Prosperity Unbound

As seen on Paul Romer’s Charter Cities Blog

The pressing need in Haiti is for food, water, and medical care, plus assistance in re-establishing basic services like policing, power, sanitation, and telecommunications.

This kind of aid and assistance has to be the highest priority now, but many people are already looking ahead. How can Haitians get access to urban infrastructure, buildings, equipment, and the know-how that can support jobs in industries like garment assembly?

Contrary to what some have suggested, a charter city in Haiti is simply not an option at this time. A charter city can only be created through voluntary agreement. Under the current conditions, the government and people of Haiti do not have the freedom of choice required for any agreement reached now to be voluntary.

In 2004, most knowledgeable observers concluded that the crisis in Haiti met the stringent criteria required for a humanitarian military intervention. A UN dispatched a force of 7000 soldiers and 2000 police officers. It made real progress, particularly after 2006. It reduced kidnappings and established a police presence in areas where criminal gangs had been so strong that Haitian police could not enter. The UN also paid for the expansion and training of the Haitian police force.

On top of its enormous human and economic cost, the earthquake has setback these efforts at strengthening the Haitian government. The case for a foreign military presence is now much stronger. The number of foreign troops is increasing rapidly. They are likely to stay much longer.

In the current circumstances, any attempt at creating a new city in Haiti under foreign control would turn a humanitarian military intervention into a humanitarian military occupation. This approach is fraught with risks that the concept of a charter city is designed to avoid.

A country that is subject to a military intervention has little true freedom of action and choice. Choice affects how people feel about an agreement after it is enacted. An agreement might be hailed as a breakthrough if entered into voluntarily. But if it were imposed unilaterally, the same agreement could generate resentment, hostility, and even violent opposition. We know, for example, that there are people who would readily move to a place like the United States and follow its rules. Yet they would violently resist an attempt by the United States to impose its rules without their consent.

Even if the motivation is humanitarian, letting a military intervention morph into a long-lasting occupation in some part of a country would risk the kind of violent opposition that colonialism generated in the past. There is no reason to take this risk. We should retain the current strategy. Military interventions should involve the shortest possible duration, should be used only to establish the necessary minimum of legitimate governance, and should not impose irreversible commitments on a nation.

However, we must recognize that this strategy, by itself, will not bring good governance or rapid economic growth anytime soon. It is the strategy that has been followed in Haiti for decades, to little good effect. It is the strategy that left Haitians in a position so precarious that an earthquake killed many tens of thousands.

There is a natural complementary approach that is a much better bet than giving colonialism another chance—letting Haitians migrate somewhere with better governance and rules. This is the surest answer to the question posed in the beginning. It can give them access to the urban infrastructure, buildings, equipment, and the know-how that can support jobs in areas like garment assembly.

Competitive pressure from emigration might also speed up progress toward better governance in Haiti. Demonstrated successes for Haitians who live together in other places with better rules might offer a model for reform that people in Haiti could follow. Even then, good governance may not emerge there. But if there were places where all Haitians could go, no one would have to be trapped by this failure.

There are clear limits on the number of Haitian immigrants that nearby jurisdictions are currently prepared to accept. But if nations in the region created just two charter cities, they could accept the entire population of Haiti as residents. There are many locations close to Haiti where these new cities could be built, but for now, Haiti itself is the one place we should not consider.

Update: Andrea Marchesetti points to some interesting news in the Comments. In response to the earthquake in Haiti, Senegalese president Abdoulaye Wade made an offer of land to Haitian migrants. He referred to “fertile” land, which could either mean that he anticipates rural rather than urban settlement or simply that the land would be located in the interior desert areas of the country. He also said that “Senegal is ready to offer them parcels of land – even an entire region.” At this point it is not clear how many migrants might be accommodated under this offer.

Guest Contribution by Rachel Beach

Per a recent article in the Washington Post:

China provides an interesting case, where hundreds of U.S. companies have chosen to do business inside the Great China Wall, even when threatened by insecurity of Intellectual Property Rights and financial assets. It is understood in financial markets that the threat of expropriation of property requires a risk premium on investments in such an environment, but even given this, when so much is at stake, businesses continue choosing to operate in the country. And many are getting stung in the process. Ebay, Google, and Time Warner number among those that have either pulled out of the market or are reconsidering, locked in legal battles to protect their interest and investments in the market.

Is it worth it? Over a billion potential customers should offer a resounding yes! But when there is potential for those same billions to steal your business concepts and intellectual property rights, your customer base, and a government to change its laws once again, acquiring much of your assets or restricting your mode of operation, the answer becomes a little more blurry. As stated by Kevin Smith, head of General Motors in China, “there are different rules in China”.

The question arises: how are companies to deal with theft of Intellectual Property Rights in a country of a billion plus people? A Washington Post article suggests that China is a “very unique country” in this regard, and attacking every violator is not the best strategy. Should it be? Shouldn’t a company strive to protect its Intellectual Property Rights wherever it does business? The question returns us to the considerations of government provisions of security of property. Where the government does not provide security, how much are private businesses and how much should private businesses invest to protect their rights and property by other means? To an extent, in a country like China, where this means any number of its billion citizens could be violating your intellectual property rights, it is a futile effort. It’s almost like chasing a flock of chickens: chase one and exhaust yourself catching it, only to find that all the others have scattered far beyond your reach. In a country like China, a business with broad potential for theft of IPR, its energies would be better devoted in lobbying the government to strengthen IPR regulations and enforcement. If this is true, how does this make China a “unique country”? The greater the market size, the greater the potential for loss (in parallel with the potential for profits).

Grabbing the perfect opportunity to reform and revive a country’s growth capacity… through a tough economic crisis!

I have been mired in the Greek economic crisis in my new capacity with the Greek government. Once again I observe a country that has been suffering from the vast permeation of informality resulting in a sluggish growth and endless leakages in public finances. Once again I notice the great opportunity to align the incentives of all parties in the Greek society for a fundamental reform that will transform the informal sector to the formal secure growing economy – based on secure rules and rights to assets.

Greece provides us with an excellent example of a country where the strength of the informal economy signals the weakness of existing rules in terms of predictability and enforcement. Combating informal property rights, establishing secure and predictable process and rules will allow the country to move not only ahead but revive its latent assets and wealth.

• Indebted Dubai puts on brave face for tower – International Business Times

from Michael Shermer’s blog “Skeptic“:

How do you turn a 3rd-world developing nation into a 1st-world developed nation? It actually isn’t that hard. Picture 3In fact, it is so simple it can be explained in a blog-length essay. You need twelve conditions. I call them the Developing Dirty Dozen:

1. Property rights.
2. The rule of law.
3. Economic stability through a secure and trustworthy banking and monetary system.
4. A reliable infrastructure and the freedom to move about the country.
5. Freedom of speech and the press.
6. Freedom of association.
7. Mass education.
8. Protection of civil liberties.
9. A robust military for protection of liberties from attacks by other states.
10. A potent police force for protection of freedoms from attacks by other people within the state.
11. A viable legislative system for establishing fair and just laws.
12. An effective judicial system for the equitable enforcement of those fair and just laws.

