Element 2.1: The Legal System
“[A] private property regime makes people responsible for their own actions in the realm of material goods. Such a system therefore ensures that people experience the consequences of their own acts. Property sets up fences, but it also surrounds us with mirrors, reflecting back upon us the consequences of our own behavior.”(24)
The legal system provides the foundation for the protection of property rights and enforcement of contracts. “Property” is a broad term that includes ownership of oneself, one’s ideas, and one’s labor services, as well as physical assets such as buildings and land. The legal system protects owners against violence, theft, or fraud.
Private ownership is an institution that involves three things: (1) the right to exclusive use; (2) legal protection against invaders—those who would seek to use or abuse the property without the owner’s permission; and (3) the right to transfer (sell or give) property to others.
Private owners can decide how they will use their property, but they are held accountable and responsible for their actions. People who invade or infringe on the property rights of another will be subject to the same legal forces that protect their own property. For example, private property rights prohibit me from using my hammer to break your windshield, because doing so would be violating your property right to your car. Your property right restricts me and everyone else from using (or abusing) your car without your permission. Similarly, my ownership of my hammer and other possessions restricts you and everyone else from using them without my permission.
The important thing about private ownership is the incentives that flow from it. There are four major reasons why the incentives accompanying clearly defined and enforced private ownership rights propel economic growth and progress.
First, private ownership provides strong incentives to maintain and take good care of property. If private owners fail to maintain their property or allow it to be abused or damaged, they will bear the consequences. Their property’s value will decline. For example, if you own an automobile, you have a strong incentive to change the oil, service it regularly, and maintain its interior. Why? If you do not, the car’s value to both you and future owners will decline. If kept in good running order, it will be of greater value to you and others potentially interested in buying it. The market price will reflect that stewardship. Good stewardship is rewarded, but bad stewardship is penalized by a reduction in the value of the asset.
In contrast, when property is owned by the government or owned in common by a large group of people, each user’s incentive to care for it weakens. Striking examples are easy to find. Did you ever watch an American cowboy movie and ask, “why are there cows everywhere but buffalo were almost driven to extinction? The answer: nobody owned the buffalo!
When the government owns housing, no individual or small group of owners has a strong financial incentive to maintain the property. Why? Because no individual or small group will pay the costs of a decline in the value of the property or benefit from its improvement. That is why government-owned housing, compared to privately owned housing, is more often run down and poorly maintained. This is true in both capitalist and socialist countries. Laxity in care, maintenance, and repair reflects the weak incentives that accompany government ownership of property, even in the midst of working markets for privately owned assets. A common saying in Soviet times captured this problem: “When everybody is the owner, nobody is the owner.” A good example is government-owned communal apartments, or ‘kommunalki,” which were widespread across the Soviet Union. These apartments housed multiple families, each with their own room, while sharing common areas like the kitchen and bathroom. These government-owned properties often suffered from neglect and poor maintenance. Residents frequently faced issues such as leaking roofs and outdated plumbing.
It is not just the lack of private ownership itself that causes problems so much as the differing interests between the users of property and the group or individual who bears the cost of misuse. Much the same problem occurs in the rental market where the private owner differs from the user. This is why rental contracts often contain long lists of how the property can and cannot be used. In Eastern Europe before the transition, it was not uncommon to climb filthy stairs past broken elevators and burned out light bulbs, only to enter gloriously maintained apartments because people cared about where they lived privately but not for common spaces.
Early in the transition, how to assign ownership rights to the housing stock became a major issue. It was clear that the units should become private property, but whose property? For houses and apartments built in the recent past, the answer was easy—give them (or sell them for a low price) to the occupants. But what about older buildings that had been seized from their owners when the communists came to power? Should ownership be given to those who lived in the unit or to those (or the descendants of those) who had their property “stolen?” The answer adopted by the Czechs was to give back (restitute) the property to its former owners but leave the sitting tenants in place covered by rent controls. This approach ran into obvious problems, as owners did not have sufficient income to maintain the property and resented not being able to sell it for its market worth.
Second, private ownership encourages people to use their property productively and to develop it in ways others value highly. While private owners can legally do what they want with their property, they can gain from actions that enhance its value to others. If they employ and develop their property in ways attractive to others, its market value will increase. On the other hand, changes that others dislike—particularly if they are customers or potential buyers—will reduce the value of one’s property.
Private ownership also affects personal development. When people can keep the fruits of their labor, they have a powerful incentive to improve their skills, work harder, and work smarter. Such actions will increase their income and satisfaction. Why are college students willing to endure long hours of study and incur the cost of a college education? Private ownership of labor services provides the answer. Because they have an ownership right to their labor services, their future earnings will be higher if they acquire knowledge and develop skills valued highly by others.
