Federal Reserve Chairman Ben Bernanke said recently that, given the ongoing credit contraction, “advanced economies like the U.S. would do well to re-learn some of the lessons” that have led to success among emerging market economies. Ironically, those economies in the 1990s accepted 10 points for promoting economic growth that were known as the “Washington Consensus.”
Advanced nations seem to have forgotten Point 10 of that consensus: how important documenting assets and transactions is to the creation of credit. Consider that most private credit is made up not of bills and coins, anchored in bank reserves, but in papers that establish rights over the assets, equity and liabilities that guarantee loans. Over the past 15 years, however, as they package, bundle and resell securities, Americans and Europeans have gradually undermined the reliability of the records that guarantee or make credit trustworthy — the deeds, titles, liens and other documentation that establish who owns what and how much, and who holds the risks.
Not having reliable information reduces confidence, which in turn leads to credit contractions, fewer or smaller transactions, and declines in demand. And these cause employment and the value of assets to fall.
The majority of us in emerging markets know this firsthand, having lived in a chronic credit contraction. To understand why there is no credit without truth, you need only walk down certain streets — the businesses that cannot get significant credit are those in the informal economy, where assets and transactions are not legally recorded and are therefore unknowable.
When property is poorly documented, markets don’t get the information needed to connect assets to finance, and governments don’t obtain the data required to detect which connections have gone awry and how to fix them. This became obvious in 2008, when a relatively small number of subprime homeowners’ inability to meet their mortgage payments ultimately triggered a global financial crisis. The world was surprised, and terrified, because no one seemed to see the connection.
The initial reaction three years ago was swift: The U.S. Treasury secretary created the Troubled Assets Relief Program to prevent a run on banks by purchasing the derivatives that financed the subprime mortgages. But officials realized within days that they couldn’t locate the assets or find criteria for pricing, buying and then removing them from the market. Given the lack of hard information, they improvised, using the TARP money to bail out the owners of the assets.
But finance wasn’t always this way. The connection between knowledge and credit was valued in the United States as far back as Thomas Jefferson’s day. During the Panic of 1819, the former president wrote in a letter to Richard Rush of his “despair” that finding the truth about how to stop credit from expanding and suddenly contracting would require “more knowledge of political economy than we possess.” He warned that U.S. citizens “had suffered themselves to contract . . . in debt,” that the nation was awash with “fictitious capital,” and that all this new credit and capital exceeded “the measure of our own wants and surplus productions.” Jefferson understood the dangers of overleveraging — and the “toxic assets” of his time — and that the way to get the information he needed was to connect finance and investment to “real capital and the holders of real property.”
For hundreds of years, the United States and Europe gathered and classified all that paper in publicly accessible records, from deeds and registries to balance sheets. Originally created for recording ownership, these data systems were gradually adapted to serve all legal interests and relationships linked to property. Credit and debt could be measured, risk and potential inferred. Matching capital and finance to property made it easier for liquidity to move in step with the general interest. This knowledge served the West phenomenally well: Since World War II, Western economies not only avoided major contractions but also grew more than in the previous 2,000 years.
Until 2008 — when we found that those systems had stopped telling the truth.
TARP authorities couldn’t locate knowledge about toxic assets fast enough because so many non-standardized types of records were scattered around the world. U.S. property and mortgage transactions records became obscured when companies were permitted to raise large amounts of financing by “bundling” mortgage loans into marketable liquid securities and recording these “derivatives” not with the traditional public registries but with the Mortgage Electronic Registration Systems, a private company whose registry reportedly holds about half the mortgages in the United States.
These derivatives had a notional value of $600 trillion to $700 trillion — 10 times the amount of global annual production. They are still outside any property memory system.
After hundreds of years of clear, reliable information on balance sheets, newer policies allowed companies to engage in off-balance-sheet accounting, effectively permitting them to appear more profitable than they really are. Information on debts is passed to the ledgers of “special-purpose entities” (SPEs) – think Enron, which had more than 3,000 SPEs — or swept into illegible footnotes. More broadly, national balance-of-payments accounts were supposed to signal facts regarding financial capital and transfers and debt. Yet no one saw the Greek or Italian sovereign debt crises coming because governments made their fiscal status look rosy by using new financial devices to swap their debts in one currency for another. An old debt looked like an inflow of new money.
We reformers in emerging economies have struggled for the past two decades, as Bernanke noted, to get our people and their assets onto the books, searching for and — whenever possible — incinerating fictitious capital to bring swarms of citizens living in economic anarchy under the rule of law.
We learned this from you, that the main source of credit is not money but the “moneyness” of property documentation. All financial activity must be documented if trust is to be regained in paper and, ultimately, in markets.
Hernando de Soto, a Peruvian economist and the author of “The Mystery of Capital,” assists governments in Africa, Asia, Latin America and the Middle East in their efforts to create market economies.