Friday, February 26, 2010

Financial Crisis: Failure to recognise the significance of property rights

Writing the foreword to the International Property Rights Index 2010, I note that "The present economic crisis, with its root in housing and property, provides a very good opportunity for people in the rich and poor countries to take a fresh look at the significance of property rights and to renew our appreciation of a system of formal ownership of property."

The International Property Rights Index is published annually by the Property Rights Alliance, an international network, based in the US.

Foreword to the IPRI 2010, by Barun Mitra

The crisis that has shaken the financial world over the last two years is ascribed to many failures – from easy money, human greed or a lack of government oversight to the lethal financial derivatives created by financial whiz kids. While relevant, much of the public discourse has ignored a fundamental cause of the present economic woes. In my view, this financial crisis is the consequence of distorting or altogether disconnecting the relationship between property and ownership.

A modern economy is built on clear ownership of property whether tangible or intangible - be it land, shares or intellectual property. It requires a commonly accepted form of documentation of that ownership, an easy method of trade of ownership and transfer of property and an unencumbered market where the transactions can be undertaken leading to the discovery of the price of the asset concerned. Once that chain of ownership is lost, it becomes almost impossible to assess the real value of the asset.

Hernando de Soto, the noted economist who unveiled the secret of property in his book The Mystery of Capital, recently wrote:
Look around: everything of economic value that you own – house and car titles, mortgages, checking accounts, stocks, contracts, patents, other people’s debts (including derivatives) is documented on paper. You are able to hold, transfer, assess and certify the value of such assets only through documents that have been legally authenticated by a global system of rules, procedures and standards. … That system [of legal property rights] produces the trust that allows credit and capital to flow and markets to work.
[De Soto, H. (2009, February 21). Toxic paper, in the Newsweek magazine.]

The first time-bomb that exploded in the dramatic chain of events leading to the financial crisis was the US housing market. It had long been in a boom phase supported by public policy aimed at widening home ownership and facilitated by an elaborate network of financial institutions. Whether owned by the US government (such as Ginnie Mae), implicitly supported by it (such as Fannie Mae and Freddie Mac) or entirely private, these institutions created an ever more elaborate chain of securities which funneled savings from across the world into securities that were issued against mortgages taken out by US home-owners.

Originating in single, often modest loans taken by US families, these mortgages were packaged by banks into so-called MBSs (Mortgage Backed Securities). Beginning in a small town in Texas, for example, a retail bank would bundle its mortgages and transfer them to a regional office. Within days, often hours, the paper would find its way to New York where one of only six rating agencies would slice the bundles into layers of securities. The rating agencies would determine what proportion of the securities should be rated AAA (the safest, with correspondingly low interest rates) based on statistics of housing loans over the earlier decade and how the remaining paper should be pegged down the ladder of safety – and up the ladder of return.

Thus rated, the paper would be offered to buyers across the world - whether banks, hedge funds, or pension funds. Having traveled at the speed of the internet from a US suburb to a small town in Germany, the securities were essentially ‘virtual’ in nature. The savings institution in Germany had no way to assess the risk underlying the paper it owned except via the rating stamped on it in New York. This risk assessment was frozen in time and in turn, derived from a series of historical default rates generated during a period when US home prices were on a steady upward path. When the downward slide began as often happens with all asset booms, there were no reliable mechanisms to reassess the risk underlying the securities.

The current financial troubles illustrate the tragic consequences if the relationship between property and ownership is blurred. For instance, the stock market operates on the basis of continuous disclosure of financial performance of companies, and facility to trade the information in comparison to other assets. These institutions allow for the price of the asset to be discovered. If the chain of ownership is lost, it becomes almost impossible to assess the real value of the asset. This is precisely what happened with the MBS.

It seems quite clear that the political attempt to promote housing in the U.S. and easy money policy stimulated the growth of new financial derivatives by repackaging many doubtful mortgages. As on earlier occasions when snake oil charmed the investors of the 19th century or the seduction of the French by the Louisiana Company in the 18th century, the housing boom in the US in the early 21st century apparently created such a sense of euphoria among investors that they failed to keep tabs on the paper trail of ownership. Thus, investors lost track of the real value of the underlying assets. But unlike in the previous centuries, today, real estate is a much smaller part of the broader economy. Also, the world economy is presently much more integrated and therefore, dispersed and diverse. Consequently, the world economy seems on a recovery course in less than two years despite the economic turmoil.

While world attention is focused on the economic situation in the US and other developed countries, the situation also underscores the perpetual economic crisis in many developing nations and poor communities. In these societies, recognition of property rights and respect for ownership is weak, and title document is often non-existent. Typically, these are places where informal economic activities dominate. But the consequences are very similar in both - lack of credit. The ironic problem of the poor is not that they do not have assets but rather, they are unable to effectively capitalize their assets. The present crisis demonstrates the rich are equally vulnerable to being unable capitalizing their assets if they lose their connection to the real economy and the clear titles that it requires.

Fortunately, the developed countries which have a well established system of property rights are in a much better position to deal with present turmoil. Despite all the talk of this being the most serious economic crisis since the great depression of the 1930s, one has not seen the streets of London or New York lined with the unemployed or impoverished outside soup kitchens. The enormously larger capital base in these countries today enables them to tide over the crisis with very little disruption. The problem seems to be that even these relatively small disturbances in an otherwise tranquil and predictable economic environment greatly magnifies the perception of these disruptions, as the former stands out sharply in contrast to the latter.

