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American Economic AssociationThe Invisible Hand and the Grabbing HandAuthor(s): Timothy Frye and Andrei ShleiferSource: The American Economic Review, Vol. 87, No. 2, Papers and Proceedings of theHundred and Fourth Annual Meeting of the American Economic Association (May, 1997), pp.354-358Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/2950945Accessed: 18/12/2009 09:14Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available rms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unlessyou have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and youmay use content in the JSTOR archive only for your personal, non-commercial use.Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained herCode aea.Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printedpage of such transmission.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact support@jstor.org.American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to TheAmerican Economic Review.http://www.jstor.org

The InvisibleHand and the GrabbingHandBy TIMOTHY FRYE AND ANDREI SHLEIFER*environment is a good deal friendlier to business in Warsaw than in Moscow.In the 1990's, several East European economies went through radical liberalization.Among them, Russia and Poland adoptedsimilar packages of reforms, including almostcomplete price and trade liberalization,macroeconomic stabilization (which Polandaccomplished five years before Russia), largescale privatization (which Russia did fouryears before Poland), and small-scale privatization. While Poland startedtwo years earlier,both reform packages were radical.Despite the similarity of reform packages,the Polish economy responded much better tothe treatment.By the mid-1990's, it was growing rapidly, while the Russian economy at beststopped shrinking. The formation and growthof small businesses was also more dramaticinPoland. According to the European Bank forReconstruction and Development (EBRD,1996), in 1995 Poland had about 2 millionsmall private businesses, whereas Russia hadonly 1 million with a population almost fourtimes larger. Even if we allow, as the EBRDdoes, that Russia had another2 million unregistered private businesses, small-business formation is still more lethargic in Russia.Why, despite similar reform packages, hasthe Russian entrepreneurial response beenweaker? Using a pilot survey of shop managers conducted in Moscow and in Warsaw inthe spring of 1996, we argue that a key reasonfor this outcome is there are very different relationships between government and businessin the two countries. In the survey, we askquestions about the legal and regulatory environment in both cities. We find that the regulatory, and to some extent the legal,I. Governmentin TransitionThere are three basic views of how bureaucrats and entrepreneursinteract during transition, as well as more generally. Under theinvisible-hand model, the government is wellorganized, generally uncorrupt,and relativelybenevolent. It restrictsitself to providing basicpublic goods, such as contract enforcement,law and order, and some regulations, and itleaves most allocative decisions to the privatesector. Many countries in eastern Europe, particularly those hoping to join the EuropeanCommunity (Jeffrey Sachs, 1994), havelooked to this model in their reforms.In the two alternative models, governmentplays a larger role. Under the helping-handmodel, commonly invoked in discussions ofChina (Andrew Walder, 1995), bureaucratsare intimately involved in promoting privateeconomic activity: they support some firmsand kill off others, pursue industrial policy,and often have close economic and family tiesto entrepreneurs.The legal frameworkplays alimited role in this model, because bureaucratsadjudicatemost disputes. Bureaucratsare corrupt, but corruption is relatively limited andorganized. An extreme version of this model,the iron-hand model, is found in SoutheastAsian countries like Korea and Singapore. Intransition economies, however, the helpinghand model has been less prevalent.In the final, grabbing-hand, model, government is just as interventionist, but much lessorganized, than in the helping-hand model.The government consists of a large numberofsubstantially independent bureaucrats pursuing their own agendas, including taking bribes(see Shleifer and Robert Vishny, 1993).While these bureaucrats adopt the helpinghand rhetoric (Shleifer, 1996), in reality theyare scarcely guided by a unified public-policystance, and they remain largely independentof* Frye:Departmentof Political Science, Ohio State University, and Columbia University, New York, NY 10027;Shleifer: Department of Economics, Harvard University,Cambridge,MA 02138. We are gratefulto Ed Glaeser andJim Hines for helpful comments, and to the HarvardInstitute for InternationalDevelopment for financial supportofthis research.354

