Hernando de Soto & Property Rights

Hernando de Soto thinks that formal property rights are the key to prosperity and that the government must clearly define and enforce specific private ownership rights.  De Soto’s thesis is that government must be efficient at clarifying the legal ownership rights for all real estate and businesses to make it easier to buy and sell them because that will encourage more investment.

In poor nations, it is typically extremely expensive to set up a legal business that can then obtain credit and that limits the ability of entrepreneurs to expand which prevents them from being able to accomplish economies of scale.  It is also impossible to sell a business if it isn’t a formal legal entity.  Small businesses usually dominate poor nations and that makes poor nations less efficient because in business, small is ugly.

Furthermore, governments cannot tax property if there isn’t clear ownership and they cannot tax informal business income.  De Soto argues that a lack of clear property rights prevents governments from collecting taxes and generating revenue to spend on the public welfare.  Poor people get stuck in an underground economy which often gets managed by extralegal mafias or tribal governance that are undemocratic and inefficient.

“The existence of such massive exclusion generates two parallel economies, legal and extra-legal. An elite minority enjoys the economic benefits of the law and globalization, while the majority of entrepreneurs are stuck in poverty, where their assets–adding up to more than US$ 10 trillion worldwide–languish as dead capital in the shadows of the law.”

De Soto claims that poorly defined property rights make a natural disaster worse:

Two recent natural disasters …grabbed our hearts – the tsunami that ravaged 11 countries on the shores of the Indian Ocean, history’s worst, and the hurricane …Katrina that inundated the city of New Orleans. Images from both regions were tragically similar: demolished buildings, floating corpses, stunned survivors, and water, water everywhere. There was one profound difference. In New Orleans, the first thing authorities did to secure the peace and assure rebuilding was to salvage the city’s legal property records that would quickly determine who owned what and where, who owed what and how much, who could be relocated quickly, who was creditworthy to finance reconstruction…

In Southeast Asia, there were no such legal records to be found, because most of the tsunami’s victims had lived and worked outside the law.

[With] the floodwaters still high, New Orleans’ custodian of notarial records, Stephen Bruno, rushed to the courthouse basement where the city’s property records were stored, hauled them out of the water and packed them into refrigerator trucks that ferried them to Chicago, where they were expertly dried. The restored documents were quickly sent back to New Orleans – 60,000 volumes now archived under armed guard…. “Abstractors” …are painstakingly going through the documents that will produce the legal tools for designing and financing the city’s recovery, allowing bankers, insurers and realtors to identify owners, activate collateral, raise financing, access secondary markets, make deals, close contracts, as well as make it profitable for utilities to pump energy and water into neighborhoods – the entire legal infrastructure that is needed to keep a modern economy in gear.

Such a scene was impossible after the tsunami of December 2004 sent …waves the size of buildings onto beachfront property from Indonesia and Thailand all the way to Sri Lanka …killing more than 270,000 …In Banda Aceh, Indonesia, 200,000 homes were washed away, most of them built without property titles. When the water receded from Nam Khem, Thailand, a well-connected tycoon rushed in to grab the valuable beachfront. The survivors of the 50 families that had occupied the shore for a decade protested, but they didn’t have legally documented property rights…

That is the case with the majority of people in the developing and ex-Soviet world, where legal systems are inaccessible to most of the poor.

Life in the extralegal world is at constant risk.

An earthquake rocked Pakistan …leaving …73,000 people dead. When a similar sized quake hit the Los Angeles area in 1994, 60 people died. The difference? …inadequately constructed housing …built outside the law ignoring construction codes.

But what poor homeowner …has any incentive to invest in safer housing and reinforced concrete without evidence of secure, legal ownership and the possibility of getting credit?

Governments are powerless to enforce legal codes when most people operate outside the law.

Typically, [rich] governments promote …private property to increase property taxes. In the extralegal economy, people may pay bribes, but no one pays taxes. Where will the [government] money for reconstruction come from? Private property in the United States is likely to be covered by insurance – an estimated $30 billion worth for Katrina. In Sri Lanka, only 1 percent of the 93,000 tsunami victims were covered.

