6 - The Effectiveness of Illegal Strategies

Summary

This chapter examines the final explanatory variable in the framework introduced in Chapter 2: the effectiveness of illegal strategies. Just as the removal of demand-side barriers encourages firms to utilize formal legal institutions, decreasing the effectiveness of illegal strategies provides incentives for firms to reduce reliance on violence and corruption. Underlying the effectiveness of illegal strategies are two key factors. First, the effectiveness of illegal strategies depends on transaction costs – the costs of acquiring information, negotiating, and enforcing a transaction – relative to the transaction costs incurred when using legal strategies. Second, the effectiveness of illegal strategies depends on the risk of sanctions. These sanctions include not only the straightforward risk of physical harmand criminal prosecution but also the risk of lost investment opportunities resulting from a reputation for illicit practices. As the transaction costs or risks of sanctions associated with illegal strategies rise, firms rely less on private or corrupt coercion.

Numerous factors affect transaction costs and the risk of sanctions, but the focus in this chapter is on three particularly key trends: (1) the expansion of firms’ time horizons, which limits owners’ and managers’ willingness to engage in risky strategies; (2) the development of the financial sector, which reduces the size of the cash-based economy and thus increases the transaction costs of illegal strategies; and (3) integration into the international economy, which increases both the transaction costs associated with and the risk of sanctions resulting from illegal strategies.

While the logic underlying each of these mechanisms is applicable to countries throughout the developing world, the specific forms in which trends manifest may differ from country to country. For instance, in the case of Russia, I illustrate how expanding time horizons reduced firms’ willingness to utilize risky strategies by analyzing the consolidation of ownership in privatized firms. The process by which Soviet enterprises were privatized created firms with highly dispersed ownership structures, resulting in limited oversight ofmanagers and insufficient protections for minority shareholders. With massive assets up for grabs, the ensuing ownership battles placed a premium on speed and ruthlessness. Under such conditions, managers and owners cared little about a clean reputation or the stability of the investment climate, and therefore willingly incurred the risks associated with illegal strategies.