Of course, we should remember what the sage pop philosopher Yogi Berra once said: “In theory, there is no difference between theory and practice. In practice there is.” Let’s call this Yogi’s Maxim. In theory, just implement the Developing Dirty Dozen. In practice, this might not be so easy. I recommend starting with just the first one: property rights. And the playbook on how to do so is already written: Prosperity Unbound: Building Property Markets with Trust (Palgrave Macmillan, 2007) by former World Bank economist Elena Panaritis, now working with developing nations around the world to build trust through property rights.

Panaritis explains how to change informal property into formal property, illiquid property into liquid property, and un-real estate into real estate. Presto-chango. It’s like magic. Property = Prosperity. Call it Panaritis’s Panacea.

Pioneered with pilot programs in Peru, Panaritis explains how to make property real and investments secure through property rights enforced through law. Unfortunately, there are plenty of other places to test this theory: about 70% of the world’s population, or about 4 billion people, are sitting on roughly $9 trillion in illiquid property. By “illiquid,” Panaritis means that the property can be lost or taken away without compensation, and it has little to no value as an investment tool outside of immediate bartering for goods and services needed at the moment.

Panaritis makes a distinction between “the haves and the have-nots,” but not as the phrase is customarily employed. What she means is those who have property rights and the security of their finances and investments, and those who do not. This difference is what, in the long run, creates a wealth or income disparity.

By “un-real estate,” Panaritis means that even if there is property you can see, if it is illiquid it means that you cannot use it to secure investments in your future, and thus you have no secure future and so your real estate is unreal. A houseboat on a river Southeast Asia is the epitome of informal property: just a family on a boat floating on a river, so precarious that it likely won’t last a single generation. How do you build a future on such an unstable foundation?

The lack of formal property rights leads to numerous economic distortions: distorted valuations up and down, distressed property markets, illiquidity of savings, limited labor mobility, weak capital markets, and limited investment in infrastructure such as utilities, energy, and telecommunications. In Ecuador, for example, having passed through the country many times on my way to the Galapagos Islands, I noted that Ecuadorians largely skipped the land-line stage on the way to cell phones. Establishing a land-line telephone infrastructure was the responsibility of the government, which they did with their usual corrupt ineptitude, leading the developing free market of cell phone technology to sweep in and displace the old with the new almost overnight. Fortunately, the Ecuadorian government was prescient enough to secure the property rights of cell phone carriers in their country, and a cell phone as property can fit in your pocket!

Without property rights, in addition to economic distortions there are social distortions: enduring inequalities, violence, corruption, criminality, child labor, and social discontent, especially among women and minorities, who have the least control of their property. As well, there are environmental distortions such as land quality degradation and poor waste management.

The solution? Simple: transform property from illiquid to liquid, or from un-real estate to real estate. Property = Prosperity. Panaritis’s Panacea. Case in point: In Peru, Panaritis worked with a woman named Margarita, a seamstress whose labor was valued in 1990 at $80/month, but who is today worth thousands of dollars a month. How did this happen? Untangling property rights and removing the bureaucratic red tape that it takes to own your own business, by reducing the number of government agencies from 14 to 2, by reducing the time it takes to obtain a license to own your own business from 7 years to 2 days, and the cost from $7,000 to $14! Now that is change we can believe in!

Can it work anywhere? Of course, as Panaritis explains:

The problem of “unreal estate” is global, but its solution local, and it can lead to unbound prosperity. The approach worked in Peru and it can be repeated elsewhere. Done right, institutional reform of property rights can reduce risk, ambiguity, costs of transactions and create new possibilities for those who hold assets informally by turning them

from Paul Romer’s blog “Charter Cities“:

The laws that govern the ownership, sale, and collateralization of property are a classic example of rules that are important to economic and human development. The story of property reform in Peru illustrates the harm that can come from bad rules, the benefits that come from improving the rules, and the difficulties reformers face when they try to change the rules.

Like many developing countries in the 1990s, Peru undertook structural adjustment programs (taming hyperinflation, privatizing inefficient government enterprises, opening up to foreign trade and investment) as part of lending agreements with the IMF and World Bank. Unlike most developing countries, Peru also made a meaningful institutional overhaul of its property rights system. This deep institutional reform helps to explain Peru’s development strength in relation to its peers.

Peru’s economy is among the best performers in the developing world. Sustained growth lowered the poverty rate from nearly 50% in 2004 to 36.2% in 2008—a year in which GDP growth reached 9.8%. Though growth slowed sharply in 2009, Peru appears set to weather the global recession without entering a recession of its own.

Elena Panaritis helped to redesign Peru’s property system as an economist with the World Bank. At the time, more than half of property owners in Peru were not registered. The goal was to formalize the heretofore informal property and give millions of Peruvians access to the productive potential of their assets.

Panaritis’ book, Prosperity Unbound, describes the experience.In the early 1990s, Peru’s property rights system was a mess—a relic of land redistribution policies of the 1960s and 70s. The policies broke up large haciendas, creating cooperatives or individual holdings but forbidding the sale of land or its use as collateral. Legal registration of redistributed land was rare. The land belonged to whoever worked it, a principle that kept people close to their informal holdings—greatly reducing labor mobility.

Duplicate property claims were rampant, and resolution of claims took seven years or more. According to Panaritis, a Peruvian wanting to register a title or execute a contract for the sale of property had to deal with 14 different government offices and hundreds of steps. Bribery and corruption were the only way to effectively title property or resolve a claim.

Rather than register people under the existing dysfunctional system, the reformers in the Peruvian government and the World Bank decided to create an entirely new system. In the early 1990s, the government rescinded the laws forbidding the ownership or sale of land, and the reformers set about registering property under a new system based in part on a registry developed by the Lima-based Institute for Liberty and Democracy.

Abrupt, nationwide changes in the rules were not feasible. Opposition to property reform was too strong, and reformers needed time to try and revise. An initial pilot program successfully registered 88,000 properties, primarily in urban areas. The pilot convinced property owners that the new system was effective and trustworthy. The demonstrated success of the new rules acted as a catalyst for change across Peru.

As formal property registration expanded through the late 1990s and the early 2000s, collateral-based lending increased. Newly formal property owners felt secure enough to make improvements to their property. With formal rights, people were free to pursue earnings opportunities away from their property without fear of losing it to another claimant. Panaritis also reports lower levels of child labor and higher levels of school enrollment among families with formal property rights compared to their informal counterparts.

The reforms made made property a tradable asset and gave Peruvians the freedom to use their property in ways that best served their interests. The reform effort was not a simple matter handing out titles under the existing system—it required the creation of a new system for registering property. To this end, the pilot program was key. It allowed reformers and property owners to try and revise the new system, the success of which engendered trust in the pilot participants and sparked enthusiasm for the reforms elsewhere in Peru.

UCLA Podcast: http://international.ucla.edu/asia/podcasts/article.asp?parentid=113153

Introduction by Professor Steven L. Spiegel
Director, Center for Middle East Development

About Elena Panaritis

Elena Panaritis, author of Prosperity Unbound: Building Property Markets with Trust (Palgrave Macmillan, 2007), is an economist and social entrepreneur. She now leads the effort of public sector reform in Greece as an honorary government adviser. Her ideas are particularly timely, especially in the context of the current global economic crisis and the ongoing efforts to eliminate illiquid/informal property markets around the world.

“It is no accident that this crisis has originated in the United States,” Elena explains. “The property system is built on a false assumption: that the property is valued correctly. Unless that’s fixed, the risk will always be far greater than necessary.”

