The Problem

The answer given to a question depends, of course, to a large extent on how the question itself has been phrased. In this study, and the book on which it is based, I am far more concerned to persuade readers I have formulated the question correctly than to gain assent to the answers I give. I regard argument about the answers as inevitable, but let there at least be agreement about the questions.

Scarcity – in which human wants outstrip the ability to satisfy them with the resources available – is the central subject of examinations in economics. Nowhere, at present, does the general problem of scarcity appear more acutely – one might say more brutally and mercilessly – than in the health sector. Human knowledge, science, and technology offer many more opportunities for avoiding and curing disease, relieving suffering, and prolonging life than the health sector can apply in practice. That is the fundamental problem of health care. There are patients who might be treated, as far as human knowledge is concerned, yet they are not treated, or not treated enough. This applies even to the richest countries, and, within them, not just to the poorest members of society, but to richer people as well. Not even there is the provision taken to the limit where the marginal health-enhancing effect of an increment in health-care expenditure would become zero; they stop far short of that. The same holds true a fortiori for a country at a medium level of development, such as Hungary.

When reforming their own countries, several observers, ideologues, and politicians in former socialist countries have pointed to Sweden as a blueprint. It is believed that Sweden, or the “Swedish model,” has combined the efficiency, dynamism, and flexibility of capitalist market economies with the economic security and egalitarianism so highly valued by many social liberals and socialists. So, an analysis of the Swedish experience, and its relevance to former socialist countries, may be of some general interest.

When addressing this issue, it is important to realize that basic features of the economic and social system in Sweden have changed considerably over time.Though attempts to divide history into periods are hazardous, in this chapter I will partition modern economic and social history in Sweden into three periods.The first, the century from about 1870 to 1970, may be called “the period of decentralization and small government.” During this period, the economic system in Sweden did not differ much from the ones in other countries in Western Europe, although Sweden was probably one of the least regulated economies in this part of the world. The second period, from 1970 to 1985–90, may be characterized as a “period of centralization and large government.” In this time span, Sweden acquired idiosyncratic features, though still within the framework of a capitalist market economy.

During the 1990s, inflation and balance-of-payments crises in developing and transition economies created strong pressures for fiscal reform. In the early reform period, the policy debate centered on how rapidly to undertake fiscal adjustments; subsequent political economy analysis focused on the conditions under which governments were more or less likely to succeed in these efforts. However, a parallel debate typically ensued over the institutions and procedures of the budget process itself. How could these institutions be designed to effectively coordinate demands on government resources and bring them into line with overall macroeconomic objectives? In this study, we examine the politics of fiscal policy in Hungary since 1990, looking both at policy and at the design of policy-making institutions. Throughout, we seek to place Hungary's experience in the broader comparative perspective of other Central European and middle-income developing countries.

Effective fiscal policy making requires that governments respond quickly to crises with an appropriate – typically contested – combination of expenditure reductions and tax increases and that they reconcile competing demands on government resources with adequate revenues over the long run. We expect that the capacity of governments to perform these tasks will be related both to general features of the political system but also to the specific institutions and procedures surrounding the budget process.

Fiscal-policy-making institutions vary in terms of the degree to which they centralize control over the planning, approval, and implementation of the budget.

By mediating the impact of macroeconomic stabilization and fiscal adjustment on the everyday life of the population, labor markets play an important role in determining the success of the transition to the market. After seven years of transition, however, the Russian labor market still seems to be performing quite differently from the labor markets in other transition countries. Hungary and Poland faced sharp declines in employment early in the transition. Unemployment rates there remain quite high even now, after several subsequent years of economic growth. The Czech Republic has little unemployment, but this must be set against slow economic restructuring and continuing government support to ailing enterprises.

In Russia, a large increase in unemployment had been widely expected even before the reform started. Nevertheless, open unemployment remained rather low until 1995, despite a 50 percent decline in production. In Russia, the standard trade-off between employment and wages was transformed into one between unemployment and underpayment with wage arrears. In 1996–98 wage arrears or significant delays in wage payments became one of the salient features of Russian economic and political development. They contributed heavily to rapidly growing public debt, thus eroding fiscal policy and generating even more political and economic uncertainty. To this extent, they became one of the determinants of the 1998 financial crisis.

