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The mystery of capital: Why capitalism triumphs in the West and fails everywhere else

by Hernando de Soto, Basic Books, 2001.

Abstract

Capitalism has triumphed in the West but has failed almost everywhere else. The world’s poor possess vast assets but are unable to produce capital from them because they don’t have legal title. Like Western nations before them, developing countries need to establish formal property law and the conversion process that will allow them to create capital.

(Reviewed by Kevin Barham June 2006)

(These book reviews offer a commentary on some aspects of the contribution the authors are making to management thinking. Neither Ashridge nor the reviewers necessarily agree with the authors’ views and the authors of the books are not responsible for any errors that may have crept in.

We aim to give enough information to enable readers to decide whether a book fits their particular concerns and, if so, to buy it. There is no substitute for reading the whole book and our reviews are no replacement for this. They can give only a broad indication of the value of a book and inevitably miss much of its richness and depth of argument. Nevertheless, we aim to open a window on to some of the benefits awaiting readers of management literature.)

Introduction

One of the testimonials on the cover of this book tells us that it not only has the capacity to change permanently the way we look at the world, but also to change the world itself. It will certainly come as a revelation to many readers.

Capitalism has triumphed in the West but has failed almost everywhere else. That is the view of economist Hernando de Soto, one of South America’s most innovative thinkers, who in this book revolutionises our understanding of what capital is and why it does not benefit five-sixths of mankind. He proposes a solution: enabling the poor to turn the vast assets they possess into wealth.

De Soto is President of Peru’s Institute of Liberty and Democracy (ILD), regarded by The Economist as the second most important think-tank in the world and which is concerned to find practical ways to bring the poor of the developing world into the economic mainstream. De Soto challenges the facile assumption that so-called poor countries are poor. As he powerfully demonstrates, they are asset-rich but capital-poor. Assets cannot become capital unless a country guarantees formal property law whereby the ownership of assets is clear and these assets can therefore be sold, bought or mortgaged, or converted into other assets. It is legal ownership that converts assets into capital but the developing world’s trapped resources cannot be converted into capital because their legal framework is underdeveloped.

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The mystery of capital

Since the fall of the Berlin Wall, capitalism remains the only rational way to organise a modern economy. Third World and former Communist countries have balanced their budgets, cut subsidies, sought foreign investment and lowered tariff barriers. The results have been bitterly disappointing for these countries and have led to economic suffering, falling incomes and rising anxiety and resentment. In the former Communist nations, capitalism is seen to have brought problems and people associated with the old regimes stand ready to resume power. Adverse reaction to capitalism has also been growing stronger as shown by the anti-globalisation riots.

When Third World countries fail to implement capitalism, Westerners often blame them for a lack of entrepreneurial spirit or market orientation. But, says de Soto, the disparity of wealth between the West and the developing world is too big for a cultural explanation. Most people want the fruits of capital and are flocking to Western countries. The cities of the Third World and the former communist nations are seething with entrepreneurs. The inhabitants of these countries possess talent, enthusiasm and an incredible ability to make a profit out of virtually nothing. They know how to use modern technology and markets are an ancient, universal tradition in these countries.

So what prevents capitalism from delivering people there the same wealth it produced in the West? De Soto maintains that the major stumbling block is the developing world’s inability to produce capital. Capital is the force that raises the productivity of labour and creates the wealth of nations. It is the lifeblood of the capitalist system. But it is the one thing that the poor countries of the world are unable to produce for themselves.

In fact, most of the poor (80% of the population of most developing countries) already possess the assets they need to make a success of capitalism. Even in the poorest countries, the poor save. The value of their savings is immense and amounts to 40 times all the foreign aid received throughout the world since 1945. But the poor hold their 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 to these possessions are not adequately documented, these assets cannot be turned into capital, cannot be traded outside of narrow local circles where people know and trust each other, and cannot be used as collateral for a loan or as a share against an investment.

In the West, every asset – land, buildings, equipment, inventories – is represented in a property document that is the visible sign of a vast hidden process connecting all these assets to the rest of the economy. This "representational process" means assets can lead an invisible, parallel life alongside their material existence and can be used as collateral for credit. They provide a link to the owner’s credit history, an address for the collection of debts and taxes, the basis for the creation of universal public utilities, and a foundation for the creation of securities which can be rediscounted and sold in secondary markets. By this process, the West injects life into assets and makes them generate capital.

