Economics of Interests: How Ukraine Fell into a Trap of Endless Reforms

Part 1. The birth of crony capitalism as the starting point of Ukraine’s failure

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In previous articles we have shown how economic losses, distrust and perceived injustice lowers public support of market reforms and demonstrated that the support for market economy will not increase while the problems of corruption and lawlessness remain unsolved. In this article we discuss why Ukraine did not manage to finish post-Soviet reforms and did not become a successful country. Why Ukrainians are exeptionnaly pessimistic about the ‘system’ and why Ukrainian rulers so unwilling to implement all the necessary changes. How with the birth of crony capitalism a country of abundant resources and great expectations fell into a trap of distrust, destructive policy, and weak economic growth.

In 1990, Deutsche Bank forecast that Ukraine will have the fastest-growing economy among the former Soviet republic. Highly educated population, proximity to Europe, balance of agriculture and industry, great natural resources. All this led to expect that Ukraine will become the region’s leader. Transition to market economy was supposed to unleash the entrepreneurial potential of Ukrainian people suppressed for decades by the Soviet regime. However, by mid-2000s Ukraine was next to last by economic growth rate among 15 post-Soviet republics, ahead of Moldova only. In 1990–2004 Ukraine’s economy grew on average by negative 2,8% per year. In 2018, Ukraine passed another psychological milestone, falling behind Moldova and becoming the poorest country in Europe by nominal GDP per capita.

Though, the recipes for success have been known for a long time. Economic and political structural reforms worked well in many post-Soviet states. They brought broad political rights and new economic opportunities to the majority of people living in Central and Eastern European and the Baltic states.

What went wrong in Ukraine? There are a lot of hypotheses and myths regarding this question like ‘Ukraine’s unique path’ and ‘faulty politicians and/or people’. While three decades of research paint a more convincing narrative. They show that Ukraine’s failure started with the birth of crony capitalism. After that, the country fell into a trap of distrust, destructive policies, and weak economic growth.

Winners take all: from the ruins of “equality” to the new injustice

In 1998, when leaders and outsiders have already emerged among the post-Soviet states, Joel Hellman published a study titled “Winners Take All: The Politics of Partial Reform in Postcommunist Transitions”. In this study, Hellman showed that the main obstacle to reforms in failed countries was not the people who suffered during the transition and started opposing further changes but small groups of “winners” who seized vast assets during the earlier stages of change and increased their political influence (Hellman 1998).

When economic liberalization began in Ukraine, it opened new economic opportunities. However, due to institutional weakness, lawlessness, and lack of restriction on abuse by power, few were able to use these opportunities. The main were seized by former members of the Soviet bureaucratic elite and a new class of politically connected entrepreneurs later known as oligarchs. Both in the country’s major industries and at the local level the distribution of national wealth was determined not by entrepreneurial talents, but by connections, violence, and political privileges.

Hellman showed that it was the partial reforms and lack of checks on power that created these privileges for early winners and caused further changes to fail. Selective state deregulation and corruption created opportunities for rent-seeking and quick accumulation of wealth by select groups. Accumulated rent was then used to acquire political influence and ability to set the rules in one’s favour. Politically connected businessmen (“rent-seekers”) and corrupt politicians (“rent-givers”) created mutually beneficial alliances. And since their resources and power were acquired in the state of partial reforms, they got an interest in maintaining the status quo to save personal gains even at the cost of significant losses for the society overall (Hellman 2011).

In terms of economy, this phenomenon led to a dramatic slide in competitiveness and effectiveness. In terms of institutions it undermined the state’s ability to fulfill its functions and disrupted the development of democracy. Ukraine got stuck in a vicious circle of underdevelopment, state incapacity, and inability to implement effective change.

Despite the ineffectiveness and the injustice of this state, it turned out to be surprisingly steady. The reasons were later explained by Daron Acemoglu. Ineffective policies and institutions can persist for decades if they benefit the people with political power. Political power lets one set the rules of the game. Therefore, if reforms that are beneficial for the society overall carry risks or uncertainty for the ruling elite it becomes incredibly hard to implement them (Acemoglu 2003). If the assets of influential players were acquired in a questionable or illegal way reforms for the rule of law will be blocked (Hoff, Stiglitz 2008).

In countries where abuse of power is limited by democratic institutions, conflicts like this are easily solved: politician and their friends from business are unable to seize much power or rent without facing consequences. However, in post-Soviet Ukraine, these restrictions were too weak to keep early winners from increasing their influence. Moreover, this process was accompanied by significant disintegration of society and increasing economic and political inequality. Consequently, newly created political and economic groups got both the incentives and resources to preserve the ineffective status quo.

Then why didn’t transition fail in all countries? Why Ukraine’s neighbours such as Poland were able to contain the influence of early winners and prevent the seizure of the state by vested interest groups?

Anti-Soviet movements and the victory of broad interests

The answer to these questions was found on the intersection between economics, politics, and society. Early reformers were afraid that democratization could cause chaos, but it was later proved that democratization was essential to successful market reforms. Countries that were effective in political reforms also succeeded in reforming the economy. Successful democratization and elite change were instrumental in the implementation of swift inclusive economic reforms that in turn were critical for further economic growth (Fidrmuc 2003). At the same time, the weakness of democratic institutions and their inability to restrict political corruption hampered economic growth of transition counties (Domadenik et al. 2014).

These conclusions debunked the authoritarian idea of “political will” and showed that there are good reasons why the leaders of successfully reformed countries were honest and technocratic. Renovation of political class and creation of democratic restrictions on power determined who gained the most from the new rules and who reaped the benefits of economic liberalization: all the citizens or only the ones with access to politics. Distribution of power among a wide range of citizens and a system of checks and balances prevented the creation of economic institutions that would be beneficial only to a small social group. At the same time, sensitivity of political systems to the interests of wider population helped to create more inclusive economic systems.

