Figure 1.1
Public Sector Share of GDP and Employment Accounted for by
Private Sector (Including Cooperatives) in Eastern Europe and the
Former Soviet Union

Now that the privatization process—in tandem with the freeing of prices and the fight against inflation—has helped to construct the broad outlines of a market economy, it is time to examine in some detail the impact of privatization (and the variety of privatization strategies that governments have pursued) on economic development. Three issues almost instantly emerge on center stage. The first is the resistance to reform of many businesses despite the change in ownership from state to private [page 4] hands. In many cases, indeed, privatization has not produced the hard decisions about restructuring that its advocates wanted and expected. Murky ownership of many industries, exacerbated by the large ownership stakes that the state retains almost everywhere in the region, contributes to this wounded result. Even in the Czech Republic, upheld as a paragon of privatized virtues by so many commentators (and by the proud Czechs most of all), many privatized firms have managed so far to avoid the root-and-branch reform that the architects of the country's mass privatization program envisioned, in part because the premier Vaclav Klaus, though sounding like Margaret Thatcher, is as keen on protecting jobs as any nostalgic Swedish socialist.

Second is the belief that in most transition countries it is hard, if not impossible, to persuade a majority of ordinary people that privatization is beneficial to them, a stricture much in evidence over the past half-decade. In the run-up to the Russian presidential elections of June/July 1996, for example, Boris Yeltsin sacked his most successful minister, one-time privatization czar Anatoli Chubais, merely to appease widespread dismay at the results of privatization. Once President Yeltsin was reelected, however, Chubais' managerial talents, honed in the vast privatization effort that he commanded between 1991 and 1994, carried him back to the center of Russian power, and he became first deputy prime minister in the Kremlin. In Romania, Ion Iliescu based his penultimate campaign for the presidency on the populist-statist slogan, "We are not selling out the country."

Ex-communist, post-communist, once-and-future communist: no matter the hyphenation and its masking or mocking intent, resentment at the effects of privatization was one of the factors that ushered communism's political heirs back into political power in Poland, Hungary, and Lithuania within only a few years of communism's short demise. Only in the Czech Republic, Moldova, and Estonia have privatization's advocates built effective electoral machines on the basis of successful strategies. Indeed, one of the striking features of the Russian presidential campaign of 1996 was President Yeltsin's early failure to recognize that there was a constituency that supported his reforms. Only when Anatoli Chubais assumed a central role in the campaign organization did Yeltsin's forces begin to make direct appeals to this pro-privatization audience.

Page 5

The third issue concerns privatization's impact on the state. Many people within and without the region hoped that divesting government of business decision making would not only encourage economic efficiency in a growing private sector, but would also make the state itself more efficient and effective in carrying out its reduced role. Indeed, the lack of reform of the state is

This last issue hints at a plausible explanation for the dilatory approach to privatization taken by governments that is often evident in the transition countries. Despite the huge prestige opponents to the regime gained after the collapse of communism, only the Czech, Estonian, Kyrgyz, Moldovan, Slovak, and Russian reform governments steeled themselves to take decisive actions on privatization early in the transition. Noncommunist leaders in Hungary, Slovenia, and Croatia—countries that, it was wrongly supposed, had advantages due to the somewhat decentralized nature of their socialist economies—probably believed that little fast action in privatization was necessary. Others—Latvia, Bulgaria, Romania, and Uzbekistan—fretted over what privatization plan to pursue. Saddest of all, under the erratic leadership of Aleksander Lukashenka, the government of Belarus opted to stick its head in the sand, condemning privatization as well as all other reforms while retreating into the tried-and-failed Leninism that collapsed in 1991.

No matter the speed at which it was undertaken, when posed as an economic cure-all privatization was bound to disappoint. Some ministers saw it as a way to close yawning budget deficits through pricey sales, others as a means to inject a source of income into, say, harried pension systems. (Macedonia, to cite just one example, earmarks 15% of all privatization revenues or an equal percent of the shares in privatized firms to the national pension fund.) Workers wanted firms to be privatized into their own hands. Pensioners and state employees wanted compensation. Ex-owners claimed that only restitution of property would bring justice. Average people everywhere in the region merely wanted their (supposedly) fair share of the spoils.

Given such often grandiose expectations, a widespread letdown was perhaps inevitable. Moreover, a more fundamental division was also at work. Most economists saw privatization as a means to develop genuine owners who would employ assets in a far more efficient way than the state. But politicians instinctively recognized that privatization was as much about power as [Page 6] efficiency and sought to skew the process to either their own direct benefit or to the benefit of their supporters, cronies, or clans. So extravagance and cynicism contributed to what followed: both not only shaped and misshaped the privatization process, but also affected evaluations of the impact of shifting the economy into private hands.

1.1
The Magic Bullet

As the postcommunist transition began, there was something almost touching about the enthusiasm manifested in the way some reformers and their advisors responded to the notion of privatization. Early thinking on privatization—theoretical and programmatic—was dominated by a somewhat naive belief in the magic powers of capitalism. Under communism, enterprises were hopelessly inefficient because the state stuck its nose in the business of business unceasingly. So the credo of privatization at its inception in the postcommunist world was: get the state out of business; release the forces of private enterprise; let specialists do what they do best, rather than knuckle under to dictates from party apparatchiks—then industry will start moving.

What most transition country leaders did not reckon with at all was that years of communist misallocation of resources and mismanagement of industry had become embedded deeply in the capital stock of the economy: firms were often located in the middle of nowhere, far from raw materials and sources of skilled labor; many enterprises were too big or too small and too vertically integrated (meaning that they tried to produce every component themselves in order not to rely on suppliers as inefficiently managed as they); there was too much heavy industry and an overemphasis on the military, too much focus on producing quantity and too little on assuring quality. It was as if the communists themselves, because of a kind of misguided ideological pride, conspired to make and keep their industry out-of-date.

It was thus misleading to blame the problems of transition economies on state ownership alone—something that brings to mind the somewhat sluggish performance of Western utilities or state airlines, or even those patronage-ridden wastrels, Italy's state-owned conglomerates. Many transition country leaders (as well as their Western advisors) averted their eyes from the fact that most of existing industry, with its voracious appetite for subsidies, was worse than useless. No matter how rapid, no move—[Page 7] from the autarky of the socialist camp, with its rigged markets, five-year plans, and shoddy goods, to the exposed fields of international competition could ever transform these dinosaurs into viable industries.

In dealing with the communist legacy, expectations that capitalism would magically make former state enterprises work were thus always a childish fantasy. Indeed, the primary genius of capitalism is not its miraculous powers to make things work better; it is what the Austrian economist Joseph Schumpeter called ''creative destruction," that is, the ability to drive out from the marketplace firms that cannot compete effectively in terms of either price or of quality. So what capitalism was bound to bring to the transition countries was a housecleaning of monumental, indeed chilling, proportions: the sweeping away of any number of substandard firms accumulated over fifty or more years during which things were uncreatively added, but never creatively destroyed.

Every postcommunist economy, to be sure, is burdened by its share of industrial dinosaurs, but not each to the same degree, and the pain of transition is directly proportional to the amount of creative destruction that market forces are apt to inflict on the former state sector. The greater the proportion of firms without any reason for their existence under the new conditions, the less privatization can do to soften the hard landing in a competitive environment. Under any regime, the nonreformable, value-subtracting firms must be closed if they are not to drain resources needed in other, more dynamic sectors of the economy. Whether or not to privatize such white elephants is, therefore, not a decision concerning their potential efficiency (the odds are that they have little or none at all), but rather one concerning the political costs of their closure under the systems of private or public ownership.

Privatization—if it is meant seriously as withdrawal of both the state's interference and its subsidies—is bound to make many firms go broke, often very quickly. Here is the fundamental political contradiction of privatization: what in the long run is in the interest of everyone—a leaner, more efficient economy—is certain to produce a lot of pain for many, usually ordinary people, in the short run. That many of the workers involved had little or no say in the incompetent decisions of the socialist era that sealed their industry's fate makes the process of restructuring all the harder for them to accept passively. No surprise then that attitude of most governments to privatization is best described by the words of the peasant girl in Mozart's opera Don Giovanni: "I would like to, and I am afraid."

1.2
Unrecognized Privatizations

So far, whatever creative destruction has taken place in most postcommunist countries is due not to privatization, at least not to the official programs people are talking about, but to macroeconomic reform. In order to stabilize currencies and put the state budget in order, governments had to cut subsidies lavished by the communists on their inefficient creations (see figure 1.2). Russian industrial subsidies have crashed since 1992, falling from 32% of GDP to 6% in 1994. Poland cut enterprise subsidies from 16% of GDP in 1986 to 3.3% in 1992. In country after country, the figures are similarly dramatic.

Slashed subsidies do force managers to wield the knife: the 150 to 200 largest firms in Hungary and the Czech Republic reduced their workforces by 57% and 32% respectively between 1989 and 1993. Looked at from this point of view, the much-deplored falls in industrial output in most postcommunist countries were for the most part actually the pruning of inefficient production and the necessary shrinkage of the bloated state sector. The figures are as follows: in Albania, 44% in 1992; in Belarus, 11% in 1993; in Estonia, 25.8% in 1992 alone; Bulgaria, 27.8% (1991); Croatia, 28.5% (1991); Czech Republic, 22.3% (1991); Macedonia, 17.3% (1992); Hungary, 18.2% (1991); Kazakhstan, 28% (1994); Kyrgyzstan, 25% (1992); Latvia, 48.7% (1992); Lithuania, 50.9% (1992); Moldova, 25% (1992); Poland, 26.1% (1990); Romania, 21.9% (1992); Russia, 18.8% (1992); Slovakia, 17.6% (1991); Slovenia, 13.2% (1992); Ukraine, 28% (1994); and in Uzbekistan, 12.3% in 1992.

As a side effect of this process, much unheralded privatization has been taking place. When the crunch of the Polish shock therapy of 1991–92 really came to be felt by state firms, many enterprises responded by selling assets they had hoarded because of the previous regime's chronic shortages. Thousands of trucks sold by desperate state companies, for example, formed the basis of Poland's thriving private-sector trucking and wholesaling industries. Without the real estate leased from cash-starved state firms, the growth of the private sector, particularly in service industries, in such countries as Hungary and Russia,  [Page 10] would have been impossible. In most countries, probably more assets have so far migrated in this way from the state to the private sector than in official privatization programs.

