Brokers and Bureaucrats: Building Market Institutions in Russia

by Timothy M. Frye

Overview

A classic problem of social order prompts the central questions of this book: Why are some groups better able to govern themselves than others? Why do state actors sometimes delegate governing power to other bodies? How do different organizations including the state, the business community, and protection rackets come to govern different markets? Scholars have used both sociological and economic approaches to study these questions; here Timothy Frye argues for a different approach. He seeks to extend the theoretical and empirical scope of theories of self-governance beyond groups that exist in isolation from the state and suggests that social order is primarily a political problem.
Drawing on extensive interviews, surveys, and other sources, Frye addresses these question by studying five markets in contemporary Russia, including the currency futures, universal and specialized commodities, and equities markets. Using a model that depicts the effect of state policy on the prospects for self-governance, he tests theories of institutional performance and offers a political explanation for the creation of social capital, the formation of markets, and the source of legal institutions in the postcommunist world. In doing so, Frye makes a major contribution to the study of states and markets.
The book will be important reading for academic political scientists, economists (especially those who study the New Institutional Economics), legal scholars, sociologists, business-people, journalists, and students interested in transitions.
Timothy Frye is Assistant Professor of Political Science, The Ohio State University.

Product Details

ISBN-13:	9780472023486
Publisher:	University of Michigan Press
Publication date:	11/12/2009
Sold by:	Barnes & Noble
Format:	eBook
Pages:	288
File size:	3 MB

About the Author

Timothy Frye is Assistant Professor of Political Science, The Ohio State University.

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Brokers and Bureaucrats: Building Market Institutions in Russia

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By Timothy Frye

University of Michigan Press

Copyright © 2000 Timothy Frye
All right reserved.
ISBN: 0472067133

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Institutions and Social Order

Sociological and Economic Approaches

The Big Picture: Specifying the Problem of Social Order

How do people trade given powerful incentives to cheat? The reliable exchange of goods, services, or votes requires that both parties to an agreement believe that the gains from compliance exceed the gains from cheating. In the absence of reliable enforcement by a third party, such as the state, the gains from cheating are often simply too tempting to ignore.

Cheating is not the only impediment to trade and social order. Unforeseen events may provoke disputes among even the most well-intentioned parties (Grossman and Hart 1986). The cost of specifying all the conditions under which a contract is valid makes all contracts incomplete. This necessary incompleteness leaves many aspects of contracts open to interpretation and subject to dispute by even the most honest individuals.

The ability of economic agents to trade goods with some degree of confidence that the agreement will not be violated is a central element of economic growth. Economic agents in countries with institutions too weak to protect property rights often decide to forgo potentially profitableinvestments. And when they do invest, they often must expend great resources to protect their rights. Across a wide range of fields, scholars argue that the failure to create institutions that protect property rights is perhaps the greatest impediment to economic growth in the developing world (North 1990; Olson 1996; Sened 1997).

We usually view the state as the organization that enforces contracts and provides the cornerstone for social order. Acting as the third party to all contracts, the state raises the costs of cheating above the gains by threatening coercion against those who violate contracts. In many instances, however, the threat of state enforcement is not credible. In countries with weak judicial systems, disorganized bureaucracies, or ineffective regional governments, the state often lacks the capacity to be a neutral third-party enforcer of many disputes. Even within developed states, the threat of state enforcement is often not credible due to the cost, length, and uncertainty of the legal process. All market economies rely on a mix of state-governance and self-governance.

This chapter identifies the incentives that create the problem of social order and presents self-governing organizations (SGOs) as one means for minimizing this problem. It critiques the two dominant theories of self-governance drawn from sociology and economics. It then evaluates these approaches against evidence from the five cases at hand and finds that they have important empirical shortcomings.

