BOOK REVIEW

The Mystery of Capital
by
Hernando de Soto

FUTURECASTS online magazine
www.futurecasts.com
Vol. 4, No. 8, 8/1/02.

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Capitalism without capital:

 

 

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  In "The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else," Hernando de Soto provides a book that is essential reading for all who profess interest in the poverty stricken of the undeveloped world. This book examines one of the primary ways in which the governments of poverty stricken nations keep their peoples and nations in hopeless poverty - keep them so hopelessly impoverished that no amount of market reforms or sound macroeconomic policies or outside aid can possibly help them.
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A decade after the ideological triumph of capitalism, Hernando de Soto still has to ask why capitalism thrives only in the West, "as if enclosed in a bell jar?"

  Prosperity still eludes third world nations and many ex communist nations (hereinafter, "undeveloped nations"). Today, it is widely recognized that: "Capitalism stands alone as the only feasible way to organize a modern economy." However, a decade after the ideological triumph of capitalism, Hernando de Soto still has to ask why capitalism thrives only in the West, "as if enclosed in a bell jar?" Capitalist and market economic policies have been widely and beneficially adopted, but they are obviously not enough.

  This is not really accurate. Few undeveloped nations have maintained both monetary and budgetary discipline - and their market reforms frequently contain far more defects than are common in the West. Argentina, for example, had a pegged currency but its budgetary process was and is an uncontrollable mess.
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  De Soto notes that many Latin American nations have tried capitalism on four separate occasions during the last two centuries and failed all four times. Numerous market weaknesses and/or lack of budgetary and/or monetary discipline played major roles in all of these failures. The degree of defectiveness is highlighted by the fact that perfection is not required for prosperity - and is far from achieved even in the advanced nations..
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  The Asian Tiger versions of crony capitalism encumbered their markets with political favoritism and corruption. Since the Asian Contagion crisis, market reforms in S. Korea and Malaysia - although far from perfect - are now being rewarded with substantial rates of renewed growth even in this mildly depressed world economic environment. Government "industrial policy" can also cripple a nation.

Undeveloped nations must free their people to take part in the domestic and global economy.

 

The people need "live capital" that comes from accessible legal protection for their interests in property.

  Capitalism without capital doesn't work, is de Soto's perceptive answer to his question. The foundations for raising capital are still absent outside the West even after adoption of a variety of market and macroeconomic policy reforms.

  "Capital is the force that raises the productivity of labor and creates the wealth of nations. It is the lifeblood of the capitalist system, the foundation of progress, and the one thing that the poor countries of the world cannot seem to produce for themselves, no matter how eagerly their people engage in all the other activities that characterize a capitalist economy."

  Undeveloped nations have been engaged in the necessary macroeconomic reforms needed to free their economies from socialist constraints and take part in the global economy. However, they must also free their people to take part in the domestic and global economy. For this - among other things - the people need "live capital" that comes from accessible legal protection for their interests in property.
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  Property interests must be properly documented and tracked. They must be legally protected, widely transferable and fungible, capable of being encumbered and subjected to their owners' obligations.
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Without legally provable and enforceable title to interests in property - without a legal "representational process" - assets are "dead capital." They are unable to support credit and substantially less attractive to prospective purchasers and investors.

  The potentialities for capital in undeveloped nations are immense. De Soto demonstrates that vast sums have been saved by the mass of people in undeveloped nations such as Egypt and even Haiti.

  "But they hold these resources in defective forms: houses built on land whose ownership rights are not adequately recorded, unincorporated businesses with undefined liability, industries located where financiers and investors cannot see them. Because the rights of these possessions are not adequately documented, these assets cannot readily be turned into capital, cannot be traded outside of narrow local circles where people know and trust each other, cannot be used as collateral for a loan, and cannot be used as a share against an investment."

  Without legally provable and enforceable title to interests in property - without a legal "representational process" - assets are "dead capital," unable to support credit and substantially less attractive to prospective purchasers and investors.
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  In the United States, de Soto asserts, mortgages on the homes of small entrepreneurs provide the single most important source of funds for new businesses. Legally enforceable and recorded title to interests in homes and other real property assets provide a link to the credit history of their owners, accountable addresses for service of process and collection of debts and taxes, a secure basis for providing universal and reliable public utilities, and the bases for creation of securities like mortgage backed bonds.
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The "implicit legal infrastructure" of western property systems maximizes the credit worthiness - (the purchasing power) - of assets and labor.

  Ownership is just the first step, de Soto points out.  The "implicit legal infrastructure" of western property systems maximizes the credit worthiness - (the purchasing power) - of assets and labor. This infrastructure was not designed for this purpose. It evolved by means of many pragmatic steps over many centuries. It evolved by trial and error - sometimes egregious error.
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  The poverty stricken nations of today are very much like the U.S. and European nations two centuries ago, the author asserts, before the development of the legal systems that support the property rights that enabled widespread prosperity. (Concepts of equal justice before the law placed the common law legal systems of even two centuries ago miles ahead of the current politicized legal systems in undeveloped nations.)

Factors that are essential but not sufficient:

 

 

 

A book that covers all the many other factors involved in the enhancement of the purchasing power of capital in a modern economy would have to be substantially larger than this one.