Figure 1.2
Government Spending Patterns 

1.3
Constructing the Capitalist Order

Unlike Lenin's revolutionaries of 1917, the makers of the privatization revolution were not about to leap blindly or blithely into the unknown. There was no need to conjure out of thin air, as Lenin and his Bolsheviks had once done, a vision of the society that they wanted to create. A market economy in the manner of those already in existence in the developed world was their goal from the outset. But so fretful were these reformers of the terrors of the unknown—and so noxious was the Bolshevik precedent of government by imagination—that they would not envision a road ahead that had not been traveled before. So cautious a vision is perhaps understandable among leaders who had lived all their lives with the dismal consequences of Lenin's improvisations and experiments. But these self-imposed limits, in turn, led to a fundamental misunderstanding and misinterpretation of the unprecedented nature of what privatization really entailed during the postcommunist transition.

In looking for tested mechanisms of privatization, it was clear that Britain's Margaret Thatcher was the first to make privatization a politically fashionable and workable policy. In 1979, she succeeded in convincing a plurality of the British people that she could put much of British state-owned industry, share by share, on the market. By selling a number of large state firms, such as British Telecom, British Airlines, and British Steel, below what the secondary market would bring, she raised revenues for the budget (thus allowing her government to be more generous than her fiscal conservatism would otherwise permit) and created millions of new shareholders who—to the shock of the Labour Party—abandoned Britain's traditional class-based politics to become firm backers of her Conservative Party.

Politicians are fast learners, and many countries—from Brazil to Mexico to the Philippines—and political leaders of all ideological stripes—including socialists in Spain, France, and Portugal—soon followed Britain's lead. When East Germany reunited with West Germany, a big push was made to sell eastern industries through a specially created agency, the Treuhandanstalt. Given the almost unbroken successes of sales in the West [Page 11] (both in terms of yielding revenue for governments and, quite often, in restoring doddering state companies to health—witness the robust vitality nowadays of British Airlines, British Telecom, and British Steel), it was almost natural for the new East European and NIS (newly independent states) governments—encouraged by their Western advisors, for whom Thatcher's sales were the only thing they knew—to see this as the right path for their countries as well.

Nothing could have been more wrong. Where market institutions exist, as in Thatcher's Britain, privatization is merely the sale of a few state-owned enterprises. State companies in Great Britain, even if somewhat less efficient, were basically a product of the surrounding capitalist culture. The sale of state enterprises, although a big job, was also a rather standard operation, not that different from taking public a closely held corporation by issuing shares to investors at large. A number of investment banks stood ready to underwrite the issue and to sell it to the public.

In the transition countries, by contrast, privatization must be a systemic change: its task is to introduce capital markets, to make genuine firm valuation possible, to create the environment in which, day in and day out, normal market transactions can take place. Above all, the very scale of the problem transcends anything known in the annals of economic history. While Margaret Thatcher's sales of a few large firms during her first ten years in office was considered a great success, Russia alone had over 200,000 state enterprises to privatize, Poland had some 8,000, Uzbekistan 3,000, Latvia and Slovenia 1,500 each, Moldova 1,300, and even tiny Estonia and Macedonia had close to a 1,000 state enterprises to privatize. By any reckoning, following the British model would have taken forever, monopolizing political energy (and talent) to the detriment of other vital reforms.

What the transition countries needed was an innovative solution corresponding to the scale and uniqueness of the task at hand. But in politics new ideas are usually either hard to come by or risky business, and the temptation to fight the next war with weapons inherited from the last war is a sin of which not only generals can be guilty.

1.4
The Insiders' Party

In this world, however, what gets done is usually not a matter of ideas, either good or bad, but of naked political power. Indeed, while a key idea behind privatization was to depoliticize the economy, there was no way to evict politics from the privatization process itself.

The hardscrabble task of effective privatization was bound to be painful, as overmanned and often insolvent firms shed labor, new owners fired old incompetent managers, and production of unsaleable goods shrank. Privatization, however, was not only going to make some people miserable; it was also certain to make a small group of others very rich, almost instantly. In a social transfer of wealth of such unprecedented magnitude, various political groups were bound to be activated and energized.

A head start in politics is eighty percent of victory, and the best organized groups are usually the winners. In transition countries, the first to mobilize were the insiders: the workers and management of state enterprises facing privatization. They were not only the most immediately affected, but also felt entitled to take over. Privatization was evidently supposed to throw out the bath water but leave the children with free run of the nursery.

Reasons for this can be found in the history of communistera reforms. It is indeed a strange irony of privatization that countries that had tried to decentralize managerial control under communism—Yugoslavia under Tito, Hungary under Kadar, the Soviet Union under Gorbachev—saw later efforts at privatizing hurt, not helped, by the results of these attempted reforms. Decentralization conferred more power on enterprise managers and workers and allowed them to develop a network of connections to managers and workers in other firms. Over time, these interests fused into something of a potent and cohesive lobby to promote insider interests.

Only when Hungary, for example, gave its managers a virtual veto power over how a firm was to be privatized did the first postcommunist government's privatization program get off the ground. Poland, where workers had also effectively organized under Solidarity and other unions, ended up with its privatization stalled by an alliance of worker-manager opposition. Because Romania's government during the presidency of Ion lliescu (1990–1996) bungled its privatization, the only privatized firms that appeared in these years came from (usually corrupt) [Page 13]

management-employee buyouts (MEBOs). The price of rapid privatization in Russia was the nearly complete insider control of all privatized firms, a topic discussed in further detail below.

Even before communism disintegrated, insiders—the very people who ran state industries, and usually ran them into the ground—jumped on the bandwagon of private property. In the limbo that most enterprises had fallen into during the last days of the old regime, factory managers were quick to spin off valuable assets into special firms under their control, leaving the state with hollow shells and massive debts.

A common ruse went something like this: You are the boss of a state firm that makes, say, bricks. You set up a firm in your son or daughter's name to which you sell 10,000 tons of bricks at or below cost price. You have the state firm you run lend money to the new private company you own and control to make the purchase. The new company then sells the bricks at market prices, pays back the loan, and reaps a big profit. Repeat this for a year or two, and suddenly you are a rich man. In the meantime, however, the state firm has slid downhill. So you make a rock-bottom bid for it. The government says yes, pleased to get another loser off its books.

Anyone who says that transition country managers are incapable of innovation ought to look at the myriad corruptions they have employed to strip valuable assets or gain ownership of the firms outright. Two examples: Managers of Tutun, a tobacco maker in Macedonia, pillaged their firm by financial manipulation. In 1990, Tutun's manager, Vasko Kuzmanovski, paid for his firm a sum equal to its supposed book value. Here's the catch: he borrowed the money (at close to no interest) from Tutun itself. The same device, rubber-stamped by the plant's employees, was used by Lithuanian ex-premier Lubys in a managerial buyout of Jonava Nitric, a fertilizer plant and one of the largest factories in the Baltics.

Everywhere, the politically connected were usually the biggest winners. The case of a former head of KISZ, the Hungarian communist youth organization, Imre Nagy (not to be confused with Hungary's premier during the 1956 revolution), is typical. In 1990, Nagy's one-man company, Vallalkozas Szervezes Kft., purchased from the old communist party its four newspapers (including Hungary's biggest daily, Nepszabadsag) for a mere 1.5 million forints. In less than a year. Nepszabadsag alone fetched over 100 million forints. [Page 14]

Although some countries, such as Hungary, moved (often under public pressure) to curb the worst abuses of spontaneous privatization once the new regime was in power, insider scams become chronic when privatization was stalled. Bulgaria is a textbook case. So commonplace are insider deals in Bulgaria that there is a name for them: Positano, from the street where the reformed communists, now socialists, have their party headquarters. By the late 1980s and early 1990s, abuse of the leasing system was the favored ploy. The case of Briljant, a factory in the old Roman town of Plovdiv, is typical. Briljant's bosses secured a DM 300,000 loan from the First Private Bank of Sofia, supposedly to buy new equipment. New machinery was secured all right, but at double the market price through First Leasing House of Sofia, a subsidiary of the bank. Bank insiders and Briljant's managers pocketed the difference.

By 1996 in Bulgaria, a more insidious ploy became, sad to say, even more popular. Privatizations were routinely corrupted under the rule of law. If insiders lost out in their bids for a company, they merely went to court and had a friendly judge annul the auction. Slanchev Den, once a luxury spa for high-ranking communist apparatchiks on the Black Sea, was clawed back by its managers through such dubious court proceedings.

Insiders are, of course, not bad per se. Many Western management theorists reckon that when managers own a piece of their firm, their incentives to push for increased efficiency and greater profits grow. But managers, and even more so the employees, have a multitude of conflicting interests in the firm—above all their employment. The problem insiders pose in the transition countries is derived from the fact that they usually "own" more than a small sliver of their firms and are not subject to external oversight. Add to this that employees of overmanned firms and incompetent communist managers have the most to lose in genuine restructuring, which means layoffs and dismissals, and you have a recipe for failure. Restructuring will fail unless real power in the firm is vested in people committed to defend the interests of capital. These are unlikely to be insiders whose conflicting interests distort their behavior. [Page 15]

1.5
Sold Out

Against the predations of insiders, prosecution has proven itself to be a puny weapon. Faced simultaneously by the overriding need to restructure economies and the political firestorms ignited by spontaneous privatization, governments needed to get a handle on what was, in the early postcommunist years, fast becoming an out-of-control process. National privatization policies were needed. In devising them, governments soon hit a fork in the road: the choice was between trying to sell a large part of state industries and the untried and populist-sounding route of giveaways. The road of privatization through sales was well traveled by others such as Margaret Thatcher, and politicians, being politicians, usually act in a spirit of "better the devil we know." Most, at least at first, opted for the tried-and-(with luck) true.

As noted previously, what is true and effective in one set of circumstances may be woefully inadequate elsewhere. So it is with privatization through sales. Certainly sales offered a number of alluring prospects, a supposed bonanza for depleted treasuries being the greatest, of course. Many governments bent backward trying to service the monumental debt payments with which the promiscuous borrowings of the old communist regimes had saddled them. Others (Poland most importantly) defaulted, but still needed large sums to keep ladling out social services (no politician likes to incur the opposition of the old, widows, and orphans).