Elena is the founder of a prototype triple-bottom-line investment advisory firm, Panel Group, and is a former World Bank economist. She has played a direct, hands-on role in creating stable property markets and preventing mortgage crisis such as ours. She created a new methodology and used it to spearhead property rights reform in Peru, with enormous and internationally recognized success. Some 9 million people benefited from the reforms in about three years.

Robert Litan of the Brookings Institute and The Kauffman Foundation of Enterpreneurship calls Elena’s work a “real contribution.”

In his Financial Times online column, Willem Buiter specifically recommends Elena’s book Prosperity Unbound. Buiter, a London School of Economics professor and former chief economist at the European Bank for Reconstruction and Development, takes “useless” and “harmful” finance based on derivatives to task and writes that “effective and efficient financial intermediation is a necessary condition for prosperity.” By contrast, he refers to Elena’s work as “useful finance” and continues: “The world described in [Prosperity Unbound], where the foundations of a productive market economy are being put in place, appears light years removed from the world of Wall Street …”

Guest Contribution by Rachel Beach

Microcredit and property rights reforms, how do they connect? The Panel Group was first asked to connect the dots between financial services to the poor and security of property in discussions with organizations such as the World Bank, Gates Foundation and International Trade Agency (ITA). The exercise brought to light a multiplicity of connections, and in the process we discovered that this is actually a very relevant and necessary discussion to promote. Indeed, it is a relationship whose identity is increasingly touched upon in current development debates.

An increasing number of articles and platforms address the importance of securing wealth bound up in physical real estate, small entrepreneurial activity and intellectual property as incentive for further investment and economic growth.  In a recent profiling by Fast Company, June Arunga – celebrated by the magazine as one of this year’s 100 Most Creative People – is asking a very common question but coming up with an answer at once banal and profound:

‘Why is Africa so poor?’ says the Kenyan, from her current home in Ghana… ‘What should be encouraged is the fundamental right of people to own land and the products of their labor, which are then recognized by courts, and can be exchanged at the market.” Asking for aid, she says, is part of the problem. “I doubt there is a parent that raises their child to become a beggar,” she says. “Gain respect. Keep your promises.”

Security and legal recognition of property for the poor is something development agencies are slowly waking up to. It is something De Soto recognized and has been both praised and vilified for – tapping into the wealth of the poor. One side criticizes him for finding another brilliant way to extort the poor, “formalizing their wealth” so it can be taxed by the government and their property sold to developers. The other side recognizes something elemental in development: access to credit and securing of property (i.e. not simply physical real estate but all forms of wealth) are essential. Between these two elements are a host of incentives. And their interplay entertains many fields of study: the psychologies of security and self-improvement, incentive to invest, the dynamic of trust and credibility between a State and its citizens, hope.

The connection between the credit-access and property-security is not merely curious, it is fundamental to development. In fact, it is a symbiotic relationship. Without a reasonable guarantee that property will be protected both from expropriation or theft, the acquisition and maintenance of investments and other assets in a given economy is illogical, as many an African dictator’s holding of properties abroad (read: securer states) and Swiss bank accounts will attest to. On the other side, without access to credit, the ability to invest is severely restricted.

Capitalism has struggled to find meaningful ways to bring the poorest brackets of society (and those operating in the “extra-legal” sectors due to any number of structural and financial barriers) into the market economy. Financial services for the poorer sectors look very different than the services to the wealthy. However, the risks they face, the way they operate, and types of basic services needed should not be treated as an exception to the standard middle-class or wealthy citizen’s fundamentals of wealth management and financial services. Indeed, the middle-class and wealthy are the minority in this world we live in.

Micro-credit is not simply a well-meaning, social business enterprise that should be patted on the back and politely applauded while we go about our business in the real world. Micro-credit is the type of financial service needed for a great majority of the world’s population. It is more than finding creative ways to “help the poor”. Micro-credit allows the impoverished to slowly rise out of a cycle of poverty. Securing of property rights for these small enterprises and private citizens gives owners legal, socially-recognized protection of their newly acquired parcels of wealth, however minute. Any high-school lecture about compound interest will attest to the benefits of savings and investment, however small one’s start. This creation of wealth then slowly builds on itself.

Neither Peru nor Bangladesh are anecdotes (as Peter Shaefer seems eager to claim in his Foreign Policy article). Yunus’ Grameen bank is expanding operations on five continents, including successful start-ups in the United States and the birth of one in Italy. Our work at Panel Group explores insecurity of property rights around the world – as Elena did in Peru during the 1990s – partnering with municipalities and governments to strengthen, streamline, and even create socially, legally recognizable ownership of physical property (i.e. real estate) where none existed before. Without the dual-expansion of financial services for the poor and security of their assets, the poor will remain in a cycle of poverty.

Guest Contribution by Henry Musa Kpaka

President Obama’s speech in Ghana outlined his commitment to sub-Saharan African economic and social development (see the Economist article, Barack Obama and Africa: how different is his policy). His message was to usher in a new strategy for development assistance from the U.S. and perhaps the rest of the West.  The debate over ending poverty and bringing economic and social development to sub-Saharan African has exhibited an increasing number of facets in recent years.   One stemming from the rather dismal results from the heavy use of aid, encouraged development agencies such as the World Bank to turn their attentions to the promotion of trade liberalization, macroeconomic and monetary stability, and privatization, all embodied in the structural adjustment programs aka “Washington Consensus”.  Following the poor results and frequent failures of this strategy, a new line of thinking emerged, one with a lot of potential to lift the continent out of poverty: institutional reform.  President Obama was quick to echo this in his Accra speech: “Africa does not need strongmen, it needs strong institutions”.

The focus on institutions as a means to lasting prosperity for all in sub-Saharan Africa has been around far longer than the Obama administration, but this administration is giving it some steam, and rightly so.  A few economists and development practitioners have written about the impacts of institutional reform in sub-Saharan Africa.  In criticizing traditional foreign aid in her book, Dead Aid, Dambisa Moyo observes that aid impairs African institutions. One implication she gives: public revenue/tax collecting institutions are largely absent because African leader build their budget with revenues coming mostly from aid.  Elena Panaritis also spends some time in her work, Prosperity Unbound talking about institutional reform in developing countries.  Panaritis, whose work focuses on transforming the informality of property and property right systems into formal legal systems in developing countries, describes the importance of institutions.  In her words, “institutions structure incentives in human exchange, whether political, social or economic. In other words, they hold together and protect the social contract by enforcing contracts and laws and providing a sense of certainty in human exchange”.

The immediate economic benefit from efficient institutions as various economists have outlined is that it reduces transaction costs of all kinds (i.e. time, money, imperfect information).  Markets work well when there is a predictable and legitimate set of rules that governs doing business.  Well-functioning institutions also promote accountability and give a voice to the poor. The Obama administration’s efforts (making a speech and creating new policy directives are two different animals, the question is how much weight will he put behind the rhetoric) to endorse this approach is certainly a step in the right direction.  My only concern is that this approach has already become another “Washington Consensus” that wipes out all other ideas.

