Understanding the transaction costs of transition: it's the culture, stupid

In the early 1990s, Central and Eastern Europe countires (C&EE) began transition into free-market, private-property economies. Thirteen years later, the Index of Economic Freedom published annually by the Heritage Foundation and the Wall Street Journal lists only one country in the region as a free market country, seven countries are listed as mostly free, nine as mostly unfree, and two as repressive. The same initial objectives of transition have clearly produced different results in C&EE. The paper argues that observed differences in the results of institutional restructuring in C&EE are not accidental. It attributes those differences to the interaction between the formal institutions of capitalism and the prevailing cultures in dormer socialist states. The “interaction thesis” is summarized as follows: When changes in formal rules are in harmony with the prevailing informal rules, he incentives they create will tend to reduce transaction costs and free some resources for the production of wealth. When new formal rules conflict with the prevailing informal rules, the incentives they create will raise transaction costs and reduce the production of wealth in the community. The Interaction thesis suggests that better understanding of the results of transition in C&EE requires analysis of the following three issues: What are the most important formal institutions of capitalism? What kind of culture is in harmony with formal institutions of capitalism? What is the difference between that culture and informal rules in C&EE countries? The paper analyzes those three issues in some detail. The findings are that the transaction costs of transition are higher the farther east and southeast one travels. Finally, the paper provides several empirical examples in support of the interaction thesis.