Interview

The poor are not the problem but the solution - Hernando de Soto

The Peruvian economist, Hernando de Soto, is founder and President of the Institute for Liberty and Democracy (ILD) headquartered in Lima, Peru. He is considered one of the most important development theoreticians in the world. He has published two books about economic and political development: The Other Path and The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. His main conclusion is that much of the marginality of the poor in developing and former communist nations comes from their inability to benefit from the positive effects that formal property provides. Without legal titles and the necessary property-related institutions, these poor cannot fully exploit their assets. The challenge these countries face is not whether they should produce or receive more money but whether they can identify which legal institutions are required and summon the political will necessary to build a property system that is easy for the poor to access. Over the last few years, Hernando de Soto has been granted several honours: The Fisher Prize in the United Kingdom, The Adam Smith Award in the United States and The CARE Award for Outstanding Development Thinking in Canada. “De Soto’s ideas about how to empower the world’s poor represent one of the most significant economic insights of our time”, says former President of the United States, Bill Clinton.

Together with the ILD, Hernando de Soto is designing and implementing capital formation programs to empower the poor in Latin America, Asia and the Middle East. Liberales staff member Dirk Verhofstadt had an exclusive interview with Hernando de Soto in his residence in Lima.

The Economist calls the Institute for Liberty and Democracy (ILD) one of the most important think tanks in the world. How did it start?

Hernando de Soto: At the end of the left wing dictatorship in Peru in 1979, we wanted to bring in new ideas. All we had here were traditional leftist messages, some of which I found very interesting. However, it was also very important to realize that we had nothing that related to a market economy and the more liberal view of democracy. So, the beginning was simply bringing in ideas from Friedrich Hayek, Jean-François Revel, Milton Friedman, and original Marxian thinking as well. We wanted to clear the air and explain that there was more substance to the kind of thinking which supports freedom and the efficient economies of the world than they suspected. One of these ideas was the relationship between marginality - where people are forced to live and work outside the system - and the law. At that time, I saw the law as the main factor of exclusion.

Take for example the history of Latin America where liberal ideas have come to government many times, but haven’t succeeded. The main reason for that failure was that they never included the excluded. [This was a harder task than it seemed.] We found that most ideas that related to freedom and productivity were well known by think tanks but had not penetrated to the political decision makers and the average person. So, the focus of the Institute for Liberty and Democracy very much became this extralegal sector - particularly on the areas of property rights and free enterprise because they are the trusses to everything else.

Do politicians understand the importance of property rights?

Hernando de Soto: If you are poor, like the majority of the people in the Third World or the former Soviet Union, you have only two things that allow you to survive - where you are living and whatever you are working with to provide you with an income. Poor people, for instance, put their simple belongings on a piece of unoccupied ground in the countryside or in the so-called pueblos jóvenes, favelas, ranchos, barrios marginales, bidonvilles or shantytowns around big cities in the developing world. If no one disputes his or her claim, a bit of a roof follows. As time goes by, and as the neighbours come to recognize the newcomer’s property, a regular structure will be added. Over time, not only do the neighbours recognize the squatter’s property, but also informal organizations may ‘register’ the ownership — unofficially, of course. The occupants have to dedicate all their time to protecting their possessions against such enemies as poachers, intruders, and, of course, the government.

If you want to understand the importance of property rights, a good place to start is the genesis of property, something that is not controversial for the entire political spectrum. Half of the governments we work for, for instance, are definitely on the left and understand that the poor do not have property and believe that they should. So the law gives a point of penetration were everybody is in an agreement. Property rights are even recognized on a global level in points nine and ten of the Washington-consensus. However, these are the only points that have never been implemented. The objective of these points is to establish free enterprise and property. This big gap needs to be filled in. That is the objective of the ILD.

In your book ‘The Mystery of Capital’, you write that capitalism is like a private club, only open to a privileged few, enraging the billions standing outside looking in. Can you explain this?

Hernando de Soto: Almost 5 billion people out of the 6 billion in the world live in either developing or formerly communist countries, where much of the economy is extralegal. Capitalism doesn’t thrive in these countries because of their inability to produce capital. However, capital is the force that raises the productivity of labour and creates the wealth of nations. It seems that poor countries cannot produce capital for themselves no matter how eagerly their people engage in all the activities that characterize a capitalist economy. In fact, the poor inhabitants of less developed countries do have things, but they lack the process to represent their property in such a way that it can create and transfer capital. They have houses but no titles; crops but no deeds; businesses but no statutes of incorporation. In other words: their property is not registered, not formally legalised. This last fact is crucial, for only through property rights is it possible to obtain credit. Property converted into capital provides the potential to create, to produce, and to grow. Landownership can only be exchanged for a loan if it is registered. The main objective of the ILD is to establish and incorporate the invisible network of laws that turns assets from ‘dead’ into ‘liquid’ capital.