Third World and former Communist countries don’t have this representational process. As a result, most of them are undercapitalised in the same way a firm is undercapitalised when it issues fewer securities than its income and assets would justify. The enterprises of the poor are like corporations that cannot issue shares or bonds to obtain new investment and finance. Without representations, their assets are "dead capital".

The poor in developing countries do have things, but they lack the process to represent their property and create capital. They have houses but not titles, crops but not deeds, businesses but not statutes of incorporation. The lack of these essential "representations" explains why people have not been able to produce sufficient capital to make their domestic capitalism work.

A conversion process is needed so capital can be extracted and processed from assets – to transform the invisible to the visible. Only the West has such a process but Westerners take it so much for granted they have lost awareness of its existence. It is "an implicit legal infrastructure hidden deep within their property systems, of which ownership is just the tip of the iceberg".

The developing and former Communist countries today face the problems once faced by Western countries. The latter have so successfully integrated their poor into their economies that they have lost the memory of how it was done and how the creation of capital began. They have forgotten how they established widespread formal property law and invented the conversion process that allowed them to create capital.

Paradoxically, capital, the most essential component of capitalism, is the one that has received the least attention. De Soto seeks solutions to five "mysteries":

The mystery of missing information
The mystery of capital
The mystery of political awareness
The missing lessons of US history
The mystery of legal failure: Why property law does not work outside the West.

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The mystery of missing information

We are so used to thinking of the world’s poor as helpless that no one has properly documented their capacity for accumulating assets. De Soto and colleagues in six different countries went out into the streets and countrysides of four continents to count how much the poorest sectors of society have saved. They found that the quantity is enormous – but most of it is dead capital.

While the poor possess far more than is generally thought, it is not represented in such a way as to produce additional value. The world of legally enforceable transactions on property rights does not exist as it does in the West.

But this was exactly how things were in the US in its early days when squatters in the "Wild West" battled for legal rights to their land, miners warred over their claims, and ownership laws differed from town to town. That past is the developing world’s today.

Before 1950, most Third World countries were agricultural societies. Most people worked on the land which was owned by a very few big landlords. Cities were small, functioned as markets rather than industrial centres, and were dominated by small business elites who protected their interests with a mass of rules and regulations.

After 1950, there was an economic revolution in the Third World as people migrated to the cities. In China alone over 100 million people have moved from the countryside to cities since 1979. Most live in shanty towns. When they arrived, they faced an impenetrable wall of rules that barred them from legally established social and economic activities. It was very difficult for the newcomers to acquire legal housing, enter formal business or find a legal job.

In the Philippines it takes 168 bureaucratic steps and 13 to 25 years to purchase a dwelling legally. In Egypt it requires 77 bureaucratic procedures to register a lot of land taking 5 to 14 years with a further 6-11 years of bureaucratic "wrangling" to build a dwelling.

Such difficulties force people to opt out of the system and become "extralegal", to live and work outside the official law using their own informally binding arrangements to protect and mobilise their assets. These informal rules are held together by a contract that is upheld by the community as a whole and enforced by authorities the community has selected.

These social contracts have created a vibrant but undercapitalised sector buzzing with hard work and ingenuity. Street-side cottage industries manufacture everything from clothing and footwear to imitation watches. Some industries and neighbourhoods have clandestine connections to electricity and water. Entrepreneurs fill gaps in the legal economy such as unauthorised buses and taxis. In Mexico, there are 2.65 million "micro-businesses". Russia has been slipping into the same patterns of informal ownership.

While Westerners may regard the extralegal sector as "marginal", it is in fact legality that is marginal. Extralegality has become the norm. The poor have devised creative ways of getting around property laws and have already taken control of vast quantities of real estate and production. (In Manila, housing springs up on land zoned for industrial use. In Cairo, residents of public housing projects build illegal stories on top of their buildings and sell them to relatives.) The real ownership status of these assets slips out of the official registry system so most people’s resources are commercially and financially invisible. Nobody really knows who owns what or where, or who is accountable. The assets cannot be used to create surplus value through multiple transactions because their unfixed nature and uncertainty leaves too much room for misunderstanding. They are dead capital.

