The Mystery of Capital, Why Capitalism Triumphs in the West and Fails Everywhere Else

Hermando DeSoto, Basic Books, 2000

Reviewed by Graham Mulligan

Capital is an abstract concept representing the potential to create something else. DeSoto and his team examined developing and former communist countries to try and understand why capitalism doesn’t have more than foothold there. In each of these countries there is economic activity and urban expansion but there is a lack of capital in the hands of the population that would allow for real entrepreneurship. Why is this? DeSoto describes the obstacles to legality and particularly property ownership that seem to run rampant in many such countries. There appear to be multiple ‘rule’ structures not coordinated or enforced evenly and consistently thus corruption ensues or just too many ‘rule’ steps exist to legally execute ownership.

The idea of ownership then, and private property rights, is the central theme. Private ownership is supported by a complex system of laws and institutions in the West that doesn’t exist in developing and former communist countries. In the West private property, recognized by some ‘title’ and representing some value and then be used to create capital. DeSoto describes something he calls ‘property effects’ that underlie this process: fixing the economic potential of assets; integrating dispersed information into one system; making people accountable (think of collateral when you go for a loan); making assets fungible (‘able to be fashioned to suit practically any transaction’); networking people (economic agents); and protecting transactions.

The developing world’s ‘industrial revolution’ is different in many ways from, for example Britain, where it took 250 years (up to the present) with a starting population of 8 million people. Megacities of 10, 20, 30 million in the developing world are industrializing, mostly since the 1960’s and some since the 1990’s. It’s much bigger, much faster and a key difference is found in the nature of commerce. Business transactions tend to be only with people you know and trust and not with strangers because the legal system doesn’t reach far enough to ensure contracts will be respected. This extra-legal organization of the economy in developing and former communist countries is enormous, constituting sometimes 60 – 70 percent of economic activity, unrecognized by official records. Although extra-legal arrangements do work they have the disadvantage of not being integrated into the formal property system and as a result are not fungible or adaptable to transactions connected to financial and investment circles or accountable to authority beyond their own social contract. Evidence of thriving economies can be found in the large slums surrounding many big cities. The slums are rarely anti-social and tend to be peaceful and productive for the people who live there. Cities attract people from the countryside because of the perceived opportunities. European cities grew this way and adapted by extending rights to the extra-legal inhabitants.

‘Extra-legals’ is the term DeSoto uses to describe the large number of poor people living outside the legally structured society. In the developing Western world 250 years ago they were the slum dwellers surrounding the big cities, doing illegal trade. In America they were the “squatters and small illegal entrepreneurs occupying lands they did not own. For 100 years in America such squatters battled for legal rights to their land and miners warred over their claims because ownership laws differed from town to town and camp to camp”. The past of Europe and America strongly resembles the present of the developing world in this regard.

How did the West evolve access to legal property rights? How did the law change in order to embrace the existence of the extra-legal economy? In Europe, Japan and the US the process involved the “collision between rule making at the grassroots level and rule making at the top”. DeSoto focuses his research on the American example in Chapter 5, examining the process of colonization and the creation of various early American states like Vermont. Vermont gained recognition from New York and New Hampshire, both of which were legal colonies under European law. The territory occupied by so many squatters that it wasn’t practical to do anything else but recognize their rights to the land they were on. British laws became irrelevant. For a time other systems prevailed such as ‘tomahawk rights’, ‘cabin rights’, and ‘corn rights’. Where land ownership was in dispute with a titled owner a new law of ‘preemption’ was used to allow the squatter to buy the land he had improved before it went to public sale. It took a further hundred years with various other land ‘sales’ and giveaways before any kind of uniformity could be established. The government of the Union of early colonies used land ‘scrip’ to pay soldiers; it gave land title to railroads; it sold acreage to settlers, but still more came and squatted. Throughout the settlement of the West squatters, now called settlers, had to organize themselves to protect their land claims. This included setting up ‘Claim Associations’ and ‘Miners’ Organizations’ that established mining-district regulations in as formal a manner as possible. Eventually Congress aligned its laws and the extra-legal laws into one.

DeSoto describes how his native Peru has struggled for 150 years with establishing property rights. Various governments, on the right and on the left, have tried to assign property rights through mandatory laws (rightists) or protecting poor people’s lands in government-run collectives (leftists). But people haven’t lived and thrived with either legal system because the law doesn’t address what they want or need, whether it is joining lands together or dividing land up for whatever purpose. In the developing and former communist countries the legal system is, in fact, a status quo system that supports whatever government is currently in control.

Formal law in these countries is increasingly being ignored. DeSoto examined international financial institutions to see if there was any successful formalization of assets in Third World countries recognized and integrated into a capital formation system. He found “nothing even remotely resembling the success of advanced nations”.

He also looked at the record of various governments in the developing world to see if they had tried to formalize property systems. They had in fact, but with zero success. Even with good intentions these governments could not impose a legal system successfully. The reason is because there already exists a property system and it is the one that local people obey because that is what they will have to live with. It is their social contract with each other and there are multiple social contracts in service of the people to suit their local requirements. Alignment is only possible if it is based in a legal system that is broad and flexible enough to accept these pre-existing extra-legal systems. Legal pluralism does not mean haphazard application of laws. In fact these extra-legal systems develop institutions to administer the social contract that exists locally. They are also biased toward participation in the larger legal system. Governments cannot achieve this objective with lawyers sitting in high-rise offices. They have to go into the streets and “listen to the barking dogs”.

An explanation of this analogy is required here:

The author, on tour in Indonesia, had a chance to visit Bali. Walking about through rice fields he realized that every time he crossed from one farm to another a different dog barked. There were no formal boundaries or markers of property but the dogs knew where one farm ended and another began.

Governments need to discover what the laws are that operate in local conditions then build a bridge to a larger encompassing system. Only by giving property holders this larger legitimacy can they use these rights to represent the value of the property to become fungible.

DeSoto calls for a “property revolution” in which the leader must “take the perspective of the poor, co-opt the elite, and deal with the…bureaucracies”. One study of economic growth in 52 countries from 1960 to 1980 showed that for every percentage point increase in the number of lawyers in the work force economic growth is reduced by 3 to 4 percent. “Economic growth is inversely related to the prudence of lawyers” (p.198). The Cold War may have ended but the concentration of wealth in the hands of the few is producing an inevitable reaction. Only by unleashing the ‘dead capital’ that exists in developing and former communist countries will capitalism realize its full potential. This is not an ideological or economical achievement as much as it is a philosophical achievement.

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