The question of what kind of reform should be promoted is addressed by Dani Rodrik: “The type of institutional reform promoted by multilateral organizations such as the World Bank, IMF, or the World Trade Organization is biased towards a best-practice model. It presumes it is possible to determine a unique set of appropriate institutional arrangements ex ante and views the convergence towards those arrangements as inherently desirable. This approach,” Rodrik continues, “encourages cross-national comparisons, benchmarking.” All of which he rightly claims are based on first-best mindset. He proposes a second-best approach where institutional reform is promoted in a case by case basis, where focus is placed on areas of quick wins and high impact results. Growing up in Sierra Leone, it was easy at first to reject a second-best approach for my continent. However, Rodrik’s idea makes a lot of sense.  Different countries, even in sub-Saharan Africa have different approaches in doing business and rely on unique arrangements of formal and informal institutions. A “one size fit all” approach may cut transaction costs in the short run but has high potential to fail.  The heavy reliance on institutional performance indicators, like the Good Governance Index, can easily misguide us, lead to waste, and subsequently to yet another retreat of a potent solution to the poverty problem in sub-Saharan Africa.  Institutional reform holds a lot of promise for development in sub-Saharan Africa if applied appropriately.

Guest Contribution by Rachel Beach

Judge Sonya Sotomayor may be sailing through the senate hearings given her highly qualified track record, a White House and Senate majority in her favor, and appeal as the first Latina judge, but one might find some relief in the expression of a few well-placed reservations.  In paradox to her background of civil rights service and concern for the constitutional protections afforded to all citizens, Sotomayor’s track record on property rights should register concern among the underprivileged and  politically weak.  Her highly controversial decision in the 2006 case of Didden v. Village of Port Chester ruled against land owners Bart Didden and Dominick Bologna whose property was condemned after they refused to pay a local developer’s extortion demands. Sotomayor’s decision went beyond the procedural grounds of the Supreme Court’s 2005 decision in Kelo v. City of New London, Connecticut, allowing the expropriation of private property for the benefit of other private interests.

Should Sotomayor reach the Supreme Court, it appears that expropriation and extortion for personal gain – if the party in question is politically-connected and affluent – can hope for federal backing.  If a developer can convince the city to rezone an area for redevelopment, and has legal ground to request condemnation of private property for his own gain then the disenfranchised should have great reason to fear her decisions.  Sotomayor’s decision exacerbates problems of the insecurity of property, and those whose property is most likely to be expropriated inhabit the lowest strata of American renters and home-owners: tenants in the ghettos.  They suffer from semi-“unreal estate”.

Here is the account of a lady who went from poor tenant to homeless to middle-class lady in Washington D.C. after struggling with the mayor’s office for years to gain the rights to purchase the condemned apartment she was renting.  Deborah was once one of those who inhabited “unreal estate”.  Her’s is one of the rare stories of the poor successfully fighting for their rights (using the right-of-first-refusal under D.C. property laws regarding tenants) and gaining ownership.  However, Sotomayer’s ruling would make  the struggles of homeowners like Deborah more difficult.  The logic of the ruling suggests that developers have the power to deny rights to tenants, not for public gain, but for the private gain of the developer over tenants.  Granted, we do not know all the details of the ruling or the case, but as the most probable soon-to-be Justice of the Supreme Court, Sotomayor’s decision seems rather discouraging,.

The current economic crisis is a property right issues (i.e. an unstable valuation of the real estate market), but a clear and established property right system especially for private individuals can be a way out of this current mess and prevents further crisis. Like in the case of Deborah, ownership of property motivates investment and entrepreneurial ingenuity which is much needed in today’s economy. Sotomayer’s ruling is indeed a red flag to such success stories as that of Deborah’s.

I contributed the following article to the Financial Times, at ft.com/maverecon

The real estate roots of the crisis in the US

July 21, 2009 3:42 pm

Today’s guest blogger is Elena Panaritis,  an expert in property rights, creating markets in illiquid real estate assets, and public sector management.  She is also the author of Prosperity Unbound; Building Property Markets with Trust, which is definitely not one of those odious get-rich-quick-in-real-estate-without-capital-brains-or-effort books.  Instead it is a get real book for social entrepreneurs about how to turn real estate possessions into socially productive, and indeed also privately profitable, capital.

This Crisis Demands Non-Traditional Solutions to Get to a Path of Quick Recovery

By Elena Panaritis

Two years after it began, there is now a coalescing of opinion about the causes of the U.S. financial crisis and what should be done to resolve it, yet there is a serious element missing both in the causation analysis as well as in the prescriptive solution. This crisis, which has infected the global economy so severely, is very much a non-traditional one that calls for a non-traditional solution. The impact in the United States so far has been worse than anything since the Great Depression: unemployment reached 9.5 percent in June, up from 7.8 percent in January, home prices were down 27% at the end of the first quarter from their 2006 peak, and 1.5 million homes were in foreclosure.  After jumping by 30 percent in February, home foreclosure rates tapered off but are again on the rise. According to the New York Times, the loss in property value could total $500 billion.

There is general agreement that the financial crisis results from a variety of factors: an extremely low household saving rate in the United States; excessive public and private liquidity creation and a wave of cheap and easy credit which was directed into real estate speculation; proliferation of “subprime” mortgage loans to high-risk borrowers, interest rates kept too low for too long that further increased incentives to over-borrow; the failure of financial supervision and regulation. However, there is a much less obvious element that everybody is missing, that of a poorly defined and weak underlying asset namely real estate/property. Indeed, it is at the heart of the crisis. A chain is only as strong as its weakest link and the weak link here is the system used to define the asset of real estate/property in terms of use and cash flow, its supply, and pricing.

In this crisis, real estate assets were badly defined for the most part, making them less securely bankable and more susceptible to price manipulation and destabilizing speculation. That’s still true, yet no one is raising the issue.

Usually, economic crises result from bad regulation and over-liquidity in the financial markets (the first four of the five factors mentioned above). Economists usually address the demand side of the assets (i.e. how an asset is financed and the credit markets around it) (as opposed to the actual regulatory infrastructure that defines and creates assets to become securely tradable with reduced risk, that is, the supply side. In this crisis, the asset (real estate) was/is for the most part badly defined – and it is this side of the equation that needs to be examined rather than taken for granted.

The current economic crisis stems from the fact that the underpinnings of the market are either broken or rotted, and in some cases there are no underpinnings. That makes it a non-traditional crisis; what we are confronting is the direct result of inadequacies in upstream property rights. This crisis combines the original sin of badly valued properties with a financial system based on harmful, unproductive gambling and incentives to continue gambling. As a result, investors in mortgage-backed securities did not have enough, reliable information on the mortgage itself. They only had information on ratings of the derivative, but not of the actual underlying asset.

We cannot achieve secure derivative trading if the information on the underpinning asset is not standardized but oblique and difficult to find – because markets run on information. In the same way we understand the need to standardize derivatives, we must understand the need to do the same for the underlying real estate assets. While we have national and international trading in asset-based securities, the information on the assets themselves is localized, and the way it is collected and reported varies from county to county and state to state.

What, then, should be done? We need to treat this crisis as an opportunity not only to install a more rigorous regulatory regime for the financial sector, but also to listen to the non-traditional economists – that is practitioners of institutional economics. They will tell us that we need to overhaul the way property rights and property values are established in this country. We need a structural reform that establishes standards for how property is evaluated and how it is offered to the market. We need a standardized repository of information about the asset of property, so that no one has to search multiple places to make sure a title is good and that there are no outstanding liens dating back decades.  We need to ensure that all buyers can access information about the pricing of property. Let’s start with a consolidation of information county by county, and use the best standardized information we can find – typically from registries of deeds and from title insurance companies – to get things going.

