Capitalism with a Comrade's Face

To postcommunist reformers, privatization was always a necessary step in the East European transition, a move away from the domination of the economy by the state and from the economic evils traceable to the lack of "real owners," capable of monitoring the behavior of enterprise managers. For much of the population, these goals were never entirely clear; what was clear to them was that privatization would inevitably make some people rich. And the public feared, indeed expected, that the people made rich by privatization would to be the very same people who had been oppressing them for decades: the communist nomenklatura.

That reformers were right in principle is not seriously questioned; after all, there is no known example of a successful economy without a market based on private property. Whether what is going on under the name of privatization in most countries of Eastern Europe can be described as a transition to such a successful property-based market economy is a question on which the jury is still out. Where the verdict is in, however, is that in most countries the people did not err in their rush to judgment: the old nomenklatura has, indeed, mutated into the new capitalist class.

According to a former leading politician in Romania, 80% of new Romanian millionaires were part of the nomenklatura; many had been in the arms industry and have since built their fortunes on arms trading (skirting the arms embargo on Croatia and Serbia being a particular boon). A survey of Russia's top 100 businessmen compiled by Moscow's Applied Politics Institute found that 61% of the country's new rich were members of the ex-nomenklatura. A Polish economist who traced the careers of several hundred top nomenklatura from 1988 to 1993 found that over half of them turned up as top private sector executives. The numbers in Hungary are reported to be higher than in Poland.

Hence the million-dollar question on which much of the future of Eastern Europe may depend: Does the fact that privatization was hijacked by the very people of the old regime it was intended to tame mean that the region's march toward greater justice and economic efficiency will be stymied as well?

The Nomenklatura Unbound

In many countries of the former "socialist camp" political personnel changes in the wake of communism's demise were much less than one might have expected. The faces atop and within the state apparatus of Romania, Belarus, or Ukraine are, after all, not that different from those who had ruled in the 1980s (though their style of governing has been significantly transformed). But even in those countries in which the collapse of the old regime was accompanied by the eviction of the old political elites, such as Poland, Russia, and Hungary, the big surprise is that party members are gliding with relative ease from politburos into company boardrooms. "Whenever I meet with a big Hungarian company," says an American diplomat turned investment banker, "I invariably am seated across the table from someone I once negotiated with when Hungary was communist."

To be sure, the profile varies in different countries. In the Czech Republic, nomenklatura managers have not been particularly successful in retaining their control on the enterprise level. (They were more successful in retaining some power, though not gaining ownership, on the level of the banking industry.) In Poland, managers blocked privatization of the biggest enterprises, thus preserving much of their control, but could not convert this control into full property rights. (They were much more successful in smaller firms.) In Russia, the power of the nomenklatura managers is at its peak, but even there workers had to be given a share, and some of the most valuable natural resources are still owned in an unclear (and thus insecure) way. Titles are also clouded in Hungary, where managerial control comes together with a web of immensely complicated corporate cross-holdings which make the very concept of ownership problematic.

But with the possible exception of the Czech Republic, the nomenklatura has been extremely successful at converting their political domination into economic might. The countries where the communists lost (at least temporarily) their hold on political power may indeed provide the most ironic twist of the postcommunist transformation: liberating the economy from a state run by the nomenklatura has liberated the nomenklatura as well.

Under the old regime, the nomenklatura's privileges had to be paid for with submission to the tyrannical will of the party and its political leaders. It was only their always somewhat precarious position in the bureaucratic pyramid that enabled the members of the communist elite to appropriate most of the returns from the nation's economic assets. Under the new system, the nomenklatura gained title to these assets and the new order gave them legal protection of their privileged status as property holders. By making them into owners of capital, privatization thus allowed them to preserve their hold on economic resources, while also giving them the freedom that the old regime denied them. Indeed, privatization has even given a degree of legitimacy to the nomenklatura's spoils that the old regime, which tried to justify them through an ideology rather than the ancient and venerable institution of private property, miserably failed to provide.

