Property rights and the wealth of nations: a cross-country study.

• Author: Heitger, Bernhard

Many studies suggest that the key determinants of economic development are the accumulation of physical and human capital and technological improvements. Traditional neoclassical growth theory (e.g., Solow 1956) emphasizes physical capital accumulation whereas endogenous growth theory (e.g., Romer 1986) presumes that investment in human capital and technological progress are the main sources of economic growth. In augmented neoclassical models, Mankiw, Romer, and Weil (1992) have shown that physical and human capital are important determinants of growth.

Nevertheless, it still remains an open question whether these factors are the real sources of economic development. There is reason to believe that if physical or human capital enlargements or technological improvements are taking place, the real growth factors must already have been unbound. (1) Accordingly, physical and human capital and technology should be seen as proximate causes of growth. (2) The still open questions are: What speeds up capital accumulation and what conditions are necessary for technological improvements? What are the ultimate causes of economic growth?

The present study hypothesizes that the missing ingredient in the theory of economic growth is incentives, which strongly depend on private property rights. Indeed, property rights are at the heart of any economic activity--nobody will become economically active if he can be cheated out of the fruits of his efforts. In addition, meaningful prices and efficient use of resources require secure property rights.

Traditional growth theory makes no mention of incentives and private property rights; they are simply taken as given. In reality this is not the case. Obviously, many countries of the Third World lack secure and well-established private property rights and there are many graduations between secure and insecure property rights, so that in fact there are diverging incentives to work, invest, and innovate. Even developed countries show distinct variations with respect to property rights.

The aim of this study is to analyze the impact of private property rights in the framework of an investigation into the causes of economic growth in an international context. The analysis is based on a modified neoclassical growth model. It is assumed that private property rights have a strong impact on economic efficiency. In addition, it is hypothesized that there may be positive feedbacks from increased efficiency to further improvements of the property rights system. The reason is that gains in economic efficiency may improve the prospects for institutional reforms. It therefore seems reasonable to investigate whether the assumed influence of private property rights on prosperity is only in one direction (i.e., purely exogenous) or whether there is also a positive feedback from improved economic development to the establishment of more efficient private property rights (i.e., simultaneous determination). In addition, the impact of property rights on the traditional determinants of economic growth will be considered to see whether private property should be treated as an ultimate source of economic growth.

Thoughts on Private Property

At first glance, it appears that classical economists, especially the English, neglected the importance of private property rights as a prerequisite for economic development. Although classical writers were not indifferent to private property, they appear to have taken it for granted. The reason may be that the legal situation in England in the 18th and 19th centuries--when even the tenant enjoyed legal security--was completely different from that on the European continent.

Adam Smith said relatively little about the importance of private property for economic development in The Wealth of Nations because he took it for granted. (3) Only at the end of his comprehensive work (Book V, Chapter III) did he state, "Commerce and manufactures can seldom flourish long in any state which does not enjoy a regular administration of justice, in which the people do not feel themselves secure in the possession of their property, in which the faith of contracts is not supported by law" (Smith [1776] 1976: 445). In his Lectures on Jurisprudence, given in Glasgow in 1762-63, Smith was much more explicit about the importance of property rights. He began his lectures with the following statement: "The first and chief design of every system of government is to give each one the secure and peaceable possession of his own property" (Smith 1978: 5).

Malthus ([1820] 1986: 249) regarded the security of private property as "among the most important causes which influence the wealth of nations." Yet, he concentrated on "the more proximate and immediate causes" of wealth: labor, capital, and land. Ricardo (1819: 175), in his study of the impact of taxes on property, stated: "For the general prosperity, there cannot be too much facility given to the conveyance and exchange of all kinds or property, as it is by such means that capital of every species is likely to find its way into the hands of those, who will best employ it increasing the productions of the country." Elsewhere, however, Ricardo rarely mentioned private property. Likewise, Mill ([1848] 1988), in his classic Principles of Political Economy, devoted only two chapters (in Book II, which was on distribution not production) to private property.

In France, Say devoted a whole chapter of his Treatise on Political Economy to "the right of property." According to Say ([1803] 1834: 132), the need for secure property rights is "so completely self-evident that demonstration is quite superfluous." Only if property is secure "can the sources of production, namely land, capital and industry, attain their utmost degree of fecundity" (p. 131). He also noted that if the "sovereign power" or government itself "practices robbery," property becomes a pure "mockery." Indeed, Say thought that, without the protection of property, "it is impossible to conceive any considerable development of the productive power of man, of land, and of capital; or even to conceive the existence of capital at all" (p. 135).

In the mid-1800s private property was viewed with growing suspicion. Engels and Marx ([1848] 1963: 59) wrote: "The Communists can summarize their theory in the single sentence: Abolition of private property." For Marx, property was more an effect of the stage through which history was passing than a cause of economic development (Bethell 1998: 114). Engels and Marx ([1848] 1963: 66-67) were not very explicit about the form property would take in the classless future, but they took it for granted that the immediate successor of bourgeois private property would be state ownership, centrally controlled.

After World War I, the Soviet Union embarked on central planning and attempted to promote economic development without well-defined private property rights. That experiment turned out to be very costly in terms of life, personal liberty, and economic prosperity. Nevertheless, many development experts believed in planning and neglected the role of property rights (Bauer 1972). The Great Depression contributed to the notion that plans could outperform markets and that "capitalism was defective" (Friedman and Friedman 1980: 94). Roosevelt's New Deal lent further support to this general assessment, as did World War II. As the Friedmans note, "At the end of the war it looked as if central economic planning was the wave of the future" (p. 95). In Europe the Marshall Plan further encouraged the belief in government spending, and in the Third World central planning was increasingly used as a tool to promote development. Keynesian policies to manage the economy were adopted widely and are still in use today.

In Keynesian theory, private property and the incentives it engenders are completely missing. It seems to be "a theory about economic activity that depends for its fulfillment upon ... economic activity itself" (Bethell 1998: 30). In the 1960s, however, some economists began to examine property rights in more detail, and economic theory began to rediscover its real foundations. This revival was closely linked with the work of Alchian (1965), Coase (1960), and Demsetz (1967). Within a few decades a wide body of research from different scholars has emerged demonstrating the importance of property rights.

Property rights affect transaction costs, incentives, and economic performance, and economic conditions, in turn, can influence the structure of property rights (Pejovich 2001). Private property rights offer individuals unique incentives to consider short- and long-term costs and benefits. Secure private property rights allow owners to pursue their personal goals and, if successful, to enjoy the fruits of their labor. Thus, private property rights provide a much stronger incentive to create wealth and to preserve the value of assets than does state ownership.

When property rights are safeguarded, individuals will be able to plan their lives within known legal rules that minimize the use of force. "The aim of the rules of law," wrote Hayek (1973: 108), "is merely to prevent, as much as possible, by drawing boundaries, the actions of different individuals from interfering with each other." Only boundary drawing--that is, the enforcement of private property rights--has made it possible to assign meaningful values (prices) to different inputs and thus allow efficient trades to take place.

In addition, if transferable (i.e., exchangeable) property rights exist, there is the possibility that one party can resolve a conflict by buying out the property rights of another (Coase Theorem). Where the interests of parties are in conflict, one option is for one party to buy the opposing interests. For example, in the case of land, the purchaser may either retain the adjacent property or resell it with a caveat on its use.

The main hypothesis that can be drawn from...