For example, a study by a team of economists led by László Bruszt showed that protests and strong civil society were crucial for post-Soviet countries’ economic success. In countries that had strong civil societies at the start of post-Soviet transformations, politicians had more incentives to serve the majority’s interests. Moreover, politically active population became a source of new political cadres. However, in countries where strong civil societies never formed or were quenched by authoritarian regimes, influential groups were able to seize resources and power and block further changes (Bruszt et al. 2010).

A later study by Canadian political scientists Lucan Ahmad Way and Adam Casey contributed to the research of this topic by showing the influence of two factors, anti-Soviet nationalist movements and geographical proximity to the EU. In Eastern European and Baltic countries anti-Soviet nationalism, shorter rule of the Soviet regime, and the possibility of joining the EU contributed to the development of non-communist political elites that supported democratization and abolishment of Soviet totalitarian institutions. On the other hand in countries with weaker anti-Soviet movement old political elites were able to preserve their influence and hamper democratization processes undermining economic reforms as the result.

Authors showed a strong connection between anti-Soviet nationalism and the level of pre-Soviet education. In countries where education was more developed before the start of the Soviet rule, a stronger national identity was formed that made it easier to mobilize the population after the dissolution of the Soviet Union. In these countries, communists lost in the first post-Soviet elections, while anti-Soviet opposition formed a wide support base. These victories led to an emergence of a new non-communist elite and swift democratization of Central and Eastern European and Baltic countries in the early 1990s. The promise of joining the EU accelerated these processes.

At the same time, out of 15 former Soviet Union republics, only Georgia and Armenia had literacy levels of 50% or higher. Consequently, most of these countries had weak nationalist movements and low rates of democratization. In Ukraine and Moldova population was divided into “Russophiles” and “Europhiles” and as the result nationalists were unable to win in the first elections and old communist elite preserved significant influence (Way, Casey 2018).

From conflict politics to a failing economy

This political divide and interfactional fighting for the new rules of the game had disastrous consequences for the Ukrainian economy. Democratization led to wide-scale economic reforms, creation of strong state institutions, and renewed economic growth only in countries with low levels of political polarization. At the same time, fighting between ex-communist and anti-communist political factions for economic and political resources decreased democracy’s positive influence on economic growth and made politics less predictable. This connection was analysed by American political scientist Timothy Frye who studied the economic growth of 25 post-Soviet countries in 1990–1998 (Frye 2010).

In countries such as Ukraine and Bulgaria competing communist and anti-communist factions had approximately equal influence in the parliament and fought for the establishment of new economic rules. As a result, the economy became dependent on the election schedule. Economic growth rates decreased in these polarized countries ahead of elections when the uncertainty regarding future economic policy increased. Meanwhile, in countries where politics were dominated by one faction such as Estonia, Poland and Uzbekistan growth rates were significantly higher (Frye 2002).

The main reasons for political polarization were high income inequality, the scale of Soviet institutional legacy and the level of Soviet elite’s entrenchment (Frye 2010).

When social division is high, each group is motivated to influence politics for its own benefit. In transition countries, it was harder to solve this conflict due to weak legal institutions. However, the existence of active groups with broad interests allowed to prevent politicians from serving to the interests of select groups and force them to serve the interests of the majority. Political leaders generally are not willing to share power with the public voluntarily. Therefore, democratization is usually carried out via protest movements and an increasing threat that the existing elite will be overthrown or through a change in the composition of the ruling elite and its interests (Acemoglu, Robinson 2001).

That is why it is not the mysterious “political will” that guaranteed the success of post-Soviet transition, but a renovation of political elites. Ultimately consistent incentives and overall political context are more important factors than the presence of separate strong-willed reformers.

In countries where elites were renovated and democratic limitations were implemented:

  • Political power came into the hands of groups with new interests and values.
  • These groups were more connected to the public and more accountable.
  • Successful democratization and renovation of the ruling class provided the society with mechanisms for controlling power and elite change while making it clear for the politicians that the change is possible.
  • When old networks fell apart, a significant share of connections and mechanisms for abuse of power were destroyed. People in the system were replaced with new ones, increasing the likelihood that they would control each other. It became harder to abuse power since there was no confidence that one’s colleagues would turn a blind eye on it and abuse themselves.
  • Therefore, a full renovation of institutions helps to escape the corrupt status quo and increases the likelihood that new rules will be enforced due to new interests and internal and external control by the participants.

Ukraine’s case proves that it is important for citizens to have an opportunity not only to choose their leaders but also to control how they use the power. Democracy does not boost economic growth when the level of corruption is high and there are ample opportunities for abuse since economic growth becomes dependent on the election results and the succession of politicians (Collier, Hoeffler 2013).

From a dysfunctional state to a depressed society

Despite the arguments about “influential winners”, Ukraine’s problem is not only about oligarchs and corrupt officials who support the status quo but also about key state institutions that have become a mechanism for rent-seeking and can be used by small groups for their own benefit. At the same time, common citizens and honest businesses have no instruments for self-defence and can’t rely upon the equal rules of the game. Under these circumstances, the majority of people have limited access to resources and networks that distribute them. Due to widespread informality of relationships between the citizens and the state, some groups become socially privileged, while others are excluded from production processes, social networks, power distribution processes, etc.

In Ukraine, reinforcement of the dysfunctional state and emergence of a society of unequal opportunities could not but influence the people’s behaviour: what they believe in, how they perceive the ‘system’, whether they abide the law and how they vote.

In the next article, we will show how Ukrainian society descended into a trap of distrust, destructive policies, and weak economic growth as crony capitalism strengthened.

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