The true paradox of privatization is thus: it allowed (or at least went a long way toward allowing) the nomenklatura to achieve something they could not have hoped for even under communism. Only in countries like Ukraine, where the economy is dominated by value-subtracting industrial white elephants, has the nomenklatura maintained an almost united front against large-scale privatization. Ukrainian bosses appear to know that their huge factories have value only in politics (with privatization inevitably leading to their closing), and so prefer to stay closely linked to the state with its handouts and rigged markets. In the more "advanced" countries, in which there were more valuable assets to be appropriated by those who had enough power to lay their hands on them, the new owners also like to get their share of political largess. But they are no longer satisfied with being dependent on the state; like all survivalists they want to turn their environment to their individual advantage; they now want the state to serve their needs. The return of the communists to power in a number of the countries in transition must be viewed in light of this role reversal.

The Resistible Rise of the Kleptoklatura

How did it all happen? The story begins a few years before the final collapse of the communist system. In countries such as Hungary, Poland, and Russia, personal enrichment of party ranks became a semi-official part of last gasp "reform" policies pursued by the regime. As the policy increasingly stressed the importance of markets and provided a limited space for private property, the comrades themselves were, of course, the best equipped to take advantage of the new opportunities. Indeed, the policy turned out to be so popular among the middle (enterprise level) nomenklatura that the top brass rather quickly lost control of the process.

The resulting scramble for riches came to be known as "spontaneous privatization." Its most notorious examples were in Hungary in 1988 and 1989, during the last months of the communist regime, when the authorities introduced new laws allowing a conversion of state enterprises into corporate legal forms, such as joint-stock and limited-liability companies. Factory managers and their cronies manipulated these laws to insulate themselves from any external control, spinning valuable assets into separate subsidiaries of which they became part-owners, and leaving the state with empty shells and liabilities.

Spontaneous privatization has spontaneously spread throughout the region. A former Securitate secret policeman, Gheorgehe Urzica, owns a string of luxury shops in Bucharest, which have never been officially privatized. What started with a few stores and small companies often ended up with theft on a grand scale, especially where, as in Romania, the old elites maintained their hold on the state beyond the collapse of the regime that had brought them to power. Victor Stanculescu, one-time head of the quartermaster corps for Ceaucescu s army, and a member of the provisional tribunal that sentenced the dictator to death, is now the owner of Romania s leading arms exporting firms, companies which have never been publicly put up for sale. A Polish banker in Lodz complained that most of his bank's bad loans were made by the old guard to their cronies (who were by then in the newly favored private sector) during the few months in which the Mazowiecki government ruled in a coalition with the communists.

But the nomenklatura rape of no country can compare with that of Russia, whose enormous wealth and natural resources fell prey to a few modern-day robber barons with a party pedigree. In what reportedly began as a conscious Soviet policy of placing various party officials into key economic posts, men like Sergei Yegorov, former chairman of the State Bank of the Soviet Union and head of the financial department of the Communist Party Central Committee, became one of the richest man in Russia and the chairman of the Commercial Banks' Association. Gorbachev's prime minister, Nikolai Ryzhkov, also made a switch "from plan to clan" and is now chairman of Tveruniversal Bank.

Connections to the often corrupt new authorities can also yield pretty good results. For example, last November, Russia s huge Uneximbank, a firm with close ties to President Yeltsin s security chief and drinking buddy, Alexander Karzhakov, was victorious in an auction to control 38% of Norilsk Nickel, the world s largest producer of that commodity (as well as of platinum and cobalt). Uneximbank, which is part owned by Norilsk Nickel (making the whole transaction a family affair), had been charged with managing the auction, and its winning bid was only half that offered by a competitor. Indeed, the $170 million Uneximbank offered was a mere $100,000 above the minimum bid level set by, wait for it, Uneximbank, who had been named by the government as the auctioneers.

The theft of the century, perhaps indeed of all time, was that of the Russian energy sector which accounts for ca. 17 percent of GDP. The assets of the oil giant Gazprom alone are valued in hundreds of billions of dollars. (According to most estimates it dwarfs General Motors, long believed to be the largest industrial company in the world.) Although companies like Gazprom were excluded from the official privatization program, 60% stakes in them have ended up, in ways that no one clearly understands, in the hands of a few company insiders, favored politicians, and banks run by the ex-nomenklatura. Among the major shareholders of Gazprom is rumored to be its former boss, now prime minister, Victor Chernomyrdin. Chernomyrdin denies any involvement, but few believe his protestations, particularly as his son is building a lavish mansion within a wooded Gazprom estate. (Russia seems to be the only democracy in the world in which the net worth of the prime minister is estimated with a potential error of a few hundred million dollars.)

