Privatization in Eastern Germany

A Neo-Institutional Analysis

Herbert Brücker

• Publisher: Routledge
• Year: 2005
• ISBN:
  9781135777432
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This text gives an analysis of privatization and restructuring by the Treuhandanstalt in East Germany. It also addresses the theoretical and conceptual problems of large-scale privatization in the transformation process.

1
Introduction

At the turn of the year from 1994 to 1995 the Treuhandanstalt was dissolved. It had, all in all, completed its task of privatizing Eastern Germany’s stock of enterprises. Eastern Germany is thus one of the first transforming economies of Central and Eastern Europe to have completed the process of privatizing the core stocks of the state-owned industrial sector. Privatization was in Eastern Germany—as it is in the other transition countries—part of a sweeping transformation program aimed at decentralizing economic decision-making and denationalizing broad segments of economy and society. A privatization process so broad in scope, one extending not only to individual enterprises and sectors but to the core areas of the economy as well, is historically unprecedented. In view of the dramatic cutbacks in production capacities and employment in Treuhandanstalt and former Treuhandanstalt enterprises, the agency’s privatization strategy continues to be controversial: the pace of privatization, the choice of privatization procedures, and the decision to refrain largely from investing in rehabilitation measures are, even today, the topic of a controversial discussion.

The focal point of the present study is an investigation of the comparative advantages of various privatization strategies and procedures. Instead of restricting itself to an analysis of the procedures practiced in Eastern Germany, the study also deals in general terms with the theory of the privatization and transformation of planned economies. It is for this reason that the study makes reference not only to the privatization strategy familiar from Eastern Germany but also includes the privatization procedures practiced and discussed in other countries in the process of transformation. Any generalization of findings obtained in a study of the privatization process in Eastern Germany must of course reflect the particular initial conditions defined by the German economic and monetary union and the unification of the two German states. While it is true that the transformation of the institutional systems in the other countries in transition likewise led both to an inflow of international capital and drops in production and employment, the scope of the influx of public and private capital was nevertheless much lower in these countries. These differences must be noted in the choice of pri-vatization strategies. On the other hand, a study of the privatization process in Eastern Germany offers the chance to observe the problems and the results of a process largely completed, one, it is true, whose pace will differ but which will, in many respects, run in similar channels.

The starting point of the study is the hypothesis that the choice of a privatization strategy has a lasting impact on both the efficiency of the enterprises concerned and the distribution of income and individual life-chances in the economies affected. The assumption that the structure and distribution of property rights constitute a central factor explaining the behavior of economic agents is by no means uncontested. For the classics of political economy from Adam Smith to Karl Marx, the structure of ownership relations was still the focal point of economic theory. But one implication of the transition to Walrasian microeconomics was that it sapped the ownership question of some of its significance as a theoretical category. It was the representatives of the Austrian School, above all Friedrich von Hayek, Ludwig von Mises, and Joseph Schumpeter, who again and again stressed the eminent significance of private ownership for the functioning of market economies. Only when the New Institutional Economics began to develop its diverse approaches did the question of ownership experience a theoretical renaissance. It has been property-rights, transaction-cost, and principle-agent theories that have subjected the incentive and sanction structure of ownership rights to an in-depth analysis. In many areas the theoretical findings and models of the New Institutional Economics share common ground with the empirically based analyses of reform economists in the transition countries. In attributing the problems faced by market-socialist reform programs to the specific incentive and sanction structure of the state business sector, these economists crossed the Rubicon separating reform and the transformation of an economic system.

In analyzing different privatization procedures and strategies, this study draws upon the framework provided by the New Institutional Economics. Not unlike transaction-cost and property-rights theories, the study is grounded on the assumption of bounded rationality. Individual ratio-nality is not only bounded, it is also unevenly distributed. If the traditional assumption of perfect rationality on the part of economic agents is abandoned, the issue of the efficiency of the allocation of property rights through privatization is no longer trivial: the highest bidder must no longer necessarily have the most productive use for a firm. The efficiency of privatization depends on how the two scarce factors of capital and economic competence are allocated.

Not all of the sections of this study are based on the realistic assumption of bounded rationality. In a discussion of the problem of restricted bidder competition (Chapter 3.4), the principal-agent problems involved in the granting of rehabilitation subsidies (Chapter 7), and the question of rehabilitation by the Treuhandanstalt (Chapter 8) are, in keeping with the formal apparatus involved, based on the more restrictive assumption of perfect rationality. Since both cases entail an analysis of the problem of imperfect and asymmetrically distributed information, the conclusions are, in my opinion, not impaired fundamentally by the unrealistic assumptions of rationality.

