Institutional Traps and Transition

Two myths have harmed many economies throughout the world. One is the theory of absolute advantage of central planning over the market mechanism, and the other is the belief that efficient markets develop spontaneously and quickly enough if appropriate economic legislation is established. Volumes have been written to debunk the first myth. The falsity of the second needs to be better understood. The problem is that inside of any legislated change there exists a room for development of different institutions, or behavior norms, and it is not simple to predict which direction will be chosen by an economy. The hypothesis that efficient institutions must arise because of natural selection does not prove to be truthful. Inefficient development can be self-supporting and stable. The supporting mechanisms were systematically investigated by Arthur (1988) for technological changes. North (1990) pointed out that the same mechanisms plaid an important role in the evolution of institutions. A number of examples have been studied in different branches of economics. The most striking examples can be found in recent history of economic reforms in Russia and East European countries. This chapter uses the ideas by Arthur and North to describe a general scheme for the formation of inefficient yet stable norm or institutions, referred herein as institutional traps. The scheme is substantially based on the concepts of transaction costs, transformation costs, and transitional rent discussed below. Then the theory developed is applied to explain emergence in Russia of barter, mutual arrears, tax evasion, corruption, and some other institutional traps. Implications for reform strategy are explored. The analysis shows that the formation of institutional traps is a major risk in any reform process, and avoidance of these traps is an urgent task during transition.