RATIONALITY IN TRANSITION: Using holistic approach to rationality to explain some

developments in the Slovenian business system

Marko Jaklic

Hugo Zagorsek

University of Ljubljana

Faculty of Economics

INTRODUCTION

The assumption of rationality, as interpreted by the mainstream economics, is one of the cornerstones

of economic science. It is believed that notion of rationality provides us with powerful tool for

simplification of economic analysis. If agent behaves rationally, his decisions can be predicted by

using logical and mathematical tools (Lange, 1945). Otherwise, it is believed, we are left in chaos of

ad hoc hypothesis, which may cover many facts, but may lack overall cohesion and scientific

refutability. The idea of means/ends rationality combined with assumptions of perfect knowledge,

complete transitive preference ordering and deliberative choice has been implanted in minds of

economists so strongly, that every attempt to question the standard concept of rationality was at risk of

being described as non-economist. Only a few decades ago, have various models, inspired mainly by

Simon’s work in this area (1961, 1972), started to emerge.

The aim of this paper is to present different notions of rationality and to develop a holistic approach to

rationality taking into account boundedness and contextuality of rationality simultaneously. We

believe that holistic approach to rationality best describes some peculiarities in the Slovenian business

system and gives potentially better advice to decision-makers in the transition process. Slovenian

economy has experienced four major transitions in the last two centuries. First began in 1848 when

feudalism was abandoned and peasants have finally became owners of their land. Second occurred in

1918 when Slovenia ceased to be a part of Habsburg monarchy and became the westernmost state of

Yugoslavia. Third happened after the Second World War, with establishment of socialism. Fourth, and

final one began in the late 1980s when Slovenia, first within Yugoslavia and after 1991 as an

independent state, abandoned self-management socialist system and started to move towards the open

market economy. What is remarkable is the fact that despite such a strong changes in business

environment, some basic, beneath the surface customs, rules of conduct and conventions have

survived virtually unchanged. It is these ancient contextual factors that play important role in

behaviour and decisions of today’s managers. It is our hypothesis that these institutions “worked

relatively well” for centuries but many aspects of these institutions have become “backward” for

Slovenian economic development in the last transition period. This is not to say that these institutions

will disappear but a high level of evolution or change in them is needed if stronger economic

development is to be achieved.

BOUNDED AND CONTEXTUAL RATIONALITY

Simon has argued that “satisficing” rather than maximizing behaviour better characterizes human

behaviour and proposed that the concept of economic man be replaced by that of administrative man

(Simon, 1961).1 Rationality of economic agents is bounded, because information is not readily

available or free, and mind also does not have unlimited deliberating capabilities. Because deliberation

and data collecting is costly, individuals are usually prepared to settle for satisfactory outcome, by

using various rules of thumb and heuristics, rather than searching for an optimal one. However, both,

unbounded and bounded rationality implicitly assume that rationality is universal, that is common to

all individuals regardless of society and historical period that they belong, and independent of

conceptual frameworks within which they operate. Economic thought in general is leaning towards

universality. While business community has long ago acknowledged cultural, religious and social

differences between nations or traditions and adapted its practices and polices to local customs,

theoretical economists still believe that all people, e.g. Aborigines, Europeans, Chinese, Arabs,

software developers, machine workers and religious fanatics, are subject to the same universal

economic laws. They may differ in their preferences, but in mainstream economics preferences are

given and are not subject of scientific enquiry. It is believed that they will all behave and decide

equally rationally, regardless of whether by that notion we assume unbounded or some kind of

bounded rationality.

This conviction has its foundations in Enlightenment philosophy, which advocates the principle of

absolute or universal truth, justice and rationality. There has to be some source of truth and value

outside human needs and cognition, which guides us throughout our existence on earth. And Reason is

the ultimate instrument of man in search of this basic, universal truth. To rationally justify is to appeal

to principles undeniable by rational people and thus rationality becomes independent of social

particularity. This approach is problematic in that nobody could find such principles (Rempel, 1999).

Various ideologies and competing systems of values and believes, either religious or non-religious,

seek to monopolize truth and justice. Thus they believe that “there are things so sacred, that they must

be protected by the arm of the state from irreverence and challenge – that absolutes of truth and virtue

exist and that those who scoff are to be punished” (Schlesinger 1989).

1 In the last decades, texts on rationality increasingly use “person” instead of “man” when describing rationality of economic agents. In our text, we will use “person” even when original authors use “man”.

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In the last two decades totally opposite, relativistic philosophical view is gaining in influence

(Westacott, 2000). Relativism asserts the relativity of truth, knowledge and rationality. Rationality is

relative to a particular conceptual scheme (world view), which can be shared among members of entire

society, culture or period, or unique for a more narrow social groups or individuals. Relativists do not

simply assert that the different cultures or communities have different views about which beliefs are

true and what behaviour is rational. Nor do they merely claim that different communities operate with

different epistemic norms – i.e. criteria of truth and standards of rationality. That seems to be obvious

at least to philosophers if not for economists. Their major claim is that no one set of epistemic norms

is metaphysically privileged over any other. Our beliefs and values do not arise from something

“higher” or “absolute”, they are product of our biology, culture, upbringing, education and “the

idiosyncratic twists and turns of our career through life” (Clark, 2000).

One of the main characteristics of human beings is their ability to justify their actions and beliefs to

others and to themselves. Most of us are trying to be self-consistent in a sense that we do not hold

obviously contradictory beliefs and that we act according to our avowed values. Our actions can be

justified if we can back them up with our believes. If we are rational, we can indicate how the

particular act or belief in question fits into a larger network of higher values and cognitive

commitments. This higher values and commitments are in accordance with our most basic beliefs and

values about what is fundamentally right and how the world fundamentally is, which serve as a

background criteria for all lower hierarchy commitments and actions. If we attempt to justify our basic

beliefs, we could maybe show that they are mutually coherent, but will not be able to provide any

logical justification for them, and prove that they are derived from something ultimate and absolute.

Strawson (1987) claims that “we have an original non-rational commitment which sets the bounds

within which, or the stage upon which, reason can effectively operate, and within which the question

of the rationality or irrationality, justification or lack of justification of this or that particular judgment

or belief can come up” (emphasis added). The rational is thus embedded and elaborated within a pre-

rational context of preferences and cognitive assumptions (Clark, 2000). Similarly, MacIntyre (1988)

asserts that rationality and justice are both tradition constituted and tradition constitutive2. Rationality

can operate only within a certain tradition that is within an already given system of assumptions and

motives.

2 Tradition in its broader meaning is for MacIntire simply an “argument extended through time”. In this paper tradition is understood as certain conceptual framework, which is common to all of its members and by which they distinguish themselves from members of other traditions. It can be defined in terms of history, geography, nationality, culture, gender, religion, major believes, et.

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Various examples demonstrate that rationality is strongly dependent of our pre-rational beliefs. 3 As

MacIntyre (1988) point’s out “there is no set of independent standards of rational justification by

appeal to which the issues between contending traditions can be decided”. There is no neutral common

ground form which to evaluate the conflicting traditions of science and religion. Although there are

many common beliefs between traditions, reliance on rationality and the power of argument will not

lead to unification of different worldviews. In other words, even if reasonable persons from all over

the world decided to sit together and tried to unite their worldviews through rational debate, they

would fail, because they originate from different traditions and thus view the world through different

conceptual frameworks.

The notion of rationality as understood both by neoclassicist and their major critics is inadequate

because it doesn’t take into the account the fact that rationality can operate only within a certain

tradition. Rationality is contextual, that is, contingent upon tradition. With help of the concept of

contextual rationality, we can study economic relations between distinct social groups more

accurately. By considering institutional and other factors that affect a society, economics scientist can

identify the conceptual framework within which that society operates, and thus identify the kind of

rationality, which is common to it. In areas where it is fairly similar to her (western, scientific,

materialistic, etc.) rationality, she can imply standard measures and solutions, known from the bulk of

economic theory. But in areas where there exists discrepancy between these two rationalities,

economist has to be aware that standard solutions will not be good enough, and has to adapt them to

suit the distinct conceptual scheme of studied society or social group. Notion of contextual rationality

can be useful methodological aid to identify, explain and eventually improve certain types of

economic behaviour that could easily be labelled as irrational.

Let us examine what are the factors, which influence and define contextual rationality. They are

certainly numerous and various but main factors are: institutions, conventions, customs, habits, beliefs,

expectations and feelings. They will be dealt with in the following section, with emphasis on their

contribution to contextual rationality.

Institutions: rules, conventions, procedures and customs. According to Simon, various rules of

thumb, heuristics and other mental shortcuts are important tools, which help individuals to cope with

their limited deliberating abilities. He implicitly presumes, that when a problem is simple and easy to

solve and all the relevant information are provided (like in some laboratory tests), agents will

optimise, that is, they will find the best solution (Hargreaves Heap, 1993, pg. 79). In other words,

3 E.g. the example of Muslim and scientist (Clark, 2000). First is capable to rationally argue about his attitude towards women “because it is the word of Allah”. Scientist could label his belief as irrational. However, if scientist tries to justify his own commitment to evidence, he will encounter great difficulties in trying to justify his conviction that something that has regularly happened in the past will happen again.

