Hernando de Soto – IT’S ABOUT PAPER NOT BUBBLES: Stopping the Meltdown


IT’S ABOUT PAPER NOT BUBBLES: Stopping the Meltdown

I recently received the following mail from Marshall Thurber, who studied and worked with R. Buckminster Fuller and W. Edwards Deming as well founded the Positive Deviant Network, about an article written by Hernando De Soto. Mr. De Soto, a Peruvian economist whose work focuses on the impact of the absence of a formal property ownership system in under-developed countries and how that lack of rights leads to endless poverty. Mr. De Soto has won numerous awards including the Milton Friedman Prize for Advancing Liberty and the Bradley Prize for outstanding achievement by the Bradley Foundation.

In this article, with Marshall’s preface included, Mr. De Soto discusses the real causes and dangers of our current economic situation:

I just received an article (see below) from David Neenan as part of Live Capital LLC. This is an extraordinary document that, hopefully, will soon be published in the New York Times. Because of this possibility please do not send it to other newspapers.

This article makes sense; please take the time to read and digest it. When you have, and if you agree with the contents, I would like you to forward it to as many influential people as you know for their assessment and ask them to get it to as many influential people as they know (network science at its best).

Your action in doing this is democracy at its best; you can be part of improving our and the global financial situation; you can help by being part of a ground swell demanding this action. In most cases, politicians don’t lead; they follow the will of the people. Let them hear your voice and those of your friends.

If our Politicians follow this course of action the economic pain will be dramatically shortened. You can clearly make a difference by doing this.

This is the first time I have ever written a request like this. Please do your part.

With gratitude,

Marshall Thurber

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IT’S ABOUT PAPER NOT BUBBLES: Stopping the Meltdown

By Hernando de Soto©

The meltdown of the global economy is due not to failing markets but to a violation of the rule of law. In recent years aggressive financiers have gutted the rule of law by taking out several essential inner mechanisms replacing them with an immense financial shadow economy, manufacturing hundreds of trillions of dollars of derivative paper so unruly, poorly recorded and untethered to real value that it has become increasingly worthless and difficult to trace. No one knows precisely how much there is or who holds it. Fear that potential borrowers could be burdened with so much of this toxic paper that they will be unable to repay their loans has initiated an inevitable chain reaction to a meltdown: as trust in legal paper breaks down, it paralyzes credit, which shrinks transactions, leading to a catastrophic drop in employment and in the value of everyone’s property.

When U.S. Treasury Secretary Henry Paulson initiated his Troubled Assets Recovery Program (TARP) last October with the widely reported objective of identifying and weeding out the toxic paper, I figured Western leaders understood that in their all-out efforts to avert meltdown the main challenge was to restore trust in the market: once TARP informed us of the amount, the location, and the nature of the bad paper, we would be in a position to know whom to help – and how to do it. Equally important, we could target the causes of this pandemonium and find ways to reform the law so that this never happens again. Once you are aware that in modern markets value travels on paper, you don’t have to be a genius to know that by restoring credibility to paper credit will resume.

Two months have passed, however, and TARP’S solution of isolating the toxic paper appears to have faded into the background. I now fear that Western authorities don’t really comprehend why mere paper is so important. In the non-Western world, where I come from, this is pretty obvious: the prosperous sector of our economy sit in their modern high rise buildings with all their assets well paperized (sending out clear signals regarding who is who, who owns what, what is where, and what is risky). But most people live in the anarchy of the shadow economy with their assets and contracts covered by paper that is endemically toxic: not recorded, not standardized, difficult to identify, hard to locate, their real value so opaque that ordinary people cannot build trust in each other or be trusted in global markets; they thus operate in a constant credit crunch and are stuck in poverty. In short, for shadow economies outside the U.S. and Europe, “meltdown” is a chronic condition.

That is why property paper is so important: it embodies in precise written form the rule of law in the market and thereby destroys its main enemies – ambiguity and opaqueness. Ever since we humans started cooperating beyond the scope of the family, the tribe, or the fiefdom, and found it profitable to transact with people and assets beyond the confines of the neighborhood, we have depended on legally authenticated written statements to get the facts about things of value. That legal authority matured over the past 200 years, until developed economies finally reached a global consensus on the procedures, standards and principles required to document facts that everyone can easily understand and trust. Today, under the rule of law, we have a formidable legal system that we call “property,” which specializes in providing all the rules and recording mechanisms needed to securely fix on paper the knowledge required to legitimately hold, transfer, transform and use the things we own, from houses to airplanes, from mortgages to stocks, and from patents to screenplays.