  Legal recognition of and protection for ownership and creditors interests in property is essential for the vital capital raising function of a capitalist economy. This is de Soto's main point, and he sets it forth convincingly and clearly. There are, however, a few minor elements of his supporting arguments that are not so convincing.
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  More important - as is typical of such books as this one and thus perhaps more of a reason for reader caution than a reason for criticism of the author - the book tends to skimp on important contextual elements. The major point is overstated and oversimplified. A book that covers all the many other factors involved in the enhancement of the purchasing power of capital in a modern economy would have to be substantially larger than this one.
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  Thus, the reader must keep in mind that - although de Soto brilliantly sets forth one of the most important reasons for the failure of economic development in undeveloped nations - this is far from the complete story.

There are cultural factors, too, that have to be developed over time - widespread public support for economic and political freedom - and a sense of civic responsibility especially important in local political governance.

 

Economic growth models - with their inputs, outputs, and incomes - miss social and political conditions and developments that are critical for economic prospects.

 

The good news is that perfection is not required. Any substantial reform effort, plus budgetary and monetary discipline, will bring rapid and substantial economic benefits.

 

De Soto is clearly aware of such    other factors and does mention or indicate the importance of some of them in passing at several points.

  There indeed is much that is essential but not sufficient for adequate facilitation of profit driven market directed commerce. Just as providing good macroeconomic and market policies is essential but not enough, adding legally recognized and enforceable property and creditors rights - although obviously also essential - will also not without more bring satisfactory results.
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  Even if property rights are enforced and made accessible, the amount of "live capital" created will depend on profitability and the effectiveness of creditors rights.
The effectiveness with which legal systems may protect creditor rights will vary. Law enforcement in these areas may make foreclosures impractical. Rule of law legal systems are scarce in undeveloped nations, as are legal systems sensitive to the needs of commerce.
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  Bank credit may not be available for small business purposes.
The burdens of taxation, regulation and/or corruption may make legitimate business unprofitable.
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  Other factors include physical and financial infrastructure - physical safety for persons and property - education - modern bankruptcy and commercial laws - enforcement of contracts - elimination of restraints on domestic and foreign competition - and relatively favorable risk/reward ratios.
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  There are cultural factors, too, that have to be developed over time. Widespread public appreciation of and support for economic and political freedom and rule of law legal systems sensitive to the needs of commerce and intended to promote justice for the individual take time and considerable education to develop. A sense of civic responsibility is especially important in local political governance.  Economic growth models - with their inputs, outputs, and incomes - miss social and political conditions and developments that are critical for economic prospects.
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  If all this sounds complex and full of difficulties, that's because it is. However, the good news is that perfection is not required, and is far from achieved - even in the advanced nations - even after centuries of development. As has been shown by China, any substantial reform effort, plus budgetary and monetary discipline, will bring rapid and substantial economic benefits.
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  Indeed, it is arguable that the Asian Tigers reaped such rapid economic benefits from their initial reforms, that they felt no pressure to continue their reform efforts. Their leaders proceeded with business as usual - placing political and personal interests ahead of the economic interests of their nations. When the  business cycle brought inevitable economic problems, they were poorly positioned to meet the challenge.
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  De Soto is clearly aware of the various other factors involved in economic modernization and the creation of "live capital," and does mention or indicate the importance of some of them in passing at several points. See "Capitalism without capital," above.
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  A fine recent article in the January - February 2001 Foreign Affairs provides a more balanced picture. Harvard Prof. Bruce Scott summarizes some of the most important of these other factors that widely hinder development in undeveloped nations. See "Good governance policies," at the end of this book review. The reader should thus take de Soto's book for its limited intended purpose - to stress the truly vital and often overlooked need for property and creditors rights - something FUTURECASTS too has stressed for several years.
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No concept of capital can be valid if it doesn't explain the differences between "live capital" and "dead capital" - among other things.

  FUTURECASTS defines capital in the dynamic terms of its constantly fluctuating purchasing power. Formulaic calculations of capital based on sums invested less depreciation - plus such factors as labor and natural resources - are too static and are  obviously invalid. That they do not explain the difference between "live capital" and "dead capital" is just the beginning of their weaknesses. See: "Capital as Purchasing Power: A Functional Definition," in this month's issue of FUTURECASTS.
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Dead capital:

  In the absence of legally enforceable title to interests in property, assets are worth little and cannot support credit. In de Soto's terms, they constitute "dead capital."
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Gray market activities are inherently "undercapitalized."

  "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 neighborhood to neighborhood or even from street to street."

  This, de Soto points out, is the reality in most of the undeveloped world containing 80% of the world's population. However, these people are not impoverished. They industriously engage in a full range of gray market activities and industries, and possess a wealth of assets. However, these assets are without the legal recognition or protections needed to turn them into usable capital. Their gray market activities are inherently "undercapitalized."
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Migrants from the countryside into the cities are thus kept in the gray market, and established city residents are driven out of the legitimate market into the gray market - a vibrant, functioning, but perennially undercapitalized economic sector.

  Examples of the incredible bureaucratic hurdles required in these nations to acquire legal title to land or to initiate a legitimate business are provided. Hundreds of separate bureaucratic steps and more than a decade of effort - and sums of money that are vast in proportion to the earnings of the people - are typically required. Then, on top of this, there are the obstacles to retaining legitimacy once it is obtained.

  "In fact, in every country we investigated, we found that it is very nearly as difficult to stay legal as it is to become legal. Inevitably, [domestic migrants into the cities] do not so much break the law as the law breaks them --- and they opt out of the system."