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agents use rules of thumb and heuristics only when problems that they are facing are very complicated

for them or when they do not have necessary information to make a decision – which is typical for

many everyday economic situations – otherwise, they optimise. But vast empirical research clearly

demonstrates (Conlisk, 1996; Stanovich & West, 1999) that agents use rules of thumb and heuristics

even when problems that they are facing are simple and easily solved.4 Evidence suggests, that rules of

thumb and heuristics are more important to human cognition than it is proposed by concept of

bounded rationality.

Institutional economists point out that rules of thumb are shared among people, and are usually not

personal affairs as one could understand from Simon’s work (Hargreaves Heap, 1993, 79). People use

various rules of thumb, conventions and procedures on a daily basis. These institutions are same for

all members of a certain tradition and help them in their everyday interactions. Why would a rational

agent follow institutions? Answer might be, that it is a rational thing to do, because other agents ensue

them too, which allows him to predict their behaviour. But question arises, why do others follow

same institutions. Certain convention is in use only because it exists, not because it is more rational to

follow one convention then others. From the neoclassical point of view it is not possible to explain

why some and not the other conventions or customs are in use. Even if we assume bounded rationality

in the sense of limited deliberating capabilities and limited and costly information, the origin of

institutions is an elusive concept. One could seek the answer in ethics and its account of what is

acceptable and what is not. Or one could turn to evolutional economics, according to which

institutions are formed as more or less unintended consequences of economic action of agents. They

can be portrayed as emerging through a process of the repeated play of certain kinds of games, such

as the coordination game or the prisoner’s dilemma (Sugden 1986). Over time, agents will hit the

strategies that are “evolutionary stable”; and these strategies, which are relatively simple bundles of

rules, become institutionalised. Certain wide spread conventions can become internalised that is it can

become a habit in a sense that agents do not deliberate about its usage but follow it automatically.

They automatically expect that other agents will follow it also.5

Habits. Unboundedly rational agent or economic person, is capable of justifying her every action and

belief, because they are an outcome of her conscious deliberation and thoughts. Boundedly rational

agent or administrative person acts on a basis of conscious deliberation as well, even if he reaches his

4 Consider for example the experiment, known among psychologists as the Linda problem (Tversky in Kahneman, 1983), where the vast majority of subjects in study made a crucial mistake in a very simple probability test on conjunction of alternatives.

5 For example, it is rational to drive on a right side of a road in USA or continental Europe. Drivers do not consciously deliberate on which side of a road will they drive and at the same time they anticipate that other drivers will do the same.

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decision in some other, different way than former. But people often act unconsciously, out of habit,

and do not even contemplate about it. 6

Hodgson (1993) drawing on the work of Koestler (1967) and Camic (1986) asserts that human mind

could be considered as a hierarchical system. The highest level is constituted of conscious and

deliberate decisions. On that level agents use optimisation, rules of thumb, heuristics, and institutions

to form a belief or reach a decision and act upon it. Lower in the hierarchy of mind are habits, which

are almost completely automated. Camic (1986, pg 1044) has defined them as “more or less …

independent desires to act in a previously learned manner …”. They can occasionally be influenced

by decisions from higher levels of mind. The lowest level in hierarchy of mind is represented by

impulses, instincts and other more or less autonomous acts, like breathing or hunger. Although we are

capable of partially controlling these impulses (i.e. we can hold our breath and not breathe for a

while) it is unlikely that we do so.

We can distinguish between two types of habits: shared and personal. Shared habits are institutions

(conventions, procedures, etc.) that have become internalised by an individual. Greeting a friend or

acquaintance, driving on a right side of a road, … , are some examples, of habits, which are common

to all the people of western tradition, and maybe even broader. Each tradition usually has some

institutions that are used so frequently that they become habits for their members. For example, all

Muslims remove their shoes before entering to a mosque. That is something that they do

automatically, without deliberation, out of habit. Some believe that shared habits are same as customs .

But there is a slight difference between these two expressions – custom is a broader notion, which

encompasses both shared habits and other institutions, unique for a particular tradition. Personal

habits, on the other hand, are characteristic for specific person. Although many persons can share the

same habit, like getting up early, fast and dangerous driving or smoking, they are not common to all

the members of society. 7 In short, habits are indispensable instrument of human mind, which enable

us to perform routine acts almost unconsciously, thus freeing our limited deliberating resources to

perform certain more demanding or creative activities.

1 THE RATIONALITY MATRIX

6 Car driving is a fine example. At first we are aware of every aspect of driving, but soon, these actions become automatic, and our attention is turned towards other issues, like keeping an eye on the traffic or conversation with fellow passengers. People do not consciously think on which side of the road they will drive, every time they start their vehicle. But habits are not unchangeable. In Australia, for example, foreigners have to and can drive on the left roadside, but they have to consciously concentrate on that. If they are not careful, they can quickly indulge to their habits and drive to the other side of road.

7 You can expect that all the Muslims would remove their shoes before entering a mosque, and all Germans would drive on the right side of the road, but you cannot suppose that all Muslims are smokers or that all Germans are early risers.

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If we link together all ideas of rationality that were previously discussed, we could realize, that there

are two dimensions of rationality. First dimension is concerned with a question of boundedness of

rationality in a sense of limited deliberating capabilities as well as limited and costly information. It

can be unbounded, if we presume that human deliberating capabilities are unlimited and that all

necessary information is available and free. Otherwise rationality is bounded. Second dimension is

involved with a question of universality of rationality. We can either assume that it is sufficiently

universal (in general or in particular case) for our purposes or that it is contextual. If we take into a

consideration impact that institutions, habits, and believes of a society or some smaller group of

people have on agents’ rationality, we assume contextual rationality. Otherwise we assume that it is

universal. For methodological purposes we can connect these two dimensions into the rationality

matrix and consider differences between various approaches to rationality (Figure 1).

Figure 1: Two dimensions of rationality – the rationality matrix.

Rationality: UNIVERSAL CONTEXTUAL

Unbounded1. Neoclassical (mainstream)

approach to rationality

3. “Philosophical” approach to

rationality

Bounded2. Limited capabilities approach

to rationality

4. Holistic approach

to rationality

The rationality matrix introduces for major concepts or approaches to the notion of rationality, which

are classified by the presumptions of its boundedness and contextuality.

(1) If we presume that rationality is identical enough among all individuals, that is universal, all

necessary information is freely available and human mind has unlimited (or virtually unlimited)

deliberating capabilities, than we operate within neoclassical, mainstream approach to rationality.

Majority of economical theories and models explicitly or implicitly assumes this kind of rationality

from its agents. It is simple and abstract concept. It allows intensive usage of mathematics and logic in

the economics and is usually associated with optimisation. Of all concepts of rationality, it is the least

realistic, that is farthest from actual human behaviour. Because of this, the real life validly and

usefulness of conclusions and solutions based upon mainstream concept of unbounded rationality is

questionable.

(2) Theories and models that take into a consideration boundedness of rationality, but still consider it

universal (either implicitly or explicitly) belong to limited capabilities approach to rationality. This

approach has significantly gained in influence in the last decades. Bounded rationality is much more

realistic notion in comparison to unbounded, albeit more complicated and unclear. Its major weakness

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is in neglecting the influence of some aspects of human rationality (like institutions, habits, etc.).

Because of this, it is for example very weak in explaining some cases of economic behaviour that

deviate from standard Western/American conceptual framework.

(3) Some consider rationality to be unbounded, but at a same time take into account differences

between different traditions, which are consequence of institutions, habits and values of a society and

their influence on its members. This line of thinking is distinctive of some institutionalists, which have

emphasized the importance of institutions on human economic behaviour. Otherwise, this concept is

mainly in a domain of philosophers who argue mostly about universality of rationality, but do not

engage into its deliberation or information limitations.

(4) Holistic approach to rationality acknowledges both, boundedness and contextuality of rationality. It

recognizes the influence of contextual factors like institutions, habits, values, on rationality, while also

acknowledging that information is scarce and costly and that human deliberating capabilities are

limited. It is the most realistic concept and its power to accurately explain economic behaviour is

probably the greatest, but it is also the most complex one, so it is probably hard to get exact and

sometimes even useful solutions. Holistic approach to rationality allows us to become aware of

complexity.8 At the same time it cautions against mindless copying of economic solutions or strategies

that have been successful in one environment to another.

8 With holistic approach to rationality we can, for example, better explain the origins and formation of preferences. For mainstream economics preferences are given that is exogenous, and their formation is not considered to be the domain of economics. But having a comprehensive and consistent set of preferences certainly requires some cognitive endeavour (Pagano, 1991). Understanding of our preferences is tiresome and pretentious activity, and sometimes requires mastering certain knowledge and skills. Because having complete and consistent set of preferences is costly and tiring activity, it is rational for an agent to be economical (bounded) and form only partial preferences. Our initial choices are also very much influenced by institutions, customs and values of the society that surrounds us (contextual) and they very much determine directions and areas where our preferences would be completely developed and areas where they would be incomplete.

