Economic Reforms and Constitutional Transition: Part II

Jeffrey SACHS, Wing Thye WOO and Xiaokai YANG

Perspectives, Vol. 1, No. 6

[Editor's Note: This article is the second part of a two-part paper. The first part, which was published in the fifth issue of the "Perspectives," investigates the features of the Soviet-style socialist system and the driving mechanism for economic transition in China, Eastern Europe and the former Soviet Union.]

3. Market-Oriented Reforms Associated with the Transition of Constitutional Rules

There are two patterns of transition. One is adopted by Eastern Europe and Russia, in which market-oriented reforms are just a small part of the transition of constitutional rules. The other is adopted by China and Vietnam, in which market-oriented reforms are implemented under communist game rules (i.e., a communist monopoly of political power). In this section, we consider the former pattern of transition.

As Sachs and Pistor (1997, pp. 3-5) indicate, the tradition of the rule of law in Russia has been absent. In the first stage of the transition from January 1992 to October 1993, reforms were implemented under the old communist regime. During this period, economic reforms were launched consisting of three major pillars: price and trade liberalization, stabilization, and privatization. From the very beginning, all of these measures remained incomplete, and indeed, some of them failed during this period. The record of stunted reforms is linked to the absence of constitutional order in several ways. First, the government often lacked the political and constitutional means to implement reforms, especially in the face of entrenched opposition from the communist-era Supreme Soviet. Equally important, the government lacked constitutional restraints on its own behavior, so that many opportunities for reform were squandered by official abuse and corruption.

The failure of stabilization, for example, can be traced approximately to the behavior of the Russian Central Bank, which issued massive and inflationary credits to the economy. The explosion of credits mainly followed the appointment of Mr. Viktor Gerashchenko, the Communist-era head of the Soviet Gosbank, as chairman of the Central Bank in June 1992. During 1992 and 1993, the Russian Central Bank transferred a very large proportion of national income (perhaps as much as forty percent of GDP in 1992, and twenty percent of GDP in 1993) to key pressure groups, political favorites of the government and the Bank, and various cronies of leading officials, with the transfers being financed by the inflation tax imposed on society at large. The Bank's books were unauditable, with large flows of untraceable money.

The common denominator of all these distortions to the reform process was the absence of rule of law in government decision-making and executive authority. Procedures were ad hoc, non-transparent, and often corrupt. Civil society was too weak to offer important countervailing pressure, so that abuses went largely unchecked. Decision-making was not guided by evenly applied general legal norms, but was rather individualized to particular enterprises and pressure groups.

The first phase of reforms saw the eruption of political power struggles that brought the country to the edge of a civil war. The second phase, which started in October 1993 and continued until the present, saw the consolidation of political and economic power by those who had gained the most during the first phase. This consolidation was accompanied by governance of more orderly rules, if not always by formal law. The state Duma operated under new rules, and elections were held as scheduled in December 1995. In addition, presidential elections were held on schedule at the end of Yeltsin's five-year term. At the same time, however, many deep constitutional problems remained. Struggles between the government and various parts of the presidential apparatus over executive power continued in a new and yet less dramatic guise,. After 1992, the presidential apparatus grew to enormous proportions outside constitutional constraints and public oversight.

Whether the rule of law has taken hold in Russia is a difficult question. Countries that respect the rule of law usually share the following features: they "divide the powers of government among separate branches; entrench civil liberties (notably, due process of law and equal protection of law) behind constitutional walls; and provide for the orderly transfer of political power through fair elections" (Sachs and Pistor, 1997). The subjection of the sovereign to predetermined legal constraints affects public and private law development in a given country. Where this is the case, arbitrary state interference is minimized, and state action - as a regulator, tax administrator, or contract enforcer - becomes impartial and predictable. It takes time to reform the judicial system, to train and/or to replace its personnel, and to replace existing laws with new ones. Nevertheless, it is important to assess whether the commitment to the rule of law, as opposed to personal fiat, however well intentioned, is apparent. Indicators for such a commitment include the division of powers, civil liberties, independent judiciary, and the orderly transfer of power.

Before 1991, hardly any of these features were established in Russia. By 1996, a number of important achievements had emerged. A new Constitution is in place, which, despite some doubts about the validity of the procedure by which it was adopted, had apparently found widespread legitimacy. Two parliamentary elections had been held under this Constitution. Most importantly, perhaps, presidential elections had been held and the unsuccessful contender accepted them.

Despite these remarkable achievements, we should also note that Russia has not yet experienced an orderly transfer of political power, so that the hardest test of the new constitutional order has not yet come about.

The new constitution acknowledges the separation of power, but a closer examination reveals the limits of these nominal commitments. In particular, the division of power between the legislature and the executive is blurred. This is most visible in the legislative power of the President, who may rule by decree, and his decrees are binding as law.

