Switch on, switch off: how law sustains the Russian system

In some card games, the aim is to collect as many cards as possible; in others it is to get rid of cards that have been dealt. There are regimes where the point of the rules is that they should be observed and others where simply they are there to be broken. This is Russia, explains Kirill Rogov

If you want to understand how the current political and social order operates in Russia, you first must understand the two important and complementary beliefs upon which it is founded. 

The first is society's recognition of widespread corruption at all levels of state and economic life, and a similar recognition of the extreme inadequacy of existing institutions (in the first instance judicial institutions). This particular belief is held by people of varying political affiliations and social status — shared equally by shop attendants, members of the opposition, low-ranking officials and political functionaries.

West Moscow's City Business Quarter. Though it understands the system as corrupt, business doesn't necessarily regard it as bad. The cost of any inefficiency and bribing, is, after all, passed on to the consumer. Picture: NVO

The second belief is just as widespread. It holds that for various reasons any change to the existing order is out of the question. In other words, when recognition of the sorry state of affairs of legal regulation does not lead to a corresponding demand for real improvement in law.  This situation is hardly some new paradox that is impossible to explain. Indeed, in economics it even has a name — “the institutional trap”. Bad institutions cause considerable losses to the economy and inconvenience to people, but on the whole the masses manage to adapt to the situation. Indeed, much more than that: part of society actually manages to derive some relative benefit from the way those bad institutions function. And another part of society doubts how competitive it will be in different, as yet unknown and hard-to-imagine conditions. Given this, the cost of reforming the institutions starts to appear too high, and the benefits insufficiently clear.  This is what seals the preservation of the status quo, despite its obvious flaws.

Later on in this article I shall attempt to describe how this institutional trap works, to explore the special features of political order that is currently being maintained in a state of temporary equilibrium.  First, I’d like to suggest we call this order a “regime of soft legal constraints”. This is a conscious calque on Janos Kornai's term “soft budget constraint”, which he used to describe the fundamental features of a socialist economy.

Bad institutions cause considerable losses and inconvenience, but the masses manage to adapt. Part of society even manages to derive benefit from the situation. This is what seals the preservation of the status quo, despite its obvious flaws.

 Soft budget constraints

According to Kornai, soft budget constraints are the basic defect of a command economy.  They reflect the fact that an enterprise has no economic responsibility for the results of its activity and can exploit opportunities to use the state budget to pay for its growing costs.  At the end of the 1980s, Kornai's concept played an important part in forming ideas about the ways (and constraints) of reforming the socialist economy.  The concept gave rise to the inevitable cycle of “liberalisation – stablisation – privatisation”, which is what was supposed to ensure the transition from the regime of soft budget constraints to a regime of tough constraints (and looked like the formula for launching capitalism in countries which were until recently socialist). 

By using a term based on an analogy with Kornai's, I wanted to emphasise that the problems under discussion are to a certain extent the successors of the problems that were being addressed during the last lap of reforming the command economy. But, before defining them more precisely and interpreting the link, we need to first describe what could be meant by a “regime of soft legal constraints”.

Soft legal constraints

This is a regime where the rules (written law) exist not to be observed, but to be broken; or at the very least are broken systematically.  It would be untrue to say that they don't work. They do work, but they work in their own particular way.

A “regime of soft legal constraints” is a regime where the rules (written law) exist not to be observed, but to be broken [...] In this system, the breaking of rules is done according to set rules.  There are unofficial rules for breaking the official rules

In some card games, the aim is to collect as many cards as possible; in others it is to get rid of cards that have been dealt. Similarly, there are regimes where the point of the rules is that they should be observed and others where the rules are there to be broken. Here, the breaking of rules is done systematically, but according to set rules.  There are unofficial rules for breaking the official rules.

This state of affairs distinguishes the current regime from a different order where rules are not adhered to because the institutions of enforcement are too weak, as they were in Russia in the first half of the 90s. Under a regime of soft legal constraints, the state has no shortage of means of enforcement. The fact that the rules are broken in a standardised way makes it possible to regard the system as a particular form of order (or permanence), which in society's consciousness can even be interpreted as a benefit (as opposed to the breaking of rules in an unregulated, chaotic way)

Written rules are created so that they can be broken, and so that it makes sense to do so.  Rules are established in such a way as to provoke infringements. As a result, the entire life of our society is becomes a kind of continuous haggle

This particular regime creates written rules so that they can be broken, and so that it makes sense to do so.  What I mean by this is that they are set up in such a way that observing them is difficult and a substantial expense, whereas the possibility of breaking them gives considerable competitive advantage. Put another way, rules are established in such a way as to provoke infringements.  As a result the entire life of our society is set up as kind of continuous haggle, organised by around individual “rights” to break certain rules, when the breaking of them guarantees convenience and advantage. The state, represented by the bureaucratic machine, plays the part of a peculiar kind of shop issuing individual licences to break the rules.

