Download Barter System in Russia

The Role of Time and
Institutional Traps
Chapters 6 and 7
Kristin Harris and Anders Hawes
The Role of Time
♦♦Market System♦♦
А) Brings a competitive equilibrium model into the
economy
Б) Individual firms/households make their own
decisions
В) Firms know more about what they need for inputs
and outputs in this system than a faraway ministry
would
The Role of Time
The Role of Time
• Privatization
o Overhaul of the entire economy not needed
o Needs to have a plan (not as strict as
command/control economy) – plan takes time
o High-capital industries (usually monopolies) have the
hardest time transitioning
o Low-capital industries have the easiest time
The Role of Time
New-Entry
More desirable for economy to replace old
enterprises with new ones
New enterprises can always enter
Causes the best economic growth
Yields higher priority than the privatization of
enterprises that were adapted to the former regime
The Role of Time
• Gradualism
– Not everything has to change at once
– Needs to be a gradual transition so certain pieces can
be stopped or reversed if need be
– The whole process requires limited guidance (gov’t)
Institutional Traps
• Institutional traps can be a major risk to a
reform process
• Transaction/Transformation costs
– Transaction Costs – “costs of an agent’s interaction with partners
within a framework of a certain behavioral norm.” (pg. 94)
– Institutional Transformation Costs – “costs of transition from one
norm to another.” (pg. 95)
• These costs can be incurred by both the state as well as indivdual
firms
• Major articles of these costs on page 95
Institutional Traps in Russia
Barter
Tax Evasion
Arrears
Corruption
Foreign Trade-related Economic
Stagnation
Institutional Conflict
Barter System in Russia
1992 Price Liberation in
Russia
Inflation Soars,
causing value
of paper
money to fall
Analysis
suggests that
price Liberation
requires
advanced
monetary
institutions to
be already in
place to avoid a
barter trap.
Russia has an
unformed,
Inefficient
Banking system
Firms begin
Barter
Transactions
(less
expensive)
Barter Exchange spreads & becomes the norm through
“Coordination Effect”
Over time, Companies
learn to design
elaborate `chains of
Barter Exchanges
(Learning Effect)
By this point, it is far
too costly to ‘break
out’ of the barter
exchange system.
“Cultural Inertia” &
uncertainty results in
conservative pressure
groups who resist
monetary exchange.
A HYSTERESIS EFFECT IS NOW IN PROCESS
Tax Evasion
Government
 Raise Taxes
 Slash Social Expenditures
Too inefficient to
prevent people from
stop paying taxes
Russian Citizen
What am I
paying taxes
for?!!
I am going to
stop paying
taxes !!
 Another “Co-ordination effect is created, followed again by a “Learning
effect”.
 Tax evasion and Bartering are joined through the “Linkage effect”, along
with arrears and corruption.
 Tax evasion becomes the norm, making it difficult and expensive to get
out. A firm also risks being under the tax collector’s scrutiny for
the rest of its days.
 Modest tax reductions can no longer help as the “Hysteresis effect” is
now in place.
India plans to overhaul tax system
By Amy Kazmin in New Delhi
Published: August 13 2009 05:11 | Last updated: August 13 2009
16:25
“India’s government is planning a big shake-up of its archaic tax system in a bid to
curb widespread evasion as it confronts a sharply widening fiscal deficit amid
expanding social welfare programs.
The plan, announced by Pranab Mukherjee, the finance minister, aims to foster
greater compliance with tax laws by lowering key corporate and personal income
tax rates, simplifying rules and eliminating exemptions blamed for eroding the tax
base.
Corporate taxes on Indian companies will drop to 25 per cent from 30 per cent.
India has long struggled to increase its low tax-to-gross domestic product ratio, the
legacy of punitive socialist era tax rates, which have encouraged widespread
evasion.”
Arrears
Inflationary stock empties
companies bank accounts
No Bankruptcy laws or restructuring mechanisms in place
Cycle of Sadness !!
Buyer only makes
partial payment
to company
Supplier does not
want to lose clients,
so they continue to
ship supplies.
Company only
makes partial
payment to
supplier
Modest tax rate
reductions
cannot helpNon-payers will
continue to avoid
taxation, and
law-abiding
taxpayers will pay
less.
 Spreads into a coordination effect & mutual arrears
 Strengthened by Linkage effect
Result  Mutual Arrears blocks the application of bankruptcy laws
Corruption
• Bureaucrats are offered more money through
bribes from the rich than what the state can
afford to pay.
• Corruption becomes tempting due to the
higher payout and the government’s
ineffectiveness to prevent it.
• “Coordination effect” is again in play, lowering
the bribe-taker’s chances of being caught even
more
Foreign Trade Related Economic Stagnation
 A Premature, ill-prepared attempt to liberalize foreign trade leads to an institutional trap.
 Protected industries cannot compete in the world market, because their products are of poorer quality.
Possible Solutions
Short Term
 Export Raw Materials
 Spend export revenues on consumption
Long Term
• Add domestic production with subsidies
that are gradually removed as modern
technology is purchased with the export
revenues.
Problems
 Manufacturing enterprises will close
 Mass unemployment
Which would cause
 Decline in labor skills
 Wider gap in incomes.
 High social tensions & social indifference.
Rising crime
And Eventually:
 Collapse of national economy once the
raw materials were exhausted or world
market stopped demanding the raw
material.
Foreign Trade Related Economic Stagnation… contd
The longer the short-term solution is in effect, the
higher the transformation cost to switch to a better
norm.

