Summer reading: property rights and social norms

My summer reading list has highlighted some of the interesting questions explored recently.

In The Birth of Plenty, William J. Bernstein’s project is to explain the level of sustained economic growth to which we have been accustomed in the last couple of centuries in the developed world. He attributes 2% average annual real growth to four factors, all of which must operate at the same time:

• Property rights
• Scientific rationalism
• Capital markets
• Rapid transportation and communication

All of this is well and good, but I have a minor quibble that sets up a major one. After a chapter for each of the factors, analogizing to an automobile, Bernstein describes them collectively as the “engine” of growth that still requires a “transmission”: the division of labor. Cute analogies are a dime a dozen, and this one does not illustrate anything useful about the relationship of the division of labor to the other four factors: He may as well just accept that he has five necessary factors. The reason this minor criticism is important is that both property rights and the implied fifth factor, the division of labor, rest on something more fundamental that Bernstein takes for granted: social norms of cooperation between perfect strangers.

When I specialize in performing music, I throw myself at the mercy of countless other specialists to provision me with all the needful and desirable things that I can no longer produce myself. This only works with a high degree of trust, trust that is ultimately rooted in social norms of cooperation.

In his discussion of property rights, Bernstein refers to the seminal work of Hernando de Soto on that subject. But it doesn’t seem like Bernstein fully understood de Soto’s larger point about property rights:

• Property rights may be enshrined in formal law, but need not be;
• Something like property rights almost inevitably arises extra-legally out of local social norms of cooperation;
• Growth only follows when property rights have been formalized so that strangers can acknowledge and implement property rights such as selling property, and crucially, accepting it as collateral for debt financing;
• Finally, that formal property rights have historically emerged as a confirmation and extension of the extra-legal claims to property based on local social norms, and not in conflict with them.

De Soto claims that only a particular type of property rights with a particular lineage launches growth and accounts for the difference between the developed and developing world: formal property rights that emerge from and align with the informal local social norms of property possession.

In de Soto’s (among many others) model, what supercharges growth is the ability of entrepreneurs to turn stored value – particularly ownership of real estate – into capital, allowing savings to turn into the investments that lead to higher productivity and therefore more goods and services. You can much more easily and at much lower cost turn your saved value into capital – for example by mortgaging your house to raise cash – when there are formal rules that allow perfect strangers to lend to you with confidence. When perfect strangers know that a loan to you is backed by property they can foreclose on in the worst case, the cost of borrowing will be driven down by competition among lenders. But those formal rules – laws – have to coincide with the social norms of property possession; otherwise they will be ignored. De Soto’s research revealed that this is precisely what has happened in developing nations, where formal property rights are only relevant to a privileged few, with the vast majority of the people inhabiting a parallel, extra-legal universe characterized by predictable and strong, but merely local, social norms of property possession. Because property claims are not recognized outside of a limited local range, savings cannot be turned into productivity-enhancing investment, and growth remains subdued, no matter how hard and how smart people in developing countries work. And as someone who has been privileged to travel quite widely, there is no doubt in my mind that people in the developing world have a more “Protestant” work ethic and greater ingenuity than what I witness anywhere in the developed world I know well (USA, Germany, France).

Growth rests on access to capital; capital rests on formal rules of property rights; but formal rules must align with local social norms. To understand growth therefore, you have to understand the nature of the social norms of cooperation that eventually get formalized and extended.