The idea that privatization can help to balance a national government's budget is dangerous nonsense when applied to the transition economies. Even if they were to succeed in replenishing state coffers, such sales would simply drain scarce capital from the very private sector that privatization is meant to create. After all, privatization was intended to transfer assets to the private sector, not the other way around.

A moment's reflection is enough to show that the hope for large revenues from privatization of most state enterprises was a pipe dream from the start. The only potential buyers for state companies with enough cash are foreigners, but they are often more imaginary than actual. Except for natural monopolies and a few lucrative plums, such as telecoms, transport, and even television, foreigners, contrary to the region's naive belief, were not keen on buying postcommunist dinosaurs. Of all the transition countries, only Hungary attracted enough direct foreign investments to make a bit of difference in its privatization program. [Page 16] and even there, most foreign investments went into utilities and greenfield (new) projects, rather than the more typical postcommunist enterprises. In other countries, especially the NIS, foreign investment is still pitifully small and likely to stay that way until confidence in reform grows, and a private economy is created by genuine privatization protected by law.

Selling to foreigners is also a political hot potato. The assets offered are usually worth little, if anything. And yet, if the price is low enough to reflect this abject state of affairs, the bureaucrats making the sale are bound to be accused of selling off the family silver to strangers and of being corrupt to boot. (In fact, because such sales are indeed politically suicidal, the suspicion of corruption is often well founded.)

That the very idea of selling thousands of companies to domestic buyers is preposterous becomes clear when one looks at the stock of domestic savings in most countries in transition. Private assets, always rather meager under a regime implacably opposed, by definition, to private capital, were made even more pitiful by postcommunist inflation. In Poland, for example, if people in 1990 were to spend half of their accumulated savings on shares of privatized firms (a completely unrealistic assumption that would mean a collapse of the new private sector), they would have enough money to pay for a mere 5–8% of the book value of Polish state firms!

What this shows is that if a sales program is to result in privatization of a significant portion of the postcommunist state sector, prices would have to be so low that the term "sale" does not really apply. Much to the distaste of those who said that only sales result in "real owners," "giveaway'' better describes what actually happens in the course of this form of privatization—except it is not a giveaway to all citizens, but to a select group which happens to be allowed to "buy" state assets for a song. That this is an invitation to political patronage of all kinds (and the mischief that implies), on the one hand, and outright corruption, on the other, should be self-evident.

1.6
Sold Slow

Sales in all their variations—tenders, auctions, MEBOs, initial public offerings (IPOs)—have another serious drawback: they are also terribly slow. Take the case of IPOs. The carefully prepared public stock offerings that took place in Poland in the early years [Page 17] of reform, after a lot of time and effort, resulted in little more than two dozen privatizations. Despite making IPOs a focus of official privatization efforts in 1994–95, Romania managed to privatize only one company, Apullum Alba Iulia, in this way. The records of IPOs in Hungary, Lithuania, and Slovenia are equally dismal, says the World Bank. Other methods produce somewhat better results, but still the numbers are not impressive.

Of course, theoretically speaking, one could simply auction off thousands of companies without any minimum prices or conditions imposed. But in fact this never happens; politicians would be skinned alive for the prices that resulted, and by renouncing conditions that last beyond the auction or sale they would emasculate themselves as ministers and could no longer exercise their power. It is only through giving out contracts for consulting firms that do valuations, getting points for "saving jobs" through requiring that the new owners keep the firm's bloated employment, and conditioning sales on specific postprivatization investments (as if bureaucrats who had fifty years to run their countries suddenly knew better than future private owners what investments will make sense) that privatization bureaucrats can stay in business. Because of the need to establish such conditions, the sale of a candy factory to Jacobs Suchard of Switzerland, for example, took more than four hundred days to run Bucharest's bureaucratic gauntlet in 1994.

So sales go slowly. Putting a "fair" price on state firms is difficult (particularly given the idiocies of socialist accounting methods), time-consuming, and one more invitation to dishonesty and political piracy. Indeed, underestimating value is the easiest get-rich-quick scheme around. When it came time to sell off Slovenia's state oil company, to cite just one example, auditors put such a cheap price on it that the sale had to be stopped (in the nick of time) when it came out that the company's managers stood to make a windfall profit of $30 million.

Negotiations between governments and potential buyers are also interminable, and this problem is complicated even more by the choice of salesmen. At the heart of the privatization programs throughout the region are government privatization agencies specially constructed to handle the transition. Not surprisingly, these bodies suffer from much the same incompetence and political interference—habits inherited from the socialist era—as any other part of transition country government. In the [Page 18]

huge lobby of Croatia's National Property Fund, indeed, there is a telling example of the new and the old: a smiling receptionist at a flickering computer screen and a clock with no hands.

One of the problems with governments running businesses (selling companies is certainly a business, and a difficult one at that) is that political objectives nearly always trump the economic objectives. In Lithuania, the Central Property Commission is merely an ad hoc group with members drawn on a temporary basis from other ministries. Members are torn in their loyalty between the CPC and their regular departments. Added confusion arises because, when enterprises are corporatized, there is no established procedure to decide which ministry nominates members to the firm's new board of directors, so board membership becomes a form of partisan political payoff. (Curiously, the perk of board membership began its life as a payoff in the region in quite the reverse way: in Hungary in the late 1980s, board seats were bestowed as a favor from newly corporatized company managers to their political patrons.)

Presidents Franjo Tudjman of Croatia and Ion Iliescu of Romania have also made this type of payoff a central means for maintaining the loyalty of their far-from-unified political machines, with well-paying board seats dangled before party members to keep them in line. In Kyrgyzstan, a sham privatization converted the State Property Fund from a regulatory body into three supposedly commercial organizations. All three became insolvent, due largely to the interest-free loans made not to newly privatized firms, but to friends in the state sector. Never one for subtleties, Slovakia's premier Vladimir Meciar, during the second of the three prime ministries he has held since the breakup of Czechoslovakia, simply appointed himself head of the presidium of the National Property Fund.

Politics also often dictates that firms in which privatization would result in large-scale layoffs not be privatized. Kyrgyzstan, Latvia, Macedonia, and Uzbekistan, therefore, use their privatization agencies as something akin to industrial hospitals. Needless to say, despite many life support measures (usually costing tax-payers a pretty penny), most patients never recover. (Latvia, alone it seems, has been willing to shut down at least some of these sick giants, perhaps because most of their employees were nonvoting ethnic Russians.) Romania's method was to hamstring its sales process even more by creating a gamut of oversight boards—a Court of Audit, State Financial Control Board, Prime [Page 19] Minister's Control Corps, and Financial Guard—that sales must run through before any privatization deal can be consummated. Small wonder then that after four years a mere 8% of the share capital in Romanian state firms has actually been privatized.

Another popular delaying trick is to announce that some companies are too valuable or "strategic" to risk having them fall into private hands. In Romania under lliescu, tobacco processing, urban transport, and even scholarly publications were deemed "sensitive" industries not subject to privatization. Slovakia's government designated wide sectors of the economy—telecoms, post, gas, oil, electricity, arms, civil engineering, pharmaceuticals, forestry, water, even a stud farm—as too strategic to be left entirely to the private sector. In toto property worth SK 150 billion (nearly 40% of the total valuation given to state companies before privatization) was placed under this special protection in 1995. So long as the Slovak premier Vladimir Meciar remains in power, many of the firms included are unlikely to be privatized; in others the Slovak government will maintain control through its so-called golden share, minority stakes that give it an effective veto over how ostensibly private firms are run.

Given these limits, it is no surprise then that only Hungary (with its large foreign investment) and Estonia (with neighboring Finland looking for a toehold in the Baltic markets) privatized a significant part of their economies by sales. And what gets privatized is usually given for a song to managers and political cronies. In theory, Albania's privatizations were to be conducted through open auctions. Instead, exemptions have been the rule rather than the exception. In a recent study the Tirana-based economists A. Mancellaria and N. Koci say that only eight firms out of 239 in the auction under examination were actually sold in this way. For one reason or another, the other 231 were exempted, and the less transparent methods used to privatize the firms predictably benefit the political friends of President Berisha, who wants to build a constituency for his anticommunist policies.

1.7
Big Graft and Small Gains

Such corruption is as nothing compared to what can be found in Slovakia. Here the governments of Vladimir Meciar junked the open and equitable system inherited from the mass privatization [Page 20] initiated by Czechoslovakia in 1990–91 in favor of a policy of selected giveaways, in which members of the government, the ruling parties, and their families and friends reap the richest rewards. A realistic fear is that this new class will carry on in the same failed ways as during the socialist era, insisting on subsidies, monopoly power, tax holidays, and friendly regulation. Moreover, the political class gets more than a say over how business is conducted; it can insist that the spoils from industries controlled by their cronies enrich their political coffers, giving their parties a powerful leg up in running electoral campaigns—an advantage Meciar used for all it was worth in recapturing the government in the autumn of 1994.

Rarely, however, can privatizations have been more private than in the case of Russia's energy and mineral resources sector. Once it was decided to shut foreign firms out of the bidding for shares in privatized oil and gas firms, the government (and not reluctantly) was obliged to sell off the crown jewels of Russian industry in rather murky ways to powerful insiders and the few domestic figures willing and able to ante up.

Among the oddest and (so it turned out to be) most politically damaging devices the Russian government hit upon to cash in on its equity holdings in the energy and resources sectors was to invite would-be bidders to make loans to the government, secured by parcels of government-held shares in big natural resource producers. If the government does not pay back the loans by September 1996, the lenders—mostly Russia's powerful private banks—take control of the state's shares of many valuable companies the government used for security. The deals show every sign of having been rigged for the convenience of insiders, who snapped up blocks of energy sector shares at firesale prices. With no money set in the Russian budget to pay back the loans, lenders looked assured of reaping rich rewards.

