Are both dimensions of property rights "efficient"?

• Author: Czegledi, Pal
• Position: Report

1. Introduction

   Once it is accepted that property rights security is the most important determinant of economic development, it is obvious we need to immediately raise the question, what are the most important determinants of property rights security? In this paper I will focus on one of the explanations which have been developed to answer that question, the so-called economic approach to property rights, or the efficient institutions view. The efficient institutions hypothesis is understood as the claim that economic development will create incentives for governments to provide a higher security of property rights. The empirical tests of this hypothesis are usually cross-country regressions with property rights security on the left-hand side and a measure of economic development on the right-hand side.

   The paper argues that, on the one hand, property rights quality is a two-dimensional concept, because property rights should be considered as the result of two constitutional decisions: one is concerned with the definition of property rights while the other is concerned with the assignment of property rights. Definition and assignment will be considered as two dimensions of property rights quality. On the other hand, property rights in the "economic" approach must be understood in a broader sense than it usually is by the empirical papers. It must also include those rights that are considered to be in the political sphere of human actions as opposed to the economic.

   The "economic approach", when carefully applied, does not imply that the one single determinant of property rights is economic development. As this view suggests that institutions are created to minimize transaction costs, culture as an important determinant of transaction costs should be considered, too. The two dimensions of property rights, however, might not equally well be determined by development and culture. We can expect that development has a greater effect on the assignment dimension while culture has a greater effect on the definition dimension. First, even if the assignment dimension is improved by economic development, the definition dimension can only be improved if economic development is based on innovation. When imitation is the main driving force, the government will not have an incentive to widen the definition of property rights beyond the level of what is needed for the markets for goods in order to reach the level which would be needed for a market for ideas. Second, the less the definition of property rights is in line with cultural understanding, the more costly it will be to enforce them.

   To test these claims empirically one needs a measure of the two dimensions of property rights. To follow the bundle of rights definition of property rights we need a broader measure than that used in the literature. I use measures of economic and civil freedom in order to derive measures for the two dimensions of property rights. The cross country regressions which are run with the measures of the two dimensions of property rights as dependent variables show that, controlled for cultural determinants, economic development proxied by GDP per capita and education have a much stronger effect on the assignment dimension than on the definition dimension, while the cultural variables affect the definition dimension more. Generally, the definition dimension is less "efficient" and better explained by deeper cultural factors.

2. The efficient institutions view on property rights

   The ancient political economy problem of having a government that enforces but does not violate property rights was reformulated as a key dilemma for comparative economics by Djankov et al. (2003). They develop a framework in which society faces a trade-off between the cost of private and public expropriation, and is supposed to choose the institutional mix with the lowest social cost given the institutional possibility frontier set by "civic capital". This framework reflects the "constrained efficient" view of institutions, which is the proposition that "the distribution of property rights is chosen in order to maximize wealth net of transaction costs." (Allen 2012, p. 399) (1)

   This general claim implies, first, that "[t]he pressure to change property rights emerges only as a resource becomes increasingly scarce relative to society's wants" (North and Thomas 1973, p. 19). That is, as explained by Demsetz (1967) in his classic paper, an increase in demand will create an incentive to solve externality problems intensified by a higher demand, that is, to define and enforce private property rights, and create a market of the good which has become sufficiently scarce. Developing this line of reasoning further, Demsetz (2002) argues that the main driving force is specialization, which reduces the personal character of exchange relations ("compactness") within the community, improves technology, and increases the complexity of social organizations. These processes are the deeper roots of the motivation to create private property.

   Second, the constrained efficient view of property rights implies that if transaction costs change, the distribution of property rights will probably change as well. This is, indeed, the argument that Allen (2012) makes to explain the emergence of different institutions in pre-modern Britain. The most important element of transaction costs is the cost incurred to "make and enforce a claim" (Holcombe 2014, p. 476) or the "costs of policing the institutions" (Barzel 1989, p.84), that is, the costs of enforcing property rights. When transaction costs become low enough, defining and enforcing property rights becomes profitable.

   The idea that higher demand and lower transaction costs of exchange will create incentives for defining and enforcing property rights implies that economic development creates incentives to increase the quality of property rights protection. (2) That is why in empirical and cross-country quantitative analyses of the determinants of property rights this hypothesis is usually formalized as a test of whether per capita income is a statistically significant independent variable in a regression in which property rights quality is the dependent one. A higher income means a higher demand and a better technology for enforcement. Discussing the reasons why development leads to an institutional system characterized by more democracy and less corruption, Paldam and Gundlach (2008, p. 68) emphasize, for example, that with development "demand for capital and skills rises" and the "increasing opportunity cost of time provides incentives for transactions to become more effective", which finally "forces administrations to become transparent and incorrupt".

   The efficient institutions view of property rights can be contrasted with others. La Porta et al. (1999) provide a test, a very similar to which is conducted by Mijiyawa (2013) with a larger database. The evidence of La Porta et al. (1999) supports the efficient institutions view and so does that of Mijiyawa (2013), although his main conclusion is that what he calls the political approach (tested as the effects of democracy, income inequality, and the abundance of natural resources) is the most relevant and robust in explaining property rights when it is contrasted with three other approaches; the cultural (tested as the effect of the share of Protestants within the population), the historical (tested as the effect of common law legal origin), and the economic (tested as the effect of GDP per capita). He finds that in the sub-sample of rich countries, as well as in the sub-sample of African countries GDP is not a relevant explanatory variable (ibid., pp. 154, 176), while in the sub-sample of poor countries the relevance of the cultural approach, that is, the significance of the share of Protestants, is lost (ibid., pp. 154, 177).

   Other cultural variables, however, are usually found to affect property rights significantly. Norton (2004) evaluates whether dimensions of culture in the data of Hofstede et al. (2010) affect property rights security and the rule of law. He concludes that they do, but not all of them. The most important dimension is that of "individualism" which "reflects people's identity as individuals or as members of groups" (ibid., p. 91). He finds that cultural dimensions together can explain roughly half of the cross-country variation in property rights and rule of law data.

   There is an extensive literature focusing on the role of culture in determining the cross-country differences of institutions. In these papers, however, the dependent variable is not property rights but a more general measure of institutions (Klasing 2013, Licht et al. 2007). This does not make them irrelevant from the point of view of this paper because property rights security accounts for a significant part of the quality of institutions, and there is a strong correlation between different factors of institutional quality (Langbein and Knack 2010, Kuncic 2014). Those papers therefore that conclude that culture has an explanatory power over institutions (e.g., Tabellini 2008, 2010, Licht et al. 2007, Maseland 2013, Williamson and Mathers 2011a,b) give some support to the claim that property rights are determined by culture to some extent.

   The main factors and theories that have been developed in the past decades to explain cross-country differences in property rights quality are well summarized by the three papers of Levine (2005), Hansson (2009), and Mijiyawa (2013) (3). The aim of these three papers is the same: to evaluate different explanations of property rights quality or security. There is of course a substantial overlap between the theories they test and the explanatory variables they use, and the conclusion they draw: it is difficult to drop any one of the different explanations. Interestingly, it is only Mijiyawa (2013) of these three who considers the "economic approach"; cultural...