Reforming property rights

Tim Besley, Maitreesh Ghatak 22 April 2009

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Whether they thought private property was a sine qua non of a free society or organised theft, classical economists, from Adam Smith (1776) to Karl Marx (1891), accorded a central position to the role of property rights or the “relations of production” in the process of economic development. However, it is only recently that mainstream modern economics has come around to this point of view. The cheerful view of economists about the efficiency of competitive markets assumes that property rights are well-defined and well-enforced. Given this presumption, it is no wonder that, for a long time, economists focused on savings and capital accumulation as the key to economic development.

But in a world where property titles are ill-defined, where legal disputes take decades to settle, where poor farmers or small business owners face eviction threats, it is difficult to imagine how they can take a long-run view – saving, investing, and climbing their way out of poverty. Security of property rights therefore is of utmost importance.

Property rights and economic exchange

The term property right refers to an owner's right to use a good or asset for consumption and/or income generation (referred to as "use rights"). It can also include the right to transfer it to another party, in the form of a sale, gift or bequest ("transfer rights"). A property right also typically conveys the right to contract with other parties by renting, pledging, or mortgaging a good or asset, or by allowing other parties to use it, for example, in an employment relationship.

By property rights, economists typically refer to private property rights, a key feature of which is being able legally to exclude others from using a good or asset. This affects resource allocation by shaping the way that individuals choose to carry out productive activities involving the use of the good or asset, undertake investments that maintain or enhance its value, and also, to trade or lease the asset for other uses.

A recent influential advocate of the importance of the link between property rights and economic efficiency is the Peruvian economist Hernando de Soto. According to him, what the poor lack is easy access to the property mechanisms that could legally fix the economic potential of their assets so that they could be used to produce, secure, or guarantee greater value in the market. Therefore, even when they have some assets, they are “dead” capital.

Economists have emphasised four main aspects of how property rights affect economic activity.

  • The first is expropriation risk – insecure property rights imply that individuals may fail to realise the fruits of their investment and efforts.
  • Second, insecure property rights lead to costs that individuals have to incur to defend their property, which, from the economic point of view, is unproductive.
  • The third is failure to facilitate gains from trade – a productive economy requires that assets be used by those who can do so most productively, and improvements in property rights facilitate this. In other words, they enable an asset's mobility as a factor of production (e.g., via a rental market).
  • The fourth is the use of property in supporting other transactions. Modern market economies rely on collateral to support a variety of financial market transactions, and improving property rights may increase productivity by enhancing such possibilities.

Secure property rights and economic development

It is possible to take a bird's eye view of the quality of property rights using cross-country data. To illustrate, we take two measures of property rights regimes using standard sources.

The first is a measure of the security of property rights from the International Country Risk Guide. It is measured on a scale between 0 and 10. A higher score corresponds to better protection of property rights. Figure 1 shows that this score is positively correlated with income per capita. In other words, countries with a higher risk of expropriation have lower levels of income per capita.

Figure 1. Expropriation risk and income per capita, 2000

The second measure comes from the World Bank’s Doing Business project. We focus on a measure of the ease with which individuals can register their property, specifically the country's rank on this measure for 172 countries. This is a purely administrative dimension to property rights and follows the logic of the de Soto argument. Figure 2 shows that this too is strongly negatively correlated with income per capita in 2000. Thus, this more administrative dimension of property rights is weaker in low-income countries (these figures are from Besley and Ghatak 2009).

Figure 2. Property registration and income per capita

Together these figures illustrate the central proposition that improving property rights is associated with economic development. However, they say nothing about the direction of causation. It is possible that economic development induces a switch to improved property rights, as opposed to property rights facilitating economic development.

The economics literature now has a plethora of micro-economic studies that suggest that securing private property affects economic decisions in the way that the theory suggests. For example, improving squatters’ rights in Peru seems to have reduced the need to use guards according to Erica Field (2007). Her work on Peru with Maximo Torrero also suggests that property titles are associated with increase in approval rates on public sector loans by as much as 12% when titles are requested by lenders (Field and Torrero 2006).

