A. Culture and economic performance

As early as 1976, James Buchanan wrote that mathematical techniques and econometrics were taking the discipline of economics in the wrong direction. “The principle that exposure to economics should convey,” he wrote, “is that of spontaneous coordination, which the market achieves. The central principle of economics is not the maximization of objective functions subject to constraints. Once we become methodologically trapped in the maximization paradigm, economics becomes applied mathematics or engineering.”¹⁰

Twenty-five years later, Enrico Colombatto argued that the process of institutional restructuring in C&EE is a cultural problem rather than merely a technical one.¹¹

There is no generally accepted definition of culture.¹²

Thus, the process of institutional restructuring is about the enactment of new formal rules. A new formal rule creates new choices for human interactions or modifies old ones. In either case, it changes the opportunity set within which the game is played. The effect of this new rule on economic performance must then depend on how individuals perceive and subjectively evaluate new trade-offs. And how individuals perceive new opportunities depends on the prevailing culture in the community. The prevailing culture thus plays a major role in determining the costs of integrating the new rule into the prevailing institutional structure. The relationship between new formal rules and the prevailing informal rules can be summarized in terms of what I will call the interaction thesis:

Of course, rules do not interact, people do. However, rules create incentives, which in conjunction with individuals' subjective perceptions of reality produce economic results.

B. Culture and transition in Central and Eastern Europe

Once we recognize that culture matters, the analysis of its effects on the transition to capitalism has to address two issues: (1) What are the most important formal institutions of capitalism, and what incentives do they generate? And (2) what kind of culture supports those incentives?

C. The prevailing culture in Central and Eastern Europe and the costs of transition

The prevailing culture in Central and Eastern Europe has a bias toward collectivism, egalitarianism, and shared values that predates communism. The community in C&EE tends to be seen as an organic whole in which individuals are expected to subordinate their private ends to the pursuit of common values (however defined). Predictably, the extended family has always played an important role in most C&EE countries.²⁰

The behavioral consequences of the nuclear family and the extended family illustrate major differences between the culture of individualism in the West and the culture of collectivism in C&EE. By encouraging the concept of a polity consisting of natural equals, the nuclear family in the West creates incentives for bonding among individuals across family lines. By emphasizing egalitarianism and collectivism, the extended family in C&EE raises the transaction costs of interactions between individuals belonging to different groups.

Professor Avner Greif of Stanford University provides an excellent comparison of the collectivist culture of the Maghribi community (a community of Arab traders) and the individualistic culture in Genoa from the eleventh to the thirteenth centuries.²¹

While egalitarianism and collectivism are important common traits in C&EE, the prevailing culture in the region is not homogeneous. The culture of collectivism and egalitarianism gets stronger the farther east and southeast one travels. For example, this is how a Bulgarian scholar, Antonina Zhelyazkova, describes the structure of contemporary families in Albania: “Family community [is] composed of three or four generations, with a high level of internal solidarity. Within the [family] there is a strict, clear-cut age hierarchy, where the father's … word is law…. [T]his is due to the age-old internal ethno-cultural mechanism, which … contributes to the preservation of their tradition.”²³

We can attribute the heterogeneity of informal rules in C&EE to the influence of three empires (Austro-Hungarian, Russian, and Ottoman), three religions (Roman Catholic, Orthodox, and Islam), and to the internal strength of ethnicity and/or nationalism. I turn now to a few examples that capture the essence of those influences.