How Derivatives Violate the Rule of Law

Guess what are the only assets not governed by the rules of law that fix property to paper. You guessed it: derivatives, the very toxic paper currently melting down the global economy. That toxicity is the direct result of legal tinkering that substituted the authoritative and tested global consensus, which underpins the rule of law, with mathematical models and ratings for hire. During the past decade, in an effort to raise capital, some financiers have taken value from where the rule of law has positioned it – the property system – and repackaged it into paper synthetically created in the shadowy area of the law that governs derivatives. Once paper crossed that line, it left behind the six automatic regulators that keep the written law in sync with economic reality:

Automatic Regulator 1: Only what is real may be recorded on paper. Derivatives law is so untethered to real value and the rules of proper record-keeping that financiers have created bonds to represent homes, borrowers, and mortgages that literally do not exist. More astonishing still, these derivatives have strayed so far from the original assets that they were derived from, that a rating agency can decide to change the initial risk classification of a given set of mortgages just to make them more marketable. In contrast, property law accepts only real assets and interests (e.g. houses, owners, equity and mortgages), and demands that all the information about them be recorded carefully in centralized registries where anyone interested can access it, relatively easily.

Automatic Regulator 2: All inter-party interests must be in sync with external interests. The financial law governing derivatives has increasingly been re-engineered to suit the narrow needs of parties in a financial contract, disregarding how derivatives affect other interests. It foments niches and clandestine passages.

Property rests on what the law calls erga omnes (“towards everyone”) obligations– for every situation, it fixes rights and obligations regarding not only the ownership interests secured by a contract but also any external interests that could suffer side effects. Property legally interconnects all interests and relationships directly or indirectly linked to an asset or a liability – whether credit or debt, vested or contingent, expectant, inchoate or consummate, potential or unliquidated – and thereby ensures that paper moves in step with the general interest. This network of signals and cross references creates common knowledge, and makes it easy for anyone to track down paper, determine the various controlling interests, and protect his own. Significantly, property law was historically developed to open up the market by undercutting the secret prerogatives typical of royal, feudal and mercantilist aristocracies.

Automatic Regulator 3: Financing must always be aligned to assets and their improvement. The importance of aligning finance to property paper to create credit was spotted early on by John Kenneth Galbraith; studying the l929 Crash, he concluded that financial crises appear when the amount of debt secured or created on the basis of assets becomes dangerously “out of scale” with the property required to pay the debt.

How does one measure Galbraith’s scale? By examining whether financing for the development of a particular asset will help generate surplus value. The reason for this is as old as Aristotle who explained that the potential of any asset is bigger than the asset itself. This justifies leveraging, since discovering and developing potential requires supplementary credit scaled to our best estimate of an asset’s possible surplus value. The message is that growth comes from improving assets – a process in which financing plays only a supporting role (as we shall see in Automatic Regulator 4).

This “improvement” principle was honored from the very start of the American Republic: title was awarded to those settlers, railroads, and universities that could make improvements on the land they claimed or were granted. Long-established property law, therefore, demands that the financier never let the assets out of his sights as a constant reminder that the purpose of financing is to create additional wealth out of them: Assets can be leveraged, transformed, combined, recombined, sliced and diced, and repackaged into any number of tranches, provided the process improves the value of the original asset. By contrast, in the world of re-engineered financial products, there are no mechanisms or incentives to ensure that the division of paper into tranches develops an asset’s potential.

Automatic Regulator 4: Property and production drive financing – not the other way around. Finance supports wealth creation but in itself creates no value. It should never be allowed to take the lead: the role of finance is to keep the exchange economy going by passing money from those who save it to those who invent and produce things. Financing is infrastructure, like roads and sewers. As Adam Smith wrote, money is the “great wheel of circulation…and it carries to market all the grass and corn of the country (but) produces not a single pile of either.” Even Marx agreed that value has nothing to do with money. This is why we have to stop looking for solutions to the meltdown that sacrifice the property and the wealth of producers to subsidize the messed up financial facilities.