The role of the government

Each level of government is entitled to hand out rights to break certain rules and, naturally, has to have the necessary powers to punish any unsanctioned infringement.  This important point must be emphasised: any bureaucratic body with authority does not concern itself with the observance of rules, but instead with the punishment of any unsanctioned infringement. So it has no interest in optimising regulation and control, nor in minimising cases of, and incentives for, breaking the rules. Its only task is to set up a bargaining space around those infringements.

The system both condemns breaking the rules, and justifies it at the same time. Critically, everyone believes that everyone else is doing it. Any attempts not to break the rules — or any demands that they be changed — begin to look marginal and deviational.

Let us explain this point by looking at the role of the traffic police in Russia. The traffic police are not bothered who has broken the highway code and how seriously.  They have no brief to reduce the number of infringements, either by removing incentives to break the rules or by using automated monitoring systems.  For them — as an authorised government body — what is important is to distribute staff at the various points where rules are usually broken and to institute bargaining around these infringements. So unlike other countries, where the roads and streets are randomly patrolled by traffic police, Russian officers are almost always positioned on stationary posts. They are much less interested in averting infringements that are a real threat to safety (aggressive or dangerous driving, for instance), than they are to monitoring compliance with a limited set of rules at certain places. The rules they check are only indirectly related to the real matters of road safety: whether drivers are in possession of documents and licence, and whether cars have the correct MOT certificate.

Everyone breaks the rules

So the system both condemns breaking the rules, while justifying it at the same time.  An informal, daily norm exists alongside the formal, written norm: breaking the formal rules is considered reprehensible, but inevitable, routine and excusable. Infringements of the formal rules are not hushed up. Indeed quite the opposite. It is critical to the legitimisation of the regime that everyone believes everyone else is doing it. If anything, it is an exaggerated belief, but it is a belief nonetheless that plays an important role in forming social stereotypes and behavioural norms. What follows on from this is that any attempts not to break the rules, or any demands that they be changed, begin to look marginal, deviational even; a fruitless attempt to do battle with tradition.

The idea of universal rule breaking is an important element in the political organisation and political legitimisation of the order as described. The upper and lower social echelons are united in corruption (in the widest sense), rather than divided. It is a unity that framed by a single hierarchy of opportunities for corruption. Thus endless conversations about corruption and discussions of how it is all-pervasive do not actually lead to the delegitimising of the established social hierarchy and political order.  They instead strengthen it and serve to promote and legalise this order as incontrovertible fact. Legal order meanwhile starts to be considered contrived and imaginary.

In a system where rules are broken, but the rules for doing so change, the greatest opportunities (or power) will be in the hands of whoever controls the changes.

 But the rules can change

The rules for breaking the rules can change. This is an important feature of the system, giving it stability, flexibility and even competitive strength. First, this fluidity means that someone who has received the right to break the rules cannot acquire extra autonomy; his links with the system and the existing order have to be constantly supported and renewed.  This fluidity also gives a kind of competitive strength to the system: beneficiaries and champions of the current round of bargaining are in no way guaranteed the same place in the second round. Indeed, the most profitable schemes are often declared off limits in the subsequent round.

Secondly, the fluidity of the rules is very important for the formation of a hierarchical management structure and the political organisation of society.  Obviously, in a system where rules are broken, but the rules for doing so change, the greatest opportunities (or power) will be in the hands of whoever controls the changes.  This give rises to a three-tiered system:

1.     Those who bargain for the right to break the rules (the perpetrators of sanctioned or unsanctioned rule breaking);

2.     Those who hand out the rights to break one rule or another (executive level); and

3.     Those who control the changes to the rules governing breaking the rules, thus controlling those who break the rules and those who hand out the right to do so (this is the political level).

This feature is peculiar to a regime of soft legal constraints and explains why Russia’s permanent “battle with corruption” is at the same time an element ensuring that it will endure.  Like other systems of control, the “battle with corruption” is not aimed at eradicating it, but at keeping the system of bargaining alive. The “battle with corruption” is in effect a regulator of sanctioned corruption, compelling the executive level to do deals with the highest (political) level over its rights to give out the rights to break the rules.

If participation in the system of vertical bargaining for the rights to break the rules is sufficiently widespread, then society has no interest in transition to another state.  Anyone who has received rights to break the rules turns out to be not only indifferent to the idea of optimising or easing the rules, but actively disinterested.