  Migrants from the countryside into the cities are thus kept in the gray market, and established city residents are driven out of the legitimate market into the gray market - a vibrant, functioning, but perennially undercapitalized economic sector. Gray market participants are not impoverished for lack of skills or enterprise.

  "Street-side cottage industries have sprung up everywhere, manufacturing anything from clothing and footwear to imitation Cartier watches and Vuitton bags. There are workshops that build and rebuild machinery, cars, even buses. The new urban poor have created entire industries and neighborhoods that have to operate on clandestine connections to electricity and water. There are even dentists who fill cavities without a license."

  The gray market provides most of the inner city transportation - buses, jitneys and taxies - and most of the food available in the markets. Their stalls and carts are everywhere. In Russia - based on clandestine electricity consumption - they account for 37% of total production in their shacks and small workshops. The gray market has grown to huge proportions in these nations. (Gray market activities are something else that econometric analyses ignore. Nor are gray market earnings included in official poverty statistics.)

  "The only real choice for the governments of these nations is whether they are going to integrate those resources into an orderly and coherent legal framework or continue to live in anarchy."

"We discovered that the way people build in the undercapitalized sector takes as many forms as there are legal obstacles to circumvent."

 

The result is that most assets are "commercially and financially invisible" - "dead capital" - unavailable for financial uses.

  Few have legal title to their land or buildings. Even where buildings were once held legally, most drop out due to difficulties in complying with applicable laws. "We discovered that the way people build in the undercapitalized sector takes as many forms as there are legal obstacles to circumvent."

  "By one route or another, almost every dwelling place in the cities we surveyed exited the legal framework -- and the very laws that could have hypothetically provided owners with the representations and institutions to create capital. There still may be deeds or some kind of record in someone's hands, but the real ownership status of these assets has slipped out of the official registry system, leaving records and maps outdated."

  The result is that most assets are "commercially and financially invisible" - "dead capital" - unavailable for financial uses.

  "Nobody really knows who owns what or where, who is accountable for the performance of obligations, who is responsible for losses or fraud, or what mechanisms are available to enforce payment for services and goods delivered. Consequently, most potential assets in these countries have not been identified or realized; there is little accessible capital, and the exchange economy is constrained and sluggish."

  De Soto's extensive studies indicate that 57% of city dwellers and 67% of rural residents in the Philippines live in housing that is dead capital. In Peru the figures are 53% and 81%. Haiti - 68% and 97%. Egypt - 92% and 81%. While each shanty or small bungalow may be worth sums ranging from mere hundreds of dollars to sometimes tens of thousands of dollars, the sheer numbers of these dwellings means that "collectively their value dramatically outweighs the total wealth of the rich."
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  Estimated values are $5.2 billion in Haiti - which is four times the value of all legally operating companies in Haiti. In Peru, it is $74 billion - five times the total valuation on the Lima stock exchange. In the Philippines, it is $133 billion - four times the valuation of domestic companies on the Philippines stock exchange. In Egypt, it is $240 billion - 30 times the value of all shares on the Cairo exchange.
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The impoverished "are NOT the problem," de Soto angrily emphsizes. "They are the solution."

 

 If the political leaders only solve "the mystery of how assets are transformed into live capital," their own people will generate all the wealth needed.

 

  And this is just the housing. It does not include the farms and workshops. "In every country we have examined, the entrepreneurial ingenuity of the poor has created wealth on a vast scale - wealth that also constitutes by far the largest source of potential capital for development." This wealth dwarfs all government assets or international aid.
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  At least $9.3 trillion - twice as much purchasing power as the total circulating U.S. money supply - is de Soto's conservative estimate of dead capital in undeveloped nations. The vast majority of the world's impoverished are not totally destitute and helpless. They "painstakingly save to construct a house for themselves and their children and - - - [create] enterprises where nobody imagined they could be built."
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  "They are NOT the problem," de Soto angrily emphsizes. "They are the solution."
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  The leaders of undeveloped nations need not beg for handouts. If they only solve "the mystery of how assets are transformed into live capital," their own people will generate all the wealth needed.
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Capital formation:

  De Soto discusses various concepts of "capital," but basically concludes that you cannot develop a prosperous economy without mobilizing the purchasing power of credit bolstered by the value of assets transferable in a broad legitimate market.
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The systems in the West developed over time as all the loose bits of property information and rules were by individual pragmatic steps integrated into one comprehensive system.

 

 

 

 

 

 

 

 

 

 

 

 

Legal title "functions as the means to secure the interests of other parties and to create accountability by providing all the information, references, rules, and enforcement mechanisms required to do so."

 

 

 

 

 

 

 

  He asserts that the process for this grew unintentionally in the West as a collateral benefit of processes designed to protect property - to define and provide legal protection for legitimate real property assets. The system developed over time as all the loose bits of property information and rules were by individual pragmatic steps integrated into one comprehensive system.
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  The result was a "formal property system" by which assets are described, relevant records are kept, title is granted, and codes of conduct established for use and transfer. The process "is hidden in thousands of pieces of legislation, statutes, regulations, and institutions that govern the system. Anyone trapped in such a legal morass would be hard-pressed to figure out how the system actually works." However, it can be described functionally by its pertinent effects.
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  Titles are recorded - along with encumbrances such as liens, leases, mortgages, and pertinent contracts - everything affecting interests in the property. A whole industry facilitates the use of these assets. Brokers, title companies, insurers, appraisers, escrow agents, etc., all protect not only the security of ownership but perhaps more important, "trust in transactions" that facilitates their financial use.

