Friday, October 14, 2011

The Cost Of Financial Ignorance

I just read here an article by Hernando de Soto in The Washington Post. De Soto is a Peruvian economist known for his work on the informal economy and the importance of a formal property rights system. I read his book The Mystery of Capital a number of years ago in which he argues that the reason capitalism thrives in developed countries is due to a well established, efficient system of property rights. It is this system of deeds, titles, incorporation, etc., which provides reliable information as to who owns what, how much was paid for it, a reliable estimate of how much it is worth and how to transfer ownership. Though developed countries take these formal property laws for granted, many poorer countries are completely lacking in an efficient, working system. For instance, in Peru De Soto estimated that to legally build a house takes 6 years and 11 months and requires 207 administrative steps in 52 government offices. To acquire title to the land requires an additional 728 administrative steps. He gives similar examples for countries such as Egypt, Philippines and Haiti. It is this lack of a working, accessible system which forces a large portion of population of these countries to form informal, extralegal systems.

In the Washington Post article, De Soto applies this same argument to the financial crisis we have been muddling through. He argues that complex modern financial instruments such as derivatives and non-traditional practices including off-balance sheet accounting, have undermined the system which has served us so well for so long. "To understand why there is no credit without truth, you need only walk down certain streets — the businesses that cannot get significant credit are those in the informal economy, where assets and transactions are not legally recorded and are therefore unknowable.

When property is poorly documented, markets don’t get the information needed to connect assets to finance, and governments don’t obtain the data required to detect which connections have gone awry and how to fix them. This became obvious in 2008, when a relatively small number of sub prime homeowners’ inability to meet their mortgage payments ultimately triggered a global financial crisis. The world was surprised, and terrified, because no one seemed to see the connection."

Anyway, I thought it was a good article and worth reading.

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