Richard Epstein: Going Red on Property Rights

Earlier this month, I attended a Chinese-American Conference in Beijing on property rights co-sponsored by the William and Mary Law School and the Tsinghua University Law School. One purpose of the conference was to award in absentia the Brigham-Kanner Prize to retired Justice Sandra Day O’Connor for her contributions to understanding the law of property. The intensive two-day discussions on property rights were open, animated, and cordial. They also revealed deep ironies in both the Chinese and American approaches to property rights.

On the Chinese side, much grand rhetoric spoke of the power and wisdom of the socialist state, which until 1988 had doggedly held that private property was illegal. Even today, Chinese property law does not grant outright ownerships to any of its citizens. Instead, it draws a basic distinction between urban and rural lands. The former are owned by the state on behalf of the people. The latter are owned by collectives that parcel out use rights to its various members. In both of these situations, the individual person in possession of a particular parcel of land has a set of precarious use rights that are respected in any dispute between private individuals, but can be overridden by the action of the state or the collectives (which are themselves under government control).

Yet once we peel away that socialist rhetoric, a more complex reality emerges. The Chinese are deeply committed to real estate development. In Beijing, private development on public lands has for over a decade proceeded at such a furious pace that more than one conference attendee described Beijing as Kelo-on-steroids, a rueful reference to old neighborhoods being ripped apart to make way for the high-rise and office buildings that now dominate the sky line. Without question, these new enterprises fueled China’s economy, which has grown for over a generation at a compound interest rate of around 10 percent. This rapid growth stands in stark contrast to the dismal and chaotic state of affairs during China’s Cultural Revolution which, from 1966 to 1976, laid waste to the nation.

In a strange way, China’s muscular development has been made possible only because of the strong legal position that the state holds over urban lands, where private use rights, as noted, only protect property owners against displacement by their neighbors but not against forcible removal by the state, which enjoys paramount title, or ultimate ownership, over the property in question. To be sure, the Chinese have imported the western practice of providing some measure of compensation to the parties whom they displaced. But it should come as no surprise that compensation does not supply, to use the American phrase, “a full and perfect equivalent of the property taken.” Rather, the entire process is located outside the judicial framework, so that there is ample reason to think that many of the dispossessed are short-changed by the administrative process. Evidently the rule of law is not a prerequisite to sustained economic development, at least to date.

Before we turn in righteous indignation against the Chinese, however, we must remember that even though our federal and state governments are required to provide “just compensation” to private property owners, that protection often falls woefully short of the constitutional ideal. Just to mention some of the glaring deficiencies in the American system of compensation, businesses normally get little to no compensation for the following: any subjective value above the market price (at which they are typically not prepared to sell), the good-will tied to a particular location, the expenses associated with getting appraisals and defending against the suit, and moving expenses. Typically, the upshot of these lax compensation rules is too many ill-conceived projects financed by taxpayer money

The Chinese have different problems. For the urban lands, the dogma against the private ownership of land can only be evaded by a technique that has been in use from Roman times with respect to the private occupation of land owned either by the emperor or the people (the same conceit that works in a socialist nation also worked in territories conquered by the Romans): Give the occupants a lease. In Roman times, these leases were either for a term or perpetual. In practice, that distinction did not matter, for in neither case could the so-called tenant resist dispossession by the state. That same risk arises in China where all the leases are for specific terms of years, ranging from 30 years for residential property to 70 years for some forms of business property.

The institutional dangers associated with these arrangements may not be apparent at first blush, but over time they matter. The source of the difficulty is that the private improvements may last beyond the duration of the lease, at which point difficulties crop up as the lease winds down to its expiration date. Expenditures to maintain and upgrade property are typically lumpy. Somewhat simplified, the tenant’s choices are to do no work at all, or to do work that creates an improvement that lasts for ten years. The tenant who has five years left on the lease thus faces the painful choice of letting the property decay for the last five years of the lease, or making expenditures, close to half of which will benefit the state.

That end-period difficulty thus leads to showdowns that well-drawn commercial leases avoid, such as the option to extend the lease or to sell the residual improvement to the landlord at a stipulated price. But under the Chinese legal regime, these property rights are ill-defined and only the state has real power at the end of the lease period. If the state extends the lease, must the tenant pay a lump-sum for renewal or face a ruinous rent hike to stay in possession? Or, will the property be taken from one owner and given to another with greater political influence? This may sound like a technical question, but literally hundreds of billions of dollars are at stake when standard socialist dogma blocks the path of outright ownership, even as the Chinese are hell-bent on outstripping capitalist nations in the game of securing material wealth.