Nor are comrades from the secret police lagging behind their ex-party cronies. General Oleg Kalugin, Russia s one time dissident KGB general, has become one of his country s richest men, trading around the world in "scrap" steel from decrepit state factories. Radu Tinu, who used to be a regional deputy head of the Securitate, is now one of the richest businessmen in Timisoara, where the Romanian revolution started.

Such business dealings are enough to evoke the worst nightmare of postcommunist transformation: that former secret police networks have been converted into national and international business structures which, often allied with organized crime, are setting up commercial empires throughout the Eurasian continent. This vision of a small, secretive elite, tied to the old regime, reconstituting itself on a large scale within the new order, may not be the most realistic of dangers (even if it cannot be fully discounted). But in the somewhat conspiratorial mindset of a significant segment of the East European public, it may go a long way to delegitimize the new democratic regime.

The Faustian Bargain

Ironically, some of the greatest gains by the nomenklatura were made neither through backroom deals in the waning days of the old regime nor through outright theft and bribery in the postcommunist period. They were made perfectly legally through the various privatization programs designed and executed by the new reform-minded governments of Eastern Europe.

Russia is, again, a prime example. In order to be able to push through their ambitious program of quick privatization, Russian reformers, led by Anatoly Chubais, had to assure that they had the support of some sufficiently powerful political and economic forces within the old system. The program had to have some losers and some winners, and the winners could not be all in the future.

The main losers in the Russian privatization program were to be the old centralized industrial structures: branch ministries, industrial associations, trusts, and other lobbies for the status quo. The main winners, the forces with which the reformers allied themselves in the great push for quick privatization, were to be the managers and the workers of individual state enterprises, provided they broke away from the old structures.

Company managers, for Chubais and his allies, were the lesser evil. Concessions in the privatization program, giving them partial ownership and outright control over their enterprises, were designed to assure their support. The gamble paid off beyond the wildest expectations of the small band of reformers in Moscow gathered abour Gaidar and Chubais. The old centralized industrial structures were successfully dispatched to the dustbin of history. Some 14,000 companies, an absolutely unprecedented number, were privatized between January 1992 and the end of June 1994 through a combination of insider buyouts (or, given the ridiculously low prices, giveaways) and voucher auctions.

The price for this? Enterprise insiders -- managers and workers -- emerged as majority owners of nearly 70% of Russian enterprises. Although top management directly acquired "only" 9% of the shares through the mechanism Chubais established, and workers ended up with 56%, shortly afterwards managers resorted to a series of measures designed to increase their stakes. They started buying up workers' shares, while at the same time preventing workers from selling to outsiders. Those who resisted were threatened with dismissal. Managers held tight to company registers and simply refused to record share transactions of which they disapproved. They bought up still more shares at public voucher auctions (which could be made less public if the managers had the sympathy of local Property Fund officials in charge of running the auctions). And many formed separate private companies, which they or their families controlled, and syphoned to them money and the most valuable assets of their enterprises. One way or another, they ended up owning a lion's share of the new capitalist property.

In no other country was the nomenklatura grab for new property as successful as in Russia. But on a smaller scale, a similar pattern of political alliance between the governing reformers and the enterprise-level nomenklatura was often the only successful brew in the drive to privatize. Whenever the Polish or Hungarian authorities attempted to privatize over the heads of the entrenched pre-1989 managers, they encountered interminable obstacles, delays, and difficulties. All the while, many firms, as long as they remained state-owned, were hemorrhaging money and value by the day. Only when the state decided to give them in one way or another to their managers -- through a form of "leasing" (in Poland), subsidized credits (Hungary), or fully leveraged buyouts (Romania) -- did privatization have a chance.

Like Phoenix from the Ashes...

The penultimate chapter of the nomenklatura rediviva is the return to political power of the by-now-former communists -- this time no longer as the "vanguard of the proletariat," but rather as a tail wagged the nomenklatura-capitalist dog. This is a also a chapter that is still largely unwritten, despite the experiences of such countries as Hungary, Poland, and Bulgaria.