The following quote from historian Perry Anderson suggests why the transaction costs of accepting the right of ownership have been relatively lower in C&EE countries that belonged to the Austro-Hungarian empire or had strong relations with the West: “The age in which ‘absolutist’ public authority was imposed was also simultaneously the age in which ‘absolute’ private property was progressively consolidated. It was this momentous social difference which separated the Bourbon, Habsburg, Tudor or Vasa monarchies from any Sultanate, or [the Russian Empire].”²⁴

Writing about informal rules in Russia and their implications, Silke Stahl, at the time a researcher at Max Planck Institute in Jena, argued that such rules are not supportive of the principles of behavior based on self-interest, self-responsibility, and self-determination. Especially important are Stahl's references to the sources of egalitarianism and collectivism in Russia: “In Russia [informal] institutions found their expression in egalitarianism and collectivism. Egalitarianism is the psychological disposition of a group of people who consider material equality as the essential base of social interaction. Collectivism … refers to a societal organizational pattern, which centers on the group and not the individual as the basic unit in society…. The reasons for egalitarianism and collectivism [in Russia] can be found in religious beliefs.”²⁵

The idea of the immorality of charging interest on loans and the absence of the concept of legal personality—still prevalent in many Islamic countries—have influenced the development of both formal and informal rules in the areas of C&EE that used to be controlled by the Ottoman empire.²⁶

Historically, communities in C&EE have responded to outside influences by creating strong informal rules developed along ethnic lines and/or around national myths (for example, the Kosovo myth in Serbia and the thousand-year dream of national independence in Croatia). As repositories of old unsettled scores, as well as of various national myths, informal rules strengthen mutual understanding within each ethnic group while simultaneously (and predictably) treating other groups as alien. The result is relatively higher transaction costs for social contacts across ethnic lines. In addition, religious differences among C&EE countries reinforce the alienation of one ethnic group from another. The Serbs in Croatia, the Albanians in Macedonia, the Turks in Bulgaria, the Hungarians in Slovakia (like the Basques in Spain and the Arabs in France) are just a few examples of alienated ethnic groups.

Analysis suggests that in the early 1990s, the prevailing culture in C&EE was not in tune with the behavioral incentives required for the successful functioning of the basic formal institutions of capitalism. This means that the conflict between the behavioral incentives of the institutions of capitalism and the prevailing culture in C&EE creates transaction costs specific to the process of transition. Transaction costs specific to transition can be categorized as subjective or objective. Giving up the predictability of other people's behavior, accepting the risks of nonroutine behaviors, and estrangement from friends and neighbors who are slower in abandoning old rules are examples of subjective costs arising from the conflict between the formal institutions of capitalism and the prevailing informal rules. Objective costs include sunk investments in the development of the prevailing informal rules, and the strength of the groups and coalitions that stand to gain from preserving the status quo (such as officials of the former Communist governments in C&EE).

A common response by most countries in C&EE to the conflict between their prevailing cultures and the institutions of capitalism was to enact “clarifying” laws and regulations. These included the reintroduction of price controls over some goods, restrictions on the flow of capital, and rules concerning laying off workers. The stated intent of these laws and regulations was to reduce the conflict arising between new formal institutions and the prevailing culture; however, the consequences of these laws, whether those consequences were intended or unintended, have been a slow return to the old system of dirigisme from above. Eventually, people ended up with a government-engineered compromise between capitalism and the old system, with the costs of transition being borne by all citizens regardless of whether they wanted institutional reforms, opposed them, or didn't care one way or the other. The legal theorist Cass Sunstein has noted the costs of these laws and regulations in C&EE. “Without strong constitutional provisions on behalf of property rights, civil society, and markets, there will probably be a substantial temptation to intrude on all these institutions, and, by so doing, recreate the very problems that such institutions are supposed to solve.”²⁸

D. Culture and the results of transition

Given that the prevailing culture in C&EE is not homogeneous, the transaction costs of transition differ from one country to another, and these differences in transaction costs translate into different transition results. Since the culture of individualism is a Western phenomenon, this analysis suggests that the results of institutional restructuring should correlate with the extent of Western influence in the various countries of C&EE. To test this hypothesis, we can divide C&EE countries into two groups: those that have had more cultural and political interactions with the West, and those that have had less or none.