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2 HOLISTIC APPROACH - Rationalizing irrationalities of Slovenian Business

System

In this section we will first identify four key contextual factors that have influenced Slovenian

economy in an unusual and sometimes even unpredictable way.9 Next we will discuss the origins and

evolution of these factors as Slovenian economy kept changing from feudalism to capitalism to

socialism and finally back to capitalism. To illustrate the persistence and power that these factors have

on all the actors of Slovenian economy, including politicians, managers, workers and consumers, we

will provide some examples of peculiarities of Slovenian economy today and try to explain them using

these factors.

Any inquiry into such a complex subject as a historical development of the country’s economy and

society is bound to be incomplete and partial. However we assert that majority of specific

developments and peculiarities of Slovenian Business System that exist today are the result of few

basic socio–economic flows, which have gradually developed in the 19th century and have survived all

the changes of the business environment practically unaffected. We have identified four major socio-

economic flows or as we will call them through the rest of this paper, four contextual factors:

Strong localism

Specificity and importance of informal networks (relationships)

High discretion and autonomy of managers

Inability of cooperation between companies

It is our intention to show that these “background institutions” have in many aspects become

“backward institutions” in the socio-economic development of Slovenia in the last transition period,

which started in the late 80s. During the last decade Slovenia has become a small open economy

(population of 2 million people), which tries to become a full member of EU. The economic success in

this new context has become the main criterion for all decision-makers (especially for managers and

politicians).

2.1 Strong localism

Slovenia is a very small but extremely diverse country. It covers the area of 20.273 km2, which is

roughly half the size of Switzerland, and yet it includes four distinct European natural habitats: the

mountainous Alps, the limestone Dinaric karst area, the fertile Panonian plain and the ardent

9 It must be mentioned, that our definition of contextual factors is similar to Whitley’s (1992) “background institutions”, which are ”patterns of social behaviour” where rapid shifts in “proximate institutions” have no significant effects on the economic development of the country.

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Mediterranean. The landscape is characterized by high mountain ranges, which are separated by lower

lying valleys. Only one sixth of its territory is level country (Plut, 1999) Four neighbour countries

Italy, Austria, Hungary and Croatia have throughout the history tried to control some of its parts.

Habsburg monarchy was first to include all of the Slovene regions. But even under Habsburg rule

southwestern parts were under Italian influence and northeastern regions under Hungarian influence.

Mountainous terrain made transportation and communication between valleys difficult, hence local

communities had developed in some sort of self-sufficient isolation. Neighbouring valleys have

evolved different dialects of speech and different economies, depending on the availability of natural

resources. They were loosely connected into larger regions of Dolenjska, Kranjska, Štajerska,

Gorenjska and Primorska. The loyalty of people belonged firstly to their local community and

secondly to their region. Not until 1848 did Slovene intellectuals issue the first political programme

for an United Slovenia and started propagating the idea of Slovenia as an autonomous republic within

Austro-Hungary or as an independent state.

Even at the end of 19th century, when the country gradually began to industrialize and the lack of

available land for cultivation caused a permanent state of crisis for peasants from all over Slovenia,

strong local cohesion and “valley mentality” have survived almost intact.10 Since there were no major

industrial towns to migrate to, peasants who were unable to support themselves and their families had

to move to other parts of Europe and primarily to the United States. Those who stayed, continued with

a basically subsistence based form of farming, where farmers traded their surplus agricultural and

traditional cottage products on small neighbouring markets. Although this system has prevented

farmers from engaging in a capitalist process of modernisation, it simultaneously prevented the

farming communities from destroying their traditional village mutualism and co-operation.

At the end of the 19th and the begging of the 20th century the country gradually began to industrialise.

But it was not an usual pattern of fast industrialisation in a few urban centres that happened in

Slovenia. It was rather a community-based industrialisation, where foreign owners had built factories

in different valleys, depending on the availability of natural resources and cheap labour (Jaklic, 1999).

Factories have served as an additional source of income for peasants, which had still primarily

engaged in an agricultural activity and considered themselves to be a farmers and not workers. This

arrangement had survived the First World War and the fall of the Habsburg monarchy. In a new

Kingdom of Serbs, Croats and Slovenes (shorter: Yugoslavia), Slovenia was the most industrialised

and most developed region. Foreign owners took advantage of the fact that it had ceased to be a

supplier of raw materials and intermediate products for Austro-Hungarian Empire and was instead in

position to supply an emerging Yugoslav market with high value finished products. As agricultural

10 For more on the “valley mentality” in Slovenia see Kristensen, Jaklic, 1998.

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prices dropped again, an increasing number of peasants sought to supplement their agricultural income

with industrial wages, which have caused the rapid growth of new factories. In this way had local

valley communities managed to keep their traditional agriculture-based way of life and

industrialisation had not only not broke strong communal bonds but had in fact enabled “valley

communities” to remain in blissful isolation with relatively unchanged costumes and conducts until

the Second World War.

The WWII has brought the new communist regime in power, and along came the new economic

system – socialism. But Yugoslav socialism was in a few distinct ways different from the Soviet kind

of socialism. Yugoslavia never succeeded in building up a strong institutionalised central planning

system. Continuous changes and reforms made it impossible for central planners to gain a strong

position like in other East European countries during that period (Prasnikar, Prasnikar, 1986). Politics

were conducted through highly shifting procedures viewed from the formal dimensions of the system

and hardly anyone could learn to master one system and plan strategies before institutions and formal

rules were changed again. Local politicians had much more political and economical power than their

East-European counterparts and they have used it to bolster economic development in their “favourite”

regions, that its in valleys that they have originated from or where they had currently lived.

Unlike in Russia and other East-European countries Yugoslav partisans that have fought in a war were

not drastically affected by political purges and bogus trials that would have eliminated potential

adversaries to the ruling clique and at the same time ruined all possibilities of creating some sort of

informal network for allocation of government funds. In Yugoslavia the politics of allocation was

much more a game of give and take within a network of former partisans which were acting in dual

roles: as politicians and entrepreneurs. Having a vast political and economical power they were able to

smooth transition into socialism to such an extent that there were no major changes in life of peasant

workers (Kristensen, Jaklic, 1998). The latter have expected from their new leaders to provide them

with a secure and steady jobs in a factory that would grant them social security but would not be to

demanding, challenging or time consuming, so that in the afternoon they could still work on their

farms or in their communities.

Throughout the socialist years localism and self-centeredness of valley communities have thrived.

People have lived and worked in their own communities and had almost not migrated to larger cities.

In 1981 less than 40% of the people lived in urban areas. 11 They were happy with routine,

undemanding and modestly paying jobs which allowed them to use their craftsmanship and

11 In the year 1995 around 50% of the people lived in urban areas. In western Europe the share of the urban population was more than 75% (Plut, 1999). Slovenia has never reached high level of urbanization, but already suburban settlements are growing faster than urban cities.

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entrepreneurial abilities in the local “grey economy” that had generated them additional income as

well as respect and status in local community.

But the socialist system could not last forever and when it has collapsed it was expected that the above

explained communal life would disintegrate along with the old socialistic companies. Price and

(international) competition became more and more important factors in a new market economy. But as

we will try to show with the case of merger of two Slovenian banks, the traditional local life is still

very strong.

2.1.1 Localism in transition: The case of banking sector

The idea behind the merger of Slovenian second largest bank Kreditna Banka Maribor (Credit Bank of

Maribor - KBM) and one of small regional banks Komercialna banka Nova Gorica (Commercial Bank

of Nova Gorica - KBNG) was sound and economically viable. In the beginning of the 90’s the larger

Slovenian banks, which possessed around 70% of the bank capital in Slovenia, were unable to operate

and were in need of rehabilitation. The reason for their financial failure originates from some

peculiarities of Yugoslav system of self-management. The owners of Slovenian banks where

companies that were at the same time their main clients. But actual control of a bank was not in the

hand of its owners but in hand of various politicians and bureaucrats. As a rule, each region had a few

major companies and a communal bank whose main purpose was to service them and local

community. Bank performance was usually not measured in financial terms but in its ability to provide

its clients with favourable loans for investing in production or for improving the living standard of the

local community.

Because of the high inflation, real interest rates throughout the 80’s where in fact negative. This

benefited companies by enlarging their actual equity and improving their capital structure 12. But it was

devastating for banks that had suffered heavy losses and were able to operate only with regular

monetary boosts from the central bank, which kept issuing new money emissions. Coupled with

bankruptcy, financial troubles of their clients and losses from the exchange rate differences, majority

of Slovenian banks was in need of serious rehabilitation in the beginning of 90’s. Their rehabilitation

12 Ribnikar (1994) asserts that inflation was “natural habitat” for Slovenian companies, meaning that they could not have grown or developed without it. In the system of self management companies were usually created by political decisions. Their equity, which at least in principle belonged to all residents of Yugoslavia, was insignificant. Most of the profits was channelled to employees and their families through larger wages, supplements for accommodation, and transportation, stipends, subsidized vacations, etc. Growth thus had to be financed by loans, which has led to very unusual capital structure, where equity represented around 10% and debt represented around 90% of company’s capital. Since nobody was foolish enough to invest their own money into a company where all additional private capital would immediately belong to some 20 million people, there was no regular way for improving companys’ capital structure and the burden of high interest payment would in the long run be to heavy to endure, even though companies have tried to carry it over to consumers via higher prices. But since nominal interest rates were not indexed, high inflation meant that real interest rates were small or even negative, as has happened in the 80’s, thus actually enlarging companies equity and improving its capital structure.