The study’s line of argument is developed in three steps. The investigation starts out by inquiring into the theoretical grounds on which the privatization of the state economic sector in the transition countries is based. Two aspects are distinguished in dealing with this question. The first is addressed in a discussion of whether private ownership constitutes a necessary condition for the coherence of a market economy. The second involves an examination of the theoretical arguments that speak in favor of the assumption that the structure of ownership relations has an influence on the efficiency of enterprises (Chapter 2).

The allocative and efficiency effects of different privatization procedures are analyzed in the second step. Proceeding from the hypothesis that privatization gives rise to nontrivial transaction costs, the allocative effects of the most important privatization procedures are subjected to a comparative analysis (Chapter 3). Privatization not only influences the efficiency of an economic system, it also affects the distribution of social wealth and individual life-chances. Privatization is therefore, in all of the countries in transition, the focal point of a political debate as fierce as it is controversial. Based on the normative criteria of John Rawls’ theory of justice, the study discusses the most important arguments posed by this debate and analyzes the distributive and welfare effects of different privatization strategies (Chapter 4).

The third and final step looks into the Treuhandanstalt’s privatization strategy in Eastern Germany. The success of a privatization strategy depends on the economic and institutional framework involved. The study thus looks straight away at the consequences of the German economic and monetary union and the transformation of Eastern Germany’s legal system for the privatization of Eastern German enterprises (Chapter 5). The analysis of the Treuhandanstalt’s privatization strategy is based on the theoretical arguments developed in Chapters 3 and 4. Chapter 6 looks into the capital requirements of privatization resulting from the value of the assets held by the Treuhandanstalt, the choice of privatization procedures, the restriction of bidding competition imposed by the Treuhandanstalt’s privatization strategy, and the empirical results of the privatization process in Eastern Germany.

The Treuhandanstalt’s privatization policy is the subject of a controversial debate. At the heart of this controversy is the issue of whether the Treuhandanstalt should have rehabilitated the firms it holds before privatizing them. This study discusses the issue of privatization versus rehabilitation in a somewhat different light: the Treuhandanstalt grants to the buyers of firms extensive rehabilitation subsidies in the form of price rebates and negative selling prices. These rehabilitation subsidies are paid to achieve political and social goals in Eastern Germany. In view of an asymmetrical distribution of information, buyers are able to pocket some of these rehabilitation subsidies by misreporting the costs of rehabilitation investments (Chapter 7). The study therefore uses a game-theory model to discuss the issue of whether the funds might be better used to rehabilitate enterprises before they are privatized, or whether it makes more sense to pay rehabilitation subsidies to the buyer following privatization. The formal framework used to compare private- and public-sector rehabilitation regimes is not broad enough to cover all aspects of Eastern Germany’s transformation process. The arguments in favor of a rehabilitation of firms by the Treuhandanstalt or by private buyers are therefore, by way of conclusion, discussed with an eye to the dynamic aspects of the privatization process in Eastern Germany (Chapter 8).

This study was originally completed in October of 1993 and submitted to the Johann Wolfgang Goethe Universität, Frankfurt/Main, as a doctoral dissertation. The data have been updated for the present book publication. To the extent that it was possible, the author has, in revising the manuscript, taken account of the literature on privatization in Eastern Germany that has appeared since October of 1993.

2
Why Privatization?

The question of ownership plays a key role in the transformation concepts of the transition countries in Central and Eastern Europe. This issue marks the crossing point from reform to transformation. While the reforms of the economic systems in Poland, Hungary and the Soviet Union during the seventies and the eighties included the abandonment of mandatory planning and the partial liberalization of prices,¹ the institutionalization of a regime of private property rights and the privatization of the state economic sector was ruled out until the break down of the Berlin Wall.²