The entrepreneurial ingenuity of the poor has created wealth on a vast scale – wealth that constitutes the largest source of potential capital for development. These assets not only exceed the holdings of the government in each country, the local stock exchanges and foreign direct investment, they are many times greater than all the aid from advanced nations and the loans from the World Bank. The total value of the real estate held but not legally owned by the poor of the Third World and former communist nations is at least $9.3 trillion – twice as much (at time of writing) as the total US money supply and nearly as much as the total value of all the companies listed on the world’s main stock exchanges.

This is trillions of dollars ready to be put to use if only we can unravel the mystery of how assets are transformed into live capital.

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The mystery of capital

Capital has fascinated thinkers for the last three centuries, but its nature has remained elusive. What is capital, how is it produced, and how is it related to money?

Assets in the developing world meet immediate physical needs such as producing food and providing shelter. In the West, the same assets lead a parallel life as capital outside the physical world and are used to generate more production by securing the interests of other parties as "collateral" for a mortgage or to assure the supply of other forms of credit and public utilities.

The enormous resources in the developing world do not produce value beyond their "natural" state because it has been forgotten that converting a physical asset to generate capital requires a very complex process.

Capital is not an accumulated stock of assets but the potential it holds to deploy new production. This potential is abstract and must be processed and fixed into a tangible form before we can release it. Creating capital requires a conversion process. This essential meaning of capital has been lost to history. Capital is now confused with money, which is only one of the forms in which it moves.

What detaches value from an asset and fixes it in a way that allows us to realise it as capital and put additional production into motion? Think of a mountain lake, suggests de Soto. Because of its elevated position, the lake has potential to generate energy. The engineer has to create a process that converts this potential into a usable form – a hydroelectric plant that converts the placid lake’s energy potential into the kinetic energy of tumbling water which rotates turbines to convert it further into electricity. The additional value obtained from the lake is not a value of the lake itself; it is a value of the man-made process extrinsic to the lake.

Capital, like energy, is also a dormant value. Bringing it to life requires us to go beyond looking at our assets as they are, to thinking actively about them as they could be. It requires a process for fixing an asset’s economic potential into a form that may be used to initiate additional production.

The formal property systems of the West produce six "property effects" that allow its citizens to generate capital. The incapacity of the rest of the world to deploy capital results from the fact that most of the people there are cut off from these effects:

Fixing the economic potential of assets. The potential value locked up in an asset such as a house can be transformed into active capital in the same way that potential energy in a mountain lake is transformed into actual energy. Capital is born by representing in writing – in a title, a security or a contract – the most economically and socially useful qualities of the asset. Property is not the house itself but an economic concept about the house embodied in a legal representation.
A formal property representation is therefore something separate from the asset itself. It represents the non-visible qualities that have potential for producing value. These are not physical qualities of the house itself but rather economically and socially meaningful qualities we attribute to the house such as the varieties of purposes that may be secured by mortgages or covenants, etc. While houses in advanced nations act as shelters or workplaces, their representations lead a parallel life carrying out a variety of functions to secure the interests of other parties (e.g. as collateral for loans, as equity exchanged for investment, as an address for collecting debts and taxes, etc).

Legal property thus gave the West the tools to produce surplus value over and above its physical assets. It became the "staircase" that took the West 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.
Integrating dispersed information into one system. Most of the assets in Western countries were integrated in the 19th century into one formal representational system. Before then, information about assets was far less accessible. Diverse informal property arrangements were once the norm everywhere and the process of integration took place over a long time. As a result of integration, citizens in advanced nations can obtain descriptions of the economic and social qualities of any available asset without having to see the asset itself. The formal property system lets them know what assets are available and what opportunities exist to create surplus value. It makes an asset’s potential easier to evaluate and exchange.
Making people accountable. The integration of all property systems under one formal property law shifted the legitimacy of the rights of owners from the politicised context of local communities to the impersonal context of law. Releasing owners from restrictive local arrangements made them more accountable as individuals – people who don’t pay for goods and services can be identified and penalised. Formal property encourages citizens to respect titles, honour contracts and obey the law. If a citizen fails to act honourably, his breach is recorded jeopardising his reputation with the rest of the system (banks, etc) to which property ties him.
While formal property systems gave citizens a stake in the capitalist game, what made this stake meaningful is that it could be lost. It showed not only the potential rewards of using assets but the dangers of doing so. In other words, legal property invited commitment.