The on/off switch

So in the regime of soft legal constraints there are legal constraints, but they operate with an on/off switch. Just as Kornai used the word “soft” in regards to his “budget constraints”, the adjective “soft” is here taken to mean a principle that written-law constraints are subject to “vertical bargaining”. It means that the system of written law is but a framework for defining the object, conditions and parameters of the bargaining.

If participation in the system of vertical bargaining for the rights to break the rules is sufficiently widespread, then society has no interest in transition to another state.  Anyone who has received rights to break the rules — and, consequently, some relative advantages — turns out to be not only indifferent to the idea of optimising or easing the rules, but actively disinterested. This would, after all, devalue the advantages he has received and lose him the investments he made during the previous round of bargaining. This is particularly important if we study the economic effects of such a legal system. There is economic machinery underlying the institutional trap of Russia’s regime of soft legal constraints.

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Private ownership and vertical bargaining

Kornai believed state property brought about the phenomenon of soft budget constraints. Precisely because of this, he argued, the national budget was compelled to absorb the growing costs of enterprise. It can certainly be asserted that Russia’s regime of soft legal constraints came into being and exists for reasons similarly related to property.

Within a system of soft legal constraints, the nature of private property is limited. It exists de jure, but is not recognised in the public at large. In society’s eyes, property rights are a special case, the material result of using one's rights to break the rules. They are the legalisation and capitalisation of such rights. The loss of property, when connected with the loss of rights to break the rules, seems completely legitimate too. In other words, the system regards the management of property as a private affair — in the sense that the nominal owner is entitled to collect and use the income from managing his asset — yet at the same time the property can also be taken away not only for strictly contractual reasons, but as a result of losing the right to break the rules.

Within a system of soft legal constraints, the nature of private property is seen as a special case. The nominal owner is entitled to collect and use the income from managing his asset, yet at the same time the property can also be taken away from him

A system in which property is managed privately, but can also be taken away, clearly requires a dual legal structure.  On the one hand, the written law is essential to guarantee the horizontal market relations associated with the management of property (credit, deliveries, sales etc). Here the controller of the assets acts as the legal owner interacting with contractors (formal law in “switch on” state).  On the other hand, the property is also subject to the “vertical bargaining” system that manages the rights to break the rules. These relations mean that the property may at any time be removed from the nominal owner, and the rights to its use to be reallocated (formal law in “switch off” state).

Of more particular relevance to Russia is what happens to an enterprise when there are no soft budget constraints —  when capitalism is “launched”, as we thought it was at the end of the 80s and in the early 90s — but soft legal constraints are in operation?  In other words, when most of the written-law constraints are in principle surmountable. 

How do companies manage?

First, severe budget constraints mean that a company cannot use any subsidies from external sources to compensate for losses (or more exactly, it generally cannot, for in a regime of soft legal constraints exceptions can be made to all rules).  This means that the company is forced to become an active player in the system of horizontal market relations, and to aim to maximise its profits.  In that sense, capitalism’s basic aim has been achieved. 

At the same time, the firm can also make use of individual rights to break the rules to reduce its administrative overheads and supplementary costs. By so doing, it acquires an advantage in the marketplace and, consequently, increases its profits to a level above that which its real economic efficiency deserves.  It is logical to assume that other firms' administrative overheads and supplementary costs will remain fairly high to compensate for the shortfall in income resulting from any concessions granted to the first firm (for instance, if tax breaks are granted to some companies, the base rate has to be set higher than necessary for others so as to achieve a satisfactorily effective rate of return).  This means that profit levels in other firms will be lower than they should be at their operating efficiency.

Two things arise from this. First, the unequal distribution of overheads and supplementary costs means that profits are redistributed from some companies to others.  Second, the size and earnings record of the profits are not a direct reflection of the company's economic efficiency.

Investing to improve economic efficiency is risky. Not only are you investing in future profits of an asset that may no be longer yours, you are actually increasing the chance it will be taken away.

Investing in the present or the future?

Theoretically it could be assumed that the owner of a firm would aim to increase his profits both ways – by reducing administrative overheads and supplementary costs and by increasing economic efficiency.  But the special features of the Russian regime make the first route preferable.  As we have already noted, property rights are generally understood to mean the rights to the results of using the asset (profit). The asset itself can be taken away at any time. Money spent on the individual rights to break written rules is a direct investment into profit here and now. Investing in increased economic efficiency is an investment into an asset whose main feature is that it can be taken away at any minute. This is a much riskier investment, which actually increases the risk of it being taken away. You will also be obliged to invest more in protecting your rights to dispose of this asset.