Unfortunately, by this very similar process of perception, the perpetual economic crisis in the poor countries where millions of people struggle to survive in an informal economic environment are seen as the “norm” rather than the exception. Unlike their counterparts in the developed countries, the poor in the less developed nations are paying a very real price for their inability to grow out of the informal economy - at times even with their lives.

A critical component of a functioning and stable system of property ownership is the property registration system. Typically, the government is the sole agency that surveys property, registers ownership and the title deed. In such a monopolistic environment, it is not surprising that many governments tend to behave as rent seekers viewing the property registration system as a way to maximize revenue. Rather the registration system should be an instrument for providing protection, facilitating transaction of property, and enabling its capitalization. The present crisis in the rich world and the perpetual crisis in the poor world should encourage us to look for alternative ways of recording property.

For instance, all property particularly tangible physical property like land and structures on it are situated locally. Could the local community, with support of agencies like banks and insurance companies, and private surveyors, undertake the process of recording and registering property in a more efficient manner? One of the additional advantages of such localized approach would be for local people to gain a much better understanding of the need for recording and formalizing property ownership.

The present economic crisis, with its root in housing and property, provides a very good opportunity for people in the rich and poor countries to take a fresh look at the significance of property rights and to renew our appreciation of a system of formal ownership of property. The International Property Right Index 2010, a unique comparison of some of the key parameters measuring different aspects of property rights, therefore, acquires special significance in the current economic environment.

I hope future issues of the IPRI report will explore the possibility of including new parameters to better capture the information regarding recording and registering property and make it even more relevant for the people across the world.

Tuesday, February 9, 2010

India Supports a Toothless IPCC

The less credibility the climate body has, the less it can do to block vital economic development. My analysis of India's relationship with IPCC is in this article titled "India Supports a Toothless IPCC" published in the Opinion Asia section of the Wall Street Journal Asia, on February 8, 2010.

Prime Minister Manmohan Singh expressed support for the United Nations' Intergovernmental Panel on Climate Change and its leader, Rajendra Pachauri, at a local energy conference in New Delhi Friday. The move has surprised many observers, but it may prove to be politically astute.

The IPCC's credibility is in tatters. From climategate to glaciergate, Amazongate, natural-disaster gate, and now Chinagate, the revelations of bad science keep coming. Given all that, plus the much-publicized flap between Environment Minister Jairam Ramesh and Mr. Pachauri over the science behind "melting" Himalayan glaciers weeks before the Copenhagen climate summit in December, superficially one might have expected the Indian government to jettison Mr. Pachauri as soon as possible.

But Delhi isn't just offering him and the organization rhetorical backing. At Friday's annual flagship event of the Energy and Resources Institute—which Mr. Pachauri has headed for almost 30 years—the prime minister offered to provide technical assistance through a newly established glacier research center. The government has also formed a network of scientific institutions to develop domestic science and research capacities on climate issues.

The explanation for this support is simple: It is in the Indian government's interest to perpetuate a weak IPCC and a toothless Mr. Pachauri at its helm. Given the recent scandals, the IPCC is hardly in a position to lobby India for carbon concessions. No one from the IPCC can again cavalierly dismiss their critics as promoting "voodoo" science or "vested interests," as was Mr. Pachauri's wont. By offering scientific support to the IPCC, the Indian government is actually confirming its lack of confidence in the U.N. body's scientific credentials.

Mr. Pachauri is now in his second term as the head of IPCC. He is not a climate scientist—or indeed a scientist at all. He is an able science administrator who built his institute from scratch. Influential governments in the rich world probably accepted Mr. Pachauri not just for his redoubtable skill in institution-building, but also in the hope that by placing an Indian like him at the head of IPCC, he might be able to influence Indian policy.

That's important because after all, if countries like China and India do not subscribe to any commitment to reducing emissions, developed countries' best efforts will not have any significant impact. Having bought the idea of man-made global warming, rich countries had to try and ensure that developing countries fell in line.

But in democratic India no leader can afford to ignore the developmental aspirations of the people. Even if some Indian elites want to sell the future of the country by agreeing to some form of restrictions on energy usage—and thus on economic growth—in the fiercely competitive world of Indian politics they stand no chance.

The IPCC was created as a way to make the world, particularly the poor, fall in line and support expensive climate-change initiatives by overwhelming them with the apparent authority of the world's leading technical body on the subject, backed by a supposed scientific consensus. This attempt was doomed to fail, because scientific inquiry does not respect consensus, and orthodoxy is anathema to scientific progress.

There is some poetic justice in this whole drama. Countries like India that were always apprehensive of institutions like the IPCC now prefer to keep it twisting in the wind. The rich countries that gave birth to the idea of the IPCC cannot afford to disown it without exposing their own underlying design. They could try to replace its head, in the hope that the new face might be able to rebuild the credibility of the institution. But having tasted blood, there is no reason why India and China should let the current advantage pass so easily.

The IPCC has been checkmated, as have so many other U.N. institutions before it. This is the inevitable consequence of the desire for global government under the misguided belief that ordinary people do not know what is in their own interest. With the deepening of democratic ideals, people power can no longer be overturned so easily. The failure of the IPCC shows that sovereignty still lies with the people, not with the aspirants for global government.