The Czech Republic, Croatia, Hungary, Slovakia, and Slovenia used to be part of the Austro-Hungarian empire. The empire, which lasted several centuries and came to an end in 1918, was short on democracy but strong on the rule of law and the enforcement of property rights. It is reasonable to expect that the prevailing informal rules in those countries have retained memories of the rule of law and individual rights. Western culture entered Poland via the Catholic Church. In addition to playing a major role in the development of informal rules in that country, the Church also helped the Poles to preserve their customs and traditions during several periods of Russian aggression (including the post–World War II years). For centuries, the Baltic states maintained strong contacts with merchants from Germany, Sweden, and Finland. Christianity arrived in the Baltic states from the West. Estonia and Latvia have become predominantly Lutheran, while Lithuania is Roman Catholic. Through religious contacts and trade, Western culture contributed to customs and traditions in the Baltic states.

In the process of transition, the Baltic states, and especially Estonia and Latvia (which have Russian minorities amounting to about 30 percent of total population), had an important starting advantage over other C&EE countries. Since de-Communization did not happen in C&EE, Communists and fellow travelers, with their well-established “old boy” network, joined the new ruling elite and provided strong support to the forces that preferred to maintain collectivist values. However, most important political positions in the Baltic states under Communist rule were held or controlled by Russians. In the early 1990s, leading Russian Communists either fled back to Russia or lost jobs and influence because of their ethnic origin. Hence, the culture of collectivism in the Baltic states lost a major source of support.²⁹

After a brief rule (1682–1725) by Peter the Great, who appreciated the importance of Western culture, the Romanovs chose to isolate the middle and lower classes in Russia from the West. The Russian Orthodox Church played a major role in helping the ruling elite to preserve this cultural isolation of Russia (and the countries dominated by Russia, such as Belarus, Moldavia, and Ukraine) from the West. To say that Eastern Orthodox churches, including the Russian church, have historically shunned the culture of individualism is merely a factual observation, which does not imply a judgment about the worthiness of their religious beliefs and dogmas. As recently as the late 1990s, the Russian church lobbied the state to prohibit or at least restrict the spread of Western influence via Protestant and Catholic churches.

The Ottoman empire influenced the development of informal rules in the parts of the Balkans it controlled during most of the period from the fourteenth through the nineteenth centuries (Greece, Serbia, Bulgaria, Romania, Albania, Bosnia, and Montenegro). However, two factors limited Turkish influence on local cultures. First, the Turks did not interfere in civil disputes between Christians, which helped to preserve local customs. Second, Christians were obliged to wear distinctive clothing, which, while marking them as second-class citizens, reinforced their ethnic loyalties.

Contrary to many local myths, the Ottomans did not repress Christian religious services. In fact, until the second half of eighteenth century, Ottoman rule was quite tolerant. Professor Andre Gerolymatos, director of Hellenic Studies at Simon Fraser University, offers this description of Ottoman rule in the Balkans: “The Ottoman era in Southeastern Europe was marked by periods of not only great upheaval and hardship, but also benevolent administration and prosperity that enhanced the living standards of all Ottoman subjects…. [The fact that] the Ottomans did not embark on wholesale forcible conversions enabled the Balkan people to maintain their identities into the nineteenth century.”³⁰

While maritime trading helped the Greeks (and the small percentage of Montenegrins living along the Adriatic coast) to become aware of other cultures, Serbia, Macedonia, Romania, Bulgaria, Bosnia, and Montenegro had no permanent access to Western culture until the early nineteenth century. The Renaissance and the Reformation, new scientific discoveries, classical liberalism, and Adam Smith all had their effects long before those countries opened their borders to the West. Interactions with Serbs living in the Austro-Hungarian empire helped the people of Serbia, for example, to open their first important window to the West only in the late eighteenth century.

