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The Mystery of Capital

Author: Hernando de Soto

Publisher: New York: Basic Books, 2000

ISBN: Center of Bus

Summary:According to Hernando de Soto's book The Mystery of Capital, what separates the haves from the have-nots is property rights. "Today, in many developing and former communist nations, property law is no longer relevant to how the majority of the people live and work. How,he asks, "can a legal system aspire to legitimacy if it cuts out 80 percent of its people?"

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The untapped value of assets held by Egyptians outside the legal system is fifty-five times greater than all the direct foreign investment in Egypt's history, including the Suez Canal. Only eight percent of city-dwellers there live in homes with clean legal title, and only seventeen percent of rural dwellers do. But the value of assets outside the legal system is thirty times greater than the value of the 746 companies on the Cairo Stock Exchange. Maybe this is a function of Egypt's history, or its class structure, or its culture. On the other hand, maybe not. You see the same story in Peru. There the assets owned by the sixty-five percent of the population operating outside the formal sector add up to $74 billion. The same story in Haiti. In Mexico. In the Philippines. Maybe the poor of the world aren't as poor as we thought.

Not so fast. Capitalism may have recently recorded its greatest victories ever, but more and more of the world's population is souring on it, and not just the well-heeled protestors at the Seattle WTO meeting or the Washington IMF/World Bank meeting. In Latin America, for instance, support for privatization has fallen from almost half the population to one-third. The mega-trend of globalization seems to be linking the elites of every country, but not much more. Why are the efforts and the investments of so many well-intentioned people and nations not more successful in bringing economic growth to the poor? The preferred reforms of the left (collective or government ownership) have failed, just as the preferred reforms of the right (privatization and formalization of existing rights) have. Why?

According to Hernando de Soto's book The Mystery of Capital, what separates the haves from the have-nots is property rights. "Today, in many developing and former communist nations, property law is no longer relevant to how the majority of the people live and work. How," he asks, "can a legal system aspire to legitimacy if it cuts out 80 percent of its people?" De Soto is the president of the Institute for Liberty and Democracy in Peru, and a Principal Advisor to the recently departed president of Peru, Alberto Fujimori. For the last five years, he has led a team of researchers at the ILD studying the problem of "formalization," or bringing people into the formal, legal economy. His team looked at five developing countries, Peru, Mexico, Haiti, the Philippines, and Egypt. It is this fieldwork that makes the book so compelling, so unlike most writing in economics. Nobel laureate Ronald Coase wrote that "If economists wished to study the horse, they wouldn't go and look at horses. They'd sit in their studies and say to themselves, 'What would I do if I were a horse?'" Fortunately, de Soto got out of his study.

In The Mystery of Capital he argues that the developing and former communist countries are going through the same process of urbanization and industrial revolution that the western countries did two hundred years ago. And, he argues, the critical, catalytic change - the creation of broad-based property rights - was so fundamental that most people didn't even notice. "The Western nations have so successfully integrated their poor into their economies that they have even lost the memory of how it was done." In school, children are taught about the industrial revolution and the textile mills of Birmingham and Lowell, but not about the legal and political struggles that helped farmers claim the land that they worked.

This development in the West did not happen overnight. In the United States, eighty years passed between George Washington's complaining about squatters ("banditti" he called them) to the passage of the Homestead Act in 1862. In Japan, the formalization of property rights took sixty years, from 1890 to 1950. In the United Kingdom, reform efforts continued from 1829 to 1925. At the same time, other countries, like Peru, attempted reforms and failed. The economist David Landes asked the question "Why are some countries so rich, and others are so poor?" De Soto would rephrase this question, "Why were some countries able to implement property reform, and others weren't?" Why, in fact, is property reform even necessary? Most nations have honest legal systems and well-documented property processes. Why can't the poor just opt in? It is economically advantageous to operate inside the system, de Soto's research shows. The amount of taxes a "legitimate" business would pay is far less than the bribes and protection money required of an extralegal business.

Making the transition, the phase shift as it were, can be expensive and often impossible. In particle physics, a quantum of energy is required to move an electron from one energy state to another. In the realm of humans, this is also true. De Soto's team conducted an experiment where they tried to open a small garment workshop in a Lima, shantytown, and to do so in full compliance with all laws and regulations. Working six hours a day, it took three hundred days and cost almost three times a worker's minimum annual wage. One is reminded of voter literacy tests in the pre-civil-rights South, where potential voters of color were allowed to vote if they were able to recite the entire US constitution by memory. There are processes in place, but the processes are designed not to work.

But maybe the formal processes are not what matters. Maybe the extralegal economy is working perfectly well. Half of the Russian economic output is from the extralegal sector. The favelas of Brazil are another example of the free market at work. The housing there may be illegal, but it is being built and lived in. Ownership of particular parcels is well understood, albeit off the record. People who don't pay their rent (which is typically quoted in US dollars) are evicted. Owners make a return on their investments. And there is enough new construction that there are always units available for rent. Sometimes the extralegal economy is healthier than the legal economy. In 1995 and 1996, the construction industry was recording only 0.5% growth. Oddly, though, sales of cement were up by 20%. It turns out that 20-30% of all construction is "unofficial."

