domain over which
individuals and groups are free to exercise decision-making

In a market economy, institutional arrangements consist of a
different constellation of constraints and opportunities--tax laws,
wage rates, contractual obligations for workers, product liability
for commodities, health insurance premiums and coverage, working
conditions in factories, farms and mines, and the like.  This
constellation of norms, conventions, habits, practices, customs,
laws, and administrative rules define choice domains; I can
change jobs, I cannot drive 90 miles per hour; I can build a house
on a particular piece of land, I cannot build a cement factory; I
can hire workers for my factory, I cannot refuse to hire them only
because they embrace an unfashionable religion.

So the institutional environment defines the choice domain within
which members of a society may operate.  But economic conditions
also influence the structure of institutional arrangements.  Patent
and copyright laws create a particular environment within which
intellectual behavior flourishes or suffers, and therefore
technological change occurs or is stifled.  When new technology and
economic opportunity arise it is necessary for new institutional
arrangements to emerge to foster development of those
opportunities.  New economic conditions--for instance a new
technical possibility--create the demand for a new law (an
institution) that in turn makes the economic environment conducive
to large investments in the development of that particular
technology.  New economic conditions create a need for a new
institutional form, and that new institutional form then creates
the new economic environment.

The Law and Markets

Markets function not because of the absence of law, but only with
the explicit presence of law.  Markets are "efficient" only when
the legal foundations exist to hold down the costs of transacting
across time and space.  To those who imagined that markets would
automatically appear if only government would get out of the way,
recent difficulties in eastern Europe must come as a surprise.

The lessons of American economic growth are dominated by the
instrumental use of the law to encourage enterprise--whether the
land acts, the creation of new mining law, or the writing of a new
water law to fit new ecological and economic conditions in the arid
western part of the nation.  Economic development requires the
instrumental use of the law--contract law, property law, bankruptcy
law, administrative law, and tort law.  The disappointing results
observed in eastern Europe--and in much of the tropics--are the
logical outcome of societies that lack the legal foundations of
exchange.  It is not enough to legitimize private property
rights.  The economy must possess a meaningful set
of institutions about transactions, as well as a coherent set of
institutions of transactions.


As we ponder the fate of eastern Europe and the former Soviet Union
it is well to keep in mind that the economy is a set of ordered
relations that indicate arenas of choice for autonomous economic
agents.  The arenas of choice given by the set of ordered relations
are defined by--determined by--convention, habit, and by rules and
entitlements represented by the legal system. These are the
institutional arrangements of an economy, and they have been too
long ignored in traditional treatments of economic development.
Exchange cannot exist without a structure of elaborate rules about
transactions.  Rules in the absence of an authority system
to give meaning to those rules are not rules at all but mere
suggestions.  Many nations, both agrarian and those in eastern
Europe, have yet to constitute themselves as meaningful authority
systems with respect to the economy as a set of ordered relations.
They may be "authority systems" in one unhappy sense of that word,
but the coercive powers of the state are not yet constructively
applied to the economy as a going concern.  A viable economy is one
in which the set of ordered relations provide predictability
without rigidity, and flexibility without chaos.  To say that
the economy is a set of ordered relations is  not to imply
rigidity.  Economics and the economy are about futurity, and a
system in which the future is not only unknown but unpredictable is
an economy with no hope.  When I say "unpredictable" I do not mean
that one can predict with perfection.  But the essential problem in
any economy is to provide a climate for independent actions with
intertemporal implications.  Chaos is the antithesis of this

The problem of economic development and the transformation
to a market economy in eastern Europe is not one of getting prices
right.  Rather, the problem is to get the rules right.  Prices are
mere artifacts of the momentary convergence of technology, ecology,
human needs or wants, disposable income, and the institutional
arrangements that indicate who can exchange what with whom, and how
much it will cost.  Only by focusing on the right rules, the
institutional arrangements, will sustainable economic
transformations occur throughout the world.


1/  As this is written, Russian President Boris Yeltsin has just
declared extraordinary executive powers in an attempt to usurp the
unruly Congress of People's Deputies.

* Daniel Bromley is Anderson-Bascom Professor in the Department of
Agricultural Economics, University of Wisconsin-Madison.

This is a periodical on public policy issues.  The views expressed
are those of the author.  We welcome your comments.  Department of
Agricultural Economics, 427 Lorch Street, University of
Wisconsin-Madison, 53706.  This publication is supported by the
Research Division, College of Agricultural and Life Sciences,
University of Wisconsin-Madison and by the University of Wisconsin
Cooperative Extension Service.  UW-Madison and UW-Extension provide
equal opportunities in employment, admissions and programming.
Agricultural Experiment Station 1450 Linden Drive University of
Wisconsin-Madison  53706.  Roger E. Wyse, Dean and Director