  "Formal property records and titles thus represent our shared concept of what is economically meaningful about any asset. They capture and organize all the relevant information required to conceptualize the potential value of an asset and so allow us to control it."

  Without such a process, asset transactions involve many difficulties "just to determine the basics of the transaction: Does the seller own the real estate and have the right to transfer it? Can he pledge it? Will the new owner be accepted as such by those who enforce property rights? What are the effective means to exclude other claimants?"
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  Without such a process, extensive procedures - involving all the neighbors - are required for land transactions. As a practical matter, this confines transactions to "local circles of trading partners." Confined to such narrow markets, property values are minimal.

  "A formal property representation such as a title - - - represents the nonvisible qualities that have potential for producing value."

  Of primary importance is their ability to enhance the purchasing power of the owner's credit by acting as security by means of liens, mortgages, easements, and covenants. Legal title "functions as the means to secure the interests of other parties and to create accountability by providing all the information, references, rules, and enforcement mechanisms required to do so." (Thus, de Soto also emphasizes that, not only ownership rights, but reliable rule of law enforcement of creditors rights and contract rights is also essential.)

  "In the West, for example, most formal property can be easily used as collateral for a loan; as equity exchanged for investment; as an address for collecting debts, rates, and taxes; as a locus point for the identification of individuals for commercial, judicial, or civic purposes; and as a liable terminal for receiving public utility services, such as energy, water, sewage, telephone, or cable services."

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  "Whether anyone intended it or not, the legal property system became the staircase that took these nations from the universe of assets in their natural state to the conceptual universe of capital where assets can be viewed in their full productive potential."

The attributes of Western legal property systems transform a home from a mere shelter into a capital asset that enhances its owners purchasing power and accountability, facilitates its use, broadens its marketability and facilitates its transfer.

  Legal title in integrated property systems radically improves the flow of information about assets, enhances the purchasing power of ownership, and facilitates transfer of interests in a much broader market. Thus, capital - flexible, productive, widely available purchasing power - is made available for productive purposes in advanced nations by means of inclusion of property and property interests in their legal property systems. The use of property can thus be determined by the best ideas of a wide group of people.
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  The attributes of Western legal property systems transform a home from a mere shelter into a capital asset that enhances its owners purchasing power and accountability, facilitates its use, broadens its marketability and facilitates its transfer.
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  Lacking such readily accessible legal property systems, best use of property in the undeveloped world is determined only by narrow circles including owners, relatives and acquaintances. Because of this inherent inefficiency and widespread loss of property value, undeveloped economic systems are chronically undercapitalized and doomed to failure.
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"A great part of the potential value of legal property is derived from the possibility of forfeiture."

 

Without legally enforceable property rights, buildings are just shelters - they are not really assets.

 

"What is needed is capital, and this requires a complex and mighty system of legal property that we have all taken for granted."

  There are other obvious benefits besides the increase in value of assets and enhancement of the purchasing power of each owner's credit. "A great part of the potential value of legal property is derived from the possibility of forfeiture." 
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  Modern property law systems impose accountability and legal restraint. Owners are induced to fulfill contracts, pay their debts, and obey the law. Property rights induce commitment. In undeveloped nations, citizens "cannot make profitable contracts with strangers, cannot get credit, insurance or utilities services," because they have no property that they can lose.
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  Accountability favorably impacts transactions in commodities and personal property as well. Instead of physically going to market with a few pigs to sell, traders in the West can buy or sell hundreds of pigs with simple telephone calls.
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  Development and use of property is facilitated by the ability to create and infinitely divide a variety of debt and equity interests in property. Separately titled and physically separate assets can conveniently be brought together for productive purposes. By providing standardized descriptions for similar properties, transaction costs of mobilizing and using assets are greatly reduced.
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  It is especially difficult for utilities to invest in expensive hookups to individual properties unless a modern property title system imposes accountability and responsibility on known owners. Without this, utilities in undeveloped nations face widespread financial losses and theft of services. Without this, buildings are just shelters - they are not really assets.
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  Stable currencies, open markets, and private businesses are indeed important, de Soto notes, but without modern property rights - legally enforceable - registered in an integrated system of records - assets cannot fully support the purchasing power of the credit of their owners. It remains "dead capital." "What is needed is capital, and this requires a complex and mighty system of legal property that we have all taken for granted."

  One reason for the widespread underestimation of the importance of property and creditors rights - as well as for the widespread underestimation of the vital roles of profits - is the continuing influence of left wing propaganda that, since Marx, has attempted to convince the credulous that these essential factors play no essential roles in capitalist productivity, and can thus be dispensed with.

Legitimating the gray market:

 

The laws as written are in conflict with the informal laws these citizens live by.

  An intriguing description of the vast gray markets in undeveloped nations is provided by de Soto. The poor have taken control "of vast quantities of real estate and productive economic units."
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  However, the laws as written are in conflict with the informal laws these citizens live by - generating discontent, corruption, poverty and ultimately violence. Conforming written law to the gray market realities is a major challenge, but one that was successfully met by Western nations between the 18th century and WW-II.
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"By easing access to formal property, reducing the obstacles engendered by obsolete regulations, and allowing existing local arrangements to influence lawmaking, European politicians eliminated the contradictions in their legal and economic systems and allowed their nations to carry the Industrial Revolution to new heights."