From an economic perspective, the close correlation between the issue of ownership and the system question is by no means self-evident: the ownership issue never played a central role in traditional microeconomics until the New Institutional Economics entered the picture (Vickers/Yarrow 1988, 1). This can be attributed to the fact that the prevailing paradigm of microeconomics, general equilibrium theory, is indifferent toward different forms of ownership (Pareto 1910, 364). Walrasian microeconomics shifted into the center of microeconomic thinking the allocation of given initial endowments and production factors to given ends. It can for that reason be interpreted as a “theory of disposition” or a “theory of possession” (Riese 1990, 20) that systematically brackets out the role ownership plays in allocation (Riese 1990, 4, 22). Seen from this theoretical angle, the organizational principle of resource allocation is the constitutive feature of an economic system, and not the issue of ownership. This is also true of the Freiburg School’s theory of comparative systems analysis, developed by Walter Eucken. It conceives of systems as being differentiated in terms of whether they set up plans centrally or decentrally (Eucken 1965, 78–79; 1975, 58–62), and the issue of ownership is logically subordinate to this (Eucken 1975, 196). In conceptual terms, what is mirrored in the distinction between planned and market economies, is the organizational principle of resource allocation as the system criterion, whereas the issue of ownership defines the crucial difference between socialism and capitalism (Riese 1991, 129; Bauer 1992, 297).

With the development of the various approaches of the New Institutional Economics, above all the theories of property rights, transaction costs, and agency costs, neoclassical microeconomics was expanded to include information costs and transaction costs, and thus opened up to an analysis of institutional phenomena (Furubotn/Richter 1991; Williamson 1990, 71; Eggertsson 1991). The approaches of the New Institutional Economics are here supplemented by developments in game theory made during the past two decades. Game theory has created a formal apparatus that can be used in particular to examine the problem of imperfect and asymmetrically distributed information in institutions (Fudenberg/Tirole 1992). Seen in terms of these theories, the incentive and sanction structure of different forms of ownership has a significant influence on the economic behavior of individuals and economic institutions. Ownership has thus become a relevant category for explaining economic activity.

This chapter will discuss the theoretical arguments in favor of the institutionalization of a regime of private ownership and the privatization of the state economic sector. For analytical reasons, two factors are separated in discussing the issue of ownership: the question of coherence and the question of efficiency of economic systems with private and public regimes of ownership. Different theories are drawn upon here to deal with these two issues: the issue of the coherence of economic systems cannot be settled within the Walrasian theoretical tradition, which is indifferent toward the institutional foundations of an economic system. For this reason, János Kornai’s theory of shortage has been selected here as a starting point for the discussion of the systems problem; Kornai’s theory is concerned with the question of the institutional conditions of the microeconomic coherence of economic systems. The discussion then goes on to consider the role of ownership for the coherence of reform and transformation strategies in the transition countries (2.1).

The efficiency problem stands in the center of the historical debate on economic accounting in socialism. While Friedrich Hayek and Ludwig von Mises, two representatives of the Austrian School, disputed the possibility of efficient allocation in an economic system whose means of production have been nationalized, a number of socialist economists, using the tools of Walrasian equilibrium theory, have sought to prove that a socialist economy can achieve Pareto-optimal allocation. At the heart of this theoretical and ideological dispute is the question of whether, within the framework of a static theory that abstracts from all information and incentive problems, it is possible to deal meaningfully with the problem of ownership (2.2).

The theoretical framework of general equilibrium theory has been expanded to include a number of approaches that can be summarized under the heading of “New Institutional Economics.” What is common to these approaches is that they extend neoclassical microeconomics to include information and transaction costs, thus opening the way to an analysis of institutional phenomena. They compare the comparative advantages of various institutional arrangements symmetrically, within a framework of market and bureaucracy failure. These approaches have, however, not developed a theory that can be applied irrespective of the framework of economic systems; as a rule they investigate individual institutional arrangements and rules under a given framework of order. These theories are therefore unable to contribute much to explaining the functional problems of planned economies, except for the general thesis that they violate the norm of efficiency compared to free markets. But they are suited to analyze the efficiency of different institutional rules and forms of ownership in the context of a market economy. This issue is of central significance for the privatization discussion: under the assumption that the institutional framework of a market economy is already given, the approaches can be used to analyze the efficiency of private and public forms of ownership. In historical terms, the institutionalization of a market-oriented framework has preceded privatization in the transformation processes in Central and Eastern Europe. And it is for that reason that findings on the potential returns of privatization may be expected from a comparative analysis of the efficiency of private and public forms of ownership (2.3).