It is worth noting that most provisions of the Constitution would not hold water if legally contested. The liberal idea that civil rights are natural-law rights and shall be used as a defense against the state seems alien to the Russian Constitution. In its language, the state grants these rights to its subjects. But what the state grants, it may also take away again. In addition, the Constitution lacks the crucial procedural safeguards to ensure the effectuation of civil liberties, including equal protection of law. "Special" laws designed for a particular person or entity, as opposed to general laws addressing an anonymous or generally defined target group, have been rampant in Russia. They provide the legal basis for tax exemptions, special privatization rules, and allocation of rights to those with the best access to the President's decree power. As a result, the state retains ample scope for arbitrariness, which not only creates uncertainty, but also provides a breeding ground for corruption. Gray and Hendley (1997) set out three basic conditions for law-based private transactions, which are good laws, sound supportive institutions, and market-based incentives that create a demand for law and legal institutions. Drawing from a comparison of commercial law development between in Russian and in Hungary, they suggest that the development of effective judicial and administrative support institutions is the most difficult task to accomplish, not only in Russia, but also in other transition economies. However, Russia still falls short of providing the first condition for law-based transactions: good laws that reduce transaction costs and enable private actors to mobilize their own rights. Pistor (1997) discusses the implications of the lack of a comprehensive corporate law at the outset of privatization for the development of property rights and corporate governance after the privatization. She traces the nature and quality of legal rules issued in post-socialist Russia not only to Russia's legal tradition, but also to policy choices made by reformers during the course of economic reform. She argues that comprehensive legal reforms were delayed in favor of speedy economic reforms based on ad hoc decisions and decrees with detrimental consequences for the development of property rights and corporate governance structures.

As indicated by Sachs and Pistor (1997), the roots of Russian exceptionalism are deep in the rule of law and in the lack of economic freedom, in comparison with the rest of Europe. The exceptionalism far predated the 1917 Bolshevik Revolution, and indeed was already dramatic in the mid-nineteenth century, when Alexander II launched his attempts at the Great Reforms (described by Owen, 1997). The exceptionalism can be traced back several centuries, plausibly to the start of the Muscovite state.

The trade-off between the benefits of constitutionalism and the demand for flexible and great executive power (Hellman, 1997), which was the focus of a debate among Russian economists and policy makers, is similar to the trade-off between the reduction of resistance from vested interests and the institutionalization of state opportunism of the dual track approach in China. Many scholars attribute Russia's poor transition performance to weak enforcement of laws. However, as Pistor (1997) points out, the weak enforcement is due to bad laws and state opportunism. A comparison between the eighteenth century Britain and France by North (1981, p. 147, pp. 158-170) suggests that the large state taxation and law enforcement capacity in Britain was due to fair constitutional order and the small state capacity for taxation and law enforcement in France's old regime was due to state opportunism and the absence of fair constitutional rules. The Chinese case provides further support for this view. The Chinese Communist Party's monopoly of political power institutionalizes state opportunism that uses laws that are often bad laws to pursue interests of the party apparatus at the expenses of society at large. This "rule by laws," distinguished from the rule of law, makes law enforcement in China very weak. Many court rulings in China cannot be enforced.

4. Market-oriented Reforms in the Absence of Constitutional Order

China's dual track approach is representative of the market-oriented reforms in the absence of a constitutional order. The Chinese Constitution (http://www.quis.net/chinalaw) is similar to other socialist constitutions in giving the communist party a monopoly of political power and rejecting the notions of separation of power and checks and balances of power. One of the differences between the Chinese and Soviet Constitution is that in the preamble of the Chinese Constitution, the ideology of Marxism, Leninism, and Mao Thoughts are taken as the source of the legitimacy of the Chinese government. Although some western legal scholars consider the preamble as having no legal effect, its notion of the source of power is similar to the old notion of the origin of power being divine, rather than based on contract and the consensus of the ruled. Negative western constitutionalists, such as Pilon (1998), would pay particular attention to three features of the Chinese Constitution. First, it is programmatic. It sets up a specific agenda for building socialism. Hence, it is more like the bylaws of China, Inc.. Second, in the Chinese Constitution, there are no genuine provisions for popular ratification. It gives no indication of how citizens join or consent to so far-reaching a program. It thus raises fundamental questions about the legitimacy of the Chinese Constitution. Finally, all citizens' rights are granted by the state and the Party whose monopoly of power is derived from "divinity," which in China means ideology of Marxism, Leninism and Mao Thoughts that needs no justification. Hence, Pilon (1998, p. 355) calls the Chinese Constitution "a program for unlimited government."

