Wednesday, March 25, 2009

Not Worth The Paper They're Printed On

Hernando De Soto is the author of The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, a book that should grace the shelves of anyone with an interest in economics. In today's WSJ, he warns that the real root cause of our current problems are not the bad loans themselves but the derivatives that have created an overall lack of trust in the true value of all paper assets:

The Obama administration has finally come up with a plan to deal with the real cause of the credit crunch: the infamous "toxic assets" on bank balance sheets that have scared off investors and borrowers, clogging credit markets around the world. But if Treasury Secretary Timothy Geithner hopes to prevent a repeat of this global economic crisis, his rescue plan must recognize that the real problem is not the bad loans, but the debasement of the paper they are printed on.

Today's global crisis -- a loss on paper of more than $50 trillion in stocks, real estate, commodities and operational earnings within 15 months -- cannot be explained only by the default on a meager 7% of subprime mortgages (worth probably no more than $1 trillion) that triggered it. The real villain is the lack of trust in the paper on which they -- and all other assets -- are printed. If we don't restore trust in paper, the next default -- on credit cards or student loans -- will trigger another collapse in paper and bring the world economy to its knees.

If you think about it, everything of value we own travels on property paper. At the beginning of the decade there was about $100 trillion worth of property paper representing tangible goods such as land, buildings, and patents world-wide, and some $170 trillion representing ownership over such semiliquid assets as mortgages, stocks and bonds. Since then, however, aggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.

A quadrillion here, a quadrillion there, and pretty soon you're talking real money. De Soto goes on to recommend that government enforce six established procedures with respect to derivatives to ensure the value and legitimacy of these paper assets and restore trust.

Government's main duty now 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.

Given the important role that property law plays as part of the foundation of capitalism itself, his proposal seems eminently prudent.

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