THE MYSTERY OF CAPITAL – WHY CAPITALISM TRIUMPHS IN THE WEST AND FAILS EVERYWHERE ELSE
by Hernando De Soto
Review by Jason Benedict – Strategist, RCE
This is an interesting book that effectively explains the role of property systems as the conceptual underpinnings of our capital systems and markets. The author shows how the relative inefficiency and injustice of property systems relegates the vast majority of people in developing and former communist countries to an extralegal existence. This extralegal existence does not allow these people to use their assets as capital.
De Soto makes the strong case that it is prohibitively difficult for those in the developing world and former communist nations to live and/or do business in the legal system therefore they have little recourse but to live in the extralegal sector. This extralegal existence is especially seen in terms of business entities and real property.
For example, in Lima, Peru it takes 207 administrative steps in 52 government offices and $1231 (31 times the monthly minimum wage) to obtain legal authorization to build a house on public lands. This takes on average 6 years and 11 months to accomplish. It takes another 728 steps to get title. p. 20
In Egypt it takes 5-14 years to navigate the 77 bureaucratic procedures in 31 different public and private agencies. p. 20
In Haiti it takes 111 steps and 12 years to obtain the privilege to purchase land. In all these countries it is nearly as difficult to stay legal as to become legal. p. 21
As a result almost all the entrepreneurial talent flees to the extralegal sector (squatting, slums, extralegal business, etc). This produces a vicious cycle where, the assets of these people cannot take on a second life as capital because of their questionable legal status. Therefore it is “dead capital.” The percentage of assets that are held extralegally is staggering:
The Philippines – 57% of the homes of city dwellers and 67% in the countryside, total value $133 billion in real estate that is essentially dead capital. To put this in perspective this is over four times the valuation of the 216 companies on the Philippine stock exchange. p. 34
Peru – 53% of the homes of city dwellers and 81% in the countryside, total value $74 billion in essentially dead capital. This is five times the total valuation of Lima stock exchange pre 1998 (slump year). p. 33
Haiti – 68% of the homes of city dwellers and 97% in the countryside, total value $5.2 billion in dead capital. This is 158 times the value of all FDI in the recorded history of Haiti. p. 33
Egypt – 92% of the homes of city dwellers and 83% in the countryside total value $240 billion in dead capital. This is 30 times the total valuation of the Cairo Stock Exchange. p. 34
The author theorizes that all this is potential capital (real estate) that is locked up and cannot be used to fund business development. He talks about the path that western countries and Japan have taken to create “systems of property ownership” and “meta rights” in this area. He posits that this is the reason that capitalism has flourished in the West and not elsewhere. In western countries properties have a value beyond their value as “dwellings”: They can be used as capital to collateralize loans. Apparently, there was a time in England and the United states when people were forces into extralegal arrangements, but they were eventually brought into the system, and the system (albeit painfully) began to recognize their social contracts and codify them into law. (Chapter 5)
He uses the metaphor of a “bell jar” to describe those who are inside the system. Those inside the jar are the have’s (capitalist) and those outside the have not’s (extralegals). p. 66
The author states the establishment (or recognition) of property law and rights has six dramatic effects (pp. 49-62):
Effect No. 1 – Fixing the Economic Potential of Assets. When property is represented by its description in a title it takes on a life as capital, and its economic potential is born.
Effect No. 2 – Integrating Dispersed Information into One System. This makes the asset easier to evaluate and exchange.
Effect No. 3 – Making People Accountable. Being inside the system makes people accountable.There is value in the system and therefore something to lose.
Effect No. 4 – Making Assets Fungible. Fungibility is essentially interchangeability through standardization. This quality helps in comparison and marketability.
Effect No. 5 – Networking People. The property system in a country is a complex web of connections that allows people to form ties in the government and private sector. It encourages this connectivity whereas in an extralegal arrangement this connectivity is a liability.
Effect No. 6 – Protecting Transactions. Unless transactions are protected it is difficult to mitigate the risk of trading and using capital.
Chapter 6 gives a process for bringing extralegals into a capitalist system. This must be rooted in reforms in the legal system. The basic idea is that social contracts and even documentation of the extralegal arrangement exist. Therefore the task for legislators is to discover law from the existing social contracts. The author argues that law not based on recognized social contracts lacks legitimacy anyway and cannot be policed. (pp. 172-174). There is a great diagram on pages 160, 161 outlining the process of property reform. There is compelling evidence that substantive reform during our time is within reach and does not constitute an insurmountable task.
In his concluding chapter he states, “…outside the West advocates of capitalism are intellectually on the retreat. Ascendant just a decade ago, they are now increasingly viewed as apologists for the miseries and injustices that still affect the majority of people. For example, in 1999 Egypt’s consultative upper house warned the government “not to be deceived any longer by calls for capitalism and globalization.” Having forgotten the crucial issue of property, capitalism’s advocates have let themselves become identified as the defenders of the status quo blindly trying to enforce existing written law whether it discriminates or not.” p. 209
The author argues that the lack of property systems in many of these countries is conjuring up “Marx’s Ghost.” He states, “…the trap that Karl Marx foresaw: The great contradiction of the capitalist system is that it creates its own demise because it cannot avoid concentrating capital in a few hands. By not giving the majority access to expanded markets, these reforms are leaving a fertile field for class confrontation – a capitalist and fee market economy for the privileged few who can concretize their property rights and a relative poverty for a large undercapitalized sector incapable of leveraging its own assets.” p. 212
The author states, “…George Soros recently observed, [Karl Marx’s insights into capital] are often more sophisticated that those of Adam Smith…for Marx property was an important issue because it was clear to him that those who appropriated the assets obtained much more than just their physical attributes. As a result, the Marxist intellectual tool kit has left anticapitalists powerful ways to explain why private property will necessarily put assets in the hands of the rich at the expense of the poor. p. 214.
The author argues that Marxist views no longer pose a threat in western countries where the majority have access to property systems.
The author argues that the success of capitalism in the west is often wrongly explained in cultural terms: Judeo-Christian values, the puritan work ethic, etc. He asserts that other cultures value hard work as do those of the west, and that our historical success in capitalism (and corresponding wealth) more closely follows the development of our property system than the rise of religious cultural values. Pp. 223-226
With this book De Soto has made a significant contribution to the argument for free markets. He has also given us another factor to consider in understanding both the causes of poverty and the path to transformation.
De Soto’s findings give real hope that transformation could happen in these developing nations. The fact that De Soto’s group (He runs a free market think tank in Peru) experienced such significant success in registering previously unregistered entrepreneurs in Peru is an example. He redesigned the Peruvian system and subsequently 276,000 entrepreneurs voluntarily registered their businesses. This generated an addition 1.2 billion USD in tax revenues, demonstrating that these entrepreneurs were not in the extralegal sector simply to avoid taxes. P. 154
An ethical dilemma is raised by the book with regards to squatting. Is squatting stealing? If someone staked out a parcel on my modest property holdings I would certainly consider it so. Nevertheless, the backdrop for the squatting in much of the developing world is quite different than someone building a shanty on my property. Much of the land is unutilized government land or land that was given in land grants to political cronies. We can’t answer the question here, but there are biblical examples of land re-distribution in Leviticus 25. There are also biblical injunctions against those who would disenfranchise the poor.
With regard to De Soto’s claim that our western success has more to do with good property law that our Judeo-Christian ethic. It could be argued that our property system came from cultural values based in a Judeo-Christian ethic, or that the culture created a context where such a system could develop. The correlation between the western-style property systems and counties that have embraced a Judeo-Christian ethic is surely not coincidental.