The Hidden Character of East European Capitalism: Recombinant Ownership

by David Stark

The central question of contemporary debates in Eastern Europe and countries of the FSU is by what means can private property become the typical form of property relations in economies overwhelmingly dominated by state ownership of productive assets? Much of that debate can be organized around two fundamental policy strategies:

• Transfer assets from public to private hands. Despite differences in the specific methods used for such privatization (such as sale versus free distribution), the common assumption is that the basic organizational units of the emergent market economy will be the pre-existing but newly privatized enterprises.
• Develop a class of private proprietors. The assumption is that this is a slower, but more reliable road to institutionalizing private property. Public policy should lower barriers to entry for small and medium-size private ventures and recognize the existing second economy entrepreneurs as the basic organizational building block of an emergent market economy.

In Hungary property has been transformed in a major way, without the country fitting into either strategy. From late 1988 to mid-1994, the number of state enterprises declined by about 60 percent; the number of incorporated shareholding companies increased more than twentyfold (from 116 to 2,679); and the number of limited liability companies increased from 450 units to more than 79,000. But some firms exist only in the courts' registries, having never produced any income. A great number of "dummy firms" were set up so that expenses (rent, telephone, apartment heating) could be charged to them. Many entrepreneurs still engage in private ventures only as a second job; tax evasion is pervasive; and although employment is slowly increasing in the private sector, the proportion of unregistered work—for which the state receives no social security payments and the employee receives no benefits—seems to increase faster. Some researchers label this transition as one "from second economy to informal economy."

Private entrepreneurs complain of the government's burdensome taxation, lack of credits, negligible programs to encourage regional or local development, and inordinate delays in payments for orders delivered to public sector firms. The private sector responds accordingly: violations of tax codes, off-the-books payments to workers, and reluctance to engage in capital investment are rampant. Such government policies and private sector responses are clearly not a recipe for the development of a legitimate private sector as a dynamic engine of economic growth.

As to the public sector, managers in large public enterprises have modified and transformed property relations; as a result, "recombinant" property has emerged, a form of ownership that cannot be considered either as private ownership with clearly defined property rights, or as a continuation or reproduction of the old forms of state ownership.

You Hold My Assets, I'm Holding Yours

The Privatization and State Holding Company (APVRt) and various institutions of local government—which typically had exchanged their real estate holdings for enterprise shares—have majority stakes in most formerly state-owned enterprises that transformed to shareholding companies. But central and local government agencies are rarely the sole shareholders of corporatized firms. The typical owners of large shareholding companies are other large shareholding companies, as confirmed by a 1993 analysis of the ownership structure in Hungary's 195 largest enterprises and twenty-five largest banks (the latter representing virtually the entire financial sector). Identifying the top twenty owners of each enterprise and bank allowed an accounting of more than 90 percent of the shares held in virtually every company. (These companies employ an estimated 21 percent of the workforce and account for 37 percent of total net annual sales and 42 percent of annual export revenues.)

Some form of state ownership is present in the overwhelming majority of these 220 companies ("companies" here refers to both enterprises and banks). In thirty-six companies foreign investors hold the majority of shares. Hungarian individuals hold 25 percent or more of the shares in twelve companies. In eighty-seven companies at least one major shareholder is another Hungarian company. In forty-two companies other Hungarian companies hold a majority stake (50 percent + 1 share). Thus, almost 20 percent of the 220 companies are unambiguous cases of interenterprise ownership, while in almost 40 percent of these large companies some degree of interenterprise ownership is evident.

Galaxy of Corporate Satellites

Under the pressure of enormous debt, declining sales, and threats of bankruptcy or, in the case of more prosperous enterprises, to forestall takeovers and to increase autonomy from state ministries, directors of many large public enterprises were taking advantage of the law that allowed state enterprises to establish joint-stock companies (Rt) and limited liability companies (Kft). In typical cases the managers of these enterprises were breaking up the organization (along divisional, factory, departmental, or even workshop lines) into numerous corporations.

It is not uncommon to find virtually all activities of a large public enterprise distributed among fifteen to twenty such satellites orbiting around the corporate headquarters. As newly incorporated entities with legal identities, these new units are nominally independent—registered separately, with their own directors and separate balance sheets. But on closer inspection, in practice their status is semiautonomous. An examination of the computerized records of the Budapest Court of Registry indicates, for example, that the controlling shares of these corporate satellites are typically held by the public enterprises themselves.

These corporate satellites are, thus, far from unambiguously "private" ventures; yet neither are they unmistakably "statist" residues of the socialist past. Property shares in most corporate satellites are not limited to the founding enterprise. Top and mid-level managers, professionals, and other staff can be found on the lists of founding partners and current owners. Such private persons rarely acquire complete ownership of the corporate satellite, preferring to use their insider knowledge to exploit the ambiguities of institutional co-ownership. Often these individuals are joined in mixed ownership by other joint-stock companies and limited liability companies—sometimes by independent companies, often by other limited companies in a similar orbit around the same enterprise, and frequently by shareholding companies or limited companies spinning around some other enterprise with lines of purchase or supply to the corporate unit. Banks also participate in this form of recombinant property.

In many cases the establishment of new corporate forms is triggered by enterprise debt. In the reorganization of the insolvent firms, the commercial banks (whose shares as joint-stock companies are still predominantly state-owned) become shareholders of the corporate satellites by exchanging debt for equity. The complex, intertwined character of property relations in Hungary means that horizontal ties of cross-ownership are intertwined with vertical ties of nested holdings: limited liability company owned by private persons, by private ventures, and by other limited liability companies, in turn owned by joint-stock companies, by banks, and by large public enterprises, in turn owned by the state.