The U.S. property rights system is severely broken. The incorrect valuation of land, properties, and thus mortgages is at the center of our current crisis, and if we don’t fix things so that mortgages are valued correctly we will not have addressed the root cause of why things are the way they are today.

Traditionally, economists are trained to assume that pricing in general is a point of equilibrium defined by almost perfect market forces, where the demand and supply meet and neither the buyer or seller has a huge informational advantage. The traditional model also assumes that markets are frictionless and transaction costs are near zero especially when we deal with the supply side. From that they continue to assume that systems (rules, regulations, norms) that define the tradability of assets are given and near perfect. But this is rarely the case. In reality the systems that define supply of land and real estate tend to be full of transactions costs and information leakages, and that makes it really difficult to follow the old maxim that a price or value based on how much one is willing to pay is necessarily the right price.

These are the same economists who, faced with a crisis, would concentrate on the downstream usage of an asset – that is, the asset’s treatment in the financial markets. They would typically pay little or no attention to the upstream definition of the asset – that is, the actual system that structures the supply of the asset – the pool of all assets ready to be traded in the market – before it enters the market. Their solutions would be all the traditional ones, that is, solutions that touch on the impacts of distorted financial markets, that is, markets for ‘downstream’ financial assets: macroeconomic stability, regulation of the financial sector, even labor regulations, and by taking these steps, they would consider transactions costs to be close to zero, and disregard societal and market wrinkles.

What about practitioners of institutional economics?  They would emphasize how the underlying asset is defined, whether all the characteristics that help determine its market price are clear, and how the original creation of the asset takes place.

And so, to whom do the powers-that-be turn for solutions in this non-traditional crisis? They are following the lead of the traditional economists and the conventional path of economic analysis.

The Obama administration’s economics team came in determined to get a handle on this crisis. There has been a concerted effort to lift the fog and manage as much as possible the systemic risk that has been created by panic over a suddenly uncertain future. The team has focused on policies to reduce uncertainty about the derivatives markets and restore confidence, to return banks to healthy levels of capital and bring tighter oversight to the derivatives markets.

These steps are needed, but they are not enough. Everyone has pointed to the greed of the financial sector, the manic behavior of banks and new lending institutions that continued to leverage up to take advantage of the spreads between their securitized assets and their ever-shorter funding maturities, the lax regulation of the derivatives markets, and the fact that almost anything could be bundled with anything else, no matter how heterogeneous – one security could include consumer debt, credit cards and home mortgages. Also there is a wide acknowledgment that when banks stop lending it both brings about a cyclical contraction and fuels a weakening of long-term productivity in any economy.

But is it enough simply to reduce uncertainty regarding the capitalization of banks? Does lifting the fog of uncertainty about the complex derivatives also cure the core problem?

No one is touching the roots of the crisis.

When Timothy Geithner, US Treasury Secretary, is asked about the signs of improvement, he points to impacts of the systemic crisis, such as unemployment, lending rates, and so on. He has yet to point to a single indicator that goes to the roots. Where is his explanation of what is being done to address the bad rules and regulations governing how property rights in real estate are established in the United States, which is the primary reason that all the systemic problems could bring us down the path to negative-equity mortgage loans? What does he have to say about long-term miscalculations of the value of mortgages on an asset – real property – that ought to be unambiguous and transparent in our market economy? What is going to be done to ensure that land valuations are not driven by guesswork?

Until the United States accepts that it has a badly flawed approach to establishing and verifying real estate property rights and to determining the valuation of property, until it puts in place a system that homogenizes and standardizes the underlying securitized assets of real estate and housing – the same way securities are required to be homogeneous prior to being traded in bundles – these underlying real estate assets will continue to be toxic. They may be less toxic, or more toxic, as the crisis ebbs and flows, but they will be toxic nonetheless – and they will be on the balance sheets of banks.

Let the traditional economists work on the things they understand. Meanwhile, let’s combine basic institutional economics with some practical reality and fix the broken system. It will take political will, strong leadership from a new and popular president, and a direct confrontation with the special interests that would like to maintain the status quo while continuing to get bailouts.

I recently returned from a whirlwind weekend at the FreedomFest in Las Vegas.  It is increasingly evident that Prosperity Unbound appeals to a larger and wider range of audiences, especially after the housing market collapse. Given the 1.5 million foreclosures in the United States in the first half of this year alone, with one in eight Americans either late on their payments or already facing foreclosure, many people are wondering how we got there. Many others ask whether the stimulus packages and administration’s approaches are really confronting the root of the problem. There seems to be no end in sight, and a great number (29%) of credit-worthy borrowers with fixed-rate home loans are among those suffering from the downward pressure on house prices. If ever there was a time to establish a more secure valuation of the underlying asset, the time is now.

Walking around Las Vegas, I saw some of the grandiose edifices under construction and left over from the real estate boom now bowing to the economy’s will. Cranes were scattered across the landscape like giant herons frozen in time. Then I discovered a side story. Scattered throughout the opulence and malls were little shops, independently owned and operated. They had been established decades ago, selling their wares and $1 bottles of water (versus $4 at posh cafés). Many resisted pressure from real estate developers and kept their specks of territory among giants. The big real-estate dollar signs that had drawn speculators to the city five years ago who are now fleeing with tails between their legs.

FreedomFest, a celebrated venue for open-market debate and thinking (with over 1,500 attendees) also seemed this year to be a popular place for talking about illiquid real estate. I presented my book and talked about my formula for prosperity for the worlds’ poor and its success rate. Michael Strong, CEO of FLOW, graciously introduced me and my work. I also expounded further on my methodology and how I apply it as a private social entrepreneur with Panel Group.  The broad interest from diverse attendees, highlighted the relevance of the methodology outlined at Prosperity Unbound, beginning with institutional economics, finance, and practically explaining how the social contract and property markets evolve as well as how we can reduce the risk for property becoming illiquid.

I had the opportunity to engage in stimulating conversations with Richard Rahn senior Fellow at the Cato Institute, John Fund from the Wall Street Journal, Barrons’ economics editor Gene Epstein, and venture capitalist Jo Pihl.

Topics ranged from evolution of mankind to evolution of markets.  Michael Shermer, a scientist, the Executive Director of the Skeptics Society and a columnist for Scientific American, delved into the evolution of humankind and societies honoring Darwin and his personal journey. Others addressed how people choose to handle their wealth, drifting into an ongoing debate about how much governance is needed for effective enforcement of contracts. Ironically, in my mind, it is the proponents of a “hands-off government” who (recognizing it or not) most desire effective government for the purpose of ensuring the security of their private wealth, property, and person … both from government expropriation and from the abuse of other citizens. The logic leads us into the arena of policy-making, in relation to the management of private wealth and property. Julian Morris of the International Policy Network, Steve Forbes of Forbes Magazine, John Mackey of Whole Foods, and others presented ways policy-making can harm markets and discussed their outlook for the Global Economy.

Then, of course, there was Yoga every morning with Gurucharan Khalsa and dancing to the Beatles at the closing gala of FF.  All in all, a good weekend.