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was one of priority tasks of the new government and the central bank. The control of banks

undergoing rehabilitation was transferred to the state Agency for Bank Rehabilitation and the state

bonds were issued to replace the non-performing assets and to prepare the banks for future

privatisation (Ribnikar, 1994).

In the beginning of the 90’s, after the initial shock of separation and loss of Yugoslav market have

subsided, there were around 30 banks in operation. Most of them were small regional banks, and even

the largest two of them were small in comparison with other European banks. Slovenian banks were

not as efficient as foreign banks and being also so small, it was feared that once the foreign

competition arrives, it would destroy Slovenian banking system. Thus an idea to merge these regional

banks into a two or tree larger banking groups (pillars) was endorsed both by the Central Bank and by

the government. Creation of a few larger universal banks would rationalise operations, uniform

information systems, cut costs and generally make banks more competitive, flexible and stronger.

With their extensive local network of branch offices, reduced costs, and better knowledge of local

conditions, such banks would be able to resist and even fight foreign competition. It was expected that

that would also benefit the corporate sector and economy as a whole.

Since KBM was almost rehabilitated and KBNG was still in trouble, Agency for Bank Rehabilitation,

together with Bank of Slovenia (the central bank), has decided that the most efficient way to

rehabilitate the latter was to join both banks into a New Credit Bank of Maribor (NKBM). Beside

immediate economical benefits of merger they wanted to give a signal and to set a precedent, which

would encourage other small banks to form a strategic partnerships and eventually merge into a few

strong and efficient banking pillars.

However, there was this issue of strong localism. KBNG covers the area of Primorska, border region

that is heavily influenced by Italy and Italian culture. KBM has it headquarters in Štajerska, border

region that is traditionally connected with Austria and German culture. Bankers from Primorska,

together with local people and companies, could not tolerate that their bank would be acquired by

“foreign” bank; that is by bank from other region. They felt betrayed and even demonstrated on the

streets against the merger (or acquisition, as they rightfully perceived it). They reasoned that the new

bank would not care enough for their local community and would use them mainly as deposit

collectors. Because headquarters of the new bank would be in Maribor, they feared that companies

from Štajerska would be better served than companies from Primorska.

But it was not a happy marriage. Ex KBNG became factually a set of branch offices of NKBM. They

were allowed to perform routine task and to approve loans up to a certain limit. The new scheme has

caused massive disapproval among the employees as well as among client companies from Primorska.

12

The system just didn’t work and nothing the management of NKBM in Maribor could do would

improve it. After few years and a number of changes in the management boards of their branches in

Primorska, they have realised that the merger is just not working and decided to apply for permission

for separation of the two banks. The CEO of NKBM has explained that they were having troubles in

overcoming regional and sociological closeness of banks. Contextual factor, which had seemed so

unimportant in an initial proposal and evaluation of the merger, has proved out to be an obstacle too

big to overcome even for the experienced management of the second largest bank in Slovenia.

Even though the idea was probably right, its execution was evidently wrong. Slovenian banks are

certainly too small for international competition and should somehow merge together. But the mergers

should not be done by some decree of authorities, especially if those authorities are oblivious to the

contextual differences between different banks. If the authorities had been pursuing holistic approach

to rationality they would try to create such an environment where banks would realise that they have

to merge in order to survive and be successful. They should probably have to encourage gradual

cooperation of the banks, first through mutual collaboration on certain projects like computer support

or joint network of ATMs. Only after the managements of different banks have gained confidence in

each other and their owners realised that the only way to achieve satisfactory return on equity was

through the economy of scale would banks voluntarily decide to join one of the few banking groups

concentrated mainly around the two major Slovenian banks. Such a mergers would be on the

partnership basis, where regional banks could still serve local companies and communities (where they

are very good at accessing the risk) while enjoying the benefits of operating at the economy of scale in

some support functions.13 Hasty and thoughtless decision about merger, made by people who did not

take into a consideration soft institutional constrains and local patriotism of Slovenian organisations

has in fact backfired and actually stopped the process of gradual merging of the Slovenian banks

which was under way. Alarmed by the negative results of merger of KBM and KBNG other banks

have decided to wait and stay independent as long as it was possible.

2.2 Specificity and importance of informal networks and grey economy

The extent of hidden economy in the 90’s in terms of unreported incomes in Slovenia might represent

17 – 21% of the recorded GDP. In its strategy for the development of small businesses Ministry of

economic affairs had estimated, that “grey economy” represented 22% of official BDP in 1996. In

1995 around 26% of the active population or 239,000 persons actively participated in hidden or 13 It is also a question if merged, centralized larger banks could be large and strong enough for international competition. It might be that this solution would only make it easier and less costly for foreign banks to take over Slovenian banks. As suggested, one solution could probably be to organize a network of small (Slovenian) communal banks, which should work closely with local SMEs and leave the space for larger foreign banks to work with larger foreign and domestic firms. However, the network co-operation between banks is to a large extent not possible because of another “background institution”; inability of managers to cooperate, which is discussed in the following sections.

13

unreported activities (Kukar, 1995, pg. 16-25). In terms of working hours that would be enough to

create some 80.000 new jobs. In the 1999 World Competitiveness Yearbook (IMD, 1999) Slovenia

was ranked last out of 45 countries earning 2,19 points out of 10 for the highest extent of grey

economy. It was also poorly ranked for the extent of tax evasion, transparency of financial institutions

and public confidence in managers (Table 1).

Table 1: Indicators of the extent of hidden economy in selected countries in 1999

 Grey economy Tax evasion

Transparency of

financial

institutions

Public confidence

in managers

A B C A B C A B C A B C

Austria 4.87 3 1 5.47 15 3 7.08 18 7 6.85 14 5

Belgium 4.41 8 2 2.45 40 12 7.55 8 4 6.45 21 7

Spain 4.39 10 3 5.09 18 5 7.11 16 6 6.71 16 6

Finland 4.26 11 4 7.02 4 1 7.93 1 1 7.57 2 1

Hungary 4.20 13 5 3.06 30 8 6.35 25 9 5.53 37 9

Netherlands 4.17 14 6 5.67 14 2 7.76 4 2 7.02 9 3

Denmark 4.15 15 7 5.43 17 4 7.72 5 3 7.24 4 2

Portugal 3.76 23 8 2.92 32 10 7.12 15 5 6.37 24 8

Ireland 3.72 24 9 4.84 20 6 6.61 22 8 6.94 12 4

Czech Republic 2.75 41 10 2.54 35 11 4.11 42 12 3.36 47 12

Poland 2.64 42 11 3.23 28 7 4.70 40 10 5.19 41 10

Slovenia 2.19 45 12 2.94 31 9 4.31 41 11 4.50 44 11

Legend: A – Mark (1-10); B – Overall ranking; C – Ranking among the 12 selected countries

Source: The World Competitiveness Yearbook 1999, IMD

Grey economy in Slovenia was acting as a kind of a social buffer, soothing the transition and making

social peace possible in spite the fact that in the year 1993, for example, some 130,000 people or 14,4

percent of active population were unemployed (SURS, 1993). It is believed that when situation would

stabilize the share of informal economy in the GDP would fall, since growing number of “afternoon”

operations would either decline or become legitimate businesses.

Informal networks and grey economy are to a certain extent present in all world economies. They are

usually viewed as an obstacle to free competition that in the end reduces the potential GDP of the

country. But in some cases, allocation through the informal networks and moonlighting economy can

14

be beneficial for country’s development. We assert, that this contextual factor has significantly

contributed to the success of Slovenian economy under socialist regime and has been beneficial also

since the 19th century. We believe that it has survived and even thrived during the last transition and

that some of the mistakes of that period are the result of mostly not seriously taking into a

consideration the impact of informal networks and grey economy. However, we think that grey

economy has become one of the important obstacles for the future economic development in Slovenia.

One of the major challenges for managers and politicians of this time is to find a way to mobilise

hidden power, creative energy and entrepreneurship of informal economy and to incorporate it into a

formal one which should become more internationally competitive.