Automatic Regulator 5: All economic agents must be motivated and forced to record their assets and transactions – the essential knowledge to infer reality. We humans have the ability to use our minds to imagine, to create, to invent, and to make all sorts of productive combinations, while being able to deceive one another, be mistaken, ambiguous, inconstant, and swept away by our ambitions. Like Janus, these two opposing aspects of the mind are conjoined; we cannot separate them. Financiers, too, can be both creative and predatory.

That is why property law has built-in restraints against too much “creativity” in transactions. The way information is recorded, arranged and formatted in property paper enables us to detect and sort out incongruities between a given reality and what is documented. It is only by fixing factual knowledge about assets on paper, as required by property law, that we can establish the framework of rules for determining what is true and thus separate what is false from what is only fantasy – thereby promoting the creative talents of the financial community and reining in their evil twins.

Like any other business people, financiers must be accountable and to keep the public informed: all effective property recording systems are paired with mechanisms that motivate and force every asset holder to continually update the information about his assets. If information about financial products had been properly registered and updated, we would now have a clearer map for a way out of the current recession; and we might have been able to detect earlier the incongruities that led to it.

Automatic Regulator 6: Clarity and precision are indispensable. Knowledge about new-fangled financial derivatives must be collated in a manner that facilitates effective accountability and the inference of risk. At present, their terms are written in ways that are so complex and literally so unreadable that they cease to have any immediate meaning; even to put a value on derivative interests is a stretch. In case of default, for example, it is excruciatingly difficult to determine the value of a cash flow to be received on assets held or to figure how much they can be discounted with any degree of accuracy.

Unlike property, information about derivatives is not standardized; instead, there are thousands of idiosyncratic bonds scattered helter-skelter all over the market. Until someone categorizes them, it will be difficult to calculate their worth in a reasonable amount of time. After default, it may be close to impossible to find out who is accountable for repaying the debt for a derivative that has been sold innumerable times. In fact, some derivative paper is so sloppily structured that not even banks have been able to figure out the contents of their own portfolios, and US courts continue to reject many foreclosures backed up by this kind of paper. Financial law seems to have overlooked the fact that proprietary paper was created to integrate and clarify, not to exclude and confuse.


The Political Challenge

The rule of law is much more than a body of norms: it is also a huge information and management system that needs these six regulators to capture, filter and process local data, until it is transformed into facts organized on paper that allow us to infer what is true and what is false. And that’s what the meltdown is: a massive collapse of trust in the rule of law as a provider of authenticated information due to a flood of derivative paper that no longer provides facts – and hence the contraction of credit.

What about the notorious bubble? A meltdown and the bursting of a bubble is not the same thing, though they can interact. While the bursting of the “sub-prime” housing bubble and the excess of liquidity that produced it may have triggered awareness that a lot of paper derived from bad mortgages was toxic, it did not produce the meltdown: a 7% of mortgage default and a 20% loss of value in the low-end housing market, though a social tragedy, is not enough to shatter trust in legal paper and freeze global credit. Nor is the meltdown due to under-regulation; the complexity and confusion in the financial sector indicates that there may be too much regulation overall.

If my analysis is right, then governments face two crucial tasks. The first is to purge the toxic paper: bankers are not lending because they don’t know how much of it is sitting in the balance sheets of potential borrowers. The second is to break the issue away from the restrictions of purely financial considerations so that authorities can see the economic collapse in its entirety and have access to all the levers necessary to avert meltdown. To purge the toxic paper, we have to step into the shadow economy, find it, count it and exorcise it. Once that happens, we may find that the toxicity is not as painful as we have been told. The $600 trillion dollars of derivatives may be the result of counting the same value many times over, and thus the final tally of the paper that is actually jamming most of the trust required to unfreeze credit may be no more than a manageable couple of trillion. In any case, the information we get is what we need to figure out the best way to deal with the crisis.