The electoral victory of the ex-communists comes in part from the public's disgust with corruption and disenchantment with seemingly slow economic improvement. In a strange twist of irony, both of these may have much to do with the nomenklatura's behavior. Will their victory now usher in a new spiral of abuses?

Although the Hungarian privatization policy has become still somewhat more friendly to management, the victorious socialists under prime minister Guyla Horn did not introduce any radical changes. Until recently, Polish communists also had their hands tied by the need to govern in a coalition and by the aggressive presidency of Lech Walesa. They could not therefore attempt any radical moves, but they were ruthless in placing their henchmen on the boards of state companies, staffing local governments with their supporters, and distributing patronage positions among allies. They stalled as long as they could the moribund mass privatization program and attempted to emasculate its anti-nomenklatura elements by insisting that privatization fund managers have personal experience in running state enterprises. Bulgaria s government of ex-communists, too, is attempting to make sure that nomenklatura managers end up in control of the investment funds that will dominate the companies included in that country s long postponed mass privatization.

Such strategies can set a country back. Slovakia was one of the early success stories of reform. Mass privatization as practiced by its early post-communist governments laid the foundation for today's vibrant economic growth of 5.8% and low inflation. But the third government of Vladimir Meciar, now little more than a year old, twisted the privatization process into a political patronage machine. State property -- from the choicest morsels such as the giant energy firm Slovnaft to small town hall recreation centers -- are sold off to handpicked insiders in a naked bid by Meciar to establish a client business class loyal to his regime. That process, which already shows signs of negating the industrial restructuring initiated by the mass privatization investment funds that have now been sterilized by Meciar, also risks undermining Slovakia's bid for eventual entry into Europe. Last November, indeed, the EU delivered a strongly worded demarche to Meciar that warned against continuation of his thuggery and corporatist strategies.

Survival of the Unfittest

"Here s to the new boss, same as the old boss," is a line English rockers THE WHO used to sing. Few can blame Polish, Hungarian, Russian, Romanian and other reformers from turning that old rock anthem into a new political lament. The nomenklatura, in transforming itself into a Kleptoklatura, seems determined to make the old socialist Pierre Proudhon's dictum ring true: "All property is theft."

But apart from undermining somewhat the legitimacy of the new regime -- perhaps of the private property regime itself -- is there something economically wrong with the nomenklatura's success? If economists are not alarmed at management buyouts in the West -- indeed, they tend to think that owner-managed companies often have distinct advantages over firms with widely dispersed ownership -- why should we be concerned about the future of the East European recovery just because their managers also want to have a share of their enterprises? Isn't this just the normal blues following every exhilarating revolutionary change, when romantic freedom fighters must make room for pedestrian and not always pure businessmen? There is a grain of truth in this. No society, after all, can be overturned overnight. Elites everywhere always contain a large number of talented people (even though under such regimes as communism and fascism the elites are immoral and unscrupulous). Some of these people, indeed, would be successful within any political system. Their communist pedigree should not matter, especially when experienced entrepreneurial talent is in short supply.

But what matters is not just the unsavory past of the nouveaux riches of nomenklaturadom. It is the fact that many among the nomenklatura would not make it under most democratic systems. At best, they rose to the top for their political loyalty rather than business qualifications. At worst, their advancement was based on the principle of a truly negative selection, with the more talented and honest people quickly bested in the Byzantine machinations of the party bureaucracy. Moreover, there is little evidence that the kleptoklatura thinks all that differently from their socialist era forebearers. Belief in monopoly, autarky, and overintensive capital investment appear to remain nomenklatura dogma, though the near bankruptcy of most states has forced a realization that new subsidized capital investment may not be in the cards for years to come. Like medieval religion, these three articles of faith reinforce each other, and threaten longterm economic health.

The postcommunist transition thus requires, for economic as much as political reasons, that many of the old guard make room for the next generation of business leaders. It is this process that gets stymied by the managerial entrenchment resulting from nomenklatura privatization.