TABLE 1-ECONOMIC ROLEOFTHE STATEDURING ntGovernment isnot above lawand uses powerto supplyminimal publicgoods. Courtsenforcecontracts.Government isHelpingabove law buthanduses power tohelp business.State officialsenforcecontracts.Grabbing- Government isabove law andhanduses power toextract rents.The legalsystem does notwork. Mafiareplaces stateas enforcer.Invisiblehand355THE TRANSITIONFROM SOCIALISMVOL.87 NO. 2Government followsrules. Regulation isminimal. Littlecorruption.Governmentaggressivelyregulates to promotesome s.Disorganizedcorruption.courts, capable of imposing their will in commercial disputes, and empowered to impose onbusiness a variety of predatoryregulations. Inthe extreme cases, the government becomessufficiently disorganized that it loses its abilityto ensure law and order and to provide basiclegal protections. As a consequence, contractsbecome privately enforced.These three models of government are"ideal types," and all real governments aremixtures of the three. Our questions try to assess how close local governments in Moscowand Warsaw are to these "ideal types" by focusing on the legal and regulatory environment. Table 1 summarizes the predictions ofthe three models of government that weexamine.II. The SurveyIn March and April 1996, we surveyed 105small shops: 55 in Moscow and 50 in Warsaw.We chose Moscow and Warsaw for two reasons. First, both Poland and Russia pursuedradical economic reforms. Second, privatebusiness in both countries is growing especially fast in the capitals, which also makes thecomparison appropriate.The shops were selected randomly fromsmall-business directories (Business KartaMoskvi and PanoramaFirmi) that include several thousand entries. The survey includes amix of private and privatizedretail shops, eachwith a staff of 5-50 employees. Most (62percent) are food shops, but we also includebarber shops, book stores, dry-cleaning establishments, and small departmentstores. Onaverage, Moscow shops employ more workersthan Warsaw shops (23.4 vs. 14.8, t 3.33),which may be due to policies promoting verysmall businesses pursued by the Polish government. On average, Warsaw shops havebeen in operation for almost 4.5 years, andMoscow shops for 3.3 years (t -4.25). Thisis consistent with Poland startingits transitionalmost two years before Russia. On average,Moscow shop managers are slightly older (44vs. 42 years old, t 1.18 ), have slightly moreexperience working in retail (16 vs. 14 years,t 0.98), but slightly less experience as managers (8.7 vs. 10.5 years, t -1.02) than theircounterparts in Warsaw. Overall, we havebroadly similar samples of shops in the twocities.III. ResultsOur questions on the legal environment address two issues: the effectiveness of court systems in dispute resolution and the role ofprotection rackets. Under the invisible-handmodel, courts are effective in resolving disputes between private parties as well as between them and the government, and there isno room for protection rackets. Under thehelping-hand model, courts play a smallerrole, especially in disputes with the government, but the government is powerful enoughto displace the rackets. Under the grabbinghand model, government is ineffective in providing basic services, courts are ineffective inresolving disputes, and in the extreme, agreements are enforced privately. The questions inTable 2 look at these alternativepredictions.In both countries, courts are rarely used.Only 19 percent of shop managersin Moscow