In the 19th century “moonlighting” was essential for the survival of Slovenian peasants and their

communities. After the abolishment of feudalism in 1848, Slovenian farmers were stuck with small

farms, which they had to buy from previous landowners. In order to do so, they had to take loans in

newly created saving and mortgage banks. They were heavily taxed by the Austro-Hungarian Empire

due to military needs for protection of borders. In addition, the hereditary rule stated that the heir had

to pay a fair share of the inheritance to his brothers and sisters in money, or the farm was divided in

equal parts. Because of that, and because of the rough farming conditions of the mountainous terrain,

small farmers were prevented from accumulation of wealth and discouraged to embark on any

entrepreneurial activity that would enable them to improve their farming conditions (Kristensen,

Jaklic, 1998). Even today, after one and half century, Slovenian farms are extremely small compared

to other European countries14. Since farmers were constantly living in a state of crisis, struggling to

produce enough to be able to pay rent, taxes and inheritance claims, they gradually began to cooperate

and help each other within their local communities. They started producing wooden crafts or textile

and offering various services on local “grey” market. United in face of a “foreign occupier” they

gradually institutionalised a system of reciprocity of services and help among neighbours. Rather than

to participate in an economy built on principles of market exchange, they developed a system which

could be kept secret and untaxed from the Empire authorities and which for these very same reasons

had a high degree of legitimacy among the population. The problem was that this unofficial, “hidden”

economical system could not by itself generate the money incomes necessary for it to be self-

sufficient. Thus farmers were forced to generate supplementary wage-incomes from sources outside

the system. Depending on what was available in their valleys they started to work in the forests owned

by the catholic church or in a mines, sawmills and factories owned primarily by foreigners. Because

income from the factories and mines was only a supplement to their farming income, it was in a way a

subsidy to the mine and factory owners, who were paying very low wages to their workers. Thus the

hidden valley system of mutuality and formal foreign capitalist system cohabited in a mutually

14 60% of farms have less than 3 hectars and the average size is 3.3 as compared to 14 hectares in the EU (Kovacic, 1996).

15

reinforcing way. Since none of the systems permanently succeeded in dominating the other, they were

able to coexist up to the end of the Second World War.

After the WWII, partisans knew that the easiest way to gain local support, create legitimacy in a rural

society and simultaneously establish authority, was to simply allow people to live on their small lots

and to create enterprises that would offer “workers” additional, though not necessarily very high

wages (Kristensen, Jaklic, 1998). Thus factories that have been established at the end of WWII could

simply be seen as collective associations for the provision of money in terms of wages. The workers

could still conceive of themselves as farmers and orient their life and careers toward this form of life

with the necessary additional income being provided for as a collective good organised and managed

by the socialistic state. Those without land, eg. craftsmen and technicians, would also find their

challenges in the surrounding community, where their skills were welcomed among the house building

neighbours and friends and not in a formal economy where they kept working on undemanding and

unchallenging jobs. The decisive sign of community integration was the “house and garden”, because

this could only be achieved through active participation in the moonlighting, which meant learning

how to play the secret game of local mutualism.

On the higher level, former partisans, now successful politicians and/or managers, played a similar

game of allocation politics. Just like local communities, they have acted by the rules of mutualism and

reciprocity on the national level. Although different fractions of partisans competed mutually to

dominate the enterprise sector and to gain influence in different state agencies, they have also

collaborated with each other and negotiated about the allocation of state funds. Thus, the success of a

manager was dependant more on his “connections” and networks that he has belonged, that on

economic performance of his enterprise. As long as he was producing satisfactory business results it

was his ability of successful lobbying which was important for the development of local community

and companies.

2.2.1 Moonlighting and informal networks in action: Case of Ljubljana Stock Exchange

With the case of Ljubljana Stock Exchange we would like to show how strong “background

institutions” are even with respect to a new institution and how the same old behavioural of informal

relationships and patterns from the past decades or even centuries are repeating.

In the year 2000 the turnover of Ljubljana stock exchange reached 269,6 billion tolars and it’s nominal

annual growth has slowed to 1,5 percent (Repovz, 2001). At the same time the amount of direct

“bundle trading”, where stock exchange was just notified after the transaction, amounted for 156

billion tolars, which was more than 20% higher than previous year. Turnover on the unofficial “grey

16

market” came to 171 billion of tolars, with annual growth of around 30%. In fact, unofficial and

untransparent turnover added up to 327 billion tolars, or 22% percent more than stock exchange

turnover. For some observers the figures are startling und worrying. The transition is almost over, but

the “grey trading” is not declining, more, it keeps flourishing.

Various explanations and solutions were offered to make clear and to abolish this anomaly of

Slovenian capital markets. Relying on the historical evidence we assert that these developments are

just a continuation of an old tradition of moonlighting and relying on the contacts and informal

networks, which have altered itself and adapted to a new environment. Some new institutions, like

Stock Exchange, were simply copied from the anglo-saxon world, because it was a modern thing to

have them. It was believed that just by introducing these institutions transition economies could

transform their economies from planning to market economies. But contextual factors can not be

ignored and the case of Ljubljana Stock Exchange clearly shows that these institutions if not

introduced properly degenerates into some sort of “freak” institutions. Some Slovenian intellectuals

with deep understanding of the nature and peculiarities of previous and present economical and

political systems, have consciously or instinctively followed the holistic approach and had suggested

the alternative for the key priority of transition - the abolishment of the social ownership of business

enterprises.15 But political leaders have decided to listen primarily to foreign experts and consultants

(the prominent place among them has Harvard economist Jeffery Sachs) who offered universal

solutions, and to ignore experienced domestic economists, as they perceived to be “contaminated” by

the previous system.

When Ljubljana Stock Exchange was founded in 1989 it was first such institution in Yugoslavia and

was widely celebrated (or criticized) as a major step toward western, capitalistic economy. In

November 1992 The Law on Ownership Transformation of Companies was passed by the Parliament.

It has introduced a combination of free distribution and commercial privatisation of companies. The

basic transformation scheme was that 10% of a company’s shares were transferred to the

Compensation/Restitution Fund, 10% to the Pension Fund, 20% was designated for free distribution to

all Slovenian citizens via ownership certificates, 60% were available for internal free distribution to

employees via ownership certificates, or shares were sold on preferential terms (50%) discount to

insiders under a special internal buy-out scheme, or on commercial terms through public offering of

shares, public tender of public auction. It was expected that real privatisation in the economic sense

would be achieved gradually. After the initial allocation of shares, a process of concentration of shares

in hands of active owners would enable greater efficiency of economy. Stock exchange was expected

to play a major role in that process. Throughout the 90’s the major function of secondary capital

market was the “consolidation of social property” (Mramor 2000). If we disregard a few cases of

15 More on this in section 3.2.2.

17

financial institutions issuing securities, primary capital market was virtually non-existent. However, as

we already suggested, even the role of redistributing wealth was performed relatively poorly.

To avoid severe plummeting of share prices caused by excess supply of shares from small

shareholders that wanted to cash in their “gifts” from the state as soon as possible, and to limit the risk

of negative effects on interest rates and economic growth, two year moratorium was put on a transfer

of shares from internal distribution. Shares from internal buy-out were transferable only between

participants of the internal buy-out until the programme concluded. That was the start of the “grey

stock market”. Although it was legally unlawful to sell these shares, various “stock-brokers” had used

an arsenal of legal tricks including futures contracts combined with high pressure selling to persuade

small shareholders to sell them their shares with generous discount. After the initial redistribution of

shares, trading on the grey market has slightly declined, and trading on the stock exchange has grown,

mainly because of foreign institutional purchases. But in the beginning of 1997, Bank of Slovenia

introduced obligatory custody accounts for all foreign portfolio investments in order to protect the

macroeconomic stability of the economy. Stock players have succeeded in persuading the public, that

these restrictions have in fact resulted in cessation of foreign purchases and decline in scope of trading

on stock exchange. But some economists believed that that was not the main reason for stagnation of

the stock market. They have emphasised the role and power of managers, which did not have any

interest to participate in stock exchange.

Off market trading started to thrive once again, this time with the shares of Mutual Investments Funds.

Actually, most people didn’t invest their certificates directly in the companies, but have rather

exchanged them for the shares of so called Authorised Investment Funds (AIF), which were in turn

supposed to acquire stakes in various public companies, diversifying portfolio and thus reducing the

risks (same as mutual investments funds in developed economies). Through lavish and costly

marketing campaign in a country that has only two million inhabitants, AIFs succeeded in attracting

around 1,2 million of shareholders (Giacomelli, 1999). But when the time came to invest them into the

shares of real companies there was not enough companies left to invest in. The government has

overestimated the value of “social” property that was liable for privatisation.16 AIF’s were left with

unused certificates and were not able to operate properly nor to officially become listed on stock

exchange. Shareholders, which were on average quite uninterested in whole “stock business”, tempted

by the offers from various stock brokerages or independent “entrepreneurs” started to sell their shares

for the fraction of nominal price. Managers of AIF have also contributed to the growth of grey stock

market. In a highly informal manner they started to swap packets of shares of companies in order to

shape a more compact portfolio and take active role in corporate governance or just to present their

16 The infamous »privatisation gap« was estimated to amount around 120 billion tolars, which was approximately 4,8% of BDP in 1998. The problem of »privatisation gap« was still not successfully solved in time of writing this article.