2.1
Ownership and the Coherence of Economic Systems

In the reform discussion underway in the countries in transition, the issue of ownership has been highlighted by a study concerned with a macroeconomic problem: János Kornai’s theory of shortage (Kornai 1980). Chronic shortage of resources has been a universal phenomenon of all Soviet-type economic systems. In contrast to neoclassical approaches, Kornai does not explain shortage as pent-up inflation due to an excessive supply of money at fixed prices (Cassel 1987); he instead assumes that the cause is to be found in the institutional structure underlying the economic system (Kornai 1980, 802; 1992, 262). This poses the question of the institutional conditions of the macroeconomic coherence of economic systems (2.1.1). The failure of market-socialist economic reforms that abandoned central mandatory planning and liberalized the administrative price system, while at the same time largely ruling out private ownership and the formation of private capital, can be explained against the background of this theory as a violation of the condition of coherence entailed by a hard budget constraint (2.1.2). This then makes it possible to infer the logical conditions for the transformation of a Soviettype economic system (2.1.3).

2.1.1
Market Regimes and Ownership

The starting point of Kornai’s theory of shortage is his description of the dichotomy of two market regimes, sellers markets with shortage and buyers markets with surplus (Kornai 1975, 231; 1980, 26; 1992, 243). Kornai’s analysis of shortage starts out at the production level (Kornai 1980, 26–30; 1992, 262–280). He formulates the problem of production in different economic systems as a problem of linear programming under system-specific constraints (Kornai 1980, 23). He distinguishes three constraints: the resource constraint as a physical barrier of production, the demand constraint as a barrier to any potential sales of goods, and the budget constraint as a financial barrier posed by revenues and stocks of assets, which may not be overstepped by spending and debt (Kornai 1980, 23). As a physical constraint, the resource constraint is given by the environment of an economic system, while the two others are behavioral constraints determined by the institutions of an economic system. Kornai elevates the constraints of production to the level of a system criterion: while socialist economic systems produce at the limit imposed by the resource constraint (“resource-constrained systems”), production in capitalist economic systems is “demand-constrained” (Kornai 1980, 26).

The concept of the “soft budget constraint” (Kornai 1980, 299; 1986) assumes a key role in the explanation of shortage: the concept of a budget constraint as a secondary condition of the maximization of individual utility is borrowed from the microeconomic theory of households (Kornai 1986, 4) and applied to enterprises in socialist economic systems. The soft budget constraint determines the behavior of economic agents via their expectations for the future. While ex post the following identity holds for the flows and stocks of money in any economic system

Monetary assets (t₀) + monetary revenues = monetary expenditures + monetary assets (t₁)

ex ante this identity is no longer given under the conditions of a soft budget constraint. The budget constraint is hard when the expectations of economic agents indicate to them that they will have to cover their expenses from their revenues and their stocks of assets. The higher the subjective probability that growing expenditures will be covered by external allowances, the softer the budget constraint (Kornai 1986, 4). In this sense the budget constraint can be defined as a postulate of the rational planning of economic agents (Kornai 1986, 4; 1980, 309).

The institutional conditions of a soft budget constraint are for Kornai soft prices influenced by firms, soft subsidies and allowances achieved by enterprises through bargaining, soft taxes that are not calculated as per clear-cut rules and hence can be influenced by the firms concerned, and soft loans that are not called in accordance with strict criteria (Kornai 1980, 302; 1986, 5). Kornai treats the cases of a perfectly hard budget constraint and a perfectly soft budget constraint as theoretical extreme cases. A budget constraint is perfectly soft if it poses no effective constraint to the behavior of a firm or any other economic agent. In classical, Soviet-type planned economies, enterprises are provided with a nearly soft budget constraint, whereas in the era of liberal capitalism in Great Britain and the USA in the last two centuries the budget constraint was close to hard (Kornai 1980, 311).

A soft budget constraint entails far-reaching consequences for the rational behavior of firms: under the behavioral hypothesis that management will be interested in expanding its enterprise (Kornai 1980, 23, 61), the demand of firms with a soft budget constraint is in principle unlimited, adjustments to changes in relative prices a...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• List of Figures
• List of Tables
• Acknowledgments
• Foreword
• 1: Introduction
• 2: Why Privatization?
• 3: Transaction Costs of Privatization
• 4: Distributive and Welfare Effects of Privatization
• 5: Transformation of the Legal and Economic Framework
• 6: Strategy and Results of Treuhand-Privatization
• 7: Transaction Costs of Rehabilitation Contracts
• 8: Rehabilitation versus Privatization: A Comparative Analysis
• 9: Conclusions
• Notes
• References