  The author compares current gray market conditions in undeveloped nations to very similar conditions in the 17th and 18th centuries in England and the rest of Western Europe. There were strenuous legal efforts to protect legitimate providers by prohibiting and punishing gray market competition. Restrictive laws bred corruption and disrespect for the law. Where the state persisted most strenuously against extralegal entrepreneurs, there was widespread unrest resulting ultimately - in France and later in Russia - in revolution. Where nations ultimately adapted their laws quickly, the transition to market economies was peaceful.
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  During the 19th and early 20th centuries, European nations began adapting their laws to the needs of common people - including popular expectations about property rights. They made the transition from dispersed "extralegal" informal arrangements to an "integrated legal property system." Extralegal systems were institutionalized, with officials and administrators and dispute resolution mechanisms and record offices.

  "Countries that made legal efforts to integrate extralegal enterprise prospered more quickly than the countries that resisted change. By easing access to formal property, reducing the obstacles engendered by obsolete regulations, and allowing existing local arrangements to influence lawmaking, European politicians eliminated the contradictions in their legal and economic systems and allowed their nations to carry the Industrial Revolution to new heights."

All must be able to enter the formal property system - not just the few with suitable political connections.

  Today, third world and former communist nations must do the same. Undeveloped nations face the task of learning about the appropriate legal institutions and of building formal property systems that are easily accessible to the poor. All must be able to enter the formal property system - not just the few with suitable political connections. "The law must be compatible with how people actually arrange their lives." It must recognize and facilitate their social contracts.
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  The development of property law in the U.S. from early colonial grantees and squatters - through failed efforts to restrict squatters - to formal recognition of existing squatter property arrangements that authorities were powerless to prevent - is explained by de Soto. Since the procedures for obtaining title were burdensome through the early years of the 19th century, the numerous and well armed squatters followed their own rough methods in which local politicians had perforce to acquiesce. Sheriffs were shot, juries refused to convict the killers and other scofflaws, the law and lawyers were in great disrepute - and great landholders like George Washington found some of their lands claimed by squatters.
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  The new central government - both before and after adoption of the Constitution - made efforts to govern its vast new lands and evict squatters. It granted vast tracts to railroads and other beneficiaries, paid off war veterans with land script, but had not the force to drive out the innumerable, determined and well armed squatters. The 19th century was marked by a great confusion of federal and state property laws. Commonsense extralegal law that developed among the people on the ground existed alongside an impenetrable thicket of codified law and judicial interpretation.
  But the U.S. is a democracy, and the numerous extralegal squatters were a political force to be reckoned with. Eventually, politicians had no alternative - and often found it in their interest - to establish occupancy right doctrines such as "preemption."
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  Extralegal property arrangements like "cabin rights," "tomahawk rights," and "corn rights" were ultimately recognized and integrated into the law. Land offices were opened in frontier areas permitting claims to be officially recognized. State politicians increasingly favored the expansion of occupancy laws - recognizing title for those who maintained uncontested occupancy for a certain number of years (varying upwards from 5 years in the various states) having made improvements and paid property taxes. ("Adverse possession" laws are still a feature of property law in the U.S.)
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  A U.S. Supreme Court decision against Kentucky occupancy law created a furor.  Rejected by the courts and political leaders of Kentucky, it proved unenforceable.
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   The author describes the claim associations of the Midwest and the miners' organizations that sprang up to register and enforce the property rights of squatters, mine claimants, and subsequent purchasers, and settle disputes among members. He points out some striking similarities between these claim associations and the "settlement contracts" of many current squatters groups in undeveloped nations. Inevitably, these "claims clubs" also protected the members claims as speculators in vast tracts of land. Inevitably, both the state politicians and courts recognized the legitimacy of these arrangements.
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  In 1866, Congress incorporated the social contract legal arrangements of the miners' organizations. These had been well drafted on the basis of existing law and precedent adapted to conditions among the mining claims and settlements. In 1872, the modern mining law was passed, recognizing miners' laws "and the right of anyone who improved a mine to purchase the title from the government at a reasonable price."
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  The 1862 "Homestead Act" similarly sanctioned titles for squatters who occupied and developed land for 5 years. By 1862, most of the land had been in fact already settled and various legal accommodations had integrated their property rights into the formal legal system.

    "The advances in the West [since the beginning of the industrial revolution] could happen only because the property rights systems required to make them work were already in place."

Benefits of integration:

  Integrated legal property systems abolished most closed groups and gave everyone access to a commercial network of the whole population. The modern "law of networks" demonstrates that the value of a network increases by the square of the proportionate increase in size.

"Many of the problems of non-Western markets today are due mainly to the fragmentation of their property arrangements and the unavailability of standard norms that allow assets and economic agents to interact and governments to rule by law."

  "A modern government and a market economy are unviable without an integrated formal property system. Many of the problems of non-Western markets today are due mainly to the fragmentation of their property arrangements and the unavailability of standard norms that allow assets and economic agents to interact and governments to rule by law."

