QUESTION 9: property right and structure (ownership structure)

All taken from HIS book, many different parts mixed together.

Differences in countries’ legal frameworks, property rights, competition, political regime, etc. may be expressed as differences in the sets of existing individual positions. In this way, a link is provided between these institutional or institutionally determined variables, and individuals’ actions. For as positions differ in typical choice situations and choice situations shape individuals’ behavior, the decisions of psychologically identical persons would differ, too.

One crucial difference between the institutional systems is the extent to which they contain productive positions; i.e. such which allow and induce those who occupy them to productive actions: saving, investing, inventing, innovating.

Of particular interest in every institutional system are the top decision-making positions which are usually classified as belonging to the political system. The key question here is what constraints (if any) are on the top political rulers. This is crucial both for the type and security of property rights of other individuals and for the probability of policies (i.e. rulers’ actions) which produce economic shocks (see sect 9) . In this sense, the basic features of the political regime and of the fundamental economic institutions are two sides of the same coin. More generally, various individual liberties are, in fact, determined by the limits on political powers and not by their verbal lists¹. If one wants to know how extensive and lasting these liberties can be one should look at constraints on these powers, including various checks and balances.

The returns to individuals’ investment depend on a crucial institutional variable: the property rights. The literature on this important issue is huge and growing; I will make here only some clarifications necessary to our discussion of innovation-based growth.

It is important to distinguish between the structure of property rights and the level of security (protection) enjoyed by those who hold them. The structure determines whether private economic activity is allowed or banned; if allowed, then what are the conditions regarding entry, functioning of a private entrepreneur, and the division of the total effects of his activity (into those which accrue to him and those that are appropriated by the other agents). This definition points out that the structure of property rights is shaped internally by the regulation, the contract law and taxation². The security of property may be defined by the extent of uncertainty with respect to the entrepreneur’s private returns from investment³.

Generally speaking, barriers to investment result either from the improper structure of property rights which are effectively enforced, or from the insecurity of property rights which have a proper structure⁴.

The first case is represented by the traditional small, kin-based communities with collective property rights which tend to equalize the individual returns, regardless of individual effort. The kin-based redistribution, based on such informal property rights discourages, given the individuals’ motivational invariants, the individual accumulation. Only the assumption of strongly altruistic or collectivist motivation could change this conclusion, but judging by the results, such an assumption is not realistic⁵.

A more modern example of the first category is represented by systems which nominally allow private property rights but subject the returns from private investment to confiscatory taxation

Widespread corruption may be categorized either as an improper de facto structure of property rights due to excessive regulations, or as a poor protection of official property rights, described by their legal definitions. Regardless of how we treat it, its impact is clear: larger corruption reduces ceteris paribus private investment compared to smaller corruption. We may conceptually separate the independent impact of the insecurity of private property rights on private investment when we envisage a situation when these rights are properly structured but the investors are subject to predation, not from the public officials but from non-official agents. This is the case of weak or failed states which do not perform well, or not at all, the constitutive function of any state: the protection of individuals and of their property, including the enforcement of contracts⁶. The huge uncertainty these situations generate, if the effective private protection does not exist, must limit investment to a very low level. Therefore, their impact is similar to an egalitarian redistribution in kin-based communities and to confiscatory taxation in some efficient but predatory states.

It is clear that some institutional systems may combine features of the models which I have sketched. For example, officials’ predation may go hand in hand with weak defense of property rights against non-official predation. High regular taxes, if spent on bloated bureaucracy or the oversized social transfers, can be combined with the low level of law and order in a country. Therefore, these “mixed” systems are also bound to produce low expected returns from private investment.

Some systems which reduce the rate of investment may be especially detrimental to investments which would embody new and superior technology, becuase such investment is likely to be more visible - because of its larger scale or its novelty - than the non-innovative investments. Therefore, it would provoke more predation, either from the officials or from private agents, in systems where private property rights are badly protected (Gonzales, 1999)⁷.