So far, no influential movement to reject the Constitution has been developed in China. The sense of crisis among Chinese people is not strong enough. This, together with the large size of China, implies that pressure for transition to constitutional rules is too insignificant for serious considerations. Hence, China's market-oriented reforms can be conducted only within the "bird cage" of communist game rules. It is not surprising that reforms are hijacked by the vested interests of the party apparatus. The arrangements in which the rule maker, the referee, the rule enforcer and the player are all the same party apparatus institutionalize state opportunism, which pursues the party's interests even if social welfare is sacrificed. State opportunism is illustrated by the government's control on the entry of private firms into important sectors and the state predation of private firms. There is a list of sectors in which domestic private firms are not allowed to operate. The sectors include, among others, banking, post and telecommunications, railroads, airlines, insurance, the space industry, petroleum chemistry, steel and iron, publications, wholesale businesses, and news services. In addition to the thirty prohibited sectors, private firms are restricted in another dozen sectors, including automobile manufacturing, electronic appliances and travel agencies (Huang, 1993, p. 88). Moreover, a stiff licensing system for international trade, wholesale and retail distribution networks, publication, and many other businesses eliminates many lucrative opportunities for private businesses, generating trade conflicts with the United States and other developed countries. The reality is that all government institutions that have power to issue licenses have vested interests in the sector where licensees operate. For instance, the Ministry of Foreign Trade & Economic Cooperation issues the license for international trade, which is the largest owner of trade companies in China. Local government committees that own local state distribution networks issue the license for wholesale and retail distribution networks. The principle for issuing a license is to promote the monopoly interest of the government institutions. Mueller (1998) documents the adverse effects of state monopoly in the telecommunications sector on economic development. This monopoly implies that the regulation maker of the sector, the major player and the referee who enforces the regulation are the same state organization. State opportunism is then institutionalized and retards economic development. In addition, China has a very stiff government approval system for establishing business enterprises. There is neither free association nor automatic registration of a company except in the Hainan Province. Furthermore, there are arbitrary and often very high registered capital requirements for private enterprises. This, together with the residential registration system and the state monopoly in housing and banking sectors, provides many instruments for the pursuit of state opportunism. As Pilon (1998) points out, all the self-dealing is, of course, supported by the fundamental game rules of the Chinese Constitution.

State predation of private firms in China started in political campaigns in the early 1950s. According to Bai, et al, (1999), it has persisted into the reform era. One persistent cause of the state predation is the ideological discrimination against private businesses amid power struggles and ideological debates within the government. As Bai, et al (1999) document, one form of state predation in the reform era is simply revenue grabbing. Governments of different levels tend to impose various kinds of taxes and fees in order to grab as much as possible from businesses in their jurisdictions. A 1988 study of private firms in Liaoning Province found that taxes and sub-charges alone would take away sixty three percent of the observed profits. When the scores of different fees were also taken into account, the tax burden was even higher. Such a tax burden made it very difficult for private firms to survive, and forced them to evaded taxes and fees by hiding their transactions and revenue (China Economic Almanac, 1989, p. 107). Ten years later, a 1998 study of private firms in Anhui Province reported that gross profits for many products were about ten percent of total revenues, whereas total taxes and fees for private enterprises added up to more than ten percent. There were more than fifty types of fees imposed on private businesses, some of which were prohibited by the government's own publicized regulations and rules. This study reached the conclusion that "owners who do not want to close down their businesses had no choice but to evade taxes" by hiding revenues (Jilin Daily, May 30, 1998). Peasants in the rural areas were major victims of excessive taxes and fees. Throughout the reform period, the Chinese government made countless promises to reduce exorbitant levies and discretionary taxes on peasants, both of which, however, continue to be widespread. In some places, sixty-one different types of fees were imposed on peasants (Ding, Yan, and Yang eds., 1995). China started to borrow from Western laws in the 1990s. But under the communist constitutional rules, the Western-style laws, such as the Corporation Law passed in 1994, and the Anti-Unfair Competition Law passed in 1993, cannot be implemented. The incompatibility between Corporation Law and the communist constitutional rules is noted by Yang (1998) and the inconsistency between state monopoly in the telecommunications sector and the Anti-Unfair Competition Law, by Mueller (1998, p. 200). It might be concluded that imitation of many Western-style laws would not work within the communist constitutional rules. The communist constitutional apparatus implies that China's reforms can only follow a dual track approach. This approach generates long-term costs that likely outweigh its short-term benefits of buying out the vested interests of the privileged class.

It seems to us that China's experience with the dual track approach does not provide much new information that institutional experiments in the rest of the world did not already provide. It just verifies again that successful economic development needs not only markets, but also constitutional order and the rule of law, which protect individual rights and provide effective checks and balances of government power. Appropriate moral codes, behavior norms, together with breaking political monopoly of the ruling party, are essential for the formation of the constitutional order.

Concluding Remarks

This paper investigates the relationship between economic reforms and constitutional transition, which has been neglected by many transition economists. It is argued that an assessment of reform performance might be very misleading if we do not recognize that economic reforms are just a small part of a constitutional transition. Rivalry and competition between states and between political forces within each country are the driving forces for constitutional changes. We use Russia as an example of economic reforms associated with a constitutional transition and China as an example of economic reforms in the absence of a constitutional transition to examine features and problems in the two patterns of reform. It is concluded that under political monopoly of the ruling party, economic reforms will be hijacked by state opportunism. The dual track approach to economic transition may generate very high long-term costs of constitutional transition that might well outweigh the short-term benefits of buying out the vested interests.

(Jeffrey SACHS is Professor of Economics at Harvard University; Wing Thye WOO is Professor of Economics at the University of California at Davis; and Xiaokai YANG is Professor of Economics at Monash University in Australia.)

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