But the evidence is that people would prefer to be inside the system. In Peru, de Soto helped design a program for bringing small, extralegal enterprises into the legal system. Approximately 276,000 entrepreneurs registered their businesses, without any promise of tax relief or other assistance. The will to operate inside the system is clearly there. It is easier to register a new business, though, than a parcel of land. A business, one can claim, is being created from scratch; land always has a prior owner.

So how can a nation begin this process of extending the legal system? Consider the experience of the United States, where formal ownership claims competed with "tomahawk rights" and "cabin rights" and "corn rights." A settler could make a claim of ownership, depending on time and place, by marking property lines with blazes, or by building a dwelling of a certain size, or by planting and harvesting a crop. Although the person carrying out these acts may not have been the clear legal owner at the time, he or she was acting in a way that asserted possession, if not ownership. When conflicting claims to ownership were brought to court, it was not unusual for a jury of one's neighbors to side with the occupant of the land rather than the absentee owner. The genius of the Western nations, de Soto writes, was that they "recognized that social contracts born outside the official law were a legitimate source of law and found ways of absorbing those contracts." The Homestead Act was more significant for recognizing the facts on the ground than for encouraging subsequent settling. Contrast this with the failure of the Peruvian constitution of 1824 to reform property ownership. There the fiat of law was not backed up with legal procedures that allowed extra-legal proof of ownership. Red tape triumphed over the will of the people.

In The Russian Revolution, the historian Richard Pipes writes that "Private property is arguably the single most important institution of social and political integration. Ownership of property creates a commitment to the political and legal order since the latter guarantees property rights: it makes the citizen into a co-sovereign, as it were. As such, property is the principal vehicle for inculcating in the mass of the population respect for law and an interest in the preservation of the status quo." Ownership has other, more immediate benefits. It encourages the development of utilities and infrastructure, since it makes it possible to bill the users. It makes it harder to pollute with impunity. If everybody owns the land, then nobody owns the land.

Most important, owning property makes people accountable for their actions, because it allows them to put something at risk. When entrepreneurs in the United States launch a new business, 70 percent of the time, the initial capital is raised by borrowing against collateral. The garage with the start-up in it probably has a second mortgage on it. In the developing world, would-be entrepreneurs don't have this access to capital. With nothing to risk, they have nothing to gain. In the US, Native Americans have struggled to take their place at the economic table. Perhaps they have been hampered by the ownership structures of their land and other natural resources. If all assets are owned collectively by the tribe, individuals don't have the means (to say nothing of cultural traditions) to become entrepreneurs.

One factor that will discourage countries from undertaking the transition de Soto advocates is their history of failed reforms. Our generation did not invent free and open markets. Four times in the last two centuries, the economies of South America have undertaken liberal reforms. As de Soto writes, "They have tried to become part of global capitalism and failed. They restructured their debts, stabilized their economies by controlling inflation, liberalized trade, privatized government assets (selling their railroads to the British, for example), undertook debt equity swaps, and overhauled their tax systems." And they failed. Without trying to blame the victim, it now seems that the problem lay in flawed legal structures. Thomas Friedman argued in The Lexus and the Olive Tree that globalization makes the nation-state more significant, not less. The countries that recovered more quickly from the Asian collapse of 1998 were the ones with better legal systems, clearer ownership, and less cronyism. What makes an economy robust is not the existence of a legal system - it is whether that system encompasses the entire economy, and not just the activities of the elite.

I found it interesting to read this book on the importance of property rights at the same time the world's software community is struggling with its own issues of the ownership of intellectual property. Is the best software created by open source community, where nobody owns the code? Will Napster lead to the creation of less new music, or just lower returns for media conglomerates? The lesson I took from this book is that widespread ownership of property is important, because it lets people leverage their assets to create new ventures. I also wondered if the problem of "dead" or unfinanceable capital might exist inside corporations. There are an untold number of bright ideas in the heads of a firm's people. But if people can't ensure that they will be the beneficiaries of their ideas, they won't share them with their employer, and these intellectual assets have no value. On the other hand, if firms could establish some version of property rights, linking future compensation to the performance of the ideas, then both they and their employees will benefit. Better property rights will improve the economy of the firm.

The Mystery of Capital is an important, well-documented, and subtle (if occasionally repetitious) work. It is not simple minded. De Soto did not choose to call his book The Capitalist Manifesto. "I am not a die-hard capitalist," he writes. "I do not view capitalism as a credo. Much more important to me are freedom, compassion for the poor, respect for the social contract, and equal opportunity. But for the moment, to achieve those goals, capitalism is the only game in town. It is the only system we know that provides us with the tools required to create massive surplus value." What de Soto is proposing is a revolution, where the five-sixths of the world that operates outside the system will be brought inside. This is the sort of revolution where there are no losers. The people that have no power acquire a stake in the system. The people who have to give up power benefit financially from a more vibrant economy. And everybody has a stake in maintaining the new status quo. Revolutions like this aren't very quick, and nobody may even notice that they are going on. But in hindsight, the most successful revolutions are unanimous, because everybody comes out ahead. Viva la revoluc√Ćon.

¬©  Center for Business Innovation, Cambridge MA.