Why does the “Russian way” of labor-market adjustment (as it was described first by Layard and Richter 1994) deviate so much from that in most of the other reforming countries? There is a number of interdependent reasons.

The program for pension system reform launched at the beginning of 1997 in Poland was called by its authors “Security through Diversity” (Security 1997). This title emphasizes that pension reform – which is designed to ensure security for the insured – must combine a pay-as-yougo (PAYG) pillar, a second, fully funded pillar, and a third, voluntary component. The program was prepared in the second half of 1996 by a team of experts appointed by Andrzej Baczkowski, who at that time was minister of labor and social policy and also the government plenipotentiary for social security reform. In the course of ten months or so, the government prepared and passed through the Parliament a legislative package consisting of three Acts, which laid the foundations of the new pension system:

1. The Law of August 28, 1997, on the Organization and Operation of Pension Funds.

2. The Law of August 22, 1997, on Employee Pension Programs.

3. The Law of June 25, 1997, on Applying the Revenues from Privatization of a Portion of State Treasury Assets for Purposes Connected with Reforming the Social Insurance System.

This package specified how revenue from privatization would be used to bridge the financial gap that had appeared, and will continue to widen, in the present PAYG pension system. In addition, it initiated reform of this system and launched a second (mandatory) and developed a third (voluntary) funded pillar of pension insurance. It also fully regulated the organization and operation of second-pillar pension funds.

When the formerly Communist countries of Eastern Europe began their transformation into market-oriented economies, reforms in social programs and services were minor parts of the adjustment agenda. Government and public attention focused mainly on other issues: macroeconomic stabilization, the opening of the economy, privatization of enterprises.

Half a dozen years into their economic transformations, however, those countries which had reasonably effectively addressed many of the initial economic challenges of adjustment began to focus attention much more squarely on pension and health-sector reforms. Hungary adopted radical changes in its pension system in mid-1997. Poland designed a similar set of reforms in two packages, one passed before the elections and change of government in autumn 1997, and the second approved in autumn 1998. Latvia had adopted partial pension reforms somewhat earlier and is now expanding its reforms, while similar measures are moving ahead in Croatia, Estonia, Macedonia, Romania, and Slovenia.

A great deal of analysis has focused on the substance of these reforms and the merits and drawbacks of specific design components. However, the context, the goals, and the character of these reforms combine to pose formidable political challenges. This chapter focuses not on design but on the politics of social-sector reforms.

Social-sector reforms are usually ‘second (or third) generation” reforms in the broad structural adjustment agenda. They are likely to unfold in a quite different political climate than initial macroeconomic measures.

Before explaining why resource booms lead to the breakdown of institutions, it is important to define my terms and map out the domain of the problem. This chapter describes some basic facts about states that rely heavily on the export of natural resources: it explains what commodity booms are, and how they can create rents; it describes the types of institutions that developing states use to manage their commodity sectors, and to cope with export booms; and it reviews earlier research on the performance of these institutions.

The chapter has three central points: many developing states face periodic booms in their natural resource exports; many of these states have institutions that include features designed to help manage these booms; and despite these institutions, states respond poorly to resource booms.

It may be helpful to mention some of the claims this chapter does not make. It does not claim that all developing states undergo natural resource booms. It does not claim that all booms are followed by institutional collapses. It does not suggest that resource booms are the only source, or even the principal source of failure in these institutions. Finally, it does not try to prove that resource booms cause institutional breakdowns: that is the task of the case studies in Chapters 4 through 7. This chapter lays out the scope of the problem. The rest of the book examines its source.

INSTITUTIONS: INTRODUCTION

Institutions are normative social rules, that is, the rules of the game in a society, enforced either through law or through other mechanisms of social control that shape human interaction.

Institutions as normative patterns of behavior serve to (partially) solve the problem of cooperation in a society by providing a more or less permanent platform of conflict resolution. They define the rules of the socioeconomic game, that is, the strategies that individuals are allowed to employ in order to follow and solve their problems. The existence of social institutions provides the first step toward overcoming the Hobbesian problem of social order, the second being the cooperation of individuals via exchange within institutional framework.