One of the conclusions in your book ‘The Mystery of Capital’ is that poor people are not the problem, but the solution.

Hernando de Soto: They certainly are, and there are very simple reasons for this. First of all, wherever we go, we see that the poor have the majority of a country’s savings, which means that they have done the majority of the work. Look at the situation in Egypt. There, extralegals have accumulated up to $ 248 billion in their enterprises and homes. This is 37 times more than all the loans received from the World Bank. It is 55 times greater than all the direct investments in Egypt and 35 times more than the value of the companies listed in the Cairo Stock Exchange.

In fact, the total value of the assets held but not legally owned by the poor in the Third World and former communist nations is at least $ 9.300 billion. So, the poor are obviously the solution.

The history of many countries shows that very poor people have built today’s wealth. The poor today form a large entrepreneurial force, but it is a force that cannot leverage its assets. And that is the situation in all of the developing countries and in the former communist nations we have been in. There is no lack of entrepreneurship. There is no lack of a will to build assets. There just isn’t the legal system to allow these assets to be leveraged the way you can do so in the West. International financial institutions have traditionally not counted these assets. Poor people have always been seen as recipients of benefits. We are changing this around by saying that whatever you are giving to them is peanuts compared to what they themselves can do. So, the direction should be to enable them, to empower the poor.

So, to solve the real problem we have to make the informal world formal?

Hernando de Soto: Well, that’s it, but it’s not the old formality. You’ve got to think of a new formality. The old one has been offered to the poor, but they have obviously rejected it. There is the law. Don’t forget that informal and customary systems of property rights exist, but mostly outside the legal framework of the country.

I am now a member of a newly created agency for foreign assistance. The Secretary General of the United Nations, Kofi Annan and the Administrator of the UNDP, Mark Malloch Brown, have set up a commission targeting private sector development. These kinds of agencies had never focused on the private sector, in spite of the fact that they are a big part of the world economy. So, the agenda seems to be moving in the right direction now.

But isn’t the main problem legislation? Don’t lawyers stick on to the existing laws?

Hernando de Soto: That’s right. The legal and administrative mechanisms for creating live capital either do not exist or are complicated, these take ages to navigate and cost far too much for the ordinary person. Rich people, on the other hand, have easy entry to business; that is, they have easy access to the tools that facilitate their entry, such as lawyers, accountants, and legal advisors who are able to safeguard their interests in the labyrinth of bureaucracy.

If a squatter wanted to acquire a legal title to his or her property, it would take at least 13 years in the Philippines, over 11 years in Haiti, and 6 years or more in Egypt.

Moreover, in business, it takes you 549 days to get a license to operate a bakery in Egypt and that is with a lawyer. Without a lawyer, it takes about 650 days. In Honduras, it costs an individual entrepreneur 3.765 dollar and 270 days to legally declare, register, and start up a business.

To create a mortgage in Mexico it takes 2 years. It takes 17 years to get a title on a house in Egypt; in Peru it used to be 21 years before we corrected that, and in the Philippines it’s 24 years. These are but a few examples of complicated ownership legislation. The procedures for getting official authorization to build are so formidable that people chose to build without authorization. The entire phenomenon forces poor people into illegitimate and informal negotiations. It forces them to create extralegal means to gain access to a home or a business.

So, what the people in these countries need are transparent laws and efficient administration. One of the main reasons that laws are so complicated, and procedures are so costly and inefficient, is that legislators in developing countries only want to adopt western rules. They remain blind to the extralegal reality. In fact, they should leave their studies and offices and investigate the extralegal sector because that is where they would find all the information they need to create a legitimate legal system that everyone would understand and accept. By investigating and penetrating the ‘law of the people’, legislators and regulators can set up a better legal system. Most of the lawyers in developing countries are educated to protect the interests of their wealthier clients and write the law to assist them. However, they have an instinctive tendency to protect the legal status quo instead of to extend it or adapt it to suit the needs of an evolving reality.

You have been working in several developing countries by giving advice to their heads of state. What is your method of working?

Hernando de Soto: To us the most important part of our work is that part that we call the diagnosis. When we are hired by heads of state, we form a team of maybe seven people from our side and a hundred from theirs. Then we draw a line and find out what’s inside the law and what’s outside the law. In the case of Egypt, we found that 92% of all the constructions and the land and 88% of all enterprises are outside the legal system. This means that the large majority of owners are not registered as such and are therefore not visible to councils, town planners, investors, banks, post offices, water companies, electricity providers, and other firms. The results of our diagnosis show politicians that something is very wrong. It even has a Marxists element of class, an element that has always been missing, even in liberalism. Because people do have specific positions. People in the so-called informal economy are the biggest entrepreneurial class in the world. There are more entrepreneurs in any Third World country than there are in the rich countries.

