Hernando de Soto & Property Rights

Note: This old post is updated at Medianism.org

Hernando de Soto thinks that legal property rights are the key to prosperity.  The government must clearly define and enforce very specific private ownership rights.  De Soto's thesis is:

Unreported, unrecorded economic activity results in many small entrepreneurs who lack legal ownership of their property, making it difficult for them to obtain credit, sell the business, or expand. They cannot seek legal remedies to business conflicts in court, since they do not have legal ownership. Lack of information on income prevents governments from collecting taxes and acting for the public welfare. "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." To survive, to protect their assets, and to do as much business as possible, the extra legals create their own rules. But because these local arrangements are full of shortcomings and are not easily enforceable, the extralegals also create their own social, political and economic problems that affect the society at large.

De Soto noted 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 also excessive regulations on new entrepreneurs in poor countries.  In Lima, Peru, in 1983,   Hernando de Soto registered a business legally without paying bribes except when absolutely unavoidable (bribes were only unavoidable twice) and without using any political connections.  Normally the Peruvian elites use their political connections to obtain a business license and the rest of society works in the informal sector without any ability to write legal business contracts to obtain business loans or insurance and in constant danger of being shut down by police for operating a business without the necessary 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 anyone in Peruvian society want onerous restrictions on entrepreneurs who would like to start new businesses?  One reason is that existing businesses do not want competition from new ones.  A World Bank study found that incumbent businesses saw their incomes drop 3% after Mexico 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 also play a part.  Liberals may have been overly willing to see regulations as being benign whereas the incumbent business owners are overwhelmingly conservative and they benefit from these particular regulations.  De Soto's work has changed ideology around the world by publicizing the insanity of these regulations that only benefit a relatively small group of incumbent business elites who often see themselves as being in favor of entrepreneurialism in general even though they dislike specific entrepreneurial competition against their own businesses.  The world bank established the Doing Business Project in 2002 to measure the cost of pro-incumbent business regulations around the globe and merely by publicizing absurd regulations, they have been reformed.  Within the first five years, there were 193 reforms in 116 countries.

De Soto says that 2007-201? US financial crisis is partly 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.