In a related study, Sebastian Galiani and Ernesto Schargrodsky (2005) have looked at the collateral effect of property rights reform. They look at a group of squatters who occupied an area of wasteland in the outskirts of Buenos Aires more than 20 years ago from the time of the study. An expropriation law was subsequently passed, ordering the transfer of the land from the original owners to the state in exchange for a monetary compensation, with the purpose of entitling it to the squatters. They find that it improved housing investment, among other things.

Between anarchy and predation

But the creation of private property rights cannot be taken for granted. The emergence of effective private property rights has had to steer a course between the twin problems of anarchy and predation. In a state of anarchy, the main problem is dispersed coercive power, as now characterises warlord societies. The obvious answer is to create a monopoly protector as suggested, centuries ago, by Thomas Hobbes. But who is to protect the citizens against Leviathan? This is the problem of predation. All societies have had to grapple with this problem at one point in their history and many continue to do so.

There are a number of ways of dealing with these issues, most notably by building political institutions that create effective checks and balances and establish the rule of law in a way that is binding on policy makers. But these require more than the stroke of a pen. A lot rests on the reputation of government that needs to recognise its long-run interest ahead of short-term gains from expropriating property. History is replete with examples where governments have expropriated their citizens. A case in point is modern day Zimbabwe, where Robert Mugabe seized the property of farmers to distribute to his political supporters.

Policymakers who are aware of the problem of predation can seek innovative ways of creating secure property. One possibility is to tolerate some amount of secrecy and anonymity in private economic decisions vis-à-vis the government, which allow individuals to protect themselves against expropriation. Another is to use more decentralised policymaking and competition between governments, what is known as market preserving federalism. Both means have arguably been used to secure property rights in China to some degree.

Laws and law enforcement

But not all state failure stems from the breakdown in law and order or from predatory states. Many governments have simply failed to invest sufficient in basic legal institutions and property registration institutions. The main priority is then to spend more in such areas to promote more secure property rights. But political economy issues are likely to be important here. To the extent that the economically powerful can benefit from insecure property rights, there may be limited political will for property rights reform. This is likely to prevail when the absence of formal property rights encourages the poor to seek refuge in networks where there is market power. The classic case is of a moneylender to whom the poor are beholden when property rights prevent their assets being used as collateral elsewhere.

In all cases, it is clear that the solutions have to be, to some degree, country-specific. The mantra of property rights reform too easily degenerates into an empty slogan. Also, property rights improvement is not a panacea especially when other aspects of an economy perform badly. But identifying the appropriate institutionalised solution is only a first step. How the political process is able to prevent the potential losers from blocking the reform is likely to be the crucial element.

References

Field, Eirca (2007) “Entitled to Work: Urban Property Rights and the Labor Supply in Peru”, Quarterly Journal of Economics, November 2007

Field, Erica and Maximo Torrero (2006) “Do Property Titles Increase Credit Access Among the Urban Poor? Evidence from a Nationwide Titling Program”, Working Paper, Harvard University, 2006

Galiani, Sebastian and Ernesto Schargrodsky (2005) “Property Rights for the Poor: Effects of Land Titling”, Working Paper, University of Washington, St. Louis, 200Marx, Karl (1867) Das Kapital, Verlag von Otto Meissner, Hamburg

Ghatak, Maitreesh and Tim Besley (2009) Property Rights and Economic Development, CEPR Discussion Paper 7243

Hobbes, Thomas (1660) The Leviathan.

Smith, Adam (1776) An Inquiry into the Nature and Causes of the Wealth of Nations, W. Strahan and T. Cadell, London

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Topics:  Development

Tags:  property rights, Hernando de Soto

Tim Besley

Professor of Economics and Political Science at the London School of Economics; and Research Fellow, CEPR

Maitreesh Ghatak

Professor of Economics and Political Science at the London School of Economics