Similarly, private ownership provides the owners of land, buildings, and other physical assets with motivation to use, protect, and develop them in beneficial ways. Moreover, those failing to do so will bear the costs in terms of lower-valued assets.
Consider the owner of an apartment complex who has no interest in providing attractive landscaping, convenient parking, on-site laundry facilities, a workout room, or a swimming pool complex. Finding renters will be difficult if potential tenants value these things highly, that is, more than the costs of providing them. If so, the apartment owner has a strong incentive to provide them. Apartment owners will be able to increase their net incomes (and the market value of their complexes) by providing consumers with what they value highly relative to cost. By contrast, owners who do not will find that their earnings and the value of their capital (their apartments) will decline. Keep in mind, however, that if renters aren’t willing to pay the cost of an amenity—such as an indoor swimming pool—the apartment owner would be making a mistake in providing it.
Private ownership even influences the productivity of resources in socialist countries. Farming in the former Soviet Union illustrates this point. Under the Communist regime, families on small private plots, which ranged up to half a hectare in size, were permitted to keep or sell the goods they produced. These private plots made up only about 2 percent of the total land under cultivation; the other 98 percent consisted of huge, collectively owned farms where the land and the output belonged to the state. As reported by the Soviet press, approximately 25 percent of the total value of Soviet agricultural output was raised on that 2 percent privately farmed land. This indicates that the output per acre on the private plots was about sixteen times that of the state-owned farms.(25)
Even a modest move away from state ownership toward private ownership can produce impressive results. In 1978 the Communist government of China began a de facto policy of letting farmers keep all rice grown on the collective farms over and above a specified grain quota that had to be given to the state. The result was an immediate increase in productivity because farmers had an incentive to produce efficiently. Once the quotas were met, the farmers were permitted to keep all of their additional output. When the word got out that the government was ignoring the official policy against such “privatization,” the practice spread like wildfire, leading to rapid increases in agricultural output and freeing farmers to move into nonagricultural sectors of the economy.(26)
The privatization of state-owned enterprises in Poland in the early 1990s serves as another good example of improved productivity. The transition started in earnest after the fall of communism in 1989, with Poland implementing one of the most ambitious privatization programs in Eastern Europe. This transformation contributed to Poland's rapid economic growth in the years following the reforms, establishing it as one of the success stories of post-communist economic transition in Eastern Europe.(27)
There were many different forms of privatization in post-communist countries. Some clearly put assets in the hands of so-called “oligarchs” while others distributed assets more equally or sold them to foreign investors with the funds going to the state budget. Even the oligarchs, however, had an incentive as profit-seeking owners to make their firms operate efficiently.
Third, private ownership makes owners legally responsible for damages they impose on others. Courts of law recognize and enforce the authority granted by ownership, but they also enforce the responsibility that goes with that authority. Private ownership links control with responsibility. This link provides owners with a strong incentive to use their property responsibly and to take steps to reduce the likelihood of harming others and their property.
Consider the following examples:. Dog owners have an incentive to leash or restrain their dogs if they are likely to bite. Car owners will be held accountable if, say, poorly maintained brakes cause damage to someone else’s property. A chemical company is legally liable for damages if chemicals are mishandled and harm others.
Fourth, private ownership promotes resource conservation as well as wise development. Using a resource may generate revenue, which reflects the desires of present consumers who want what the resources can provide. But future consumers, too, have a voice, thanks to property rights. An owner of a resource, say a woodlot or small forest whose trees could be harvested now or later, faces a decision. Will the timber be more valuable today or in the future? In other words, will the expected value of the trees be greater when mature or if logged today? And will that future value exceed their present value now by more than the cost of holding and protecting them for future use? If so, the owner has an incentive to conserve—that is, hold back from current use—to make sure that the resource will be available when it is more valuable. In recent years many African countries have realized that assigning private ownership (or small communal village ownership) to local wildlife results in a market for tourism including limited big-game hunting that has led to rapid increases in previously endangered species.
Private owners will gain by conservation whenever the future value of a resource is expected to exceed its current value. This is true even if the current owner does not expect to be around when the benefits accrue. Suppose a sixty-five-year-old tree farmer plants a crop of Douglas fir trees that typically take fifty years to grow to their optimal harvesting level. Does this elderly tree farmer have an incentive to conserve the trees for future use? With private ownership rights, the answer is “yes.” With private ownership, the market value of the farmer’s land will increase as the trees mature and the expected day of harvest moves closer. So even though actual logging may not take place until well after the farmer’s death, the owner will be able to sell the trees (or the land including the trees) at any time, capturing their increasing value. As long as the growth of the mature trees is expected to increase future revenue more than alternative investments would, the farmer will gain by conserving the trees for the future.