So let’s start counting. “It’s an impossible task,” say the Wall Street types I’ve talked to, insisting that “derivative paper is too complex and tangled up to sort out.” This is just not true. Most of us make a living finding things and untangling them without asking for a medal –from doctors locating the source of an infection to paleontologists who recreate a dinosaur that lived millions of years ago from a fossil revealed by a rock fall. Americans and Europeans, in fact, used to be brilliant at finding toxic paper: lawyers and bureaucrats did exactly that to sort out conflicting claims after the California Gold Rush, to tame the Wild West, to pick up the pieces of Europe’s crumbling feudal order, to re-assemble Japan after World War II, and to reunify Germany after the fall of the Berlin Wall.

That is how capitalism was built. Today, in developing and former Soviet Union countries, we are constantly searching for toxic paper in our shadow economies –informal titles, licenses, contracts, laundered money and identity documents – in an effort to bring the people who hold the paper into the mainstream.

So why are most Western treasuries avoiding the search for toxic paper? My best explanation is that they continue to deal with the meltdown mostly within the narrow context of derivatives law and its constituency. This puts them at a tremendous disadvantage. First, the law that governs derivatives does not have the automatic regulators required to keep paper tethered to reality, the indicators to size up the damage, the information-sensitive agents to detect toxic paper quickly, the categories to classify the obstacles to reform, or the tools to sort out the growing conflict of interest between the holders of derivative paper and the rest of society. And second, the financial community –which typically provides the staff for dealing with all things financial— doesn’t have the inclination, the incentive or the economic interest to carry out the nitty-gritty, down and dirty job that is routinely done by ordinary working people.

That is probably why some financial types keep saying, “Let the market do its work.” Well, that’s impossible in the current situation. Modern legal markets only work if the paper is reliable and people have some access to credit and information, which will not happen until the toxic paper jamming the system is dealt with. “Let the market do its work” now means, in effect, “let the shadow economy do its work,” and that is a very different proposition. In a shadow economy, with no widespread information and credit, the only people skilled at operating in the darkness are the vulture capitalists and the loan sharks who will devour producers with good credit scores but no credit, along with the recently unemployed, at bargain basement prices. And they will continue to do so until the stock of wealth of those who produce has paid off the undocumented debt generated by the toxic paper.

If you have ever wondered why there is so little enthusiasm for market economics in the Third World, now you have the answer: markets don’t work well when they operate without transparency, in the shadows and outside the rule of law. That’s what the violence was all about in the Wild West, in the black markets of the 1930’s, and today in the crime- and war-torn zones of developing nations.

What we are facing is a once in a lifetime event when the legal institutions that coordinate a production system have fallen into grave disrepair. This is a legal and political challenge. Legal because it is the result of American and European governments having allowed the paper that represents their assets cross the line from the rule of law into an incomplete legal space where arbitrary interests preside and paper swirls mindlessly out of control. It’s a political challenge because only fixing the law can eventually stop the meltdown.

The main duty of government is to bring the whole toxic environment under the rule of law where it will be subject to enforcement. No economic activity based on the public trust should be allowed to operate outside the general principles of property law. The rule of law sustains all economic activity, all of society, even freedom itself. This was true under Roman law with its convention “ubi societas, ibi ius” (where society is, there lives the law). And it has become even more widespread as globalization and international treaties have increased over the past 50 years. Financial institutions will have to serve society and fully report what they own and what they owe, just like the rest of us, so that we get the facts necessary to find our way out of the current financial maze. They must be moored to reality and they must learn to put on paper statements about real things instead of statements about statements. Never again should financiers lose sight of facts and real value –homes, industries, services, patents, ideas, dreams and their potential. That is the only way to ensure calculability and create verifiable audit trails.

It is now time for politicians to muster the courage to rise above the narrow focus of financial specialists and take their position on the commanding heights, where they can view all the problems of a failing order and use all the levers of the law to address them. Markets were never intended to be anarchic: it has always been government’s role to police standards, weights and measures, records, and not condone legalized sharp practices in the darkness of the shadow economy.

Once it is clear that the meltdown is not about bubbles but about paper, government can step in to block the meltdown –in the name of property, capital, competitive markets and prosperity for all – without being accused of pandering to state socialism.

One response to “Hernando de Soto – IT’S ABOUT PAPER NOT BUBBLES: Stopping the Meltdown

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