The Bank of Oliver Twist was posted by: lettrist on: June 26, 2009

URL: http://utopiaorbust.wordpress.com/2009/06/26/the-bank-of-oliver-twist/

Guest Contributor: Rachel Beach

Following the logic of Amartya Sen in Development as Freedom, individual property rights in a transparent system is a fundamental means as well as an end to development.  The Lettrist (blogger) is right to remind us that “the poor have always had ‘sizeable amount of assets’”.  The point is to find a way to secure their assets for their own benefit.  For many, one of their most valuable assets, land, is not secure.  Unable to use it as collateral, the poor lose one of their only means to access credit.  Mohammed Yunus, founder of the ever growing micro-credit banking movement, realized how critical access to credit is to upward mobility of the poor.  Just imagine your life without credit cards, access to loans, or any other means of credit. 

There is a plethora of property titling and land reform regimes gone wrong.  Think Zimbabwe.  In the wake of Peru’s achievements, the World Bank and many other well-meaning development agencies have bungled property titling projects by seeing property rights as a panacea for all ills. 

The problem, as Lettrist was right to point out, is looking at “titling” as a solution in a vacuum … a problem that pervades much development work today.  He cannot, however deny the unique successes of Peru.  I understand that advocates such as DeSoto invite strong criticism, but strong property rights is a cornerstone of development.  This is what Elena Panaritis, when at the World Bank and together with the Peruvian government carried out and proved in Peru (as outlined in her book Prosperity Unbound).  The reforms have been noted world wide for a specific reason.  They were not carried out in a vacuum.  Panaritis studied the political institutions, social motivations, and historical backdrop of the property titling mess, using a method she calls Reality Check Analysis.  Elena and her team went door-to-door surveying potential participants and proscribed a complete overhaul the agencies responsible for registering property.  Under a succession of presidents and parliaments, reforms responded to growing public demands for recognition of property.  It was not something foisted upon them, nor was it gentrification.  The reforms followed a specific sequencing of policy and events designed to address problems unique to Peru’s history, regulation, institutions.  This generated their rare success in property rights reform. 

Lettrist must not be aware of the actual benefits a properly-enacted property rights reform given his statement that “no one can be sure if land titling would benefit the poor at all”.  The results spoke for themselves in Peru.  The reforms were designed to cater not to large scale developers, but the poor and middle class who had experienced long-term insecurity of property.  Within three years the markets welcomed seven million new players.  Security of private ownership increased by 94%, initial property values increased by 42%, personal investment [i.e. home improvements, extensions] increased by more than 72%, the probability of child labor among participants decreased by more than 28%.  These are the positive elements of a reform designed to bring excluded sections of a society into the formal market. 

On the other hand the Lettrist was very right in saying that “capitalism has no serious strategy for reaching the poor in the extra-legal sector”.  Those in the extra-legal sector are entrepreneurs.  They simply lack access to formal markets and capital, and create their own informal markets.  Security of property rights is the fundamental bridge to the formal sector.  It provides a capitalist answer for bringing informal activity into the formal economy.

Appropriate community-based property rights systems empower citizens.  Rather than being a “wolf in sheep’s clothing”, they give both citizens a restored trust and mutual gain: the government gains revenue streams, but in return has a responsibility to provide public goods which citizens had previously been deprived of such as access to water, electricity, and roads.  Entrepreneurs can register businesses and invest in the formal economy.  They can secure loans and improve their lives and livelihood, assured that all their efforts will not be swept away by arbitrary expropriation.  Entrepreneurs in the informal sector function, but not efficiently.  Panaritis was not primarily concerned with preventing extra-legals from “bringing down the game” but bringing excluded entrepreneurs into the game.  The point being that as the percentage of citizens forced to live in a semi-informal state (parts of their daily lives secured in the legal sector, and parts outside where they cannot find access) increases, the legitimacy of a government decreases.  If the current government has not found a way to secure the property and person of a large portion of its citizens, nor provide public services to them, nor include them in formal market structures, it has failed to fulfill its role.  It is only expected that citizens would seek an alternative governing body i.e. Abimael Guzman, founder of the Sendero Luminoso aka The Shining Path.

I participated in a fascinating one-day seminar hosted at Stanford University, in Palo Alto California, cosponsored by the Hoover Institution and the Kauffman Foundation on How and Why of Promoting Entrepreneurship Abroad.  The seminar featured a panel of leading economists, a senior State Department Official, organizations promoting entrepreneurship, and foreign-born entrepreneurs who have succeeded in the States. The seminar was organized by Richard Boly, a national security affairs fellow at the Hoover Institution.

What I found intriguing was the energy in the room, the vibrant discussion, and the fact that leading economists, entrepreneurs, and policy makers increasingly recognize a key obstacle to entrepreneurial development abroad: the problem of informality.  Informality is the spontaneous generation of markets transaction outside the formal structures because of high barriers to entry generated by both public and private organizations (e.g. massive amounts of red-tape or curbing venders in a sector with heavy licensing fees or barriers created due to special interests).  Foreigners from India, Latin America, China, Eastern Europe find easier to have a chance to develop their entrepreneurial ideas in the United States than back home (e.g. generally lower barriers to entry).  There were a number of world leading entrepreneurs present including venture capitalists and businesspeople from Argentina, France, India, and Italy (go here for a list of panelists).  It was also a treat to listen to Robert Litan, the revered economist and ask for his views on my work and Prosperity Unbound.  He was sincerely encouraging, and thought the work was a contribution to this area.

Being an economist myself, or I should better qualify: a student of economic behavior, I very much cherished the insights of economist Paul Romer and his thoughts about informality and the tax it imposes on economic growth and entrepreneurial development.

As our discussions explored entrepreneurial behavior what became very clear is the fact that the roots of entrepreneurship are essentially ideas such as that of intellectual property rights (IPR).  IPR is basically the creation a secure environment that allows an entrepreneur to experiment with and incubate his ideas.  Entrepreneurs must be gifted in problem-solving. They also have to be very good risk managers, carefully sifting out weak ideas and coaxing strong ones into a practical reality.

One disturbing curiosity: the dearth of women entrepreneurs in attendance, especially young ones. Though the women in this space were very few, they weighted quite heavily in caliber as was the case with Vinita Gupta.  She was the first Indian Woman to take her company public in the U.S.  Vinita left a profound impression on me in our private conversation as she explained how it was for her to be both a successful entrepreneur a wife and mother. The stories of all entrepreneurs woven into the theoretical context of economics made a captivating and action provoking seminar.

Useless finance, harmful finance and useful finance

http://blogs.ft.com/maverecon/2009/04/useless-finance-harmful-finance-and-useful-finance/#more-1357

April 12, 2009 6:31pm

Useless finance

A derivative is a contingent claim whose payoff depends on the performance of some other financial instrument or security.  For instance, an American equity call option gives the purchaser of the call the right (but not the obligation) to buy a share of equity from the issuer or writer of the call option at or before some future date at a price determined today.  A credit default swap (CDS) is a credit derivative contract between two (counter)parties in which the holder makes periodic payments to the issuer in return for a payoff if the underlying financial instrument specified in the contract defaults.

A derivative contract is formally identical to a lottery, a (simple or compound) bet or gamble.  Like any financial claim, any derivative is  an ‘inside asset’ – it is in zero net supply.  Because pay-offs associated with a derivative contract are functions of observable properties of other financial claims (prices, interest rates, default states), the derivative contract either re-packages existing underlying uncertainty or creates additional ‘artificial’ uncertainty.  It would create additional extraneous uncertainty if it added some noise of its own to the fundamental, exogenous uncertainty that is presumably reflected in the features of the underlying security that determine the pay-offs of the derivative contract.