Table 1 divides C&EE countries into those that experienced greater and lesser influence from the West. The table then provides data from the Heritage Index of Economic Freedom in order to measure the results of institutional restructuring. Since institutional restructuring is a process rather than an event, the table shows the results of transition in two different years, 1996 and 2004.³¹

Economic freedom in Central and Eastern Europe and the effects of prior Western influence

Table 1 provides striking evidence in support of the interaction thesis, which states that the conflict between the incentive effects of the formal rules of capitalism and the prevailing culture of a given country creates transaction costs specific to the process of transition in that country. In 1996, the Heritage Index ranked only Estonia and Czech Republic as mostly free countries. All other countries were ranked as mostly unfree. The mean rating of the countries influenced by the West was 3.1, already close to the mostly free ranking. The mean rating of the countries not influenced by the West was 3.5.

In 2004, the Heritage Index ranked all countries influenced by the West, except Croatia, as free or mostly free, and all those not influenced by Western culture as mostly unfree or repressed.³²

The evidence in support of the interaction thesis has an important implication. By assuming that the road to capitalism is a technical problem, economic reforms based on neoclassical economics ignored the fact that capitalism is much more than an alternative method for the allocation of resources. It is a way of life. The effort to impose the transition to capitalism via the strong hand of the state had the effect of forcing upon ordinary people institutional changes that were alien to the fabric of community life in C&EE. This became more true the farther east and southeast one traveled. All that ordinary people got was the switch of one set of institutions for another set, neither of which they chose for themselves.

This failure of neoclassical economics to recognize the importance of cultural values has been observed by the economist Douglass North: “Many Latin American countries adopted the U.S. Constitution (with some modifications) in the nineteenth century, and many of the property rights laws of successful Western countries have been adopted by Third World countries. The results, however, are not similar to those in either the United States or other successful Western countries. Although the rules are the same, the enforcement mechanism, the way enforcement occurs, the norms of behavior, and the subjective models of the actors are not [the same].”³³

A. Framework for analysis

An alternative method of transition is to identify and enact formal rules that would encourage voluntary changes of informal institutions in Central and Eastern Europe. The three critical factors that would encourage the process of spontaneous changes in informal rules and reenergize the process of transition from within the system are the market for institutions, the carriers of institutional restructuring, and the margin of acceptable behavior. I will discuss each of these in turn.

B. Changes in informal rules and transition

A spontaneous change in the prevailing culture means a change in the margin of acceptable behavior. And to change the margin of acceptable behavior requires an individual willing and able to take the risk of overcoming the objective and subjective costs of carrying out a submarginal activity. Human history is full of successful and unsuccessful attempts by pathfinders to change the margin of acceptable behavior. Successful cultural changes at the margin range from the social acceptance of interracial marriages, single motherhood, and cohabitation arrangements in the West, to allowing young people to choose their own partners in marriage in many developing countries, to truly major changes like the birth of Christianity. However, the basic mechanism of change is pretty much the same.⁴⁰

Suppose that a new idea or opportunity for human interactions were to become available to a community from without or be discovered from within. In either case, the agent of change would be the pathfinder who perceives prospects for personal gain from exploiting such new opportunities. If the new opportunities for human interactions were not in tune with the prevailing culture in the community, a conflict would arise between the pathfinder trying to exploit those opportunities and the community at large. That is, the behavior of the pathfinder would be below the margin of acceptable behavior. In practice, such conflicts have surfaced in many different forms in Central and Eastern Europe. People have said that individuals seeking new contractual arrangements are foreigners “who want to take our money abroad,” or women “who should be staying at home,” or enterprising men “who want to profit at other people's expense,” or Baptist missionaries “who want to destroy our Orthodox faith.”

While the costs of changes in formal rules imposed from above are borne by taxpayers, including those who either oppose or do not care about reforms, the pathfinder bears the costs of innovation.⁴¹

If my analysis is correct, then spontaneous changes in informal rules have four important social consequences:

James Buchanan has contrasted this method of institutional restructuring with alternatives that rely on the strong hand of the state:

Detailed analysis of the factors through which the free market for institutions affects the prevailing informal rules in C&EE, and the circumstances upon which those factors depend, is beyond the scope of this essay. However, it might be useful to point out briefly the effects of two important factors, entrepreneurship and the corporate firm, on cultural change.