The lack of legal property explains why citizens in developing counties cannot make profitable contracts with strangers or get credit: officially, they have no property to lose. They are taken seriously as contracting parties only by their immediate family and neighbours. Meanwhile, citizens of advanced countries can contract for anything reasonable but the entry price is commitment backed up by a pledge of property.
Making assets "fungible". A formal property system transforms assets from a less to a more accessible condition so they can do additional work. Unlike physical assets, representations are easily combined, divided, mobilised and used to stimulate business deals. By uncoupling the economic features of an asset from its physical state, a representation makes the asset "fungible" ["exchangeable" or "substitutable"], able to be fashioned to suit practically any transaction.
Representations make it possible to compare different assets. Assets can be divided without touching them – a factory can be owned by countless investors without affecting the physical integrity of the physical asset. Standard formal property documents are crafted so that an asset’s attributes can be easily measured. While Westerners may adapt and combine their assets to produce continually higher valued mixtures, Third World people remain trapped in the physical world of rigid, "non-fungible" forms.
Networking people. By making assets fungible, by attaching owners to assets, assets to addresses, and ownership to enforcement, and by making information on the history of assets and owners easily accessible, formal property systems converted the citizens of the West into a network of individually identifiable and accountable business agents. It radically improved the flow of communications about assets and their potential and enhanced the status of their owners who became economic agents able to transform assets within a broader framework. Legal property encourages utilities such as electricity and water to invest in production and distribution facilities to service buildings by reducing the risk of theft of services and the financial losses from bill-collecting among people hard to locate. It also provides businesses with verifiable information about assets and their owners which leads to credit records.
The legal property system of an advanced nation is the centre of a complex web of connections that helps ordinary citizens form ties with both government and the private sector, and so obtain additional goods and services. It creates a network through which people can assemble their assets into more valuable combinations. Many title systems in developing nations fail to produce capital because they do not acknowledge that property can go way beyond ownership.
Protecting transactions. The formal Western property system works like a network because all the property records are continually tracked and protected by public record-keeping systems and other private services. The systems protect both the security of ownership and that of transactions but they emphasise the latter. Security is mainly focused on producing trust in transactions so that people can more easily make their assets lead a parallel life as capital. In most developing countries, the law is more focused on protecting ownership. The Western emphasis on security of transactions allows citizens to move large amounts of assets with very few transactions (For example, Third World people have to take their pigs to market and trade them one at a time, while commodity traders in Chicago deal through representations which enable them to make deals for huge quantities of pigs with little concern about the security of transactions.)

The six effects of an integrated property process mean that, endowed with representational existence, assets can do economic things they could not do before. It greatly reduces the costs of knowing the economic qualities of assets by representing them in a way our senses can quickly pick up. It makes it easier to agree on how to use assets to create further production and increase the division of labour.

"The genius of the West was to create a system that allowed people to grasp with the mind values that human eyes could never see and to manipulate things that hands could never touch."

The substantial increase of capital in the West over the last two centuries is the consequence of gradually improving property systems which allowed economic agents to discover and realise the potential of their assets.

Much of the marginalisation of the poor in developing and former communist countries comes from their inability to benefit from the six property effects. De Soto refers to the French historian Fernand Braudel who wondered why, in the beginning, Western capitalism served only a privileged few which he described as a "bell jar" cut off from the rest of society. De Soto believes the explanation lies in restricted access to formal property, both in the West’s past and in developing and former Communist countries today.

The bell jar makes capitalism a private club and enrages the billions of outsiders. But governments in Third World and former Communist countries have been slow to realise a bell jar exists.