Sales may be slow, but when governments say that they want to speed up the process, look out. Parliamentary debates over a so-called Law to Accelerate Privatization stalled Romania's mass privatization scheme throughout 1995 and well into 1996, all the better for the country's nomenklatura to continue the grab for riches which sales gave to them. When a new mass privatization law at last emerged from this limbo, a caveat ratified ownerships acquired in all previous privatizations (96–97% were MEBOs), no matter how dubious. [Page 21]

In selling state assets, perhaps governments should think small. Privatization of shops, restaurants, and other service companies—what is known as "small privatization"—which was most often accomplished through sales has usually been an unqualified success. Why? Although insiders were nearly always favored (the Czechs were the solitary exception here), separation of ownership and management in such small businesses is not desirable, and secondary markets developed rather quickly, allowing insiders to sell their new acquisitions for an immediate windfall to someone truly interested in investing in the business. (Where small privatization did not work, as in Russia, the state put a lot of restrictions on resale, employee dismissals, and change in the line of business—for example, if the shop was a barber shop, so it must remain.)

Rapid privatization of retail operations delivered immediate and tangible benefits in the countries where it was tried. In 1990, less than a year after communism's collapse, for example, there were over 300,000 private stores operating in Poland. Dreary state stores with empty shelves gave way to brightly painted private outlets meeting the long-suppressed needs of consumers. In even the most laggard country, shops and kiosks broadened dramatically the variety of goods on offer. Such individual and family-run businesses soon became nimble in reallocating resources and introducing more modern business methods, most importantly in demanding and getting from other small private businessmen an improved distribution system. Politically, these small business owners and their employees delivered significant support for reform politicians.

1.8
The Giveaway Way

If sales could not deliver sweeping privatization, at least not quickly, what strategy would succeed in doing so? A few private firms in a sea of state companies was not the decisive break with the state-owned economies of the past that the postcommunist countries needed. So how could a "critical mass" of private firms be created?

The sheer size and complexity of privatization seemed to counsel against simple remedies. Yet the most daring privatization adventure is, at its heart, a simple scheme. Riddled with the sorts of caveats and exceptions to be found in most sales privatization programs, the blueprint for mass privatization undertaken [Page 22] by the Czechs would have been unworkable. Instead they wielded a broad brush and can fairly claim (despite a serious balance of trade crisis in the spring of 1997, a result of the government's timid postprivatization strategies) unique economic as well as political successes, a tricky balance.

A giveaway to the wide public was the privatization method pioneered by the leaders of what was then still Czechoslovakia. Slovaks inherited the scheme after the "velvet divorce," but a series of governments headed by Vladimir Meciar since Slovak independence have done everything they could to gut the program and undo its effects. Under the Czech scheme, each adult citizen would buy privatization vouchers for a nominal sum. These vouchers could then be converted into shares of privatized companies at a gigantic multistage central auction during which hundreds of companies were offered simultaneously. (Two "waves" of such sales resulted in the privatization of most state firms.) An individual could take part in the auction or exchange vouchers for shares in an investment fund which then used this "voucher capital" to bid for much larger stakes in many auctioned companies.

The amazing—and unique in transition countries—thing about the Czech program was that insiders received no special treatment whatsoever. Nor, also uniquely, were the most valuable state enterprises excluded from the program; firms had no choice but to privatize, though they were given some breathing room in how to go about it. This made the vouchers, which carried no puffed-up monetary face value, truly attractive. The reason why nearly all adult Czechs chose to participate was that, given the high value of the assets on offer, many privatization funds could promise a more than tenfold return in one year.

In their fears about potential and real abuses of the process, most leaders of transition countries ended up throwing out the baby with the bathwater by devising overregulated privatization programs (see table 1.2 and figure 1.3 to 1.7). Czech premier Vaclav Klaus' policies, however, were shaped not by fears but by an utter commitment to let the market decide. It can be argued, however, that Klaus has given the Czechs too much of a good thing: lack of government regulatory oversight has contributed mightily to the woeful state of the Prague Stock Exchange. The hands of investment fund officers were not tied, and they could decide on any promotion and investment strategy they liked. [Page 23]

Figure 1.3
Method of Privatization for Medium- and Large-sized
Enterprises in the Czech Republic (Percentage of Total by Value)

Figure 1.4
Method of Privatization for Medium- and Large-sized
Enterprises in Hungary (Percentage of Total by Value)

Figure 1.5
Method of Privatization of Medium- and Large-sized
Enterprises in Poland (Percentage of Total by Number)

Figure 1.6
Method of Privatization for Medium- and Large-sized
Enterprises in Russia (Percentage of Total by Number)

Figure 1.7
Method of Privatization for Medium- and Large-sized
Enterprises in Estonia (Percentage of Total by Value)

The thinking behind this mass privatization was based on a few simple but important assumptions:

• The state should not try to make money on privatization: this slows down the process and, except when monopolies such as telecoms are sold, usually fails as well. (That the Czechs were not saddled with heavy government debts, as were Poland and Hungary, made it easier for them to avoid this blunder.)

• Privatizing individual companies is a difficult business; no easier, in fact, than running them. Hence, a state that failed at running firms for fifty years would not be allowed to wreck privatization by trying to engineer the postprivatization structure of firms either. The important thing was to get the state out of business decision making as quickly as possible and leave in place a system open enough to evolve on its own.

• Privatize privatization: the investment funds at the heart of mass privatization were never conceived as the last word in the new system. They were, however, expected to do what state bureaucrats would not: decide which companies to sell and to whom, find qualified ''core" investors, lead the restructuring effort—in short, begin the work of creating real businesses. [Page 27]

1.9
Pale Imitations

The apparent success of the Czechs on the political as much as the economic front and a growing realization that sales were unlikely to produce meaningful results made the Czech model popular with subsequent reformers elsewhere—or so it seemed as country after country jumped on the voucher bandwagon.

Russia pursued a mass privatization program consciously modeled on that of the Czechs. So too Kyrgyzstan and Moldova. Poland endlessly discussed and inched toward its own mass privatization plan. Romania bests everyone by having not one but two. Lithuania, Ukraine, and Bulgaria have made various half-hearted moves to implement their imitations of a voucher scheme.

Even wayward Belarus stopped its long march backward long enough to announce in the spring of 1996 its own spin on mass privatization. After only a few weeks, and despite all the pain inflicted by the government's lack of reform, the program attracted more than 5.6 million Belarusians to apply for vouchers, 70% of the eligible population. (To be sure, their actions may be little more than wishful thinking, given the snail's pace of Belarus' privatization up to now: at most, says the EBRD, 15% of GDP is in private hands. Indeed, today the few private companies that run afoul of President Lukashenka, such as Agroprom-bank, are renationalized by the sort of Leninist legality abandoned almost everywhere else in the ex-communist world.)

But as in art, copies pale against the original. Russia is the most interesting case. "Fast and loose" is probably the best way to sum up its privatization policy. No one doubts that it has been extraordinarily swift. Between January 1993 and June 1994, an estimated 14,000 to 15,000 companies were privatized through various giveaways, including voucher auctions. Over 60% of Russian industry is now in nominally private hands. Most critically, the power and control of the central and branch ministries—the heart of communism's economic darkness—was shattered, hopefully forever.

The problem is that the private hands that gained control of privatized firms are usually the same ones that ran Russia's economy into a ditch under socialism. The program's architects, under the leadership of Anatoli Chubais, apparently believed (probably correctly) that the weak Russian government would never get privatization off the ground without the support of an [Page 28]

important constituency, and that if insiders did not benefit directly, first, and in a big way, they would form an insurmountable roadblock to privatization.

To buy insider support, managers and employees received all sorts of preferences. Of these, the most important was the right to buy majority stakes in their firms at outdated book value. "Buy" is in fact a misnomer. Inflation had eaten into these book values to such an extent that a Volga car on the books of a Moscow taxi company by August 1992 was worth a mere Rb 2,000 to Rb 3,000, that is, $10 to $15. By buying a voucher on the secondary market at a 50% discount to its nominal value and using it to pay the state for shares, these prices could be cut by half again. Here is a sale as a giveaway if there ever was one.

So skewed was the process that voucher privatization resulted in near-absolute insider domination of Russian industry, with managers and workers in control of about two-thirds of the shares in privatized firms. Up to 30% of shares were sold at voucher auctions open to the public (with insiders trying, by fair means and foul, to buy up these shares as well; cases of intimidation and unannounced auctions were not unknown). Remaining shares have remained in the hands of the state, which is the largest single shareholder in most firms, though to meet budget shortfalls, beginning in late 1996, the Kremlin has started selling some key oil and infrastructure holdings.

Was this deal with insiders akin to Faust's pact with the devil? It is too early to say. Pernicious side effects are already visible; whether or not they are chronic is still to be determined. After shares are consolidated in the hands of insiders, trading virtually stops. Outsiders sometimes try to put a foot in the door by attempting to buy shares directly from workers, but these attempts fail because management threatens to dismiss workers who sell their shares—unless it is to the managers themselves, of course. Managers also balk at opening the shareholders' registry and refuse to record transactions of which they disapprove. (Moldova was one of the first to crack down on this abuse by creating its State Registry Coordination Unit.)

Privatizing Russia, a study by Maxim Boyko, Andrei Shleifer, and Robert Vishny (all once advisors to Chubais) argues that these side effects were a necessary price to pay if privatization was to be secured in any form. The fundamental cause of economic inefficiency in the communist system was the Leviathan-like influence of politics over economic affairs. Privatization's  [Page 29] purpose was to see that industry was removed from state control. This depoliticization was far more important, say the study's authors, than the particular corporate structures that emerged from it.

But are Russian firms doing better under the new system? The jury is still out, to be sure, and some observers see signs of change. Others do not, and the improvement, if any, is certainly not dramatic. Although the backs of the old branch ministries and trusts have certainly been broken, a worrying concentration of ownership has emerged among a few big Moscow-based banks.

The long-term hope of Russian privatization must be that insider ownership is inherently unstable. Eventually, the well of revenues tapped by diverting enterprise assets to other private companies, or from pocketing employee shares on the cheap, will run dry. If the government is prepared to close the spigot of state subsidies even more, managers might be forced to turn to sources of finance that will bring outside influence to bear. But for now, the main effect of the Russian giveaways has been to entrench existing insiders, including the largely incompetent nomenklatura management. Perhaps most ominously, as we shall see presently, the political payoff of the great insider giveaway is sometimes questionable in terms of their influence on policymaking. Boris Yeltsin's reelection as president, however, would not have been likely without the financial support of the new elite created by privatization.

1.10
Polish Hesitations

Poland after Solidarity's victory of 1989 was the cradle of many ideas that led to the new giveaways. Although the first postcommunist government got bogged down in ill-starred IPOs and other sales, discussions of giveaway schemes were ripe in early 1990. Janusz Lewandowski, future minister of privatization, had even proposed a voucher program as far back as the 1980s.