Another reason why the nomenklatura capitalism matters is that it prevents an evolution of corporate governance that is necessary if Eastern Europe is to join the world economy. Owner-managed companies of moderate size can have very beneficial economic effect, as Germany with its Mittelstand has showed. But unless a few people or families are to own most of a country's wealth, large industrial enterprises require a separation of ownership and managerial control. And when managers do not own more than a small share of their companies (when they are mostly "agents" rather than "principals"), their performance must be monitored, so that they work for the owners rather than slacken and enrich themselves at the owners' expense.

The danger of such "agency problems," as economists call them, is particularly serious in Eastern Europe, where managerial pilfering of social (and thus nobody's) property has a long tradition. The only way to combat this is to make sure that all productive assets have a clear outside owner, a genuine capitalist in the boardroom, who can protect the interests of the company (and -- indirectly -- society) against the rapaciousness of unscrupulous insiders.

In this context the moral unacceptability of nomenklatura capitalism also has economic significance. The new regimes, albeit imperfect, have a certain degree of democratic transparency which today makes naked theft far more difficult. Nomenklatura acquisitions must, therefore, be partly hidden and partly clothed in some kind of legitimizing garment. These embellishments and subterfuges are not just a proverbial fig leaf; indeed, they may be quite costly in terms of future efficiency. To hide nomenklatura ownership, inefficient structures, such as the impenetrable maze of Hungarian corporate cross-holdings, may need to be created, and they are likely to make all ownership weaker. Or to legitimize managerial grabbing, workers must be given a lion's share of the company, which makes future restructuring (which often requires layoffs and changing old and inefficient ways of doing things) that much more difficult.

A House Divided?

Visitors to Eastern Europe often hear complaints that little has really changed, that the nomenklatura is as strong as ever and that privatization has merely tinkered at the rigging on the ship of the party regime. This is patently not true. An entirely new class of entrepreneurs, owning their new businesses, is playing an ever increasing role. Much of privatization, especially of smaller firms, is also producing the kind of restructuring necessary to move many countries on the way to solid growth. (And privatization has also brought political benefits. Czech Republic's Vaclav Klaus is the only reformer in the region with a solid majority behind him. In Russia, Anatoly Chubais is the only member of the early Gaidar team who survived the successive defeats of reform politicians. Even in Moldova, privatization minister Ceslav Ciobanu attributes -- in part -- reconciliation between the government and the seccession Trandniester region to the economic stability privatization has helped bring about.) But privatization is certainly not moving along the course expected by most reformers. The forces of the past have simply shown themselves to be much stronger and more resilient.

To damn privatization because it has, in part, been hijacked by the old nomenklatura would be foolish. There is no way East Europeans could have maintained their overgrown public sector or shrink it without some unexpected side effects. But neither should the massive economic coup by the ex-communists be ignored, for as long as the nomenklatura remain powerful players on the region s business scene, their presence will have potentially serious consequences.

The hopeful sign here is that, according to many observers, the ties that bind the nomenklatura are dissolving. The peak of its influence was the remarkable social contract with the briefly dominant reformers: that if the nomenklatura permitted democratic and market reforms to proceed, the reformers would permit the nomenklatura to get rich. There are hints, however, that this Faustian bargain may be costly for the devil as well. For shortly after its consummation, privatization began to place uncontainable pressures on the nomenklatura, as first the unity of the kleptoklatura and the old central bosses began to crumble and then the interests of those who managed to lay their hands on genuinely viable businesses began to diverge from those who need continuous state support. For successful nomenklatura capitalists the economic liberalization at the heart of privatization contains within it elements of great appeal. After all, why steal Gazprom if you cannot make billions from it!

Habits of the past will certainly continue, with many nomenklatura managers forming alliances of convenience with their former political soulmates. But the long-term hope for privatization, for growth, and for democracy, must be this: a nomenklatura divided against itself cannot stand.

Roman Frydman, Kenneth Murphy, and Andrzej Rapaczynski are directors of the Privatization Project’s Project Syndicate. Frydman and Rapaczynski are authors of "Privatization in Eastern Europe: Is the State Withering Away?" and Murphy is the author of "Retreat from the Finland Station: Moral Odysseys in the Breakdown of Communism."

The authors are directors of the Project Syndicate of the Central European University Privatization Project. The opinions expressed here are those of the authors.