De Soto and his Influence
For many of the world’s poor, the promises of capitalism are nothing more than empty rhetoric. Latin American economist Hernando de Soto is one of those providing the fresh thinking that is required, with his focus on the legal aspects of economic development in emerging economies. De Soto has an unusually varied background. Son of an international diplomat, he spent his youth living in various countries, including Canada, before attending the Université des Hautes Études Internationales in Switzerland, then gaining business experience as the head of a European engineering firm.
In 1980, he returned to reside in his native Peru and was struck by the difficulties facing the more business-minded
of his fellow Peruvians. His curiosity led him to hire several young lawyers to start documenting the laws governing Peruvian commercial activity. From this start grew his think tank, the Institute for Liberty and Democracy (ILD), based in Lima, Peru’s capital. In 1986, de Soto gained international prominence with the book The Other Path, which documented the neglected small-scale entrepreneurial activity in the developing world. In his next book The Mystery of Capital (2000), he extended this study with a more wide-ranging argument. How do we explain the gulf separating the privileged one billion who live in the industrialized West, as well as a few other rich enclaves, from the remaining five billion members of humanity? De Soto’s answer is deceptively simple. It is not a scarcity of material things, he answers, but an intangible entity. Individuals in the West have long taken this entity for granted, but it remains outside the grasp of most of the globe’s inhabitants. This entity is a workable definition of capital. Capital serves a technical role in production. It also serves a more general social function. De Soto highlights one of these social aspects of capital – to what extent individuals have the ability to own assets such as buildings and machinery. The ability to own private capital is at the heart of any market system. Without it, individuals are unable to exchange, lease and pledge productive assets, which means there are obstacles to entrepreneurial activity at every turn. It is just this type of property ownership that, de Soto contends, is unavailable to most people who live in low income countries.
The Extralegal Sector
How is this situation possible? Don’t poor countries have modern legal codes? De Soto responds that private ownership of capital may appear to be well established in these nations, but not if we consider the actual context in which most citizens live. Imagine a country where nobody can identify who owns what, addresses cannot be easily verified, people cannot be made to pay their debts, resources cannot conveniently be turned into money, ownership cannot be divided into shares, descriptions of assets are not standardized and cannot be easily compared, and the rules that govern property vary from neighbourhood to neighbourhood or even from street to street. According to de Soto, this scenario describes life in a large portion of the developing world, as well as in many former communist countries, where much, if not most, economic activity is conducted unofficially outside the formal rules of law, in what de Soto refers to as the extralegal sector. He cites a range of statistics to support his case. In Venezuela, for example, more than half of all workers are thought to be employed in extralegal enterprises. In the former Soviet states, almost 40 percent of production is estimated to be unofficial. By de Soto’s reckoning, the value of illegal dwellings in Egypt is US$240 billion, or 30 times the value of companies on the Cairo Stock Exchange. In Haiti, untitled real estate is considered to have a value four times as high as all assets of the country’s legally operating companies, and nine times all government assets. The comparable figure in Peru is US$74 billion. De Soto contends that 85 percent of urban land, and between 40 percent and 53 percent of rural land in emerging economies is held extralegally, representing an aggregate value of US$9.3 trillion.
These numbers may be approximate, but they highlight a tremendous problem. Regardless of whether the extralegal sector makes up a quarter, a half, or even more of these nations’ economic activity, this phenomenon is one deserving far more scrutiny than it was given before de Soto publicized his ideas. For the millions who live and work in the extralegal sector, property rights are virtually absent. Instead, these individuals must set up their own informal social contracts, which may provide some of the security of property ownership, but not the potent benefits from using capital as an entrepreneurial tool. Given the drawbacks of living in the extralegal sector, why does it continue to be so large? Extralegal status may simply be a way of avoiding taxes, or it may have deeper roots. De Soto and his associates have expended considerable effort to prove the latter. For example, de Soto’s researchers documented the legal process needed to open a small garment shop on the outskirts of Lima. Their estimate was that almost a year in full-time work and more than US$1000 in registration fees would be necessary. They have found similar results elsewhere in emerging economies. As for the length of time needed for legal authorization to build a house on state-owned land, they have estimated almost seven years in Peru, from five to 14 years in Egypt, and about 19 years in Haiti. Moreover, the work required to stay legal once formal title is acquired has been found to be almost as great as the initial task of becoming established. No wonder only the middle classes in many emerging economies can live in the formal economy. For the bulk of the population, doing without formalized property is necessary, despite all the additional costs that extralegal status imposes.
De Soto uses a metaphor coined by French economic historian Fernand Braudel to describe the gulf that separates the world’s legally secure rich from the extralegal poor. The rich capitalist world exists in a state of suspension very much like a bell jar, used to cover delicate objects. This divides it from the poorer parts of the globe, just as the early trading cities in medieval Europe could once be distinguished from their much poorer rural surroundings.1 Over time, this bell jar of prosperity will expand, just as it has done in past centuries. But the jar will stretch quickly only if the bulk of humanity is allowed to use its existing assets as productive capital. How to accomplish this? Top-down solutions are not sufficient, says de Soto. Rescinding bad laws is obviously important. But pre-existing extralegal arrangements can be incorporated in formal property systems only if a grassroots approach is used. ‘Discovering the people’s law’ is how de Soto terms this process, and it is one that has been implemented by de Sotos’s institute in Peru during the 1990s. This experience showed that political action is required to effect such changes, since strong leadership is needed if new legal arrangements are to evolve and flourish:
Only at the highest political level can reform command overwhelming support and wipe out the willful inertia of the status quo. Only the top level of government can prevent bureaucratic infighting and political conflicts from paralyzing the progress of reform … Emancipating the poor surely falls within the responsibilities of the nation‘s leader.2
In the short term, governments in many developing countries may continue to ignore the lack of property rights among their poor. However, de Soto is convinced that change is possible – especially if the poor themselves, as well as local economic elites, can be convinced of the mutual gains to be won by an extension of property rights. But this support will be won only through persuasion. De Soto has had ample experience in the political arena, given his past role as a presidential adviser in Peru. In the 1980s and early 1990s, his institute helped push through legal reforms to encourage the country’s extralegal entrepreneurs to register their companies, and to reduce the output of coca – the agricultural product used in making cocaine. But this political involvement occurred at a time of civil disorder in Peruvian life. His institute’s headquarters were bombed by the Shining Path guerillas, and the institute’s direct political influence waned after de Soto publicly split from a former Peruvian president, Alberto Fujimori, citing Fujimori’s increasingly dictatorial rule.
Spreading the Word
Since then, de Soto has taken on the mantle of international proselytizer. A gifted speaker, fluent in several languages including English, he has a knack for explaining his theories in easily understandable terms. His books are his primary tools – manifestos arguing that world poverty is not primarily the result of exploitation by multinational corporations. Instead, de Soto wishes to show the everyday usefulness of private property in curing poverty, and to convince his readers that the main obstacles to economic development are practical rather than cultural, local rather than international, legal rather than economic, the result of too little capitalism and not too much. The main lessons from de Soto’s theory are for emerging economies. If his outlook is correct, then economic development is not something the rich West can paternalistically administer for others. It is a challenge that must be faced by citizens of poor nations themselves, through building their own 21st-century version of capitalism. If they do, argues de Soto, the world’s capitalist revolution has only begun.
1. Fernand Braudel, The Wheels of Commerce (Harper and Row, 1982), p. 248.
2. Hernando de Soto, The Mystery of Capital (Perseus Books, 2000). p. 188.