The Role of Property Rights

For this week's newsletter I have a short lesson on property rights and their role in making an economy work. It's an excerpt from 99 Lies, part of the Secrets Package.

Lie # 11 - Free Markets Are The Reason For U.S. Prosperity

The idea that free markets are the reason for the economic success of the United States is one of partial truths that are so common in areas of economics. It is easier to understand than the whole truth. Property rights and how they are handled is perhaps more important. That's what the latest research shows.

Many countries have free markets but slow or chaotic economies. Some even try to copy the same market rules and laws as the United States, but the result isn't the same. What's the difference? Don't ask a U.S. economist. The most systematic research on capitalism is now being done at the Institute for Liberty and Democracy (ILD), located in Lima, Peru.

Peruvian economist Hernando de Soto and his group have traveled the world, and found that the crucial difference is not our relatively free and open markets, but our property law. The research is deep and the findings are not easy to explain in a few paragraphs, but here's an example: Did you know that most entrepreneurial activity in this country is financed in part from home equity, either directly or indirectly? Indirectly would be with credit cards, for example, which are often rolled into a home mortgage consolidation loan.

This doesn't happen in many other countries, because of laws that make it hard for a person to lose their property. You see, because it is easy for a bank to take your house when you don't pay on your mortgage loan, they are willing to make the loan. It may seem ironic, but the fact that our property can be easily taken allows for use of that otherwise locked up equity. A business, a car, a contract even - all of these forms of property and more are clearly defined here, and can be used as collateral.

In many countries, titles are not clear, and the law doesn't define various properties well. For example, in Haiti, even after owning their homes for generations, most people don't have a clear title. This makes it almost impossible to sell. Furthermore, even if the title was clear, if foreclosure law isn't clearly defined, no bank or finance company can loan money on a person's home or other property.

Now imagine a man with a farm that is worth $200,000. He needs a tractor to make it efficient, though. However, he cannot offer any part of his land as collateral, because the lender has no clear way to take the land if the farmer defaults. He cannot borrow, and so cannot develop. He is land-rich, and yet is effectively poor. In fact, I have met people in other countries who have land worth as much as $200,000 yet cannot afford indoor plumbing.

Now imagine a famous singer who wants to start a new recording studio. He finds investors to put up the capital, but they demand collateral. He could use the rights to his own songs as collateral - but only if the property laws allowed for this. In the United States this is possible, but in places where intellectual property rights to music are not clearly defined by and transferable under the law, he is out of luck.

People may be free to go out and sell what they want, but the inability to accumulate capital due to poor property law can prevent many from ever growing their businesses. For some of the fascinating research in this area, read De Soto's The Mystery Of Capital. I rarely recommend books, but that one is worth reading. It demonstrates just how important property rights and the associated laws are.

Economists and politicians need to understand the role of property law in an economy, before they tamper with it too much. Suppose, for example, a law is passed making it difficult for a bank to take a home that has been pledged as collateral, when the borrower is in default. Lenders would stop lending against the equity in a home (would you lend that much money if you had almost no way to get it back?). Since most new businesses are financed at least in part from home equity, such a law would be disastrous to the economy.

Note: If you are interested in the rest of 99 Lies, you can learn more here: The Secrets Package.

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