  Those third world migrants who settle in advanced nations prosper within the modern commercial systems of those nations. However, undeveloped nations lack these systems. So internal migrants enter into and build the gray market in which they struggle to survive. At the expense of the legal order, they invent "a variety of extralegal arrangements to substitute for the laws and institutions" that would permit them wider commercial success.

  "What national leaders are missing is that people are spontaneously organizing themselves into separate extralegal groups until government can provide them with one legal property system." (Unfortunately, in many undeveloped nations, the leaders really don't give a damn whether their people live or die. They care only for themselves and their supporters.)

  The people themselves can solve many of the problems of explosive urbanization, de Soto affirms. "With the ability to increase their productivity through the beneficial effects of integrated property systems," ordinary people can specialize in ever-widening markets and increase capital formation.
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Bribes and commissions are extracted, credit is greatly limited, transactions limited and difficult, financing mechanisms are unavailable, contracts are unenforceable, insurance is unavailable, and growth opportunities are severely restricted.

Property owners would gladly assume modest tax payments if legitimacy did not carry so many other costs and difficulties.

  Without this, gray market activities become "enormous" and never make it into official statistics. The urban explosion exists because economic opportunities are vastly greater in the cities even under defective legal systems. Everywhere, the vast impoverished shantytowns pulse with entrepreneurial vigor and ardent striving - but with results limited by inadequate property laws. Gray markets employ 50% to 75% of the labor force in these countries, provide between 20% and 66% of total economic output, and cover 70% to 80% of all real estate holdings.
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  However, gray market activities are inherently inefficient and expensive. Bribes and commissions are extracted, credit is greatly limited, transactions limited and difficult, financing mechanisms are unavailable, contracts are unenforceable, insurance is unavailable, and growth opportunities are severely restricted. They are inherently undercapitalized.
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  The "extralegal" arrangements of the gray market are not criminal in intent. These arrangements are needed to build homes and businesses and provide services and regulate living conditions and transactions for those not politically well connected.
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  The author summarizes some of the many costs of running gray market businesses -- the need to hide operations, to bribe officials, the inability to obtain low interest credit or attract investors or obtain insurance or organize for limited liability - or expand operations to prosperous proportions that may attract official attention. Gray market participants cannot advertise.
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  Property owners would gladly assume modest tax payments if legitimacy did not carry so many other costs and difficulties. (Gray market businesses will only come in out of the gray market if they can operate more profitably legitimately.)
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The process of integration:

  "The recognition and integration of extralegal property rights" is a key element in achieving capitalist prosperity. This is essential to release "the aspirations and energies of the common people."
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The "consensus between people as to how - - - assets should be held, used and exchanged" must be studied, recognized and integrated into formal legal conventions.

 

Emancipating people from bad laws is a political responsibility, not a legal process.

 

 

 

 

 

 

 

 

 

 

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  To do this, undeveloped nations "must find the real social contracts on property, integrate them into the official law, and craft a political strategy that makes reform possible." Even well meaning integration efforts cannot be simply devised and imposed from the top. The "consensus between people as to how those assets should be held, used and exchanged" must be studied, recognized and integrated into formal legal conventions. It is not a task merely of "perfecting existing rights," but of giving "everyone a right to property rights." Emancipating people from bad laws is a political responsibility, not a legal process.
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  Without this, it is impossible to end the "legal apartheid" between the elites who have legal property rights and can thus create live capital, and those extralegals who cannot.

  Multiparty democracy - and the pressure of democratic politics - may prove to be an essential ingredient if the vested interests in the status quo are to be overcome. However, democracy has had only limited success in overcoming bureaucratic obstacles and corruption in India, and both Singapore and Chile moved forwards under benevolent despotisms - as China does today.

  The author relates many of the efforts that have in fact been made in undeveloped nations to provide accessible property rights. However, these were imposed from the top without regard for existing extralegal arrangements and popular needs and expectations. They thus had little popular understanding or support. Property law and titles "imposed without reference to existing social contracts continually fail."
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  As de Soto points out, when the public supports the law, the government can enforce it against occasional violations. When the public doesn't support it, government is helpless to enforce it (except in the most smothering tyrannies). 

  "Any attempt to create a unified property system that does not take into account the collective contracts that underpin existing property arrangements will crash into the very roots of the rights most people rely  on for holding onto their assets."

  De Soto describes a vast bureaucratic revamping and administrative effort suitable for investigating and analyzing gray market business and property arrangements and bringing gray market businesses into legitimate commerce and extralegal  property into a formal legal system. The law works when usages are transformed into customs, and customs eventually into law.

  This is clearly a top-down administrative effort - dependent on the benevolence of existing widely corrupt and sometimes demagogic or autocratic governance in undeveloped nations. Without the electoral pressures of a democratic electorate educated in the importance of property rights, overcoming vested interests is difficult and, if overcome, guaranteeing those property rights for the long term may be impossible.
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  In the U.S., de Soto acknowledges, the integration process was not entirely top-down. It was facilitated because the extralegal systems so frequently were well drafted by people familiar with legal precedents and formal property law. The widespread availability of help from trained lawyers at most localities undoubtedly assisted this process. The ability of well armed property claimants to forcefully protect their own claims gave strength to the extralegal systems. Some or all of these factors are missing in undeveloped nations - even when they are democracies.

Extralegals are in fact law abiding - but to their own laws rather than to the government's laws. This law must be "discovered." It cannot be imposed from the top.

