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Property rights: capitalism’s bedrock

May 5, 2009

Secondary school students of economics are taught that land, labour, capital and entrepreneurship are the factors of production. Ostensibly, balanced budgets, removal of subsidies, foreign investment friendliness and lower tariffs, ginger the cocktail of economic progress. Curiously, the transformation of land from dead to live capital and the rule of law are taken for granted.

Collateralisation of property rights – advanced in Western countries and archaic in most developing countries – seems to have been omitted from the brew. Capitalism has triumphed in the West because legal rights over assets such as land, backed by information on who owns what and the rule of law, has hugely enabled economies of developed countries to thrive.

Emerging economies, from Mexico in 1994 to Argentina in 2001, swallowed bitter IMF pills to survive past crisis. A post-crisis take home: saving for a rainy day, led to the accumulation of large foreign reserves. Other countries bulked up as well. As the economies (and reserves) of China and India grew, commodity prices climbed steeply. Earnings of resource-rich African countries swelled. They in turn, after years under the burden of debt overhang, stashed dollars for the future.

A savings glut ensued, filling the gaping current-account deficit of a spendthrift US economy. Cheap manufactured goods from China and similarly priced IT and back-office services from India held down real wages and boosted corporate profits in developed countries. Rather than spike inflation, the excess liquidity created was funnelled into house prices; inflating a waiting bubble: subsidised home-ownership.

Mortgage ie, securing a loan by offering property as collateral, is an important source of wealth accumulation, but more so, finance for entrepreneurs in the US. Alas, this asset class is at heart of the implosion of modern finance. Dodgy mortgage-backed securities were packaged, rated triple A and sold off to disperse risk.

Trading in these complex securities dwarfed the underlying financial claims. Things turned awry when borrowers began to default. The collective hubris of erstwhile lords of finance overlooked the laxness of informational preconditions for subprime loans. Securitisation of mortgage loans induced sloppy lending standards. Yet benefits of private-ownership of say, a business, house or intellectual property, cannot be gainsaid.

Some emerging economies have reduced their reliance on external finance – another lesson from the past crisis. One more soft spot has been revealed: export-dependent economies are prone to, not decoupled from, external shocks. Thus recent expansionary stimulus packages, geared at inducing domestic demand, must not be used in isolation. Better property rights have a multiplier effect. To extract more growth and enhance competiveness, improved property laws in these economies will encourage budding entrepreneurs. Such laws build confidence, finance private consumption and, investments by old and new firms.

In other words, small businesses, mostly in the informal sector, will access formal sector finance when their property can be credibly offered as collateral. In the words of Hernando de Soto, a renowned economist, “With titles, shares and property laws, people could suddenly go beyond looking at their assets as they are (houses used only for shelter) to thinking about what they could be (security for credit to start or expand a business).”

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