It is believed that prior to 1500 living standards differed little across countries and time (Parante and Prescott, 2000). I think that this historical fact can be explained by institutional factors: all societies until that time have had some variety of the innovation-blocking systems described above, or a succession of such systems; the latter case may be called unproductive transitions. The common features of these systems were: 1) improper structure of property rights, i.e. such which excessively taxed individual rewards or heavily restrained freedom of private action and/or created producers’ monopolies; or 2) acute insecurity of properly structured property rights. An additional role might have been played in some cases by the availability of lucrative non-economic options and by social norms which penalized economic activity in general or innovations, in particular. A command economy, which belongs to the first category, constituted the modern version of the innovation-blocking system. However, in its essence it was not very different from much older systems which abolished private ownership and/or competition

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Let us start with the direction of reforms and remember that we are dealing with the situations whereby some variant of growth-retarding institutional system exists at the beginning. Successful reforms must then take a direction towards a liberal system. Depending on the specifics of the inherited institutional framework, it will mean changing the content of property rights by removing the ban on private entrepreneurship, privatization, deregulation, reduced taxation, and fiscal reforms, or increasing the protection of these rights, if they are properly structured. As an empirical observation, I can’t find a single example of successful reforms which would have a different direction; institutional economics can explain, I believe, why such reforms cannot be successful: they would further weaken the incentives to invent, to innovate, to save or to work.

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Let us assume a list of institutional variables (I₁, I₂, … I_n) which correspond to various dimensions of countries’ institutional systems. Each variable is a set of alternative states. For example, a variable such as the structure of property rights would consist of communal, state, private property rights regimes. Another variable, the protection of property rights, is a set of various levels of this protection, etc. Each institutional system is a combination of interconnected states of different institutional variables which can co-exist, i.e. can form the system, even if, taken together, they perform badly⁸. For example, command mechanisms cannot co-exist with free entry; it requires a rigid multi-level organizational structure of the economy (c.f. Balcerowicz, 1995).

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The most important institutional variables which are behind these forces are the structure and the level of protection of property rights and the related factors: the degree of an economy’s openness, the extent of anti-competitive regulations, the fiscal position of the state. Variables which are responsible for the systematic forces of growth may be called propelling institutions. Institutional growth barriers may be equated with weak propelling institutions.

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1. This is why James Madison, the main author of the U.S. Constitution and a convinced proponent of these liberties was not enthusiastic about the Bill of Rights but pushed for the constraints on political powers.↩

2. Property rights with reduced decision-making power (the control rights) of their holders because of regulation are often called “attenuated.”↩

3. This uncertainty may be expressed by parameters (e.g. standard deviation) of the statistical distribution of possible returns or by some subjective measures based on investors’ perceptions.↩

4. This formulation expresses the general idea that the effect of the content of property rights and of the level of their protection on economic efficiency, are not additive. If the content is improper, i.e. the property rights guarantee a private or public monopoly, it is doubtful whether their increased protection increases the overall efficiency, as it implies that competitors who dare to enter the monopoly fiefdom, would be more harshly prosecuted. In contrast, the case of property rights providing for a free enterprise, the higher the protection of individual entrepreneurs, the better for economic efficiency.↩

5. The communal nature of property rights is not the only reason for the low level of economic development of traditional, kin-based communities. Some of them have more individualistic property rights, but the scope of private transactions is limited by the enforcement which does not go beyond members of the group (see, e.g. Greif 2006).↩

6. I leave aside here a fundamental question to what extent private protection (either contractual or self-help) can substitute for the state protection. This issue deals - in its philosophical dimension - with the rationale for the very existence of the state. For a profound discussion, see Nozick 1974. See also Greif (2006).↩

7. This is why high official taxes without predation may be less detrimental to innovation-based growth than low taxes and insecure property rights.↩

8. Capacity to co-exist, i.e. to last as a system, should be distinguished from performance. Badly performing combination of institutional variables can form a system i.e. they can last.↩