While the Poles dithered and quarreled until the political opportunity of the reform governments evaporated, Lewandowski and his successors (with the help of the London investment house of Warburg) continued to dream up ever more complicated giveaway schemes. In conscious contrast to the Czechs, who relied on market spontaneity, the Polish plan was to spoon-feed small investors with shares of state-sponsored, indeed, state-[Page 30] organized, investment funds. Each fund would marry a foreign management firm with a local institution and a politically packed board of directors. Shares of each privatized company were divided into identical packets, with a "lead" fund holding one large bloc and the rest distributed evenly among everyone else.

When, after three years of political fumbling, Poland's mass privatization program got off the ground in the autumn of 1996, the number and size of the companies to be privatized (participation was voluntary) shrank so much that the term "mass" privatization became a joke. Fifteen National Investment Funds (NIFs) were made overseers of 512 mostly small companies of dubious worth. Fund managers were given ten-year contracts and large state-subsidized fees to improve company performance.

No sooner were the funds created than feuding broke out between state-appointed board members and the foreign managers. Two funds tried to kick foreigners off their management teams, Fund 11 evicted American bankers Wasserstein Perela, and Fund 13 Japan's Yamaichi International and a Hong Kong group, Regent Pacific. Only when the government stepped in, fearing the ignominious collapse of its long-delayed and loudly trumpeted program, and removed board members hostile to foreign participation was this abuse stopped.

Chauvinism and cultural clashes fan the resentments of local board members. But more serious sources of dispute are opposing attitudes toward the restructuring of firms. Many NIF board members see their job as doctoring sick companies and the funds as little more than industrial hospital wards. NIF advisors usually prefer to practice triage: sacrifice terminally ill companies in order to save scarce resources for firms with the best potential for long-term health and profits. With the government throwing its weight behind NIF industrial quacks, the mass privatization program to which it paid lip service soon became bogged down in a morass of politically inspired restructuring, meaning that in most cases (the closure of the Gdansk shipyard, birthplace of Solidarity, being a rare exception), no real restructuring has taken place at all.

More generally, experiences with privatization funds throughout the region are mixed. Most funds are not reliable corporate governance watchdogs. A number of fly-by-night operations in Russia collapsed in disgrace. Romanian Private Ownership Funds (POFs) are self-promoting rent-seekers, with [Page 31] no concern for their shareholders. Lithuania's funds also either ignore their shareholders or buy their silence. Invalda, a fund with 26,000 shareholders owning parts of sixty companies and another twenty outright, paid its shareholders dividends of 10% since its founding, though only half its firms make money.

1.11
Czech It Out?

So giveaways turn out to be no panacea either, at least not everywhere. Are they really doing as well as is billed in booming Prague?

The main problem with Czech privatization is the ownership structure of the funds; more precisely, of the management companies that usually exercise total control of them. In some ways, what happened is easy to understand. Mass privatization was a logistical nightmare, with its need to distribute vouchers, convince individual citizens to participate, and assure that privatized companies did not end up owned by thousands or even millions of small shareholders. This last point was the most worrying, for fragmented ownership is almost equivalent to no ownership at all. Such a pattern of nonownership would leave firms at the mercy of their insiders, and we have seen what that means. This is why investment funds that concentrate ownership control on behalf of dispersed owners are a necessary element of mass giveaway.

To ensure that investment funds with some degree of public confidence were created, the Czechs allowed existing state banks to form and manage privatization funds. The gambit paid off, in the sense that the process was smooth and 70% of voucher holders opted to deposit their vouchers with funds. But it is undeniable that a price was paid. Eager to insulate themselves from outsider control and to gain control of as many Czech firms as possible in one fell swoop, the bank funds promptly used a good portion of their vouchers to buy bank shares.

Czech funds and the banking system soon became embedded in a dense web of cross-ownerships. Take the case of Prvni Investicni, the biggest investment company and a subsidiary of Investicni Banka. It administers fourteen funds, two of which (Bankovni Investicni and Rentierky Investicni) have over 50% of their holdings in the banking sector. Indeed, of the six largest Czech banks and financial groups—Komercni, Ceska Sporitelna, Ceskoslovenska Obchodni, Investicnia a Postovni, Zivnobanka, [Page 32] and Ceska Pojistovna (Czech Insurance)—only Zivnobanka does not have a piece of Komercni, Ceska Sporitelna, and Ceska Polistovna. Cross-ownership ranges anywhere from 50% for Ceska Pojistovna to something near zero for Ceskoslovenska Obchodni. With the networks illustrated above "you do not negotiate a transaction," says one fund manager, "you negotiate as part of a relationship."

Some academic observers are not bothered by the power of the Czech banks, pointing to the fact that the country had traditionally followed the German model of universal banking in which financial institutions both lend money to companies and serve as corporate monitors. But although this model served Germany well for decades (it is now being rethought in its homeland), is it the right one for the new Czech circumstances? In theory, such ownership is supposed to work well because information about firms gleaned through close lending relations between a firm and bank, further consummated through seats on company boards, allows banks to monitor company managers and permits shareholders to reduce their risks.

So goes the theory. In practice, these close links make many economists in the region go weak at the knees. First, there is suspicion that Czech investment funds prefer to use their power to pressure companies whose shares they control into buying financial services from the fund's banking master rather than to restructure their operations. (Lithuania tries to curb this risk through banning bank shareholdings in investment funds.)

Second, the system breeds insider dealing and inhibits transparency, which consequently retards the development of capital markets. Prices on the Prague Stock Exchange (or the rival RM-System) are often a mystery, and most deals (estimates go as high as 90%) are struck in private. Funds get a sneak preview of company books and investment decisions through the seats they control and manipulate on company boards and can often influence the market to the detriment of small (often their own) shareholders.

Third, with bureaucratic cultures derived from their mother institutions, bank funds are reputed to be lazy. They care less about monitoring managers and restructuring than about lucrative seats on the boards of the companies in their portfolios. Consequently, managers still claim to trade off shareholder interests against those of employees and other shareholders. [Page 33]

But perhaps the greatest danger of the Czech experiment is continued high levels of state ownership of banks themselves. The Fund of National Property (FNP) is often the biggest shareholder in the banks, with 48% in Komercni (the country's biggest) and 40% in Ceska Sporitelna. Cescoslovenska Obchodni has even more government strings attached: 20% is owned by the FNP, 20% by the Ministry of Finance, 27% by the Czech National Bank, and 24% by the Slovak National Bank.

As long as the government is in the hands of parties (and individuals) committed to nonintervention, its stake in the banks may not be a big problem. But if the government were to change hands, a new regime could lean on banks to, in turn, lean on funds that control most of the Czech economy. By the standards of depoliticization, does this amount to successful privatization?

Despite these question marks, prospects for the Czech experiment are better than most. Spurred by more aggressive nonbank investment funds, much restructuring is undoubtedly going on. Managers do get fired, payrolls are cut down to size, and pressure by outside owners on managers is greater than in any other transition country.

Perhaps the most important change of all is a tidal wave of ownership reconfiguration taking place. In this "privatized privatization," known as the "third wave" (the first two being the official auctions that took place during mass privatization), investment funds are putting together controlling packages of many firms and selling them to interested foreign and domestic investors.

By 1995, powerful outsider players began to enter the fray. The Bahamas-based corporate raider Michael Dingman, in cooperation with Harvard Funds, purchased controlling interest in some of the most important Czech companies. These shares were managed by Dingman's famously no-nonsense Stratton Holdings. Other deals were smaller, but an estimated five hundred companies quietly changed hands that year. Nothing comparable—even in absolute terms, not just relative to the small size of the Czech Republic—has yet taken place anywhere else.

The largest investment funds are also feeling the heat. Plzenska Banka, after being taken over by the upstart private financial group Motoinvest, began a buying frenzy of investment privatization fund shares. Frightened by this challenge, the banks managing the most powerful funds—Komercni Banka, Zivnostenska Banka, and Ceskoslovenska Obchodni Banka—bought [Page 34] back at a high price shares acquired by Plzenska. Unwilling to pay such greenmail, Creditanstalt and a number of others were forced to sell their funds to the Motoinvest group.

Even the transparency of the so far rather shady deals might be increasing. New laws to protect minority shareholders and increase disclosure requirements were passed on the initiative of Tomas Jezek (the first Czech privatization minister and, later, the Prague Stock Exchange's reform-minded chairman). However, only when the Czech balance-of-trade crisis in the spring of 1997 threatened to spread to the capital markets did Premier Klaus assent to putting real teeth into the bourse's watchdogs.

1.12

The Politics of Privatization

In democracies, the worst that can befall a government that badly miscalculates a policy is time spent as an opposition party. In many transition countries, however, reform governments carried with them not the fear of a spell in the political wilderness, but the nightmare of elimination altogether: the return to power of a communist apparatus that would snuff out not only privatization, but democracy as well.

Add to this the fact that no government in any country likes a planned increase in unemployment, nor do they like taking on entrenched lobbies or facing vengeful strikes; they do so, if they do so, in the belief that the consequent unpopularity will be limited or short-lived and eventually outweighed by a wider recognition that their actions were necessary. Privatization, therefore, was more than a bet on the future of the economy, it was a desperate political gamble as well.

Indeed, politicians understood from the start of the process of transformation that privatization was as much about power as about economic efficiency. All, in the end, sought to skew the privatization process to their electoral benefit. Their political choices, however, will have long-term consequences for the health of their countries's economies and politics beyond the next election. The bet governments made in their choice of privatization programs was between appeasing existing lobbies, such as insiders, and creating entirely new constituencies. In essence, it was a choice between the past and the future. The worry for those who gambled on the future was this: would there [Page 35] be enough time for new constituencies to take shape (and organize as voting blocs) before the gamblers would have to face their voters again?

Prague's Vaclav Klaus, as we have seen, was the sole leader to roll the dice in this high stakes game. His macroeconomic and stabilization policies, despite doses of Thatcherite rhetoric, may have trimmed and fudged far more than those undertaken in Poland, Estonia, or Latvia. And they did, indeed, succeed in muting the political shock of transition by dampening down the pain of unemployment. But where Klaus and his government excelled was in pushing through in record time the most extensive privatization scheme ever undertaken. Almost single-handedly, this action not only put zest into Klaus' government, but also created a new cadre of reform enthusiasts.

