Property as Sequential Exchange: The Forgotten Limits of Private Contract

In this paper, published at the Journal of Institutional Economics (2017), I trace the disconnection between economic analysis and property law as well as repeated policy failures in land titling and administrative simplification to a theoretical choice: most law-and-economics analyses of “property” rights have retained a contractual view that is essentially bilateral and therefore in fact deals with personal instead of property rights. Applying economics to property law holds the promise of enlightening such policies but requires that the focus be placed on sequential exchange as the distinctive feature of property markets.

The paper first analyzes how the prevalent contractual emphasis—in particular, the almost universal reliance on an assumption of bilateral “single” exchange with only two parties and a single contract—ends up fostering three biases that inadvertently support systematic policy blunders: overemphasizing the initial allocation of rights, paying little attention to legal rights and overestimating the power of private ordering.

• First, retaining the single-exchange assumption leads the law and economics of property to emphasize the initial allocation of rights because recurrent allocation is not even conceivable in such a setup. Inadvertently, this focus on initial allocation provides a fitting framework for unbalanced efforts in both land titling and business formalization. Indeed, most projects in these areas concentrate expenditures in the first steps of the process (such as titling land parcels and formalizing business firms), paying hardly any attention to the need for recurrent allocation (that is, for registering subsequent transactions and keeping firms formal in the future).
• Second, disregarding the foundational role of legal rights lends support to institutional reforms with mistaken priorities. This is the case of, mainly, land titling projects that confound and even privilege geographical over legal demarcation of land. Similarly, simplification reforms often pursue synergies by integrating contractual and administrative registries, losing sight of the fact that, since each register serves  a different function (respectively, private and fiscal), they require different organization.
• Lastly, disregarding contract interaction and sequential exchange leads to overestimation of the effectiveness of private ordering in many different areas, from traditional conveyancing to the modern application of blockchain technology. Policy consequences are visible in an array of institutional and regulatory reforms that naively liberalize outdated palliative services, such as those of conveyancers and notaries public, without realizing that success likely hinges on reforming property registries instead. Meanwhile, underdeveloped or ineffective registries remain untouched.

Getting these policies right requires a better understanding of the institutions of property markets, which in turn entails replacing the single-exchange assumption with an assumption of sequential exchange, in which at least three parties are involved, at least two contracts between these three parties interact and, as a consequence, bilateral contracting— the primary solution for use externalities—may itself cause substantial negative externalities.

These differences in the structure of the problem and the nature of the externalities hold important consequences for public action. In particular, two additional elements of public ordering (with “public” broadly understood as serving the interest of all market participants) are needed to contain exchange externalities: first, mandatory rules must establish the conditions for property (real) enforcement; and, second, enforcers must enjoy a wider scope of impartiality. Private-ordering arrangements can play an effective role in providing verifiability services but only under such conditions.

Moreover, the interaction between contract and property law also changes, with contract law governing the inter-party manifestation of the consents needed in what is necessarily a double-stage (private and public) property transaction. Property law institutions—that is, those dealing with all types of sequential exchange—also become the key mechanism for making truly impersonal exchange possible, this being understood as exchange in property, that is, in rem rights, the only rights whose value is independent of parties’ personal attributes.

I contend that this sequential-exchange perspective is necessary for understanding the functional dependence between economic and legal rights, and also for economic analysis to illuminate the institutions of property markets. To date, most models in law and economics contemplate contractual problems and solutions. Such solutions are only suitable for personal exchange so they force market participants to rely on personal safeguards and squander the potential benefits of in rem enforcement and impersonal exchange. Moreover, this purely contractual view is behind a variety of misinterpretations of empirical findings and specific policy failures in issues related to impersonal exchange: for example, when reforms focus too narrowly on the liberalization of private contractual specialists (conveyancers, title insurers, patent lawyers, investment bankers) without properly developing market-enabling central units, such as registries and organized markets for financial derivatives. More generally, such reform policies tend to disregard the conditions of public ordering that are necessary for public agencies to perform their functions and for private or hybrid ordering to play an effective, if complementary, role. The paper explains how these elements of public ordering can be taken into account, which should allow for more exhaustive consideration of the tradeoffs involved when deciding on the level of in rem enforcement and how to implement it.

The accompanying discussion with Doug Allen, Dean Lueck, Claude Ménard and Henry Smith clarifies and deepens the theoretical analysis.

In my response (“How Should We Model Property? Thinking with My Critics”), also published at JoIE, I argue that, to deal with the complexity of property, we must abstract secondary elements, such as the physical dimensions of some types of assets, and focus on the interaction between transactions. This leads me to point out several methodological imperatives as to how we should best study the institutions of property markets. I reiterate that this task requires replacing the bilateral contractual conception with a sequential-exchange assumption. Not only does the sequential-exchange framework capture the main problem of property in the current environment of impersonal markets. It also provides criteria to compare private and public ordering, and to organize public solutions that enable new forms of private ordering. However, two key positions in Coase’s “Problem of Social Cost” are seen as perfectly suitable to the study of property markets, namely, considering the definition of property rights separately from transaction costs and focusing on the comparative analysis of real institutions.

First published at the JoIE Blog (June 27, 2017).