18

balance sheets in a more favourable way.17 These transactions did not go through official stock

exchange market but were just reported after their execution. Due to these transactions nominal value

of assets of AIFs was artificially raised, which allowed for the companies that manage AIFs (usually

owned by banks) to realise profits of 5,1 billion tolars, although the funds that they have managed

experienced loss of 40 billion tolars in 1996 (Giacomelli, 1999).

Many managers of companies have used “grey market” trading for the concentration of ownership but

also for hostile takeovers of other companies. Through various informal meetings, managers of

acquiring companies tried to persuade their more or less close friends who held leading positions as

managers of other companies or financial institutions to sell them their shares in company they wanted

to acquire. In the same manners managers of the “victim” company, which was as a rule always

against the acquisitions, tried to convince the same “friends” not to sell their shares.18 Whatever the

deal was, following transactions were rarely carried out through the stock exchange.19

Heritage of the past and customs acquired through the decades of operation are hard to change in a

single decade of transition. The fact is that informal economy and networks have a long history of

relatively successful activity. Although in the long run their efficiency could not be compared to that

of a market economy, they contributed to a higher standard of living in the past and probably to a less

painful transition in the 90’s. Old socialistic economy was formally abolished and new market

economy with all its appendages was introduced, but the old ways of doing things have survived. That

is one of the major reasons for the stagnation of Slovenian stock market. All major economic players

including managers, financial institutions and government officials prefer to do their business on

informal basis through direct negotiations and avoid stock market and its institutions. Since they all

participate in the grey market, except for the lonely voice of the Ljubljana Stock Exchange, there is no

real interest in abolishing it for the being.

17 Ribnikar (1999) asserts that unlike foreign mutual funds, AIFs are not real financial intermediates. They do not assist in flow of funds from surplus financial cells to deficit financial cells, that is from citizens to companies. They have two distinct functions that do not benefit companies. Their first function is to make it possible for their shareholders to easily sell their free shares. Since most of the shareholders which sell their shares use newly acquired money for every day consumption the only macroeconomic effect is just short term increase in consumption and decrease in saving. Second function of AIFs is to transform their portfolio through transactions on the stock markets. Whereas mutual investment funds in developed economies attempt to lessen the risk by diversifying their portfolio, AIFs are doing just opposite. They are concentrating their assets and are gradually changing into a holding companies, which take an active role in the governance of the companies. Since large part of their transactions does not take place on capital market but on unofficial grey market, they do not contribute to the development and growth of Stock Exchange.

18 This is a very similar game to that among different fractions of managers after the WWII competing for power. For more on this see Kristensen, Jaklic, 1998.19 Even government has contributed to the growth of grey market. Arguing that the cost of placement on the stock exchange were higher then the benefits of it, the Treasury department has decided not to place some government bonds on the stock exchange.

19

2.2.2 Could it be done differently

At the end of the 80s and at the beginning of the 90s some economists have suggested different

approach, closer to holistic approach to rationality, to the subjects of privatisation and establishment of

capital markets in Slovenia. Ribnikar (1994) argued that privatisation that was proposed by foreign

experts and some domestic politicians is inappropriate and would only aggravate the transition,

because it did not consider properly the essence of the previous system. Ribnikar (1998) has suggested

different kind of privatisation that took into a consideration the real condition of the economy and

some contextual factors like high power of managers. According to him, “social capital” should

belong to all the people, but shares should not be distributed to them. It should be transferred to an

institutional investor in form of preferential shares.20 This public institutional investor would be

passive but firm owner of the company, meaning that it would not be in a hurry to sell its share and

would demand adequate return on equity. Only in case of the most important business decisions like

selling or acquisition of the company or in case of unsatisfactory performance of managers would it

exercise its right as an owner. The right to actively manage the company would belong to a private

investor or investors which would bring new capital to the company.21 The nominal amount of

“public” equity in company under management of public fund would stay the same, but its share in a

company would gradually reduce. This kind of privatisation would be socially acceptable and

probably economically more efficient than the selected one. All people would benefit from it in the

long run and on more equal footing. Managers (new investors) would be interested in increasing the

value of the company. Money of companies would be saved.22 General savings and investments would

not decrease and personal consumption would not increase as it was the case with the selected

privatisation scheme.

2.3 High discretion and autonomy of managers

In a survey about the behaviour of the companies in the transition period,23 top Slovenian managers,

when asked about the goal of the company, have as the most important rated principle of ensuring

long-term survival of the company. By itself this would maybe not be so important, given the

instability and uncertainty of transitional markets. But theoretically correct principle of maximization

of share value was rated as second to last (Figure 2). Thus the most important goal of the company in

20 This could very well be a pension fund.21 It was expected that these investors would primarily be managers of the companies.22 Companies have spent a lot of money just paying the consultants who were making valuations of the companies. Many managers also tried to decrease the value of the company in order to ensure higher shares of ownership to them and other internal owners, which had a negative impact on their real operations in the market. 23 A group of researchers at the Faculty of Economics in Ljubljana has conducted an extensive survey “Behaviour of Slovenian companies and financial institutions in the period of transition” in 1997 and 1998. We gathered substantial data about all aspects of business behaviour of 70 large Slovenian companies (with more than 500 empliyees) and 130 medium sized companies (from 250 to 500 employees).

20

developed (especially anglo-saxon) economies, that is maximisation of the shareholder value, is

among the least important principles for Slovenian managers. Could we ascribe it only to their

ignorance (bounded rationality) or is there something more substantial (contextual) about it?

Figure 2: Importance of some financial principles for top finance managers

Source: Survey “Behaviour of Slovenian companies and financial institutions in the period of transition”, EF,

1999

In another survey24 managers of 250 Slovenian companies with more than 50 employees were asked

about their opinions on principal-agent relationships and more specifically about the suitability of

different kinds of owners from their point of view. 59% of the questioned managers feel that owners

that acquire the company through purchases on capital market without the consent of the management

is not suitable owner of the company. Because owners appoint managers and one of the main

functions of the stock markets is to allow anyone with enough money and interest to become an

owner, the most appropriate answer would definitely be “It is not my business”. Yet only 11% of the

questioned managers had opted for it (Figure 3). Most managers feel that they are foremost loyal to the

company and responsible for its well-being and do not feel that they work for the owners of the

company (Figure 4). Only 22% has stated that they work primarily for the benefits of the owners. It is

interesting to note, that almost as high number of managers, that is 21% of them, feels that they work

and are responsible for the well being of the society as a whole. Thus it seems that Slovenian

managers have a highly developed sense of social responsibility. They do not acknowledge AIFs, state

funds and small shareholders as real owners, because they believe that these groups are often confused

in their role of owners (they are not “wilful” owners, they have become owners by the government

24 Survey was conducted by the research group SPEM and by the leading Slovenian business newspaper “Finance”.

21

decree). Thus they are loyal to the company, which is a rather confusing idea, but suitable for the

confusing transition times.

Figure 3: Is an outside buyer that has bought the company through the capital market without the

consent of the management suitable owner?

Source: GV, 2001

Figure 4: Loyalty of Slovenian managers

Source: GV, 2001

The types of owners that are the most influential in the opinion of managers and the types that they

pay the most attention to, are larger Slovenian or foreign owners and AIFs. The least important groups

were small shareholders and various government funds. Obviously strong and knowledgeable owners

that could interfere with the work of the management are not welcomed by top Slovenian managers,

although such owners would certainly be more beneficial to the company than weak or uninterested

ones. Only 18% of questioned managers would approve of “strong owners” like AIFs or foreign or

domestic strategic partners having substantial power in their company (Figure 5). Most of them or

54%, would rather have state or employees as owners of the company. About one fifth would be most

22

happy with highly diversified ownership structure, where no single owner would have power to

question managerial decisions.

Figure 5: Optimal ownership structure as seen by top Slovenian managers

Source: GV, 2001

Judging from the above-mentioned research results, even ten years after the beginning of transition to

market economy, Slovenian managers still do not act as their counterparts in developed economies.

They openly disregard owners, which are primary stakeholders in the company and consider

companies as their own property, which only they could run successfully. Slovenian managers were

highly autonomous in the past, and they have managed to preserve their independence and sovereignty

in the leadership of the companies even in the new market system (Whitley, Jaklic, Hocevar, 1997).

The transition seems to have neither caused gains nor losses in power and influence compared to the

old system. Thus the selected model of privatisation, which was supposed to limit the power of

managers, has in fact failed. As suggested by Ribnikar, it would be much better if managers were

allowed to become the actual owners of the companies.

In a previous system of self-management authority and legitimacy of the managers was rarely

questioned. “Peasant workers” were usually content with simple jobs that provided modest but steady

income, and that did not require some elaborate organizational or managerial techniques. Since those

that did not operate according to the rules of a “fair days work” where usually punished by the local

communities within which the factories were located, managers rarely had to exercise power and

formal authority within the enterprise which could lead to workers discussion and initiation of political

action against them. (Kristensen, Jaklic, 1998). They could even be in favour of increasing rights of

23

participation, co-determination and self-management without jeopardizing their own position. Rather

these reforms contributed both to conceal their real power and to influence and to legitimise their

surprisingly strong position in the social life of a socialist country.