To be sure, the Czech privatization route posed obvious political risks, not least that rapid change may produce the unsettling impression of things being out of control. But by shunning insiders (for the most part), the moral basis of the old socialist politics was fatally weakened—a situation helped in no small measure by formal legal curbs on the communists. Because envy and resentment are not the ingredients of political stability, mass privatization needed to spawn a broad spectrum of people who considered themselves "winners" in the grand gamble of privatization. Here Klaus succeeded, probably beyond expectations, in creating from scratch a powerful electoral constituency, one unconnected to the old ways of doing things: tens of thousands of shopkeepers who had purchased their stores at genuinely open auction; thousands who had property that had been confiscated by the communists restored to them, and were thus likely to be unwavering in their support; and many new shareholders in privatized large firms. Here, indeed, the lessons of Prime Minister Thatcher's privatizations were correctly applied as large swathes of the population became interested shareholders in Klaus' success. A survey in 1996 of 1,450 Czechs by the Institute of Sociology of the Czech Academy of Sciences shows the depth of this support. Some 79% of the respondents who participated in both waves of voucher privatization declared themselves satisfied with the process of reform; only 37% of those who participated in one wave, or sat out the reforms altogether, voiced similar support. Entrepreneurs and those who had property restituted to them support reform even more robustly, with 76% of the former and 66% of the latter endorsing the country's emerging economy. Moreover, by giving birth to powerful private financial institutions dependent on the continuation of reform, Klaus also created a financial support system for his efforts.

Did appeasement of insiders elsewhere deliver political benefits to the appeasers? If so, they are hard to find. Reform governments that assumed that they could overcome or cover up envy and resentment at insider privileges soon learned that they could do neither. Leading reform politicians in Estonia, Lithuania, Hungary, Poland, and Russia were often rudely turfed onto the street at the first opportunity by voters who deeply resented the special benefits afforded insiders.

This inability of reform politicians to forge a political base among insiders—indeed, the scale of insider ingratitude—is stunning. For example, as compared with those working in new or even state firms, employees in privatized Russian companies are the least likely to vote for reform politicians and among the most nostalgic for communists, reports a 1996 survey by J. Earle and R. Rose (''Causes and Consequences of Privatization: An Empirical Study of Economic Behavior and Political Attitudes In Russia"). Moreover, these employees are equally stodgy in their economics; they are the most negative about their firms and are openly unwilling to work to improve things (see table 1.3).Because the attitudes of Russian managers were not surveyed, it is impossible to say where their political loyalties now lie, though studies of where Russia's political parties go to get financial backing hint that such managers provided the lifeblood of finance for the communist Gennadi Zyuganov's presidential campaign in 1996. But a glimpse at Hungarian insider managers gives a clue. When asked about their view of the political and economic changes since 1990, Hungarian managers were harshly pessimistic, longing for state aid, and supportive of a redistributive system (see table 1.4). Indeed, the greater insider control a manager has of his firm, the more he seems to yearn for the old ways of socialism.

This is a far cry from the strong support for reform found within Czech managing circles, a clear reason why Vaclav Klaus broke form with other reform politicians in not getting the electoral boot, but instead holding on to power in the May 1996 Czech elections—granted, by the skin of his teeth, as Klaus was forced to form a minority government, his coalition claiming [Page 36 through Page 38]only 99 of the 200 seats in parliament—Klaus was reelected not just for his radicalism, but also for his results. Mass privatization was the first step in proving that market economies can deliver the goods to more than a few.

1.13

Where to From Here?

Against the odds, privatization in a number of transition countries shows that the broad superstructure of a capitalist economy can be put in place (historically speaking) much faster than many expected. Indeed, by the increasing pressure it puts on state enterprises as well as its continuous strengthening of the private sector, privatization is a big contributor to the robust growth some transition countries are now seeing. And it has demonstrated its centrality if the role of the state in the economy is to be redefined.At the start of the privatization process, democracy was a help, not a hindrance. This is unusual because in long-standing democracies, consistent, lasting public support for tough economic medicine has often proved to be elusive. Certainly, Estonia, the Czech Republic, Russia, Albania, and Moldova had the luxury of initiating the toughest parts of their privatization programs with broad democratic backing, both within their parliaments and among the people at large. In each, it now seems clear, privatization spawned a number of independent institutions—stock markets, banks, shareholders, and other private property owners—that will, as time passes and economies begin to grow, continue to strengthen free-market democracy.If pursued energetically, as in the Czech Republic, privatization actually energizes rather than devours the impulse to reform. A number of countries, indeed, are now moving beyond the industrial and small business privatization that dominated the first years of the process of transition. Following Hungary's lead—where it was an effort born of budgetary desperation—Estonia, though running a budget surplus, is well down the road in plans to privatize its basic infrastructure: railways, ports, telecoms, and the national power grid. Latvia and Kyrgyzstan are making sounds about moving in this direction, too.

But other transition countries continue to face instability in pressing their privatization programs forward in the wake of public uncertainty and insider opposition. The longer they wait and fritter away the special "window of opportunity" provided by the

Figure 1.8
Extent of Privatization

fall of communism, the more "normal" democratic politics becomes, with special interests clamoring ever more effectively for exceptions and privileges, and the tougher it will be to take decisive action (see figure 1.8).Many places—and this is clearly a reason for long-term hope—seem to have developed the political maturity necessary for constancy of purpose in privatization and, hence, success. The determination with which governments stick to reform efforts (though, no doubt, at times in a stop-and-go fashion) and are rewarded for it by voters (such as in the Czech Republic, Slovenia, and the less-developed Moldova) suggests to optimists that public recognition of the general benefits of privatization is beginning to take hold.

Page 40

There are laggards, of course: Ukraine pays a high price for its faint-hearted reforms (though the irony is that most Ukrainians blame reform, not the absence of it, for their woes). Macedonia, Uzbekistan, and Belarus still fail to acknowledge that state-dominated industries do not work and are a ceaseless drain on the treasury, though in late 1996, Uzbekistan's president Islam Karimov seemed poised to bite the bullet and embrace mass privatization, and Romania's flawed privatization program seems destined, despite government interventions, to undermine ongoing state control of supposedly privatized industry. Nonetheless, signs of a new maturity should not be taken for granted: populism and short-termism may merely be in remission, preparing to rear their heads if prosperity does not reach the general population soon.

Austere governments such as those in Prague, Chisinau, Tallinn, and Riga may be voted winners so long as memories of communism are still fresh in people's minds. Once they fade, the lure of subsidies and renationalization may come back. In some cases, notably Russia, despite Boris Yeltsin's reelection in July 1996, the big fear is that privatization may still fall victim to political instability, even if the process itself has gone too far to be reversed easily.

The reason why privatization remains an issue in dispute is often a matter of institutions. Privatization's results and prospects reflect the fact that countries are making do with immature political and economic arrangements. The most extreme examples are Ukraine, Bulgaria, and most of all, Belarus, where heavily centralized governments have not found a sensible way to redefine their roles and where the legal framework for (and public support of) private property is ephemeral. The politics of privatization in many other countries is dogged either by explicit restrictions and maintenance of large swathes of state control, or by outright corruption. It is hard to think of any transition country in which the new institutional setup is complete.

From its birth in the region, privatization was an awesome and awe-inspiring task. Succeed, and the link between state and economy would be broken, hopefully forever; fail, and the transition from communism itself would be placed at risk. The lesson that most governments—some vehemently, others by paying lip service—say that they learned during the first few years of privatization and restructuring is that a muscular private sector is vital to the future well-being of their countries and that privatization is  [Page 41] an essential tool in reaching this goal. The lesson that none of them has fully been able to decipher is how to make all their new privatized "owners" begin to behave like real owners. That code is yet to be broken.

[Page 42]

2
Capitalism with a Comrade's Face

To the myriad reformers who assumed power in the socialist world after communism's collapse, privatization was always a necessary step in the postcommunist transition to free markets and democracy, a move away from absolute domination of the economy by the state and from the economic evils traceable to a lack of "real owners" capable of monitoring the behavior of enterprise managers. For much of the population, the goals of the privatization process were never entirely clear or comprehensible; what was clear was that privatization would inevitably make some people rich. And the public feared, indeed expected, that the people who would be made rich by privatization would be the very same people who had been oppressing them for decades: the communist nomenklatura.

That reformers were right in principle in their move toward privatization is not seriously questioned; after all, there is no known example of a successful modern economy without a market based on private property. Whether what is going on under the name of privatization in most countries of Eastern Europe and the former Soviet Union can be described as a transition to such a successful property-based market economy is a question on which the jury is still out. Where the verdict is in, however, is that in most countries the people did not err in their rush to judgment: the old nomenklatura has, indeed, mutated into the new capitalist class.

According to a former leading politician in Romania, 80% of new Romanian millionaires were part of the Ceausescu-era nomenklatura; many had been in the arms industry and have since built their fortunes on arms trading (skirting the arms embargo on Croatia and Serbia was a particular boon). A survey of [Page 43] Russia's top one hundred businessmen compiled by Moscow's Applied Politics Institute found that 61 % of the country's new rich were members of the ex-nomenklatura. A Polish economist who traced the careers of several hundred top nomenklatura from 1988 to 1993 found that over half of them turned up as top private sector executives. The numbers in Hungary are reported to be even higher than in Poland.

Hence, the million-dollar question on which much of the future of Eastern Europe may depend: Does the fact that privatization was hijacked by the very people of the old regime it was intended to tame mean that the region's march toward greater justice and economic efficiency will be stymied as well?

2.1

The Nomenklatura Unbound

In many countries of the former socialist camp, political personnel changes in the wake of communism's demise were much less than one might have expected. The faces atop and within the state apparatus of Romania, Belarus, or Ukraine are, after all, not that different from those who had ruled in the 1980s (though their style of governing has been significantly transformed). But even in those countries in which the collapse of the old regime was accompanied by the old political elites' eviction from power, such as in Poland, Russia, and Hungary, the big surprise was that party members were soon gliding with relative ease from politburos into boardrooms of many companies. "Whenever I meet with a big Hungarian company," said an American diplomat-turned-investment banker, "I invariably am seated across the table from someone I once negotiated with when Hungary was communist."