 

Most "informals" do have "some physical artifact to represent and substantiate their claim to property."

 

The integrated system must be widely acceptable as genuinely legitimate and sufficiently reflective of both legal and extralegal reality to be self-enforceable.

 

  The transformation effort must be made "easy, safe, and cheap" for the people. Extralegals are in fact law abiding - but to their own laws rather than to the government's laws. This law must be "discovered." It cannot be imposed from the top. In most undeveloped nations, it is actually quite similar to Western social contracts.
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  The problem is to "decode" extralegal law sufficiently to encode it as part of the formal legal system and reform the formal legal system sufficiently to facilitate and make the integrated system widely accessible. Most "informals" do have "some physical artifact to represent and substantiate their claim to property." Even in Haiti, all urban extralegal property interests are in fact evidenced by some form of writing. Local authorities - police, sanitation, urban planners - actually have extensive records of extralegal property claims. In some rural backwoods, however, oral traditions may predominate.
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  "Representations are the result of a specific group of people having reached a respected consensus as to who owns what property and what each owner may do with it." They are common sense and clear. People want to make their property claims as clear and transparent as possible.
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  Government must then begin the practical task of integration of the extralegal system with the legal system - discarding what is not useful or enforceable and absorbing what works. The integrated system must be widely acceptable as genuinely legitimate and sufficiently reflective of both legal and extralegal reality to be self-enforceable.
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  The role of the legal profession in these nations is to learn "the peoples' law" and integrate it into the formal legal system in practical ways.
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  In nations like Peru, when people were provided with legally protected title, they were relieved of the burdens of protecting their property interests and could concentrate on the economic potential of their assets. They were no longer anonymous, but had become legally accountable - and credit worthy.
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Politics:

  Appropriate political strategy at the top is essential to overcome the opposition of those with vested interests in the status quo. This requires marshalling political support from the mass of the people who are extralegal.
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  Of course, reforming the law is just the beginning. Implementation has problems of its own.
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  Many in the elite - the productive members of the elite - can be brought on board the political bandwagon by emphasis on how much they can profit from a growing and thriving legitimate economy.

  Inevitably, however, the bureaucrats who must lose much of their permitting powers will be threatened - and politicians and autocratic regimes may also feel threatened by the expanding political power that comes with economic resources derived from the legitimate market. Recent reforms in Russia designed to remove obstacles to the conduct of small business have been smothered by the bureaucracy that grants permits and enforces various standards.

  However, there are myriad benefits of accessible legal protection of interests in property that should make the effort widely attractive. Beyond the obvious economic benefits are vast gains in civic participation and responsibility, public planning, law enforcement and respect for a legal system that protects everyone's property rights. It also generates public support for the government.
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Experts from advanced nations must have enough humility to realize that the systems that work in their nations are not suitable for undeveloped nations without appropriate modifications.

  The lawyers are viewed as one of the chief obstacles by de Soto, since they have the ability to lawfully sabotage economic reforms and capitalist expansion. As least some of them must be brought on board to craft the actual reformed "artifacts of formal property." He then cites some very dubious economic analysis that indicates an inverse relationship between economic growth and the number of lawyers. (If that were so, the U.S. would be an economic basket case and the Soviet Union would have buried the capitalist world. Nevertheless, it is indisputable that by abuse of their powers, lawyers can oppress economic activity.)
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  It is also important for expert advisers from advanced nations to have enough humility to realize that the systems that work in their nations and with which they are familiar are not suitable for application in undeveloped nations without appropriate modifications. The local rules that enforce extralegal rights and the networks of relationships that sustain them must be understood and accommodated.
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Without widely accessible property rights, economic reforms that open up economic systems benefit only the small elites who have access to the formal property systems.

  Technical mapping and recording property is not enough, since extralegals who still face obstacles in the formal system have no incentive to provide data needed to keep these records current and reliable. Technical mapping and recording can be very helpful - but only after gray market property owners are enticed into the informal system by ease of entry and the benefits it offers, and are made to feel secure that those benefits will remain for the long term.

  Although he correctly recognizes the continuing popular attractiveness and threat of Marxist concepts in undeveloped nations, de Soto actually takes them seriously as  economic theory instead of recognizing them as just the propaganda myths of the modern world's most successful advocacy scholar. As with all propaganda myths, Marx provides a hodgepodge of half truths, selective scholarship, lack of essential context, and gross stupidity.
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  The obvious tip off is Marx' ridiculous effort to disparage profits and finance - which are actually the essential determinants of the purchasing power of capital and play numerous other essential roles in capitalist productivity. If you can destroy profits and the financing mechanism, you reduce "live capital" to "dead capital" and destroy capitalism - which of course was the objective of Marx' propaganda myth. De Soto's book brilliantly demonstrates the gross stupidity of leftist efforts to distinguish between "industrial capital" (the Good Guys) and "financial capital" (the Bad Guys).
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  The author fails to deal directly with the connection between profitable usage and the value of capital assets. But, of course, that is not the primary concern of his book. Also, while repeatedly referring to creditors rights and modern legal systems, he does not in this book go into the details - the essential mechanisms for enforcement of creditors rights and development of modern financial institutions - without which, even titled property remains "dead capital." But that, too - although certainly not overlooked - is not the primary concern of his book.

  De Soto correctly points out that, without property rights, economic reforms that open up economic systems benefit only the small elites who have access to the formal property systems. Good political institutions and property law are essential parts of the good governance needed to facilitate profit driven market directed commerce.