In the developing world, few people have an official address, never mind the kind of legal title to their assets required by insurers.  In the developing world, neither capital nor credit will venture where there are no clear property rights.  …for developing countries without an adequate legal property system, peace itself is on the line – as was the case in the United States before more widely accessible legal property law gradually turned violent squatters into noble pioneers.

Before that, squatters had threatened to burn George Washington’s farms unless he gave them title. …That’s where developing countries are today.

The bloodshed can be stopped. Livelihoods and businesses could be reconstructed in the developing world. But first the poor must be legally empowered.

We take the law for granted; but without legal documents, people do not exist in a market. If property, business organizations and transactions are not legally documented, they are fated to remain forever uninterpreted and society cannot work …Legally created titles and stock certificates generate investment; clear property records guarantee credit; documents allow people to be identified and helped; company statutes can pool resources for recovery; mortgages raise money; contracts solidify commitments.

Four billion of world’s six billion people do not have this ability to create wealth and recuperate from disaster. Their constant tragedy is to live without the benefit of a single rule of law. …Only if the poor themselves are legally empowered will they be in a position to turn the next tsunami into just another storm.

There are excessive regulations on entrepreneurs in poor countries that prevent them from establishing legal businesses and only legal businesses can write legal business contracts, apply for bank loans, buy business insurance, copyright a brand, or be sold.  In Lima, Peru, in 1983, Hernando de Soto registered a business legally without using any of his political connections and he tried to avoid paying bribes except that it was absolutely unavoidable twice.

Peruvian elites normally use their political connections to obtain business licenses and other advantages.  Most Peruvian businesses are part of the informal sector where there is constant danger of being shut down by police for operating a business without the necessary permits.  Small, informal businesses pay no taxes, but they also have to pay extra bribes to police and/or “protection money” to local mafia to keep from being shut down for operating without the legal permits.

Hernando de Soto’s research team followed all necessary bureaucratic procedures in setting up a one-employee garment factory in the outskirts of Lima. The factory was in a legal position to start operations 289 days and $1,231 later. The cost amounted to three years of wages—not the kind of money the average Peruvian entrepreneur has at his or her disposal. “When legality is a privilege available only to those with political and economic power, those excluded—the poor—have no alternative but illegality,” writes Mario Vargas Llosa in the Foreword to de Soto’s (1989) book.

De Soto did the same process in Tampa, Florida, where it only took two hours to obtain a permit to open a small business.  The process took over 1,000 times longer in Peru.  Why would someone in Peruvian society want onerous restrictions on entrepreneurs to prevent them from being able to start new businesses?  Peruvian elites own legal  businesses and they do not want new competition.  A World Bank study found that incumbent businesses in Mexico saw their incomes drop 3% after the government simplified business registration because increased competition lowered prices.  Workers also gained a 3% increase in employment and the number of businesses increased 5%.

Ideology may help explain why onerous business regulations developed.  Liberals may have been overly willing to think that business regulations were benign due to an ideological bias whereas incumbent business owners tend to be conservatives, and they are happy to have these regulations that benefit them by limiting potential competitors.  Incumbent business elites have a pro-entrepreneur ideology because they see themselves as being successful entrepreneurs even though in reality they dislike new entrepreneurs who could become their competition.     Because of de Soto’s work, publicizing the insanity of regulations that only benefit a small group of elites, the World Bank established the Doing Business Project in 2002 to measure the cost of pro-elite regulations around the globe that protect incumbent business.  They have succeeded in getting reforms merely by merely doing a bit of social marketing and publicizing the absurdity of the regulations.  Within the first five years, there were 193 reforms in 116 countries.

De Soto pioneered an interesting ideological niche.  He is a conservative who uses free-market language to promote greater government involvement in distributing property rights to the poor.  He has promoted land reform and greater equality without using those terms.  ‘Land reform’ is usually a hot-button concept that is generally associated with the far left, but de Soto has gotten conservatives to enthusiastically embrace his version of land reform.  Leftist land reformers typically want to redistribute land from rich elites to their poor tenants.  De Soto noticed that there are vast amounts of land (he claims US$ 10 trillion worth) in poor nations without any clear legal title.  Rather than stepping on the toes of rich landowners, de Soto only wants to redistribute the ownership of the unowned (or government-owned) land to the poor tenants who live and work on it.  This is why de Soto has been much more politically successful than liberal land reformers.