To be sure, the profile varies in different countries. In the Czech Republic, nomenklatura managers have not been particularly successful in retaining their control of the levers of economic power on the enterprise level. (They were more successful in retaining some power in the banking industry, though not in gaining ownership.) In Poland, managers used (and abused) their entrenched positions to block privatization of the biggest enterprises, thus preserving much of their control, but could not convert this control into full property rights. (They were much more successful in gaining such title to property in smaller firms.) In Russia, the power of the nomenklatura managers was unbroken by privatization, but even there workers had to be given a share, [Page 44] and some of the most valuable natural resources are still owned in an unclear (and thus insecure) way. Titles are also clouded in Hungary, where managerial control comes together with a web of immensely complicated corporate cross-holdings that make the very concept of ownership problematic.

But with the possible exception of the Czech Republic, the nomenklatura has been extremely successful at converting its political domination into economic might. The countries where the communists lost (at least temporarily) their hold on political power may indeed provide the most ironic twist of the postcommunist transformation: liberating the economy from a state run by the nomenklatura has liberated the nomenklatura as well.

Under the old regime, the nomenklatura's privileges were paid for by submission to the tyrannical will of the communist party and its political leaders. (This was, in many ways, a comfortable servitude. Even nowadays, some managers look with wonder, and perhaps even indignation, on those who advocated escape.) It was only the always precarious position of these managers in the bureaucratic pyramid that enabled the members of the communist elite to appropriate for themselves much of the return from the nation's economic assets. Under the new system, emancipated from control by the political center, the nomenklatura gained title to these assets, and the new order gave them legal protection for their privileged status as property holders. By making them into owners of capital, privatization thus allowed the former nomenklatura managers to preserve their stranglehold on economic resources, while also giving them the freedom that the old regime denied them. Indeed, privatization has even given a degree of legitimacy to the nomenklatura's spoils that the old regime miserably failed to provide as it tried to justify them through an ideology rather than the ancient and venerable institution of private property.

Here is the true paradox of privatization: it allowed (or at least went a long way toward allowing) members of the nomenklatura to achieve something they could not have hoped for even under communism. Only in countries such as Ukraine, where the economy remains dominated by value-subtracting industrial white elephants, has the nomenklatura maintained an almost united front against large-scale privatization. Ukrainian industrial bosses appear to know that their huge factories have value only as political chips (with privatization inevitably leading to their closure) and so prefer to stay closely linked to the state with its [Page 45] handouts and rigged markets. In the more "advanced" postcommunist countries, in which there were more valuable assets to be appropriated by those who had enough power to lay their hands on them, the new owners also like to get their share of political largesse. But they are no longer satisfied with being dependent on the state; like all survivalists they want to turn their environment to their individual advantage; they now want the state to serve their needs. The return of the communists to power in a number of the countries in transition must be viewed in light of this role reversal.

2.2

The Resistible Rise of the Kleptoklatura

How did this transformation of the nomenklatura happen? The story actually begins a few years before the final collapse of the communist system. In countries such as Hungary, Poland, and Russia, personal enrichment of party ranks became a semi-official part of the desperate, last-gasp "reform" policies pursued by reform-minded communist regimes such as Mikhail Gorbachev's in Russia. As the policies of perestroika and its regional clones increasingly stressed the importance of markets and provided a limited space for private property, the comrades themselves were, of course, the best equipped and best placed to take advantage of the new opportunities. Indeed, the policy turned out to be so popular among the middle (enterprise level) nomenklatura that the top brass rather quickly lost control of the process.

The resulting scramble for riches came to be known as "spontaneous privatization." Its most notorious examples were in Hungary in 1988 and 1989, during the last months of the communist regime, when the authorities introduced new laws allowing conversion of state enterprises into corporate legal forms, such as joint-stock and limited-liability companies. Factory managers and their cronies manipulated these laws to insulate themselves from any external control, spinning valuable assets into separate subsidiaries of which they became part owners and leaving the state with empty shells and liabilities.

Spontaneous privatization was soon spreading throughout the region. After Nicolae Ceausescu's bloody fall, a former Securitate secret policeman, Gheorgehe Urzica, quickly came to own a string of luxury shops in Bucharest, places which had never been officially privatized. What started with a few stores  [Page 46] and small companies often ended up with theft on a grand scale, especially where, as in Romania, the old elites maintained their hold on the state beyond the collapse of the regime that had brought them to power. Victor Stanculescu, one-time head of the quartering corps for Ceausescu's army and later a member of the provisional tribunal that sentenced the dictator to death, became the owner of Romania's leading arms exporting firms, companies which had never been publicly put up for sale. A Polish banker in Lodz complained in 1995 that most of his bank's bad loans were made by the old guard to their cronies (who were by then in the newly favored private sector) during the few months in which the Mazowiecki government ruled in coalition with the communists.

But no country can compare with that of Russia, whose enormous wealth and natural resources fell prey to a few modern-day robber barons with a party pedigree. In what reportedly began as a conscious Soviet policy of placing various party officials into key economic posts, men like Sergei Yegorov, former chairman of the State Bank of the Soviet Union and head of the financial department of the Communist Party Central Committee, became among the richest men in Russia and, in Yegorov's case, the chairman of the Commercial Banks' Association. Gorbachev's prime minister, Nikolai Ryzhkov, also made a switch ''from plan to clan" and is now chairman of the Tveruniversal Bank.

Connections to the often corrupt new authorities can also yield pretty good results. For example, in November 1995, Russia's huge Uneximbank, a firm with close ties to President Yeltsin's former security chief and drinking buddy Alexander Karzhakov, was victorious in an auction to control 38% of Norilsk Nickel, the world's largest producer of that commodity (as well as of platinum and cobalt). Uneximbank, which is partly owned by Norilsk Nickel (making the whole transaction a family affair), had been charged with managing the auction, and its winning bid was only half that offered by a competitor. Indeed, the $170 million Uneximbank offered was a mere $100,000 above the minimum bid level set by—wait for it—Uneximbank, who had been named by the government as the auctioneers.

The theft of the century, perhaps indeed of all time, was that of the Russian energy sector, which accounts for at least 17% of Russia's GDP. The assets of the oil giant Gazprom alone are valued in hundreds of billions of dollars. (According to most  [Page 47]  estimates it dwarfs General Motors, long believed to be the largest industrial company in the world.) Although such companies as Gazprom were excluded from the official privatization program, 60% of stakes in them have ended up, in ways that no one clearly understands, in the hands of a few company insiders, favored politicians, and banks run by the ex-nomenklatura. Among the major shareholders of Gazprom is rumored to be its former boss, now prime minister, Victor Chernomyrdin. Chernomyrdin denies any involvement in the company's affairs nowadays, but few believe his protestations, particularly as his son is building a lavish mansion within a wooded Gazprom estate. (Russia seems to be the only democracy in the world in which the net worth of the prime minister is estimated with a potential error of a few hundred million dollars.)Nor are comrades from the secret police lagging behind their ex-party cronies. Oleg Kalugin, Russian's one-time dissident KGB general, has become one of his country's richest men, trading around the world in "scrap" steel from decrepit state factories. Radu Tinu, who used to be a regional deputy head of the Securitate, is now one of the richest businessmen in Timisoara, where the Romanian revolution started.

Such business dealings are enough to evoke the worst nightmare of postcommunist transformation: that former secret police networks have been converted into national and international business structures which, often allied with organized crime, are setting up commercial empires throughout the Eurasian continent. The vision of a small, secretive elite, tied to the old regime, recombining, reinventing, and reconstituting itself on a large scale within the new order may not be the most realistic of dangers, even if it cannot be fully discounted. But in the somewhat conspiratorial mindset of a significant segment of the East European and ex-Soviet Public, it may go a long way to delegitimize the new democratic regime.

2.3

The Faustian Bargain

Ironically, some of the greatest gains by the nomenklatura were made neither through backroom deals in the waning days of the old regime nor through outright theft and bribery in the postcommunist period. They were made perfectly legally through the [Page 48] various privatization programs designed and executed by the new reform-minded governments of Eastern Europe and the newly independent states of the Soviet Union.

Russia is, again, a prime example. In order to be able to push through their ambitious program of quick privatization, Russian reformers, led by Anatoly Chubais, had to ensure that they had the support of some sufficiently powerful political and economic forces within the old system. Otherwise, their reforms would go nowhere in the apparatchik-dominated Duma. The program had to have some losers and some winners, and the winners could not all be in the future.

Chubais chose as the main losers in the Russian privatization program the most inefficient and deadening structures of the old regime: the old centralized industrial bureaucracies such as branch ministries, industrial associations, trusts, and other lobbies for socialist stagnation and the status quo. The main winners, the forces with which the reformers allied themselves in the great push for quick privatization, were to be the managers and the workers of individual state enterprises, provided they broke away from the old structures.

Company managers, for Chubais and his allies, were the lesser evil. Concessions in the privatization program, giving them partial ownership and outright control over their enterprises, were designed to assure their support. The gamble paid off beyond the wildest expectations of the small band of reformers who gathered about Yegor Gaidar and Chubais in dachas on the outskirts of Moscow in the winter of 1991–92 to devise the privatization of the socialist state. The old centralized industrial structures were successfully, and rather swiftly, dispatched to the dustbin of history. Some 14,000 companies, an absolutely unprecedented number, were privatized between January 1992 and the end of June 1994 through a combination of insider buyouts (or, given the ridiculously low prices, giveaways) and voucher auctions.

The price for this? Enterprise insiders—managers and workers—emerged as majority owners of nearly 70% of Russian enterprises. Although top management directly acquired "only" 9% of the shares through the mechanism Chubais established, and workers ended up with 56%, shortly afterwards managers resorted to a series of measures designed to increase their stakes. They started buying up workers' shares, while at the same time preventing workers from selling to outsiders. Those [Page 49] who resisted were threatened with dismissal. Managers held tight to company registers and simply refused to record share transactions of which they disapproved. They bought up still more shares at public voucher auctions (which could be made less public if the managers had the sympathy of local Property Fund officials in charge of running the auctions). And many formed separate private companies that they or their families would control and siphoned to them money and the most valuable assets of their enterprises. One way or another, they ended up owning the lion's share of the new capitalist property.