If the creation and trading of derivatives were costless, derivatives result in zero-sum redistributions of wealth between the issuers and the owners of the derivative contracts.  Costless derivatives would be redundant if markets were complete.  When markets are incomplete, as they are in our unfortunate universe, introducing derivatives can either lead to an increase or to a reduction in efficiency and social welfare. Lower efficiency and social welfare are possible even if creating and trading derivatives were costless.  Derivatives may improve the allocation of risk, but there is no guarantee that they will.  It is my contention that the unbridled explosion of certain categories of derivatives has done considerable harm, and that it is necessary to regulate all derivatives trading.

How can creating lotteries, even if they only mirror fundamental underlying uncertainty, be welfare increasing?  The usual argument involves examples where there is a given quantum of ‘objective’ or ‘exogenous’ uncertainty in the world, e.g. uncertainty about endowments, technology and tastes (all assumed exogenous – only economists would treat technology and taste as exogenous, of course!).  Markets for risk trading are incomplete and creating derivatives markets does not alter the objective/exogenous uncertainty in the world.  Creating and trading derivatives is costless.

In such a world one can imagine a pension fund that wishes to hold default risk-free 10 year government securities, but unable to find them in the market, instead holding 10 year AAA corporate bonds and CDS to cover the default risk of these corporate securities.  Provided the writer of the CDS is creditworthy, the pension fund could achieve its preferred portfolio mix.  If the writer of the CDS has the appropriate capital structure and balance sheet, it could be both willing and able to bear the default risk on the corporate bonds than the pension fund.  For the lottery created by a derivative contract to be welfare-increasing, it will have to produce a positive monetary pay-off for the purchaser of the derivative in exactly those ‘states of nature’ where the purchaser will be worst off, while at the same time ensuring that the corresponding negative monetary pay-off for the writer of the derivative does not hurt the writer of the derivative too badly.

It would of course be more direct to draw up contracts contingent on the exogenous uncertainty directly.  If the pension fund’s ‘endowment’ were to be negatively correlated with that of some other legal entity, and if the two endowments could be observed and verified, an endowment-sharing rule could be specified that would make both parties better off.  You would not start looking for contracts specifying payments that are contingent on endogenous risk, such as default risk or the behaviour of some price or interest rate.

Derivatives, insurance and gambling

Consider the CDS.  The purchaser pays a premium to the writer of a CDS.  That is the price of the lottery ticket, or the price of the betting slip.  If the underlying security specified in the contract defaults, the writer of the CDS pays the owner of the CDS a specified amount of money.  That’s the lottery prize, or the winnings of the bet.  In the UK where there are more legal forms of gambling than in most other countries, many conventional financial instruments or securities have been ‘re-engineered’ as formal bets.  Spread betting on exchange rates, interest rates, stock prices and now also house price indices is a popular form of investment.  The reason is that earnings from gambling are not taxed.  The government presumably does not tax the gains and losses from gambling because (ignoring the value added of the gambling industry) gambling winnings equal gambling losses, so if the tax code allows loss offsets, there is not much point (ignoring progressivity of taxation & other complications) in taxing the gains and losses from gambling.

Derivatives can be used to provide insurance (paying a premium to buy protection against a possible loss) or to gamble (paying a premium to acquire the opportunity to benefit from a possible gain).   CDS can provide either insurance against loss or an opportunity to gamble.  This is because the buyer of a CDS does not need to own the underlying security or other form of credit exposure.  The buyer does not have to suffer any loss from the default event and may in fact benefit from it.

When purchasing an insurance contract, the insured party is generally expected to have an insurable interest in the event against which he takes out insurance.  This simply means that he cannot be better off if the insured against event occurs than if it does not occur.  Determining what constitutes an insurable interest is often complicated in practice, but simple in principle: you have an insurable interest if, when (a) the future contingency you insure against occurs and (b) the insurance contract performs (something you cannot necessarily count on, without assistance from the tax payer, if you buy your CDS from AIG), you are not better off than you would be if the insured-against future contingency did not occur.

Clearly, CDS contracts don’t require an insurable interest to be present.  Many other derivatives likewise don’t require an insurable interest to be present.  Short selling a share of common stock in the hope/expectation of a fall in the price of the equity without either owning or borrowing the stock (naked short selling) is an example of a derivative contract without an insurable interest.

Why should the state care about gambling through derivative contracts?

Harmful finance

(1) Gambling is addictive

Like all forms of gambling (deliberate risk-seeking), gambling in the derivatives markets can be addictive.  This may create a paternalism-based argument for regulating, restricting or even banning the activity.  Having observed derivatives writers, purchasers and traders in action, it is clear that the thrill of the gamble is part of the motivation behind this activity.  The monetary gains and losses figure prominently, of course, but the bungee-jumping, sky-diving, tight-rope-walking-without-a-net dimensions of derivatives trading definitely play a role.  It cannot be a coincidence that there are so many more male than female traders and other operators in the financial markets.  Testosterone is not underrepresented in the trading room.  And the thrill of taking a wide-open position can be addictive.  I wouldn’t be surprised if Gamblers Anonymous had a special chapter for derivatives gambling.

I am generically underwhelmed by arguments for protecting compos mentis adults against themselves based on paternalism, but the list of arguments would not be complete without it.

(2) Moral hazard or micro-level endogenous risk.

This is the familiar argument already mentioned before, that if the insured party (the purchaser of a CDS, for instance) can influence the likelihood of the insured-against contingency (the default of the underlying security) occurring without the writer of the insurance contract (the issuer of the CDS) being aware of this, there is an obvious case of market failure and potential source of inefficiency.  It’s also likely to be an illegal form of market manipulation.

(3) Derivative contracts as “bearer lottery tickets”

Unlike most conventional lotteries, the lottery tickets created as part of many derivatives contracts are traded in secondary markets, sometimes over the counter (OTC markets), sometimes on organised exchanges.  These lottery tickets or betting slips are not just traded after they are issued (sold by the writer in the ‘primary issue market’), most of these derivative contracts are bearer securities: their ownership is not registered.  The owner is anonymous.  Listed common stock, by contrast, is an example of what I have called a ‘registered security’.  There is an ownership register, which is, at least in principle, in the public domain.  Clearly, establishing the beneficial ownership of an equity share may not be a simple matter of looking in the shareowners register in the jurisdiction where stock is listed, but with bearer securities the task is hopeless.

The writer of the derivative contract does not in general know the identity of the current owner of the contract.  If the writer does not know this, the supervisor and regulator, or the state agency in charge of macro-prudential supervision (typically the central bank) does not know it either.  There is therefore absolutely no way to determine whether the current distribution of the ownership of derivative contracts is systemically stabilising or destabilising, whether it is too concentrated or too dispersed.  When a notional gross $60 trillion worth of CDS outstanding at the peak (yes, I know it’s ‘only’ $30 trillion now and much of it is ‘offsetting’ in some ill-defined way) and possibly around $400 trillion gross outstanding of total derivatives, we are talking ignorance on a cosmic scale.