Creating Institutions: Demand and Supply

Agents seeking to create institutions that mitigate the problem of social order face obstacles on both the demand-side and the supply-side. On the demand side, agents must overcome the first-order collective action problem of organizing to create an institution that promotes cooperation (Olson 1965; Hardin 1968). Focusing on an actor's choice to contribute to an irrigation project whose benefits are available to an entire community easily captures this logic. When the choice is made in the absence of a third party to compel members to contribute, each individual will have weak incentives to contribute to the project. Because everyone can expect to enjoy the benefits of the project whether or not they contribute, each member prefers to enjoy the benefits without making a contribution. As each group member can foresee this logic, few contribute, irrigation is not provided, and all group members suffer. Individual demand for an institution is rarely sufficient to explain its production.

It is less well recognized, but agents must also overcome a collective action problem on the supply side. Robert Bates notes: "The new institutionalism is contractarian in spirit. Institutions are demanded because they enhance the welfare of rational agents. The problem is why are they supplied?" (1988, 394-95; also Ostrom 1990, 42). All players seeking to provide a public good may agree that they would be made better off by its provision, but each member wants someone else to supply it. Moreover, agents with resources to supply an institution often have the ability to parry demands for an institution. For example, supply-side agents within the state may blunt demands for an institution by using coercion or co-optation against interest groups. Satisfactory explanations for the creation and maintenance of institutions should account for both their demand and supply.

Self-Governing Organizations: Repositories of Reputation

Many works present a bleak outlook for the creation of public goods, but a diverse group of scholars working in the new institutionalist tradition in political science, economics, anthropology, and sociology argue that under certain conditions agents can overcome the problem of social order without turning to an outside agent for enforcement (Geertz 1962; Granovetter 1985; Ostrom 1990; Putnam 1993; Ensminger 1996). They suggest that group members can often minimize the problem of social order by creating self-governing organizations that write rules, resolve disputes, and levy sanctions against members without turning to external enforcers. One familiar form of SGO is the rotating credit society, which consists of a group whose members "agree to make regular contributions to a fund, which is given, in whole or in part, to each contributor in rotation" (Ardener 1964, 201). Putnam notes that "rotating credit associations have been reported from Nigeria to Scotland, from Peru to Vietnam, from Japan to Egypt, from West Indian immigrants in the Eastern United States to Chicanos in the West, from illiterate Chinese villagers to bank managers and economic forecasters in Mexico City" (1993, 167).

SGOs are a common feature of complex and simple economies. They include groups as diverse as the National Association of Securities Dealers (NASD) and the Teachers' Credit Union in the United States, communal farmers in Torbel, Switzerland, the microbanks of Bangladesh, and the Law Merchant of the Champagne Fairs of medieval Europe. In addition, many groups exploiting common-pool resources, including irrigation systems or fisheries, create SGOs to minimize overuse. Because the state lacks the resources to resolve many economic disputes and because economic agents are often reluctant to use courts, self-governing organizations play a vital role throughout the world.

To distinguish an SGO from other organizations, I define it as a voluntary, private group whose members are engaged in exchange and seek to provide forms of public goods for each other on governance issues, such as dispute resolution, sanctioning, and rule making. These groups are voluntary. Members may be excluded for violating rules, but non-members are not compelled to join. These groups are also private. The state may oversee the activities of an SGO, but primary authority for resolving disputes, writing rules, and levying sanctions lie with the SGO, not the state.

SGOs provide different types of public goods for their members. Many SGOs, including those in this study, supply a type of public good known as a club good that is exclusive in its consumption but joint in its supply (Olson 1965, 36-43). Non-members may be excluded from consuming the benefits of the group, but exclusion often incurs considerable costs that must be borne by group members. The goods available to members in good standing are also joint in their supply. Each member's contribution will be effective only if others also contribute. For example, access to a private arbitration court within an SGO is available only to group members, but individual group members would prefer to see other members bear the costs of creating and maintaining the court. These club goods, such as contract enforcement, monitoring, and sanctioning, are subject to free riding.

