Toward a theory of the effects of the interaction of formal and informal institutions on social stability and economic development : prepared for The Conference on Formal Institutions and Informal Arrangements in Transformation Societies, University of Potsdam, Germany, October 7 - 9, 1998

The purpose of this paper is to develop a testable theory, the interaction thesis, capable of explaining why do we observe differences in economic stability and growth rates between various countries; or - the same thing - why less efficient countries do not duplicate economic policies of more successful ones. The new institutional economics provides the basis for the development of the interaction thesis. Analysis identifies the effects of the interaction of formal and informal rules on incentives and transaction costs as a major factor affecting economic stability and growth rates, and the method of choosing formal rules as a major circumstance upon which the consequences of the interaction of formal and informal rules depend. While the new institutional economics is a fast-growing method for analysis of economic and social issues, it is also a young method still in the process of creating its own mainstream. Some scholars see the new institutional economics as an attempt to enlarge the scope of ability of neoclassical economics to explain a larger class of real world events. Others consider neoclassical economics merely as a point of departure for redirecting economic analysis toward the effects of alternative institutions on economic behavior; Libecap said that "the new institutional economics retains its general attachment to neoclassical economics with its emphasis on individual maximization and marginal analysis, but with attention to transaction costs, information problems, and bounded rationality". This paper is in tune with those scholars who consider the new institutional economics to be a sui generis method of analysis, with strong ties to the subjectivism of the Austrian School and the public choice theory. In the first section of the paper I briefly define the four concepts upon which the interaction thesis rests: formal and informal institutions, property rights, and transaction costs. Then I develop the interaction thesis and consider its effects on social stability and growth. Finally, I turn to the evidence for refutable implications of those effects in Eastern Europe.