Until the early seventies the power of managers depended on their relationship with and

embeddedness in the network of “old partisans”. Since allocation negotiations, deals, and decision-

making were highly informal, the rules and strategies of the game could only be learned through

continuous participation. In effect, the longer managers from local enterprises had participated in the

game, the better they were able to play it with expertise. Thus, if workers in a local plant used the

formal rules of self-management to elect a new manager, they would risk losing a skilful lobbyist

capable of safeguarding their interests in exchange for a more popular person who might cause them

financial losses. Nevertheless the power of managers was not absolute. Jaklic (1999) indicates three

main criteria that were used by workers and the population of individual localities to measure and

assess their managers’ performance. First was their ability to generate financial and other resources.

Second was their ability to generate jobs and incomes through these resources that could answer the

local needs for monetary wages. In the beginning, this ability was primarily measured in terms of

quantity. Later, however, jobs and incomes became dependent upon their ability to produce products

that could be also sold on western markets by employing technologies imported form the West. Third

criteria was their ability to provide their workers with inexpensive loans to finance the building of new

houses, stipends for the children of workers, and similar services necessary for the growth and

prosperity of the local community. If the comparison with other manager within the same or a

neighbouring locality was in disfavour of local managers, workers had the right to and could in fact

turn their manager down by evoking the formalities of the Yugoslav self-management system. In

effect, as long as they have kept their workers and local community happy, socialistic managers had

unquestioned autonomy.

At the end of 70’ as Yugoslavia was becoming more and more dependent on foreign trade and was in

need of foreign currency, managers of those companies, that were able to sell their product to the

western markets, gained new and undisputed power. As long as they kept exported goods at some

“socially acceptable” price level and bringing in a hard currency, their decisions and actions where not

questioned. Losses from the sales on the foreign markets were compensated by raising prices on

domestic markets, where buying power of domestic consumer and enterprises would simply be raised

by printing more money. Gradually, managers and their sales forces learned to allocate surpluses

outside their official bookkeeping, thereby accumulating “private” funds of currency in foreign banks

or hoarding them at home. With their newly acquired wealth they were able to enhance their status in

local community and also significantly contribute to expansion and growth of grey economy as major

buyers of moonlighting goods and services and as a major suppliers of valuable foreign currency.

24

When Slovenia became independent in 1991, one of the major issues was which role managers should

play it the privatisation process. The initial proposition of the law followed the already explained

Ribnikar’s logic, which was to give managers the power and responsibility. This proposition was

based on the assumption that managers already had power, it only needed to be controlled properly. 25

Because new political parties wanted to get rid of the old managers which were perceived as “red

directors”, that is managers with strong political links to the communist party politicians, and wanted

their share of control over the economy, they supported privatisation concept that was supposed to

limit the power of managers. Finally the law was a compromise between concepts of a decentralised

multitrack and diversified approach with most of initiatives coming form enterprises and massive and

speedy privatisation, centrally administered by the Government and based on free distribution of

shares to the population. However, this kind of privatisation gave a lot of discretion to top managers,

allowing them to form different coalitions in order to retain control. At the end of privatisation process

the outcome for majority of the companies was that 60% of the shares was in the hands of internal

owners and 40% in the hands of external owners. Whereas in USA shares are predominately in hands

of individual owners and in Great Britain institutional investors have a prevailing influence, in

Slovenia shares are primarily in hands of internal owners and AIFs. Although it was expected that

uninterested individual shareholders, that is mainly workers, would gradually sell of their shares to the

“real” owners (so called “second round of privatisation”), managers have managed to rettain this

dispersed ownership structure, where small internal owners control around 60% of the shares

(Giacomelli, 1998).

Therefore it seems that the same old game between local communities, workers and managers was

being played under different set of rules. Managers have managed to retain their power and autonomy

by preventing strong external owners to take control in the firms.26 Although workers participation in

25 The power of managers was very clearly exercised through “wild privatisation” which was very common at the beginning of the 90s, when many managers of socially owned companies took advantage of a very liberal federal (Yugoslav) company law that was still valid at that time. This law allowed them to create new companies by dropping down some of their assets and later at least partially privatising these newly established companies without much supervision (Korze, Simoneti, 1993, p. 213). It was not an unusual procedure for managers to simply sign commercial contract favourable to private companies (often owned by the very same managers) and in this was transfer business activity to bypass companies without proper compensation. 26 Some believe that the power of manager came with significant costs, which could in long term seriously weaken the companies. Since majority of employees in Slovenian companies were also their major owners, the problem of “employeeism” occurred (Nuti 1997). “Employeeism” denotes the situation where workers that are also owners have such a power in decision making process that they can bias the decisions towards raising the wages and keeping surplus work force. Prasnikar and Svejnar (1998), using model composed from investment and income equations with data from Slovenian companies, showed that employees of Slovenian companies indeed seize for themselves important part of added value (rent-seeking behaviour), which would have to be used for investments. They show that during the first part of transition (1991-1995) amounts of funds allocated for investments were established in negotiations between employees and managers and have found positive correlation between the negotiating power of managers towards employees and the extent of investments of the company, and negative correlation between former and the rate of growth of wages and other personal incomes. However, we claim that in the companies where managers and workers do not feel threatened from the external owners employeeism does not arise. E.g. one of the highest value-added per employee company, with extremely high annual investments, JUB, is controlled (majority ownership) by managers and workers.

25

decision-making process was formally reduced, they have effectively managed to retain important

negotiating power towards managers, since they acted in dual role of employees and owners. There is

always a chance that unsatisfied workers could sell their shares thus enabling hostile takeovers. Ten

years after the beginning of the transition, Slovenian managers still do not behave as scientists,

consultants or their counterparts from the developed economies would expect them to behave. They do

not pursue the “right” goal of the company, manipulate ownership structure of their companies, view

external owners with hostility, maintain strong links with the local community and are reluctant to

undergo any investments or changes that could jeopardise their position within the company or within

the society. But viewed from the contextual perspective they are by no means irrational. Because of

specific historical circumstances, institutions and customs, as well as limited information and

deliberating capabilities, they act as any other manager would act in this situation. They act rationally.

Whether their actions are good for the economy as a whole is not their concern, they leave it to

politicians to figure it out and steer the socio-economic development in the right direction. But in

order for the latter to do so, they must firstly truly understand why former behave the way they do.

In short, behaviour of Slovenian managers can be holistically explained, allowing for boundedness and

contextuality of rationality. Firstly, their power and autonomy originates from the previous system and

they have managed to keep it almost intact, as any selfishly rational person would do. Secondly,

undeveloped capital markets, low liquidity of shares and unpredictable investors who rely more on

information about the moves of foreign buyers or major capital players like central bank or

government than on financial data about the performance of the companies (Mramor, 2000, pg. 391),

make it almost impossible for shares to reflect the true value of the company. They are either

underrated or overrated, do not react on signals from the company and can not be reliable base for

allocation of capital and motivation of managers. Thirdly, AIFs, which are one of the most influential

and powerful institutional owners of companies, are not acting as responsible owners. Since their

shareholders have got their shares for free, and the values of their shares are very low because of the

“privatisation gap”, they do not strive for maximisation of value of their portfolio, but prefer

maximising cash flows that would enable them to cover their extraordinary high operating costs and

commissions of managing companies. Thus they exercise high pressure on managers for higher

dividends and are not overly concerned about the value of the shares in their portfolio. Fourthly,

internal owners, which are usually the largest group of shareholders, do not evaluate their managers on

the basis of increases of share value. Since they can benefit from the company in many different and

subtler ways, they do not demand that managers follow the principle of maximisation of share value.

2.4 Inability of cooperation between companies

26

Distinct feature of Slovenian business system is inability of corporations to form higher forms of

cooperation. When studying contractual relationships of companies, Jaklic and Hocevar (1999)

concluded that customer and supplier relations in Slovenia are as a rule short term and arm’s length 27.

Better collaboration between companies and the development of long-term relations characterised by

risk and information sharing and by cooperation in marketing, finance or R&D is inhibited because of

the weak financial discipline, incomplete legislation and continuous changes in business conditions.

But more importantly low trust and uncooperativness are legacies of previous political and economical

systems that have survived and adapted to the new market conditions.

Although high degree of internal cohesion and cooperation was characteristic for Slovenian local

communities in the past, there was little collaboration outside the community or between different

“valley communitys”. Powerful natural obstacles, such as mountain ranges and rivers, along with the

lack of roads and other means of communication, has led to the development of small isolated and self

sufficient communities, which did not cooperate with other communities in order to survive. After the

Second World War “brotherhood and unity” of all Yugoslavian nations was strongly propagated, and

development of infrastructure that would connect all the cities and villages was one of the priority

tasks of the new regime. But that didn’t improve cooperation between the different regions of Slovenia

simply because there was no need for it and it was impossible to obliterate local-patriotism of valley

communities. One of stronger character traits of Slovenian people is envy and jealousy of somebody

else’s success. So if one region was successful, the neighbouring regions did not increase cooperation

with it in order to profit from its success, but have instead put greater pressure on their own managers

and companies to improve their business results and somehow outshine the success of the first region.