More specifically, SGOs resolve two incentive problems. First, they create institutions that deter members from cheating by threatening to punish guilty parties at a relatively low cost. If information was free, then concerns for reputation would be sufficient to deter cheating and group members would not need to invest their resources in creating SGOs. Group members would know who was cheating and avoid them. Information is, however, costly. To deter cheating SGOs must create institutions that transmit accurate information about a member's reputation relatively quickly and cheaply to other members (Milgrom, North, and Weingast 1990).

Second, SGOs create institutions that provide incentives for group members to deliver punishment. Because punishing members not in good standing with the group is costly, SGOs must provide incentives for members in good standing to punish rogue members (Elster 1989). For example, group members who continue to trade with rogue members despite the declaration of a group boycott would then be subject to a boycott themselves.

To overcome these incentive problems, all SGOs rely heavily on shared information among group members. By circulating information about the trading practices of group members, SGOs increase concerns for reputation and strengthen contract compliance without turning to an external enforcer. SGOs make reputation work more efficiently to insure contract compliance by recording transactions and making this information available to group members at low cost. Fearon and Laitin note: "To support trust and cooperation among people who interact frequently, individuals need to be able to condition cooperative behavior on their partner's past behavior or history. That is, it must be possible to identify people who have cheated or exploited in the past if they are to be sanctioned and others deterred from misbehaving in the first place" (1996, 718). SGOs shift incentives from cheating to compliance and thereby promote social order, if only on a small scale.

In general, we can think of SGOs as repositories of the reputations of group members (Kreps 1990a). By serving as a reputation repository, SGOs can promote trade among group members who do not know each other, but can rely on the SGO to inform them that a particular group member has a reputation for dishonesty. This allows members to trade with a larger group of partners than is possible in simple forms of bilateral trade based on personal relationships. By expanding the scope of the market beyond individuals with personal ties, SGOs can make possible many trades that otherwise would go unmade. Indeed, Douglass North (1990) cites this shift from personal to impersonal trading as central to the development of modern economies.

Despite the diversity of SGOs, they all share certain features. First, they rely on the free flow of information among members. Second, members, rather than state agents, write, monitor, and enforce rules that guide the SGO. SGOs have autonomy from state agents either through recognition of the rights of the organization or the failure of state agents to intervene. Third, group members themselves levy sanctions without resorting to an outside party to pay for the enforcer. Fourth, SGOs present crosscutting incentives for their members. Members must cooperate with other members to establish and maintain rules that structure their interactions, but they also compete based on price for market share and profits. These crosscutting incentives make it difficult to create and maintain an SGO.

SGOs bear a resemblance to other organizations, including the state, trade associations, and private firms, but differ from these organizations in important respects. Max Weber defines the state "as an organization that successfully upholds a claim to a monopoly on the legitimate use of physical force in the enforcement of its order" (1964, 154). This claim can also be exercised by SGOs, whose members place themselves under the immediate jurisdiction of the rule-making and sanctioning bodies of the organization. SGOs differ from the state, however, because the costs and benefits of governance accrue disproportionately to group members, not to all citizens (Stiglitz 1989). Moreover, SGOs lack obligatory membership and a basis in territory--two oft-cited components of the state (Mann 1984).

SGOs also differ from trade associations. Both often lobby, create standards, and advertise for their members, but SGOs also provide services that are typically core responsibilities of the state, such as dispute resolution and rule making. These core functions of the state are performed initially by the SGO, with the state exercising the power of review.

Finally, SGOs differ from private firms because the members of the organization individually produce revenue that is then used to pay for services provided to the group. Group members retain the residual profit from their efforts (Ostrom 1990). In many cases group members compete with each other for profit. In contrast, the individual members of private firms jointly produce outputs whose profits are then divided among the members of the firm (Alchian and Demsetz 1988). The crosscutting incentives facing the members of groups seeking to govern themselves and trade with each other are a distinctive feature of SGOs.