In both the economic and sociological literatures, the term “institution” is often used to designate organizations of every kind. To avoid confusion, it is useful to distinguish sharply between institutions constituting the rules of the game and organizations as corporate actors, that is, as groups of individuals bound by some rules designed to achieve a common objective (or to solve a common problem). Organizations as “corporate actors,” as Coleman (1990a) calls them, are collective units characterized by a set of procedural rules that define the coordination of the individual members who have pooled their resources for a joint purpose.

This book grew out of my dissertation, which in turn reflected my concern about tropical deforestation in Southeast Asia. In 1994 I visited the region's leading timber-exporting states – the Philippines, Indonesia, and Malaysia – to learn more about their forests and forestry policies. Unlike some observers, I believed that these governments were wise to authorize logging on at least a limited scale, and to convert a portion of their forests into agricultural land. The United States had done much the same thing in an earlier era, using its abundant forests to spur development; why should not developing states today make a similar choice?

I was initially impressed by the forest policies of these three states – or, rather, four states, since in Malaysia forest policies are made at the state level, and most of Malaysia's timber came from the autonomous states of Sabah and Sarawak on the island of Borneo. I was also struck by the dedication of many of their foresters. Yet I gradually realized that the policies of their forestry departments were systematically ignored by politicians, particularly when it came to distributing timber concessions. As a result, these governments had at times authorized logging at rates far above the sustained-yield level, even in forests that were ostensibly set aside for “sustainable” forestry.

This book offers what may with reservations be described as a theory of how the institutional framework of a society emerges and how the exchange processes within this framework take place. We already possess a wealth of theoretical knowledge concerning the emergence and functioning of social institutions, as well as numerous fully developed theories explaining how markets work. The main purpose of this book is to show that both social institutions, defined as the rules of the game, and exchange processes can be analyzed in terms of a common theoretical structure. We propose that a problem-solving model of individual behavior inspired by evolutionary epistemology and cognitive psychology may provide such a unifying theoretical structure. A problem-solving model based on solid experimental findings from the cognitive sciences provides a synthesis of the two basic models currently employed in the social sciences: those of Homo oeconomicus and Homo sociologicus. This model, in turn, is the key to incorporating issues relating to institutions and institutional change and issues relating to the functioning of the markets in a genuine political economy.

Such a political economy can be understood as a transformation of neoclassical economic theory into a discipline that seriously considers the issue of institutions. In fact, the thrust of our argument is that any serious student of economic phenomena must pay attention to the institutions framing these phenomena.

THE NEW INSTITUTIONALISM AND THE GERMAN ORDNUNGSTHEORIE

Our analytical focus in this and the following chapter will be on how the institutions, formal and informal, affect the market processes. Which role do institutions play when individuals pursue their problem-solving activities in the market? In this chapter, our primary purpose will be to show on an aggregate level that institutions can be best understood as the rules of the market game that channel the market process in a certain direction. In the next chapter, this contention will be underpinned by providing an individualistic basis of this phenomenon by employing the theory presented in Part I of the study.

Before proceeding to our main issue, a question should be mentioned that we will not address further, though it is very important. We have defined institutions as normative social rules, that is, as the rules of the game in a society, enforced either through law or by other mechanisms of social control that shape human interaction (Section 6.1). The notion of “human interaction” involves normally two aspects: (a) a process of voluntary exchange between individuals or (b) the voluntary pooling of resources by individuals for a common use. These two kinds of human interaction are commonly called “market” and “organization.”

CONVENTIONS

We have distinguished between three types of informal institutions according to the enforcement agency: conventions, moral rules, and social norms. Conventions are those social rules that are to a large degree selfpolicing in the sense that, after their emergence, no individual has an incentive to switch from the rule that everyone else is following. For a systematic discussion of conventions, we shall pose the four questions formulated in the previous chapter and we shall attempt to answer them.

1. Why Do Conventions Exist? Social conventions are solutions to social problems that are stylized in game theory as coordination games. The simplest case of a coordination game (two players, two alternatives) is presented in Fig. 5. Two Nash equilibria exist in the game, with either coordinated solution being an equilibrium. In the coordinated cases, no individual can improve his situation by deviating from playing his part in the equilibrium, given that the other individuals play their parts in the equilibrium. This means that if all individuals expect the others to play their parts in the Nash equilibrium, they are all better off when they play their parts in it.

The exemplification of the coordination game makes it clear that coordination problems are interaction situations of interdependent problem solving on the part of the individuals involved.