De Soto points out that a financial crisis, like the one we had in 2008, creates problems due to the same sort of dynamics that keeps poor countries poor:  ill-defined property rights.

Why does ownership matter so much? 

Ownership means that I have something to lose. If you’re a banker, it means that you’ve got collateral. It also means that I’m credible, so you can give me credit. When you think about it, whether it’s ownership, whether it’s credit, whether it’s capital, whether it’s identification, none of the things that make a modern economy are possible without property.

How does this relate to the financial crisis? 

The enormous amount of derivatives that had poured into the market—there are close to $600 trillion of these papers around—are also not recorded in a global or centralized manner, or in a manner that allows you to begin to quantify them. [Former SEC Chairman Christopher] Cox thought that maybe the toxic part of all of these assets was $1 trillion to $2 trillion. [Treasury Secretary Timothy] Geithner told us there’s maybe $3 trillion or $4 trillion. Nobody really knows, so in a way [they’ve created an] informal or shadow economy. This unidentified paper is the source of uncertainty and the credit contraction.

So they’re unidentified in the same way that ownership of, say, a slum in Peru or Africa is unidentified. 

That’s right. We have worked in places like Tanzania and Egypt and Ethiopia. When you go visit a home there you don’t find justification for it through the books. In other words, it’s not centrally available information. When you talk about shadow economies in many places, it’s not only the economy of gangsters. It’s also economies that are legal in every respect except for the fact that the paper, which backs up the ownership or the evidence that something exists, is not easily and publicly available. That creates the shadow.

Has the subprime mortgage market become a shadow economy? 

Subprime mortgages are not a shadow economy. But what happened is that a lot of these mortgages got repackaged into securities. Then they became collateralized debt obligations and some of these mortgages were sliced and diced and put into tranches. When some of these mortgages went sour and people started defaulting on their payments, then of course a lot of the securities tied to them also started defaulting. But when you try and trace who’s ultimately responsible for the value of that paper, you couldn’t find it. That’s the part of the market that has become the shadow.

ill-defined property rights in the subprime mortgage sector caused a meltdown. Does the same happen in the developing world? 

Yes. That shadow hopefully is a temporary condition in the United States and in Western Europe. And it might pass in a year or 10 years, but it will pass. That passing condition that’s occurring now in developed countries, that’s a chronic condition in developing countries. We’re always chronically in credit crunches—because you don’t know who owns what, nobody dares lend to somebody else. Bringing the law to emerging markets is possibly the most important measure that can be taken to help these countries become rich. Look at the Iranians, look at the North Koreans—they’re building nuclear plants. Look at the computer—they’re being built in northern India. The issue isn’t the expansion of technology. We can all get it, borrow it, buy it or steal it. The issue is how do you get a legal system that allows people to cooperate so as to create more complex systems and objects.

So at this point, a Wall Street banker in a $10,000 suit is encountering basically the same problem that Nairobi slum dwellers have had to deal with for decades or more. 

Absolutely. The difference, however, is that in Nairobi they are still struggling to understand that a property system is the best way that they can do things. In the United States, every piece of land, every house, every automobile, every airplane, every manuscript for a film, every patent is written up and recorded and described. There’s only one thing in the United States which is not recorded in such a way and that’s derivatives. We’re only talking about 7 percent of the subprime market being in default, yet it is causing a major contraction in your economy. You’re not getting your credit flowing because you don’t know what is where and who it belongs to.

I am a big fan of de Soto’s work, but more private property rights aren’t always better.  Slavery is a form of property right that is particularly pernicious.  We are better off both morally and economically because of banning that kind of private property partly because slavery creates excessive inequality.  One of the key reasons de Soto’s work has been beneficial for development is that he has focused on issues that will create greater equality of property rights.  Rich elites have always gotten government help protecting their property rights.  Even though de Soto doesn’t talk much about equality, he really cares about the disadvantaged and he promotes more equality of property rights.  He wants poor people to get the same kind of government assistance in defining and protecting property that rich people have always gotten in every nation.

For more about Hernando de Soto’s work, see this VOX EU article and Alan Krueger’s NYT article.