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The mystery of political awareness

If there is so much dead capital in the world in the hands of so many poor people, why haven’t governments tried to tap into this potential wealth? The answer is that the evidence they needed has only become available in the past 40 years as billions of people throughout the world have moved from life on a small scale to life on a large scale. This migration to the cities has rapidly divided labour and spawned in poorer countries a huge industrial-commercial revolution – one that, incredibly, has been ignored.

What we have is one huge, world-wide industrial revolution: a gigantic movement away from life organised on a small scale to life organised on a large scale. For better or worse, people outside the West are fleeing self-sufficient and isolated societies for the cities in an effort to raise their standards of living by becoming interdependent in much larger markets. The Third World and former Communist countries are experiencing the same industrial revolution that happened in the West over two centuries ago. The difference is that this new revolution is happening much faster and transforming the lives of many more people.

The cities of the Third World have been transformed by a tide of humanity into megacities with huge populations and their political and legal institutions have been overwhelmed. The failure of the legal order to keep pace has forced the new migrants to invent extralegal substitutes for established law. Whereas anonymous business transactions are widespread in advanced countries, migrants in the developing world can only deal with people they know and trust. This is a problem because the wider the market, the greater the division of labour. And as labour grows more specialised, the economy grows more efficient and wages and capital values rise. A legal failure that prevents enterprising people from negotiating with strangers defeats the division of labour and traps entrepreneurs in smaller circles of specialisation and low productivity.

National leaders are unaware that the gigantic movement away from life on a small scale to life in a larger context is causing the growth of the extralegal sector and the breakdown of the existing legal order. They are unaware that people are spontaneously organising themselves into separate extralegal groups until the government can provide them with one legal property system.

Governments have missed the real problem because they have not seen that the growth in the world’s extralegal populations has generated a new class of entrepreneurs with their own legal arrangements. They don’t see that the real cause of the disorder is not population or urban growth but an outmoded system of legal property.

Most governments cannot compete with the growth of extralegal power. Extralegal ventures have already overtaken government efforts to provide housing for migrants and the poor. They are not, however, integrated into the formal property system, they are therefore not "fungible", and their members are not accountable outside their own social contract.

Few governments recognise that the problems they face are not new. The countries of the West went through similar problems during their own industrial revolutions. Law in Western European countries only began adapting to the needs of common people, including their expectations about property rights, during the 19th and early 20th centuries. Politicians finally understood that the problem was not people but the law which was discouraging people from being more productive. Living standards only rose when governments reformed the law and the property system to ease access to formal property and facilitate the division of labour.

As the poor flow into the cities, creating extralegal social contracts and a sea change in expectations, they are forcing a major redistribution of power. Governments have to accept this fact and begin to catch the wave rather than be engulfed by it.

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The missing lessons of US history

We have forgotten, de Soto claims, how the successful capitalist nations made the transition to capitalism. At some point in their past, all Western nations made the transition from dispersed informal arrangements to an integrated legal property system. This had little to do with technical advances that made documentation easier (although this plays an important supporting role).

The crucial change was about adapting the law to the social end economic needs of the majority of the population. Gradually Western countries became able to acknowledge that social contracts born outside the official law were a legitimate source of law and to find ways of absorbing these contracts. Law was thus made to serve popular capital formation and economic growth. This property revolution was always a political victory – the result of a few enlightened men in each country deciding the official law made no sense if a large part of the population lived outside it.

The most pertinent example is the United States and de Soto takes a detailed look at the way the US property system evolved. More than 150 years ago, the US was a Third World country. The governments of the young states were trying to cope with the law and disorder of migrants, squatters, gold diggers, and illegal entrepreneurs. American governments tried to stem the exponential increase of squatters (George Washington called them "banditti") and the extralegal arrangements that they evolved. Eventually, they conceded that the land system had broken down. The Homestead Act of 1862 which entitled settlers to free land simply for agreeing to live on it and develop it was the recognition of a fait accompli. Americans had been settling and improving the land extralegally for generations. US politicians gradually modified the law to integrate this reality into the official legal system. This left the assets of the settlers and miners ready to be converted into capital.

The recognition and integration of extralegal property rights was a key element in the US becoming the most important market economy and producer of capital in the world and in releasing the energies and aspirations of it people.