Here, in a savage irony, reformers charged with the task of undoing Marx's dismal handiwork seemed, instead, only to prove socialism's founder correct in at least one of his prophecies. Production is dominated, he said in Capital, by "magnates…who usurp and monopolize all advantages in this process of transformation." In the early stages of privatization, indeed, the authority of the nomenklatura managers appeared as total as that exercised by the great capitalists of the Victorian Age as portrayed by Marx. Privatization itself seemed to be set in their interest alone. By all visible evidence, decision-making power in many privatized firms is theirs.

In no other country was the nomenklatura grab for new property as successful as in Russia. But on a smaller scale, a similar pattern of political alliance between the governing reformers and the enterprise-level nomenklatura was often the only successful mix in the drive to privatize. Whenever the Polish or Hungarian authorities attempted to privatize over the heads of the entrenched pre-1989 managers, they encountered interminable obstacles, delays, and difficulties. All the while, many firms, as long as they remained owned by the state, were hemorrhaging money and value by the day. Only when the state decided to give them in one way or another to their managers— through a form of "leasing" (in Poland), subsidized credits (Hungary), or fully leveraged buyouts (Romania)—did privatization have a chance.

2.4

Like a Phoenix from the Ashes

The penultimate chapter of the nomenklatura rediviva is the return to political power of the by-now-former communists—this time no longer as the "vanguard of the proletariat," but rather as [Page 50] the tail wagged by the nomenklatura-capitalist dog. This chapter is still largely unwritten, despite the experiences of such countries as Hungary, Poland, and Bulgaria.

The electoral victory of the ex-communists comes in part from the public's disgust with the corruption and disenchantment with seemingly slow economic improvement. In a strange irony, both may have much to do with the nomenklatura's behavior. Will their victory now usher in a new spiral of abuse?

Although Hungarian privatization policy has become still somewhat friendlier to management since the return to power of the so-called ex-communists, the victorious socialists under Prime Minister Gyula Horn did not introduce any radical changes to the reform strategies already underway. Until late 1995, Polish communists also had their hands tied by the need to govern in a coalition and by the aggressive presidency of Lech Walesa. They could not, therefore, attempt any radical moves, but they were ruthless in placing their henchmen on the boards of state companies, staffing local governments with their supporters and distributing patronage positions among their allies. They stalled as long as they could the moribund mass privatization program and attempted to emasculate its antinomenklatura elements by insisting that privatization fund managers have personal experience in running state enterprises. Until being routed in parliamentary elections in the spring of 1997, Bulgaria's government of ex-communists, too, attempted to make sure that nomenklatura managers gained control of the investment funds that dominated the companies included in that country's oft-postponed, and easily manipulated when in force, mass privatization program.

Political manipulation of privatization can set a country back. Slovakia was one of the early success stories of reform. Mass privatization as practiced by its early postcommunist governments laid the foundation for vibrant economic growth and low inflation. But the third government of Vladimir Meciar, which assumed power in late 1994, twisted the privatization process into a political patronage machine. State property—from the choicest morsels such as the giant energy firm Slovnaft to small town hall recreation centers—was sold to handpicked insiders in a naked bid by Meciar to establish a client business class loyal to his regime. That process negated some of the industrial restructuring initiated by the mass privatization investment funds that Meciar sterilized and helped undermine Slovakia's bid for early [Page 51] entry into NATO. In November 1995, indeed, the European Union delivered a strongly worded demarche to Meciar that warned against continuation of his thuggery and corporatist strategies, and when the first list of five postcommunist countries to begin membership negotiations with the European Commission was announced, Slovakia was not among them.

2.5

Survival of the Unfittest

"Meet the new boss, same as the old boss" is a line English rockers the Who used to sing. Nowadays few can blame Polish, Hungarian, Russian, Romanian, and other reformers from turning that old rock anthem into a new political lament. The nomenklatura, in transforming itself into a ruling kleptoklatura, seems determined to make the old socialist Pierre Proudhon's dictum ring true: "All property is theft."

But apart from undermining somewhat the legitimacy of the new regime—perhaps of a private property regime itself—is there something economically wrong with the nomenklatura's success? If economists are not alarmed at management buyouts in the West—indeed, they tend to think that owner-managed companies often have distinct advantages over firms with widely dispersed ownership—why should we be concerned about the future of the postcommunist recovery just because their managers also want to have a share of their enterprises? Isn't this just the normal blues following every exhilarating revolutionary change, when romantic freedom fighters must make room for pedestrian and not always pure businessmen?

There is a grain of truth in this. No society, after all, can be reshaped overnight. Elites everywhere always contain a large number of talented people (even though under such regimes as communism and fascism, the elites are immoral and unscrupulous). Some of these people, indeed, would be successful within any political system. Their communist pedigree should not matter, especially when experienced entrepreneurial talent is in short supply.

But what matters is not just the unsavory past of the nouveaux riches of this new model nomenklaturadom. It is the fact that many among the nomenklatura would not make it under most democratic and free market systems. At best, they rose to the top for their political loyalty rather than business or professional qualifications. At worst, their advancement was based on [Page 52] the principle of a truly negative selection, with the more talented and honest people quickly bested in the Byzantine machinations of the party bureaucracy by sycophants and thugs. Moreover, there is little evidence that the kleptoklatura thinks all that differently from its socialist-era forebears. Belief in monopoly, autarky, and capital investment appear to remain nomenklatura dogma, though the near bankruptcy of most states has forced a realization among them that new subsidized capital investment for their firms may not be in the cards for years to come. These three articles of faith reinforce each other and threaten long-term economic health.

The postcommunist transition thus requires, for economic as much as for political reasons, that many of the old guard make room for the next generation of business leaders. It is this process that gets stymied by the managerial entrenchment resulting from nomenklatura privatization. Another reason why this nomenklatura capitalism matters is that it prevents an evolution of corporate governance that is necessary if Eastern Europe is to join the world economy. Owner-managed companies of moderate size can have very beneficial economic effects, as Germany, with its Mittelstand, has shown for many decades. But unless a few people or families are to own most of a country's wealth, large industrial enterprises require a separation of ownership and managerial control. And when managers do not own more than a small share of their companies (when they are mostly "agents" rather than "principals"), their performance must be monitored so that they work for the owners rather than slacken and enrich themselves at the owners' expense.

The danger of such "agency problems," as economists call them, particularly serious in the transition countries of Eastern Europe and the ex-Soviet Union, where managerial pilfering of social (and thus nobody's) property has a long tradition. The only way to combat this is to make sure that all productive assets have a clear outside owner, a genuine capitalist in the boardroom, who can protect the interests of the company (and, indirectly, society) against the rapaciousness of unscrupulous insiders.

In this context, the moral unacceptability of nomenklatura capitalism also has economic significance. The new regimes, albeit imperfect, have a certain (and growing) degree of democratic transparency which today makes naked theft far more difficult [Page 53]. Nomenklatura acquisitions, therefore, must be partly hidden and partly clothed in some kind of legitimizing garment. These embellishments and subterfuges are not just a proverbial fig leaf; indeed, they may be quite costly in terms of future inefficiency. To hide nomenklatura ownership, inefficient structures (such as the impenetrable maze of Hungarian corporate cross-holdings) may need to be created, and because they distort the legal environment, they are likely to make all ownership weaker. Or to legitimize managerial grabbing, workers must be given the lion's share of a company, which makes any future restructuring (often requiring layoffs and changing old and inefficient ways) that much more difficult.

2.6

A House Divided?

Visitors to the postcommunist countries often hear complaints that little has really changed, that the nomenklatura is as strong as ever, and that privatization has merely tinkered at the rigging on the side of the party regime. This is patently not true. An entirely new class of entrepreneurs owning their own businesses is playing an ever-increasing role. Much of privatization, especially of smaller firms, is also producing the kind of restructuring necessary to move many countries on the way to solid growth. (And privatization has also brought political benefits. The Czech Republic's Vaclav Klaus is the only reformer in the region to win reelection in an environment in which he faced no real neocommunist threat. In Russia, Boris Yeltsin succeeded in winning a second term as president and quickly brought Anatoly Chubais, the central figure in the country's privatization program, back into the center of power in the Kremlin. Even in Moldova, privatization minister Ceslav Ciobanu partly attributes reconciliation between the government in Chisinau and the secessionist Transdniester region to the economic stability privatization has helped bring about.) But privatization is certainly not moving along the course expected by most reformers. The forces of the past have simply shown themselves to be much stronger and more resilient than anyone expected.

To damn privatization because it has been hijacked in part by the old nomenklatura would be foolish. There is no way East Europeans could have maintained their overgrown public sector or shrunk it without some unexpected side effects. But neither should the massive coup by the ex-communists be ignored, for [Page 54] as long as the nomenklatura remain powerful players on the region's business scene, their presence will have potentially serious consequences. Given a competent business organization, capital is now available throughout the postcommunist world, but the mere possession of capital is no guarantee that the requisite talent can be obtained and organized so that a firm will prosper. Privatized firms must rely, on the main, on external sources for this talent. Unlike capital, it is not something a firm can supply to itself.

The hopeful sign here is that, according to many observers, the ties that bind the nomenklatura are dissolving. The peak of its influence was the remarkable social contract made with the briefly dominant reformers in the heady early days of reform; if the nomenklatura permitted democratic and market reforms to proceed, the reformers would permit the nomenklatura to become rich. There are hints, however, that this Faustian bargain may be costly for the devil as well. Shortly after its consummation, privatization began to place uncontainable pressures on the nomenklatura as, first, the unity of the kleptoklatura and the old central bosses began to crumble and, then, the interests of those who managed to snap up genuinely viable businesses began to diverge from those who needed continuous state support. This shift has been disguised because, as was true under socialism, the position of the nomenklatura was thought to be immutable. That decision-making power should move outside the charmed circle of the nomenklatura seems unnatural to its members, and those within such firms who argue for such a dispersal seem to be in search of frivolous novelty. Yet for successful nomenklatura capitalists, the economic liberalization at the heart of privatization contains within it elements of great appeal. Here is where and when the logic of nomenklatura control begins to unravel. After all, why steal Gazprom if you cannot make billions from it!

Habits of the past will certainly continue, with many nomenklatura managers forming alliances of convenience with their former political soulmates. But the long-term hope for privatization, for growth, and for democracy must be this: a nomenklatura divided against itself cannot stand.