Good governance policies:

  A more balanced picture of the complex factors that constitute good governance that facilitates profit driven market directed commerce was provided by Harvard Prof. Bruce Scott in "The Great Divide in the Global Village," Foreign Affairs (Jan. - Feb., 2001), pp. 160-177. He deals principally with some of the major policy and governance factors inhibiting development of undeveloped nations.

  Instead of catching up, undeveloped nations keep falling further behind. Scott examines two of the primary causes for the failure of capitalism in the undeveloped world, and the resulting growth of inequality.

  "First, the rich countries insist on barriers to immigration and agricultural exports." (And textile exports, too!)
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  "Second, most poor nations have been unable to attract much foreign capital due to their own government failings."

  Scott points out that immigration barriers imprison peoples in poorly run nations, and thus reduce reform pressures.

  In this respect, most third world nations are not like the old relatively sparsely populated Soviet satellite nations. Population outflows would have to approach gigantic proportions before the political elites of India or Pakistan would even notice them. Most of the African kleptocracies wouldn't care if they lost half their populations - as some of them are currently losing to AIDS and other diseases. Scott recognizes that such levels of immigration are politically unfeasible.

  And Scott is absolutely right in stressing that the limitations on labor mobility constitute one of the fundamental economic weaknesses of modern globalization - and that rich nation barriers to poor nation exports are unconscionable.

Policies and institutions rarely protect individual rights or private initiative for the bulk of the population, and allow elites to skim off rents from any sectors that can bear it.

  Effective economic governance institutions and policies as well as enforceable property rights are essential preconditions for economic development. 

    "Economic development requires the transformation of institutions as well as the freeing of prices, which in turn requires political and social modernization as well as economic reform. The state plays a key role in this process; without it, developing strategies have little hope of succeeding. The creation of effective states in the developing world will not be driven by familiar market forces even if pressures from capital markets can force fiscal and monetary discipline. And in a world still governed by 'states rights,' real progress in achieving accountable governments will require reforms beyond the mandates of multilateral institutions."

  Capital inflows can effectively raise poor nation living standards and provide both employment and technology. However, high savings rates may be even more important. The Asian Tigers, Singapore and China - with varying success commensurate with the quality of governance - provide prominent examples. (Effective use of domestic savings as productive capital depends on effective investment markets and banking institutions and good governance that makes investment attractive.)
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  Other than the Asian Tigers and China, developing nations have not been able to take advantage of export opportunities. They remain limited to exports of raw and semi-processed materials.

  "Systemic barriers at home and abroad inhibit the economic potential of poorer nations, the most formidable of these obstacles being their own domestic political and administrative problems."

  Scott convincingly equates the developmental differences between the northern and southern states within the U.S. during its first 150 years with the developmental differences experienced by the various types of nations today. It all depends on factors of economic governance.
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  Inequalities within poor countries continue. Poor people in these nations suffer from unjust law enforcement similar to what was once experienced by black sharecroppers in the Southern U.S. Privileged elites fight to protect the status quo, even if that condemns their nations to continued poverty. Policies and institutions rarely protect individual rights or private initiative for the bulk of the population, and allow elites to skim off rents from any sectors that can bear it. "The economist Hernando de Soto has shown how governments in the developing world fail to recognize poor citizens' legal titles to their homes and businesses, thereby depriving them of the use of their assets for collateral." The losses involve many trillions of dollars.

Getting the governance institutions "right" is now recognized as equally essential as getting the market pricing mechanics "right." But even the most advantageous change always hurts some who benefit from the status quo. The problem is clearly political as much as economic.

  Democracy alone is not enough to ensure good economic governance, Scott accurately points out. Bloated public sectors, patronage, dependency and corruption can all thrive in democratic systems.
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  Getting the governance institutions "right"
is now recognized as equally essential as getting the market pricing mechanics "right," Scott emphasizes. But even the most advantageous change always hurts some who benefit from the status quo. The problem is clearly political as much as economic.
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  Poor nations with low educational standards face massive challenges just achieving political and economic stability under liberalized systems. Yet, stability is essential to attract investment. "Institutional deficiencies, not capital shortages, are the major impediment to development."

In Europe, competition between states forced a continuing progression of reforms. States were forced to facilitate private commerce as a prerequisite for state power and survival.

  The essential institutions have been slowly developed in the West by evolution and sometimes by revolution - and by trial and error - during the last half millennium. In Europe, competition between states forced a continuing progression of reforms. States were forced to facilitate private commerce as a prerequisite for state power and survival.

  Economic reform efforts must always be viewed as an ongoing process. Even in advanced nations - as new technological, economic, social and political realities emerge - appropriate institutional responses are required. Then there is the continuous accumulation of policy blunders, as political leaders put personal and political interests above the economic interests of the nation. Inevitably, periods of severe depression and/or inflation arise to force periodic cleansings of this baggage.

  Scott accurately points out that almost all modern advanced nations got their start under mercantilist, export oriented economic regimes. He questions whether most poor nations are likely to develop the political capability needed to take advantage of the free trade model. For them, mercantilist export forcing development may be the best model to follow. Thus, Scott asserts, wealthy nations "should allow poorer nations considerable freedom to tailor development strategies to their own circumstances."

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Copyright 2002 Dan Blatt