For centuries pessimists have argued that we are about to run out of trees, critical minerals, and various sources of energy. Again and again, they have been wrong. Why? They fail to recognize the role of private property. It is instructive to reflect on these doomsday forecasts. In sixteenth-century England fear arose that the supply of wood—widely used as heating fuel—would soon be exhausted. Higher wood prices, however, encouraged conservation and led to the development of coal. The wood crisis soon dissipated.
Even when a specific resource is not owned, the market for other resources that are privately owned can often solve problems. In the middle of the nineteenth century, dire predictions arose that the world was about to run out of whale oil, at the time the primary fuel for artificial lighting. Because there was no private ownership of whales, there was no incentive to conserve them for future use. As the whale population dwindled, the price of whale oil soared. But the higher whale oil prices increased the incentive for entrepreneurs to find and develop substitutes. With time, this led to the discovery of commercially profitable sources of petroleum, the private development of relatively cheaper kerosene, and the end of the whale oil crisis.
Later, as people switched to petroleum, predictions emerged that this resource, too, would be exhausted. In 1891, the U.S. Geological Survey concluded that finding oil in Texas was unlikely. In 1926 the Federal Oil Conservation Board estimated that the U.S. supply of oil would last only another seven years.(28) In 1972, the Club of Rome's report "Limits to Growth" predicted that economic growth would lead to resource depletion and eventual societal collapse within the 21st century.(29) While the report raised valid concerns about unsustainable resource use, many of its near-term predictions have not come to pass, thanks to efficiency improvements, the discovery of new resources, and shifts towards more sustainable development practices. In 1968 Paul Ehrlich's book "The Population Bomb" predicted that rapid population growth would lead to mass starvation and societal collapse in the 1970s and 1980s. Indeed, Ehrlich claimed that England would “cease to exist” by the year 2000. In a famous, but true, anecdote economist Julian Simon offered Ehrlich a bet. “You pick any five resources you want and any year in the future and I bet their prices will have fallen (after adjusting for inflation).” Ehrlich took the bet and he and his advisers picked five raw materials: chromium, copper, nickel, tin, and tungsten. The bet was made in 1980 and by its end in 1990 the prices of all five had fallen, despite global population having grown by almost a billion people.
While overpopulation remains a concern, the dire predictions of global famine did not materialize on the scale forecasted. Advances in agricultural technology (the Green Revolution), improvements in crop yields, and family planning initiatives helped to avert the predicted crises.
All of these doomsday forecasts and many others have proven to be not only wrong but spectacularly wrong. Why? Private ownership provides the answer. When the scarcity of a privately owned resource increases, the price will rise. The increase in price provides consumers, producers, innovators, and engineers with incentives to (1) conserve on the direct use of the resource, (2) search more diligently for substitutes, and (3) develop new methods of discovering and recovering larger amounts of the resource. To date these forces have pushed doomsday ever farther into the future, and there is every reason to believe that they will continue to do so for resources that are privately owned.
Well-defined and enforced property rights are also crucially important for the realization of gains from trade. As discussed in Element 1.4, trade moves goods toward people who value them more and makes greater production possible as the result of gains from specialization and large-scale production methods. A legal system that provides evenhanded enforcement of contracts and protection of property rights reduces the uncertainties accompanying trade. In turn, this results in more trade, thereby expanding both the gains from trade and economic progress.
A legal system that protects property rights and enforces contracts in an evenhanded manner provides the foundation for the mainsprings of economic growth: gains from trade, capital formation, and resource development. In contrast, insecure property rights, uncertain enforcement of agreements, and legal favoritism undermine trade, investment, and the productive use of resources. Throughout history people have tried other forms of ownership, such as large-scale cooperatives and government ownership, under both socialism and communism. On any scale beyond the small village with a strong cultural harmony, these experiments have ranged from unsuccessful to disastrous. To date, no institutional arrangement other than private ownership within the framework of the rule of law has provided individuals with as much personal freedom and as strong an incentive to serve others by using resources productively and efficiently.
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It should be noted that for them to be effective in promoting growth they must be clearly known and enforced. While everyone in a village in a developing country may know who “owns” a particular piece of land it is hard to sell that land or use it as collateral to borrow money to invest in a new tractor. One of the most cost effective development strategies focuses on providing clear ownership titles to traditional users of land. For example, in 2013 Rwanda formally registered over 11.3 million out of the estimated 11.5 million land parcels in the country at a cost of about $6 each. Within a few years these titles had been used to support 2.6 BILLION dollars of investment loans.(30)