If, on the other hand, you choose to invest in rights to break the rules, you are not only increasing your current profit but also reducing the risk of the asset being taken away. What is more, the greater the profit of a company depends on exclusive, personal agreements set up by the owner-manager, the more it actually belongs to him, and he to it. This is what makes the choice between our two profit maximising strategies so straightforward.

Hence the conflict between Russia’s regime of soft legal constraints and the institution of private property. Private ownership encourages investments to maximise current profit and deters investment in future profit.  However, the nominal owner, increasing his profit by non-economic means (breaking the rules), is supporting a regime in which his right to ownership is by definition limited.

Similarly, in a situation when increased company profits are no direct reflection of economic efficiency, it follows that owner-managers cease to have a clear idea of the how efficient their business is.  If your profits grow by 15-20% per year, and your costs by just 5-7%, this certainly looks like evidence of an efficient company.  But if we calculate that the growth in profits derives 75% from non-economic factors (soft legal constraints), then it is clear that the company's efficiency is actually decreasing. 

In this way the owner-manager becomes dependent on a system which distributes rights to break the rules. He doesn't know how competitive he would be or whether he would be able to cover his day-to-day expenditure without the system.  The more successfully the business develops in the regime of soft budget constraints, the greater the likelihood, and the firmer his personal conviction, that he would not.  This is what economists call the “gilded cage” effect.

Under a regime of soft legal constraints, prices will be higher than they might otherwise have been. The consumer will have to cover both the additional costs of buying the rights to break the rules and the increasing inefficiency of the company

The company in the marketplace

Let us consider what this means for the market, rather than for the particular company.  We have seen that, as a rule, a firm's presence and position in the market is determined not solely by the balance between supply and demand (horizontal market relations), but by the conditions of “vertical bargaining” over rights to break the rules.  It only makes sense to purchase these rights if other companies in the marketplace are in some way limited by their observance of the written rules.  The “vertical bargaining” system has to act as a filter regulating access to various sectors of the market. In this case, investments into rights to break the written rules (law) are no longer an additional cost:  they can be passed on to the customer (monopoly rent).

If the country is operating under a regime of tough budget constraints, i.e. no routine subsidies, only the end customer can ensure that the company recovers any money it spends on subverting the written rules.  It follows that under a regime of soft legal constraints, prices will be higher than they might otherwise have been. The consumer will have to cover both the additional costs of buying the rights to break the rules and the increasing inefficiency of the company.  

This explains why businessmen working inside the system don't generally regard the regime as unsuitable or bad for business development. All they have to do to be completely happy is concentrate on current profit and accept the long-term possibility that they might lose the asset.  Just as individuals show little interest in a system where the written rules are simple and observed, so the manager of an asset shows little interest in ensuring his long-term rights of property.  The lack of these rights is made up for by the relatively high profit level, which is more than it might have been had such property rights existed.

Twenty years ago, reformers of socialism believed the “launch of the market” would — through tough budget constraints  — transform enterprises into independent players free from vertical bargaining controls. The logic of this new situation suggests the need for creating new institutions supporting and protecting competition, for this is the only way that an enterprise can profit from its independence. In other words, Russia’s regime of soft legal constraints looks like a way of compensating for the effect of the tough budget constraints that accompanied the launch of the market.

As long as severe budgetary constraints are in operation, a firm — at any rate a medium-sized one — cannot risk going into the red, as it would go bankrupt.  This system of “half-capitalism” has the distinct potential for self-propagation and viability in conditions which are not conducive to overall development.  There is a danger such a “twilight” state, with low potential for development, could go on for quite a long time.  

If the potential of the regime of soft legal constraints is to be realised to the full, it follows that some of oligarchs occasionally have to leave the stage.

The main beneficiaries of the regime of soft legal constraints are by no means Russia’s “oligarchs”. Clearly, their ability to break the rules tops the charts, but their companies may be taken away at any moment. The main beneficiaries are instead the bureaucracy, which hands out the rights to break the rules.  Its power is not so much based on the existence of various oligarchs, as the continual reproduction of the process of “making the oligarchs”.  If the potential of the regime of soft legal constraints is to be realised to the full, it follows that some of oligarchs occasionally have to leave the stage.

Russia’s regime of soft legal constraints creates two co-existing logics: the market logic of horizontal relations and the logic of “vertical bargaining”.  The regime of soft legal constraints is the trigger for moving from one logic to another.  The guiding rule of the first is the principle of severe budget constraints and it permits the economy to make a profit.  The goal of the second is to redistribute that profit outside the marketplace.

A Russian version of this article was first published at InLiberty.ru

 

About the author

Kirill Rogov is Senior Research Fellow at the Gaidar Institute for Economic Policy, Moscow. 

Read On

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Ledeneva, A. How Russia Really Works (2006)