Network Called "Recombinet"

The limited liability companies that began as corporate spinoffs are sometimes linked through ownership ties to more than one shareholding company and, significantly, often linked to other limited liability companies. This network of direct and indirect ties between recombinant properties, linking entities in a given configuration, can be called "recombinet." The recombinet is not a simple summation of the set of horizontal and vertical ties; rather, the characteristics of "horizontal" and "vertical" should be replaced with such concepts as "extensivity," "density," "tight" or "loose" coupling, "strong" or "weak" ties, structural holes, and the like.

The existence of pervasive interenter-prise ownership and the emergence of the recombinet organizational form suggests that the actual (de facto) economic unit of the Hungarian economy is not the individual firm but a network of firms. The real units of entrepreneurship and of restructuring are not the individual personality or the isolated firm but the social networks in which previously unidentified resources are recognized and recombined. Property is already being reorganized along such lines; but such networks are not acknowledged in public policy. As long as the policy of privatization is based on getting the highest price for a set of assets already bundled in a given enterprise, and as long as the policies of restructuring and debt consolidation operate on a strictly firm- by-firm basis, the network properties of the Hungarian economy will be underutilized. Networks will remain shady as long as they remain in the shadows of official policy.

Extend these findings to the East European region: the postsocialist economies cannot be adequately represented in a two-sector, public sector and private sector, model. The old property divide has been so eroded that what once might have been a boundary is now a zone. Perhaps the most ironic legacy of state socialism is that at precisely the time that political and economic actors are trying to free the economy from the grip of state ownership, our thinking about property remains essentially Marxist. Policy advisers are busy looking for the owner, although—as developments throughout the industrial countries show—transforming property rights has more to do with renegotiating relations among a wide set of actors to resolve their claims over different kinds of property rights.

Reorganization in Central and Eastern Europe is yielding new property forms that are neither statist nor private; economies in the region are mixed, not because there are state-owned firms and privately owned firms but because the typical firm is itself a combination of public and private property relations. In these new property forms the characteristics of private and public are dissolved, interwoven, and recombined. Property in East European capitalism is recombinant property and its analysis suggests the emergence of a distinctively East European capitalism that will differ as much from West European capitalism as do contemporary East Asian variants.

Do these organizational monsters contribute to "creative destruction?" That litmus test is based on a widely held assumption that economic development will be best promoted by "allowing the selection mechanism to work" through bankruptcies of underperforming enterprises. Recombinant property would not receive an unambiguously positive score measured by this standard. These kinds of interenterprise ownership are classic risk-spreading and risk-sharing devices that mitigate differences across firms. By dampening the performance of the stronger and facilitating the survival of the weaker firms in the interenterprise recombinet, they might even impede creative destruction in the conventional sense.

But is a tidal wave of mass bankruptcies the long-term cure for the postsocialist economies? An absolute hardening of firms' budget constraints could destroy enterprises that would otherwise be quite capable of making a high performance adjustment. Wanton destruction is not creative destruction, and recombinant property might save some of these struggling but capable firms through risk- sharing networks that do not require massive state bailouts. Extremely high uncertainties in the postsocialist economies can lead to low levels of investment with negative strategic comple-mentarities (as when firms forgo investments because they expect a sluggish economy based on the lack of investments by others). By mitigating disinclinations to invest, risk-spreading might be one means to break out of otherwise low-level equilibrium traps. Firms in the postsocialist transformation crisis are like mountain climbers assaulting a treacherous face, and the networks of interenterprise ownership are the ropes lashing them together.

Diversity Is Beautiful

Economic development in Central and Eastern Europe does require more exit (some, indeed many, firms must perish) and more entry as well. But for destruction to be creative, these deaths must be accompanied by births, not simply of new organizations but of new organizational forms.

Socialism failed not only because it lacked a selection mechanism to eliminate organizations that performed poorly but also because it put all its economic resources into a single organizational form—the state enterprise. Socialism drastically reduced organizational diversity and in so doing prohibited a broad repertoire of organized solutions to problems of collective action. The relative paucity of organizational diversity in Eastern Europe gives added urgency to the question, where do (new) organizational forms come from? There are three types of processes generating new organizational forms in Central and Eastern Europe:

• Imperfect reproduction. The existing organization or its former personnel tries to establish a new venture by reproducing a successful form. In most cases the outcome is an imperfectly reproduced organizational mutant. If it survives, a new organizational form takes hold. It can contribute to change only at a slow rate, so its importance is negligible.
• Diffusion from outside. Western multinationals are entering Central and Eastern Europe, directly bringing in new managerial practices that have strong indirect demonstration effects. Foreign investment can fit neatly into the existing monopolistic structure inherited from state socialism. Many Western multinationals are all too eager to privatize state-owned enterprises because of the inordinate market share that they command. Cigarette manufacturers, for example, are notorious for paying top price in exchange for state concessions that virtually guarantee monopolistic markets. And automobile manufacturers seek state subsidies, preferential credits, and strict import restrictions to reduce competition.
• De-institutionalization. Rules that once maintained boundaries between separate organizations are relaxed and organizational boundaries become blurred, generating new organizational forms. In the Hungarian economy, in a process that began in the early 1980s, previously well defined organizational clusters gradually overlapped; broad economic, legal, and social changes eroded the boundaries between state and private property.

An economy's dynamic efficiency rests on diversity, which hinges on its ability to develop new organizational forms. Without diversity an economy cannot adapt to changes in the environment—or it can adapt only at extraordinary cost. It is not in finding the right mix of public and private, but in finding the right mix of adaptability and accountability, that post-socialist societies face their greatest challenge.

David Stark is Associate Professor of Sociology and International Business at Cornell University. His article, "Recombinant Property in East European Capitalism," will appear in the American Journal of Sociology, vol. 101, no. 4, January 1996.