356AEA PAPERS AND PROCEEDINGSand 14 percent in Warsaw reportedusing themin the previous two years (t 0.66). This maysimply reflect the high costs of using courts inboth countries. However, when asked whetherthey needed to use the courts but did not, 45percent of Moscow managers answered yes,whereas in Warsaw, only 10 percent did (t 4.32). Either Moscow shop managers haveless faith in their courts, or they face more disputes that potentially require court intervention than do their counterpartsin Warsaw.When asked whetherthey "could use courtsto defend their rights if the governmentgrosslyviolated their property rights," 50 percent ofMoscow respondents, and 41 percent of Warsaw respondents, answered yes (t 0.86).Evidently, businesspeople in both countrieshave significant skepticism about the independence and effectiveness of courts in disputeswith the government. On the other hand, when"the government" is replaced with "a business partner" in this question, 65 percent ofthe Moscow respondents, and only 38 percentof the Warsaw respondents, answer yes (t 1.97). One interpretationof this finding is notthe greater credibility of the Russian courts,but the greater availability of alternativemeans of dispute resolution in Warsaw. Finally, we find that 57 percent of the Moscowshops have hired legal counsel, compared toonly 36 percent of Warsaw shops (t 2.2).This may reflect greater interest in litigation,but more likely, lawyers are needed in Russiato deal with bureaucrats. Overall, we find agood deal of skepticism about the legal systemin both countries.We also ask about private ratherthan publicprotection. In Russia, shopowners often payprivate security agencies to protect them fromcrime and to help resolve disputes. This institution is known as "a roof" in Russia, and"an umbrella" in Poland. We asked the respondents whether it is true that one cannotoperate a store in their city without a roof (anumbrella). In Moscow, 76 percent answeredyes, whereas in Poland only 6 percent did(t 10.10). A related question is whether ashop managerhas been contactedby the racketin the last six months. In Moscow, 39 percentof the respondents answered yes, whereas inWarsaw only 8 percent did. These data makeclear that private enforcementof law and orderMAY 1997TABLE 2-LEGALQuestionUsed courts in thelast 2 years?Needed to usecourts, but didnot?Can use courtsagainstgovernment?Can use courtsagainstbusinesspartner?Contacted byracket in thelast sixmonths?Does one needroof/umbrellato operate?ENVIRONMENTWarsaw (n)Moscow (n)t0.14 (50)0.19 (53)0.660.10 (50)0.45 (53)4.320.41 (46)0.50 (52)0.860.45 (38)0.65 (52)1.970.08 (50)0.39 (54)3.910.06 (50)0.76 (54)10.10Notes: The table presents the fraction of affirmative responses to questions in Moscow and Warsaw and the t testof differences in responses.plays a greater role in Russia than in Poland.Since the respondentsin both cities are equallyskeptical about courts, the likely reason for thehigher incidence of protection rackets in Russia is the greater failure of simple police protection (order as opposed to law) in Russia.The next set of questions deals with theregulatory environment, and the closely related problem of corruption (Table 3). Webegin with a naive question about the helpinghand model. We ask, "Does the local government hinder, have no influence on, or helpsmall business?" The answer is basically thesame in the two cities: it has no influence. Atleast in their stance toward small business,both countries are very different from the EastAsian model.We then ask several regulatory questions.When asked how long it took to register theirbusiness, Moscow respondentsreportedan average of 2.7 months, compared to 0.7 monthsin Warsaw (t 5.02). When asked how manyinspections they had last year, Moscow managers reported an average of 18.56, and Warsaw managers 8.99 (t 3.46). Moscow shopmanagers are also more likely to be fined byinspectors than their counterpartsin Warsaw:

TABLE 3-REGULATORYENVIRONMENTWarsaw (n)Moscow (n)tHinders:5No influence: 41Helps: 4(50)Hinders: 8No influence: 39Helps: 6(53)-0.19Time to registerbusiness(months)?0.72 (47)2.71 (51)5.02Inspections lastyear?9.0 (49)18.56 (55)3.46Percentage ofshops finedby inspectorslast year?46 (49)83 (52)2.72Number ofdifferentagenciesconductinginspections?2.65 (49)3.58 (55)1.84How legallyvulnerabledo you feelon scale of I 10?3.6 (50)5.1 (55)3.91How often doesone need tobribeofficials onscale of I 5?2.21 (47)2.9 (53)2.52QuestionLocalgovernmenthelps smallbusiness?357THE TRANSITIONFROM SOCIALISMVOL. 87 NO. 2Notes: The tablepresentsresponsesto questionsaboutgovement regulationandcorruptionand resultsof t tests of the differencebetweenWarsawand Moscow.83 percent reported having paid fines compared to 46 percent in Warsaw (t 2.72).Fines are likely to be a good measure ofregulatory burden, as well as a proxy forcorruption.One measure of the severity of the regulatory burden is how concerned the shop managers are about being in violation of someregulations. To get at this issue, we ask shopmanagers how "legally vulnerable" they feel,on a scale from 1 to 10. The mean answer inWarsaw was 3.6, compared to 5.1 in Moscow(t 3.9), consistent with the greaterregulatory burdenin Russia. Anothermeasureof regulatory burden is corruption, since a standardway to get aroundthe difficult regulations, requirements,delays, and fines is to pay a bribe.We ask our respondents somewhat discretely:how often does one need to bribe officials todo business in your city, on a scale from 1 to5, ( 1, almost never; 2, rarely;3, sometimes; 4,often; 5, almost always). The mean responsein Warsaw was 2.2, compared to 2.9 in Moscow (t 2.52). We also explore the structureof corruption by asking how many differentkinds of inspectors visited the shop. On average, 3.58 different agencies conducted inspections of Moscow shops, compared to 2.65 inWarsaw (t 1.84). If we accept the Shleiferand Vishny (1993) view that the amount ofbribes increases with the number of independent bribe-takers,this evidence points furtherto the greater burden of corruption and regulation in Moscow than in Warsaw.In sum, our evidence indicates that shopowners in neithercountry are particularlykeenon using courts, though the Russian respondents have a greater need for them. On theother hand, private protection is used muchmore extensively in Russia than in Poland.Regulations in Russia appearto be a good dealmore oppressive to business than they are inPoland. This is reflected in some measures ofregulation, in the greater legal vulnerabilitythat Russian respondents feel, and in thegreaterburden of corruptionin Moscow.The more predatory stance of Moscow'sgovernment toward business is consistent withthe greaterdynamism of such business in Warsaw. One further finding corroborates thisview. When asked to rate the problem of product market competition on a scale from 1 to10, Moscow shop managers' average answerwas 4.8, compared to 6.2 in Warsaw (t 2.3).Evidently, the Polish shopkeepers have theirrents extracted by competitors, while the Russians have rents extracted by bureaucrats.IV. ConclusionWe have presentedsome evidence fromMoscow and Warsaw shops on their dealings withlegal and regulatoryinstitutions.While neithergovernment is an "ideal type," the evidencepoints to the relatively greaterrelevance of theinvisible-handmodel to describePoland,and ofthe grabbing-handmodel to describe Russia.The ows that Polish local governmentsare more supportiveof business. This evidenceis consistent with the greaterenergy shown bysmall business in Poland than in Russia despitesimilareconomic reforms.This conclusion suggests that, to understandtransition experiences, it is not enough toknow how much of a standardmenu of radical

358AEA PAPERS AND PROCEEDINGSreforms a country adopts. The regulatorystance that national and local governmentstake toward business can perhaps explain asmuch as the package of reforms. This conclusion also raises a broader question: why dodifferent governments follow such differentmodels? We defer a discussion of this questionto future work.REFERENCESEBRD. Transition report 1995. London: European Bank for Reconstructionand Development, 1996.MAY 1997Sachs, Jeffrey. Poland's jump to a marketeconomy. Cambridge, MA: MIT Press,1994.Shleifer, Andrei. "Origins of Bad Policies:Control, Corruption, and Confusion." Rivista di Politica Econmica, June 1996,86(6), pp. 103-24.Shleifer,Andrei and Vishny, Robert. "Corruption." Quarterly Journal of Economics,August 1993, 108(3), pp. 599-617.Walder,Andrew."China's Transitional Economy: Interpretingits Significance." ChinaQuarterly, December 1995, (144), pp.963-79.

American Economic Association The Invisible Hand and the Grabbing Hand Author(s): Timothy Frye and Andrei Shleifer Source: The American Economic Review, Vol. 87, No. 2, Papers and Proceedings of the Hundred and Fourth Annual Meeting of the American Economic Association (May, 1997), pp. 354-358 Published by: American Economic Association

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