De Soto concludes that, as in the US in the 19th century, the challenge of capitalising the poor in developing countries is ultimately a political challenge that has to be reformed with legal tools. The main lesson is that pretending extralegal arrangements do not exist or trying to stamp them out without a strategy to channel them into the legal sector, is futile.

Today in many developing countries, property law is no longer relevant to how the majority of people live and work. How can a legal system aspire to legitimacy, de Soto asks, if it cuts out 80% of its people? The US experience shows correcting this legal failure is a threefold task: identify the real social contracts on property, integrate them into the official law, and craft a political strategy that makes reform possible.

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The mystery of legal failure: Why property law does not work outside the West

Formal property is more than just ownership or a system for recording assets – it is an instrument of thought, representing assets in such a way that people can work on them to generate surplus value. That is why formal property must be universally accessible – to bring everyone into one social contract where they can cooperate to raise society’s productivity.

Governments in developing countries have long been trying to open up their property systems to the poor but have failed because they operate under some misconceptions. They presume, for example, that people in the extralegal sector are trying to avoid paying taxes. Not so, says de Soto. In Peru, where he designed a programme for bringing small extralegal entrepreneurs into the legal system, 276,000 entrepreneurs registered their businesses voluntarily and four years later tax revenues from formerly extralegal businesses totalled $1.2 billion.

Another assumption is that real estate assets are not held legally because they have not been surveyed and recorded. Again, that is not the issue, says de Soto. What keeps people in developing countries from using modern formal property to create capital is a bad legal and administrative system. Inside the "bell jar" are elites who hold property using codified law borrowed from the West. Outside the bell jar, where most people live, property is used and protected by extralegal arrangements. The crucial point is that property is not a physical thing that can be mapped. Property is not a primary quality of assets, but the legal expression of a consensus between people about how those assets should be held, used and exchanged.

Law is the instrument that fixes and realises capital. It is the representation of assets fixed in legal property documents that gives them the power to create surplus value. The challenge in developing counties is not to put all the nation’s lands and buildings into the same map but to integrate the formal legal conventions inside the bell jar with the extralegal ones outside it. No amount of surveying and mapping will do that.

It is both a legal challenge and a political challenge. The legal challenge is to weave all the separate, extralegal property arrangements of developing countries into a single system from which general principles of law can be drawn – to integrate all the many social contracts "out there" into one all-encompassing social contract.

But how is this to be done? De Soto tells how, when he was walking through rice fields in a developing country, he had no idea where the property boundaries were. But the dogs knew. Every time he crossed from one farm to another, a different dog barked. The dogs were ignorant of formal law but knew very well which assets their masters controlled. To build a formal property system in these countries, you have to travel the streets and countryside listening to the "barking dogs", discovering the "people’s law". To integrate all forms of property into a unified system, governments must find out how and why the local conventions work and how strong they are. The failure to do this explains why the many past attempts at legal change in developing countries have not worked.

The political challenge in "lifting the bell jar" is to overcome resistance from the tiny, powerful minority who will feel their interests threatened. This is a job for the country’s top political leadership who have to take charge and make formalisation of property law a pillar of government policy. They must take the perspective of the poor by walking the streets and listening to the barking dogs. They have to co-opt the elites by persuading them that legal integration will help all interest groups in the country by generating an expanding market and encouraging law and order. Politicians also have to deal with the custodians of the bell jar – in particular, the lawyers. They will have to choose courageous lawyers to lead the national formalisation programme. These are the ones who believe that law is made to serve life and not the other way round, the ones who will persuade their colleagues that the system they defend is hopelessly outdated.

Creating a property system that is accessible to all is primarily a political job because it must be done by people who understand that the final goal is not drafting elegant statutes but putting capital in the hands of the whole nation.

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The base of the pyramid

The suggestion that the poor are in reality asset-rich supports the assertion of business guru CK Prahalad that there is a great opportunity waiting at the "base of the economic pyramid" for those multinational firms with the imagination to grasp it (see the summary of The Fortune at the Bottom of the Pyramid.) For managers and firms who want to pursue that opportunity, de Soto’s book is essential reading.

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