Economic development in Slovenia was therefore mostly result of intense competition between its

regions and regional companies, and not the product of benevolent socialistic cooperation and

collaboration between different people or companies. Even though most managers of socialistic

Slovenian companies belonged to informal networks, had extensive contacts with each other and even

negotiated about the allocation of funds and implementations of new western technologies, their

companies as a whole did not cooperate between themselves and have usually operated quite

independently from each other.

27 Sako (1992, 1994) distinguishes two basic types of inter-firm relations: a) Arm's length contractual relationships (ACR) which combine low mutual dependence between companies, short-term relations, concentration on price and detailed contracts, low trust in the competence of suppliers and goodwill of costumers, low degree of technology and risk sharing, and b) Obligational contractual relations (OCR) which combine long-term mutual dependence and trust with considerable information, technology and risk sharing. Iner-firm relations in the Anglo-Saxon countries are examples of the former and Japanese and some other Asian countries are examples of latter. In general one would expect that in economies where the government does not share risk with private companies, does not foster the development of intermediaries between companies and regulates market bundaries and where developed capital markets exist, there are more incentives to develop short-term ACR relations between the companies. On the contrary, in those countries where the government plays and active role in the development of the economy and where the destiny of the bank and industrial sector depens on a credit-based financial system, one can expect the development of long-term OCR links.

27

In the 70’s and 80’s three additional factors influenced inter-company relations and reduced the

possibility of emergence of more long-term relationships, where companies would mutually trust each

other and collaborate in some business functions like R&D or sales. First, political pressure had forced

companies to formally integrate into conglomerates called “Composite Organizations of Associated

Labour”. Around 46% of these companies consisted of smaller companies from different or unlinked

activities (Kiauta et al, 1975, pg. 4). Creation of these conglomerates was solely on political basis and

was not based on an examination of the economic synergies of such integrations. Because of

oppressive nature of these mergers there was no real cooperation between individual units of

conglomerates. There was no centralised control, which would create overall strategy for achieving the

greatest possible synergies. Flow of funds between companies was usually from the successful

companies to bad ones (Hocevar, Jaklic, Zaman, 1999). Since unprofitable companies were not shut

down their losses were covered by the well-performing companies. Data from that period confirm that

the profitable and successful companies were interested in high salaries and in the lowest possible

accumulation, because the accumulation would anyway be lost within the system (Kiauta et al, 1975).

This situation decreased the motivation of the well-performing companies and disabled the

development of the most promising companies. This resulted in a loss of trust between individual

units, which, under those conditions, was aggravated by the absence of a corporate strategy.

Second, the position of Slovenian companies on domestic market and the international trade regime

had a substantial impact on inter-firm relations. Before 1989 the Yugoslav market was very protected.

Even though Slovenia was the most export oriented Yugoslav republic, majority of sales were made

on the domestic market. In 1990, after serious decrease of sales on Serbian market, because of boycott

of Slovenian goods by the raising Serbian nationalists, Slovenian companies made around 82% of

their sales on the domestic market, and only 18% was exported to other countries (ZMAR, 1992, pg.

6). Main motivation for export was to receive foreign currency that was used to import products or

inputs for profitable sale on the Yugoslav market. Therefore companies were able to export their

products at lower prices than on domestic market and to compensate their losses and make profits with

sales of imported goods and their own products on domestic market. As the premier oligopolistic

companies of protected Yugoslav economy, Slovenian companies didn’t have to work hard to be

successful. Because of this, there were no incentives for stronger collaboration and joint development

with domestic or foreign partners in order to improve their position on international markets. Since

Slovenian companies had a dominant position on the “easy” Yugoslav market their managers thought

that they did not need to collaborate in order to be successful.

Third, Yugoslav banks were institutions for giving loans, and not intermediaries in a rational sense

(Ribnikar, 1989). In the past a group of dominant large banks dominated the Slovenian financial

system and these banks were established by companies that were at the same time owners and

28

borrowers. Commercial banks acted on their local (republican) territories as central banks. The

National Bank of Yugoslavia was the central bank of all republican ‘central’ banks. Liquidity was high

if the monetary policy was expansive enough. There was no need to examine credit capabilities of

bank customers or bills as in the end everything was paid by the National Bank, which was far from

being an autonomous agent (Ribnikar, 1989, p.69). The result of this system was higher and higher

inflation which finished in hyperinflation at the end of the 1980’s. In sum, the previous economic

system allowed companies to share their risks or transfer them to others in a very peculiar way. Risks

were quite ‘democratically’ distributed throughout the system - meaning that there was always

somebody outside the company to pay for the bad decisions of the managers - and there was no need

to establish deeper OCR relations with partners at home or abroad.

Loss of the Yugoslav market at the beginning of the 90’s forced Slovenian companies to orient

themselves toward west and to increase their export efforts. Only those companies that were in serious

trouble sought powerful foreign enterprises to invest in them. Lack of trust and inability of cooperation

can best be observed in a recent wave of mergers and acquisitions of prominent Slovenian companies.

Since radical restructuring has negative effect on the short-run revenues and profits, managers are

reluctant to authorise any major reforms or reorganizations within the company as this could shake

their influence both within the company and outside of it. Acquisitions, on the other hand, have

usually both short-run benefits in form of increased cash flow from the newly acquired company and

long turn benefits in strengthening the company, making it more capable to resist inevitable foreign

competition and making it harder for other enterprises to acquire it. Since there is still very little trust

or cooperation between managements of acquiring and acquired companies most Slovenian takeovers

are in fact hostile takeovers (hostile to the management). Slovenian managers take acquisition very

personally, as an attack on them directly, and are determined to fight till the end, even though it is

clear that merger would be beneficial for both companies. The defending managers usually try to

involve local community and even politicians to participate in their defence. Acquisitions are often

portrayed as a means for one region (usually central Ljubljana region) trying to conquer and subjugate

another, usually marginal region.28 By exercising their influence in the community and even on the

national level, defending managers have as a rule managed to make an acquisition more costly and in

some cases even managed to prevent it29.

28 For more on this “exercise of power” of different managers and its consequence on regional economic development in Slovenia see Kristensen, Jaklic, 1998.29 Example of “Slovenian” merger is attempt of a very dynamic and successful Slovenian company Comet to merge with similar, but less successful company Swaty. Since both companies had complementary assortment of product in the machine engineering field, had a strong presence abroad and were relatively small the merger would be beneficial for both companies, especially for Swaty, which could gain access to some markets where Comet had a leading position. Management of Comet wanted takeover to be a friendly one, but management of Swaty was against it, probably because of fear for their yobs. They started strong campaign against the takeover as though “foreign” company is going to acquire their loved company. They have obviously managed to persuade some government officials not to allow the merger. Although Comet had fulfilled all the necessary legal requirements and it was established that merger would not be harmful to the competition in this area, government, which had a power to ban the merger, decided not to allow the takeover to take place. Comet filed a suit against the government because of lack of explanation for the government ban. After a few years of struggle Supreme Court has

29

ruled that the ban on merger was not in accordance with the law. But then in was to late for Comet, which was exhausted by the legal battle. An Italian company has stepped in and become the owner of Swaty.

30

CONCLUSION

It was not the intention of this paper to present the “right” answers to the challenges of transition in

Slovenia. Forces behind boundedness and contextuality of rationality are such that changes can be

expected only through actions of decision-makers (managers, entrepreneurs, politicians, bankers,

owners, workers, customers,…) and the final outcome can rarely be predicted by a social scientist.

However, we wanted to show that if the holistic approach to rationality which assumes both,

boundedness and contextuality, would be taken more seriously in the transition process of the last

decade, better results could be achieved from the transition. And the same probably holds true for the

future. Probably the biggest challenge for Slovenian decision-makers is how to overcome narrow-

mindedness of “valley-communities” and open them to global challenges.

We have argued that during the transition period the context has changed considerably in Slovenia,

which will presumably have a considerable effect on the “background institutions” in the longer period

as well. Because of the nature of “background institutions” we do not expect them to disintegrate but

to evolve gradually into a new quality. We believe there are many possibilities for this to happen in a

way which would support faster socio-economic development in Slovenia. For example, there are

well-known cases of the Third Italy and West Jutland in Denmark where strong localism helps local

companies to be internationally competitive. International cases also show that informal networks and

grey economy could represent a solid basis for the proper entrepreneurial development. High

discretion and autonomy of managers could help in developing a special type of “family” SMEs with a

similar marketing and R&D logic to German “Mittelstand” companies. Inability of cooperation by

managers could help the acquisition process and the establishment of a few larger companies, which

would be open to global investors’ opportunities and pressures as well. On the other side, we have

seen that there is local mutualism present which could support the development of cooperation

between some SMEs, presumably newly established and coming from the grey sector, to become

competitive outside their “valleys”.

Based on the understanding of Slovenian specifics and knowing the successful cases Slovenian

decision-makers could form their own rational decisions for economic success. A social scientist could

help with this respect. In addition, much more has to be done with respect to theory and methodology

of contextual rational decision-making.

31

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