(4) Risk-seeking by the over-confident

Even if the secondary markets for derivatives functioned properly (no bubbles, no liquidity seizures, no wide-spread defaults), these secondary markets can, like the primary issue market, redistribute the additional risk represented by any derivative either in a way that improves the ultimate allocation and sharing of risk or worsens it.  Once a new derivative market is created, this market can either be used to hedge existing risk or to take on additional risk. I have seen no reliable statistics on the identities of the counterparties in the leading derivatives markets.  My best guess is that most of the activity is not between households and financial intermediaries or between non-financial enterprises and financial intermediaries, but among financial intermediaries, mainly among different banking or shadow-banking player. Much of this trading appears to be driven by overconfidence and hubris.  I have yet to meet a trader who did not believe that he or she could not beat the market.  Because collectively these traders effectively are the market, they are collectively irrational, as they cannot beat themselves.  So the risk ends up being concentrated not among those most capable of bearing it, but among those most willing to bear it – those most confident of being able to bear it and profit from it.

(5) Churning

The collective hubris of the banking sector (broadly defined to include all the shadow-banking sector institutions like hedge funds, private equity funds, SIVs, conduits, other investment funds, AIG-style insurance companies etc.) means that enormous volumes of bets are placed on the behaviour of endogenous variables.  The first consequence of this is that, since derivatives trading is not costless, scarce skilled resources are diverted to what are not even games of pure redistribution.  Instead these resources are diverted towards games involving the redistribution of a social pie that shrinks as more players enter the game.

The inefficient redistribution of risk that can be the by-product of the creation of new derivatives markets and their inadequate regulation can also affect the real economy through an increase in the scope and severity of defaults.  Defaults, insolvency and bankruptcy are key components of a market economy based on property rights.  There involve more than a redistribution of property rights (both income and control rights).  They also destroy real resources.  The zero-sum redistribution characteristic of derivatives contracts in a frictionless world becomes a negative-sum redistribution when default and insolvency is involved.  There is a fundamental asymmetry in the market game between winners and losers: there is no such thing as super-solvency for winners.  But there is such a thing as insolvency for losers, if the losses are large enough.

The easiest solution to this churning problem would be to restrict derivatives trading to insurance, pure and simple.  The party purchasing the insurance should be able to demonstrate an insurable interest.  CDS could only be bought and sold in combination with a matching amount of the underlying security.  Ideally, it ought to be possible to for me to buy a CDS by demonstrating an insurable interest in terms of my “utility”, i.e. by demonstrating that, should the underlying security default, I would be worse off in one way or other, not necessarily because I own the underlying security.  In practice, this would be wide open to abuse and manipulation.

(6) Macro-endogenous risk

Financial markets are inefficient in any of the ways specified by James Tobin in a great 1984 paper – information arbitrage efficiency, fundamental valuation efficiency, functional efficiency or Arrow-Debreu full insurance efficiency.[1] Financial markets even often are technically inefficient. A market is technically or trading efficient if it is liquid and competitive, that is, it is possible to buy or sell large quantities with very low transaction costs, at little or no notice and without a significant impact on the market price.  We have seen many examples, from the ABS markets and the commercial paper markets to the interbank markets of massive and persistent failures of technical or trading efficiency.

Even in those financial markets that are reasonably technically efficient, like the US stock market, the foreign exchange markets and the government debt markets, Tobin saw frequent departures from efficiency in the less restricted senses of the word.  He accepted that financial markets possessed what he called ‘information arbitrage efficiency’ that is, that they were informationally efficient in the weak and semi-strong sense. You cannot systematically make money trading on the basis of generally available public information. Clearly, however, trading profitably on the basis of insider information is possible.

He did not believe that financial markets consistently possessed ‘fundamental valuation efficiency’: financial asset prices do not necessarily reflect the rational expectations of the future payments to which the asset gives title.  Key financial markets, including the stock market, the long-term debt market and the foreign exchange market are characterised both by excess volatility and persistent misalignments, that is, prices deviating persistently from fundamental valuations.

Tobin also contested the notion that the financial markets delivered ‘value for money’ in the social sense. “the services of the system do not come cheap. An immense amount of activity takes place, and considerable resources are devoted to it.” (Tobin [1984, p. 284]). Tobin referred to this aspect of efficiency as ‘functional efficiency’. Finally, the system of financial markets can be efficient in the technical, information arbitrage, fundamental valuation and functional senses without possessing what Tobin called Arrow-Debreu full insurance efficiency, that is, without supporting Pareto-efficient economy-wide outcomes.  The reason is that real world financial markets interact with labour and goods markets that are inefficient in every sense of the word.

When financial markets are inefficient, the distinction between fundamental, exogenous variables and endogenous variables disappears.  CDS prices can become quasi-autonomous drivers of the bond prices.  The tail can wag the dog.  The redistributions of wealth associated with the execution of derivatives contracts can trigger margin calls, mark-to-market revaluations of assets and liabilities, forced liquidations of illiquid asset holdings through fire-sales in dysfunctional markets, defaults and bankruptcies.  Activities in derivatives markets, including futures markets, can feed back on sport markets and real production, consumption and storage decisions.

Unbridled derivatives markets may be liquid, but the question is, to what purpose?  If, as I believe, there is no economic rationale for ‘naked’ CDS positions (that is, CDS that do not insure an open default position in the underlying security), then liquidity of the CDS market only serves those who want to trade naked CDS.  This, in my view, only wastes real resources through (a) churning and (b) unnecessary bankruptcies.

Useful finance

I want to end on an upbeat note.  I believe that effective and efficient financial intermediation is a necessary condition for prosperity.  To those who doubt this, I recommend a reading of two books about the true microfoundations of financial intermediation, Hernando de Soto’s, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, New York: Basic Books (2000) Prosperity Unbound: Building Property Markets with Trust, by Elena Panaritis (Palgrave MacMillan 2007).  If you have only time for one, read the shorter work by Elena Panaritis.  It describes the fascinating story of how personal possessions (characterised through informal, insecure property rights) were turned into secure property rights and thence into productive capital through a World Bank project in Peru.  The book shows the importance of local knowledge and of a deep understanding of the institutional prerequisites for a successful market economy based on collateralisable wealth (especially real estate).  To raise the quality of the rule of law in the property sector to the point small businesses can credibly offer land and other real estate as collateral for formal sector finance requires a formal titling authority, a state capable of reliably maintaining property records, a functional judicial system, corruption levels bounded from above etc.

The world described in these books, where the foundations of a productive market economy are being put in place, appears light years removed from the world of Wall Street and the City of London.  In Peru, access to formal sector finance on reasonable terms thanks to the newly created ability to offer collateral and perfect security interest, has lifted many out of grinding poverty.  In Wall Street and the City of London, massive resources and lobbying power were devoted to turning complex, long-term relationships into tradable securities – preferably into tradable bearer securities, even when the informational preconditions for this transformation to be effective were not satisfied.  Increasingly, as in the case of bearer instruments like mortgage-backed securities for instance, the ultimate issuer and the current owner of the instrument knew nothing about each other.  And even with simpler bearer securities, most of the time no-one knows who the current owner is, not even the supervisor and regulator.

The endless churning of contingent claims, including derivatives, when the purchaser has no identifiable insurable interest, turns financial intermediation into a market-mediated betting shop.  Then the betting slips become bearer securities and are themselves traded, either OTC or on organised exchanges, and the derivative transactions volumes expand to dwarf the transactions in the markets for the underlying financial claims (let alone the markets for the underlying real resources).  At that point, the betting tip of the financial tail of the real economy dog does all the wagging.   It does not create value but redistributes it in a way that consumes real resources and exposes the real economy to unnecessary risk.  It’s time to tame the tiger.