A politically unstable country is more likely to choose
the short-term option…. which is what Russia did.

The Lesson:
For proponents of shock theory – it is
vital to resist the temptation of
choosing the short-term strategy
option.
Institutional Conflict
Russian institutions tried to create a western-style
corporate system, even though U.S. Institutions
were so different from Russia’s cultural tradition.
Conflict in transferring institutions from one
cultural environment to another can result in
Non-viable institutions (eg. Russia’s bankruptcy law)
Mutant Structures – stable but inefficient structures, a
form of institutional trap (eg. Joint-Stock Company)
Reform Process and the State
Large-scale economic reform can be carried out, but requires:
1)Preparation of the economy for transformation
2) Effective provisional institutions to guide the reforms
3)Proper rate and sequencing of the reforms
4)Consistent discretionary economic policy
And MOST important task of the reformative state is-
5) AVOID INSTITUTIONAL TRAPS!!
The Reform Process:
Transitional Rent and Reform Failures
Rate, Preparedness, and Sequence of Reforms
Industrial Policy
Transitional Rent and Reform Failures
Privilege-generating rental income- limitation posed on the free flow
of resources or the level of prices.
A margin was made between retail and wholesale and paid as rent
to the state budget to be redistributed.
However….
Most was stolen by high-ranking officials and shadow dealers
So…
Limitations were lifted
But…
Russia wasn’t prepared at that time for such a change, and their
losses have been tremendous
Some regions continued to collect the rent and firms pocketed the
money
• There are two viewpoints as to how to carry out reforms:
1) Shock Therapy- as quickly as possible. The belief is that
reforms are sililar to surgery and have to be carried out as
quickly as possible to minimize suffering.
2) Gradually!
There are 3 key arguments for the gradualist viewpoint:
Government needs to
acquire the funds to
finance the
transformation costs
When reforms are too
rapid, it is extremely
difficult or impossible to
make adjustments or
correct mistakes
Shock liberalization of
prices inevitable leads to
barter and arrears traps if
there is no efficient banking
system to avoid inordinate
transactions costs
Industrial Policy
• Industrial Policy should be aimed at protecting select
companies from bankruptcy & industries in dire straits.
• Important process for the transitional period is the
emergence of large corporations, because a large
corporation
– Can make major investments
– Reduces market transactions, taking edge off barter &
criminalization problems.
– Facilitate tax collection
• A long term industrial policy, combined with antimonopoly measures& proper corporate governance
could help overcome institutional traps.
Conclusion – Things to consider…
• Every reform should be preceded by efforts to forecast &
forestall possible institutional traps.
• Once an institutional trap is formed, breaking out is very
difficult.
• To get out, measures should be directed at weakening the
stabilizing mechanisms that support the traps (coordination, linkage & inertia effects).
• If the government is weak or passive, reforms are doomed
to failure.
• “Naive attempts to imitate economic organizations of more
developed countries result in institutional conflict. Wise
reform strategies would help economies find their own
forms of the invisible hand”.
The end (With thunderous applause) !!!