The situation is every bit as complex on rural lands, where over 600 million Chinese citizens live. These individuals are often at risk of being plundered by local governments. But the deep problem lies in the form of the rural citizens’ individual holdings. Just after the 1949 Communist takeover, the new government faced a stark choice on how to allocate these rural lands to members of the collectives. The farmers themselves preferred an arrangement that gave each family strong property rights for a given plot of land. The socialist ideology of the time, however, rejected that ownership solution. Instead, it allowed local collective authorities to reallocate the land periodically among the collective members.

The ostensible justification for these maneuvers was to use nonmarket mechanisms to take changed circumstances into account. Thus an expanded family would obtain a bigger parcel of land than a smaller family. This search for equity sounds nice on paper but it suffers from two fatal defects. The first is that the short time horizons under these leases give all farmers the strong incentive to neglect long term improvements, the benefits of which could be taken from them at any time. The second is that the supposed neutral tests for reallocation are easily undermined by political favoritism, intrigue, and revenge. Ordinary capitalist systems use voluntary exchanges with mortgage financing to shift assets from people who no longer need them to those who do. The prospect that gains from good husbandry can be captured from sale thus leads owners to better develop land whose value is stripped away by socialist practices.

Unfortunately, the mad dash to develop Chinese land poses new challenges to the tenants who live on these inefficient collectives. As with urban lands, an informal system of just compensation applies when these lands are taken over by the state. But the benchmark for the compensation is the low value that state coercion imposed on them in the first place. There is thus a serious political risk that low-ball compensation to a hapless tenant will result in major windfalls for the connected developer who purchases that land at a bargain price. The moral of this story is that artificial constraints on prices in a state with broad eminent domain powers can trample little people in the name of social progress.

That lesson was not lost on conference honoree Justice O’Connor when she wrote her now iconic dissent in Kelo v. City of New London, where she prophesized that “[n]othing is to prevent the State from replacing any Motel 6 with a Ritz-Carlton.” The obvious message was that big people should not be able to trample little people in the name of overall development. The Kelo decision and Justice O’Connor’s dissent are filled, however, with their own set of ironies.

The first of these is that Justice O’Connor’s misshapen 1984 opinion in Hawaiian Housing Authority v. Midkiff compounded the problem of eminent domain abuse. In Midkiff, she held that it was fine for Hawaii to transfer the landlord’s interest in his own property to a sitting tenant, so long as that tenant had ponied up in advance the money needed to acquire that land. Worse still, she uttered the fatal words that to this day define the lax standard that state and federal governments must meet in order for a taking of private property for public use to be just, as the Fifth Amendment of the Constitution requires. For a unanimous Court, she wrote that the state only had to show that its activities were “rationally related to a conceivable public purpose”—it turns out that they always are.

Midkiff thus nudged the American system of strong property rights in the wrong direction, making it resemble the absolutist system of Chinese state control, thereby putting a damper on real estate development in the United States. That problem has been compounded by U.S. rent control laws that allow tenants to barricade themselves into possession of a property in perpetuity by paying below market rentals. Rent control laws introduce some of China’s systematic imperfections into the American scene. One illustration of this risk is Justice O’Connor’s unfortunate 1992 decision in Yee v. City of Escondido, which barred the owner of a plot of land from reclaiming that site from a mobile home owner who entered the property under the terms of a year-long lease. If the property owner let the mobile home owner on the land for one year voluntarily, then, as Justice O’Connor argued, the owner had to keep them on forever, as the local rent control board determined the rent to be “just, fair and reasonable,” by reference to a laundry list of factors that never lets the landlord increase the rentals to market value.

This scheme essentially creates a perpetual lease that requires the owner to sell his land for far less than its market value. Yet Justice O’Connor held that this forced occupation of property did not amount to a physical taking, such that the landlord could only recover the premises if he determined to put the property to some other use, of which none would be allowed. It is important to note that in its own way, a decision like Yee gutted the very system of private property that the Takings Clause was intended to protect. This taking is clearly for the private purposes of the sitting tenant, who does not have to pay market value.

The same political intrigue that undermines the operation of market institutions on Chinese land now does so here, but with far less justification. After all, we are not in the position of having to play catch-up for the misdeeds of a cultural revolution. This country has prospered by a strong respect for the rule of law, which is undermined for no good reason by local governments that trample on the property rights of their own citizens.

It is therefore deeply disturbing that Justice O’Connor, along with her colleagues, both liberal and conservative on the bench, validated a destructive system of rent control. When it comes to identifying the many sources of American decline, one item that deserves a high place on that list is the gratuitous destruction of private property rights, a process that has been aided and abetted by the Supreme Court for too long. It is indeed ironic that as China tries to codify a system of private property rights, the United States seems all too willing to move in the wrong direction.

Richard is a Senior Fellow at the Hoover Institution, a Professor of Law at New York University Law School, and senior lecturer at the University of Chicago. He blogs at Defining Ideas.