SGOs occupy a space between the state and the market. Like all economic agents, SGO members compete for market share based on price. They also however agree on a set of rules that are binding upon all members. Members grant SGOs the power to resolve disputes and levy sanctions, functions that are typically fulfilled by the state. In many instances SGO rules may have little basis in the formal law and may not be explicitly recognized by the state (Ellickson 1991).

SGOs have a parallel in the literature on institutions in international relations. Robert Keohane and Elinor Ostrom (1995) note that domestic agents seeking to exploit common-pool resources and states in the anarchical international system face a similar set of incentives. In the absence of reliable third-party enforcement, farmers in a commonly held irrigation system and states abiding by an international arms control agreement can gain individually by not violating rules. To reduce cheating, states in the international arena and domestic agents managing common-pool resources often try to create SGOs that identify rogue members, resolve disputes, and levy sanctions without resorting to a third-party. Table 2 distinguishes SGOs from other common forms of organization.

Self-Governance and Social Capital

Self-governing organizations are often cited as examples of groups possessing a high degree of social capital. According to this view, these groups allow members to trade without resorting to an external enforcer and often exhibit the forms of deep generalized trust that are characteristic of social capital. For example, Putnam discusses at length the role of social capital in promoting decentralized trade in a wide variety of settings (Putnam 1993, 167-81). Yet definitions of social capital are somewhat ambiguous and merit a brief comment.

Many treatments of social capital seem to conflate two notions: trust based on reciprocity and cooperation based on the fear of social sanctions (Levi 1996). For example, Putnam defines social capital as "features of social organization, such as trust, norms and networks that can improve the efficiency of society by facilitating coordinated action" (Putnam 1993, 167). This definition includes two components: trust and norms of reciprocity; and dense networks that punish group members for violating rules. These two notions, however, should be kept analytically distinct because they rely on different causal mechanisms: one relies on trust based on the expectation of reciprocity without necessarily invoking a sanction for abusing trust, and the other relies on cooperation based on a fear of punishment from other members of the social group. These two mechanisms differ in an important way. Norms of reciprocity based on deep trust are often specific to individuals who have interacted for a long period of time, while cooperation based on a fear of social sanction is often more general. For example, anyone who finds themselves in a dense network of overlapping social organizations will cooperate with other group members due to a fear of sanctions, whether or not they trust other group members. Empirically, these groups often overlap, but the different causal mechanisms suggest two different processes are at work within the singular concept of social capital.

Due to confusion surrounding the term, this book does not rely on social capital as a causal mechanism. Instead, it relies on a more restrictive rational choice assumption that individuals are guided primarily by calculations of self-interest without including references to norms of generalized trust. This approach avoids the difficulty of disentangling generalized trust from cooperation under a threat of some form of sanction because the two are often observationally equivalent. The more expansive assumption of human behavior as a mixture of self-interest and generalized trust may be empirically accurate, but it conflates two types of behavior--trust based on expectations of reciprocity and cooperation based on fear of punishment. More important, if we can demonstrate that cooperation can occur with a more restrictive assumption of human behavior guided solely by rational choice, then we should also be able to demonstrate it easily in settings where people trust each other without a threat of sanction.

SGOs may promote social capital by giving group members many opportunities to sanction other group members--even in the absence of the kinds of deep trust that Putnam describes. In the cases at hand I argue that brokers fearing social sanctions levied by other members of the organization managed to create institutions that allow them to trade without a third-party enforcer. Indeed, we can view SGOs as organizations that increase the opportunities for members to use formal and informal social sanctions to punish proscribed behavior.



Continues...

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Editorial Reviews

Winner: American Association for the Advancement of Slavic Studies (AAASS) 2001 Edward A. Hewett Prize

AAASS Edward A. Hewett Prize

Winner: American Association for the Advancement of Slavic Studies' 2001 Edward A. Hewett Prize

American Association for the Advancement of Slavic Studies (AAASS) Edward A. Hewett Prize