Over the past fifteen years or so, your Institute has worked in Peru, Egypt, El Salvador, the Philippines, Honduras and Haiti. In which country are you working now?

Hernando de Soto: We are currently working with the Mexican government. We have finished the diagnosis. Seventy-eight million Mexicans - this is almost 80 percent of the total population - is either living or working in the extralegal economy. They produce approximately 35% of the GNP. In total there are about 137 million hectares of rural real estate, 11 million houses, and 6 million businesses that are not registered. Those are assets that can only be used as a shelter or as business tools, but not as a means to obtain collateral for a loan, to generate investment or to create additional functions to obtain surplus value. The whole value of this ‘dead capital’ amounts to $ 315 billion. That is equivalent to seven times the value of all known oil reserves in the country and 31 times the value of foreign direct investment. So, we are advising President Fox on the ways to reform all of this in order to integrate the excluded citizens. An efficient means is designing a legal framework to transform property and businesses into liquid assets. And by reducing the costs and increasing the benefits of operating legally, they can increase public tax revenues.

Is there a relation between corruption and the lack of property rights?

Hernando de Soto: Yes, of course. Because a great part of corruption is essentially the purchase of the law; that is, you pay somebody to stop looking your way or to draft the law in a certain direction. When I was working in the Middle East, there was an entrepreneur that I got to known so well that I could ask him about corruption and pay-offs - ‘baksheesh’ is the local word. He explained: “I love baksheesh because it gives me certainty and predictability.” They change the law continually. We have calculated that the government brings out about 30.000 new rules every year. None of these is enacted in a transparent manner, with public participation. The result is that the law is totally unpredictable and only serves the powerful and those who have the means to remain informed. So, from this point of view, ‘baksheesh’ gives a kind of predictability. All the entrepreneur had to do was pay-off five key policemen either near his workplace, or where he made his transactions. And he knew what his outcome would be.

Now, traditionally that is what the law is supposed to do - give you predictability. However, if the law is inadequate, then your way of getting predictability is corruption. Therefore, when you have property rights - understanding ‘property rights’ as your right to do business, hold shares and carry out business transactions - it is clear that people will not look to corruption for security and predictability, wherever you go in the world.

Some people say that culture is separating the Third from the First World. Do you agree?

Hernando de Soto: That is a myth. I really don’t think culture has very much to do with the fact that some people are desperately poor and others are wealthy. It’s an unfair proposition. It predisposes people to do the wrong things. It may even have racist implications. Instead of focusing on culture, let’s take away all of these enormous legal obstacles that poor people have to face. We’re absolutely convinced it does work because people are actively in enterprise all over the world. Countries that are less occidental than Latin American nations were poorer than us barely 50 years ago - like Japan, Taiwan and South Korea - changed their laws and are now in average 10 times wealthier than we are. Most of the people who say that ‘cultural’ handicaps do exist don’t have much solid facts to prove it. Development will not be achieved by throwing money at the problem but rather by radically changing the legal systems. And I don’t think it is primarily an IMF or World Bank responsibility. I think it’s a local responsibility.

Despite privatisations and deregulations, the Russian economy is not doing well. Do you attribute this situation to a property rights problem as well?

Hernando de Soto: There is only one way of knowing that and it is by getting the numbers on the shadow economy, which is precisely what we at the ILD do. It’s like in medicine: the doctor has to see the patient. You can have the best written law in the world, but if it doesn’t work on the ground it is only ink on paper. I wouldn’t be surprised if in Russia the law looks good on paper, but, on the ground, it doesn’t work. This is why a very important ingredient of any reform towards the market is feedback from the people so that you can create law based on general consensuses and on people’s beliefs. There is no way of designing it in the air as bureaucrats of the old class often do. If you want to get law that is enforceable you’ve got to go get to the street!

How is it possible that those liberal ideas were never popular in Latin America?

Hernando de Soto: Since liberation from Spain in the 1820’s, many governments have tried to bring in a liberal revolution in Latin America several times. We have tried to follow the US model or the Western European models. Latin Americans have privatized railways, lowered tariffs to zero, and opened our economies to foreign investment. And we have failed nearly every time. The reforms made sense for a very small group of people at the top, but for the majority, it didn’t fit their interests. The big mistake each time has been that although people were inspired by liberal ideas, in fact, they never had much interest for the poor. I would say that these people who pretended to be liberal, were not liberals but conservatives. By not caring for the poor, they gave the opportunity to the populist and communists to gain much ground.

Can we say that capitalism is in trouble?

Hernando de Soto: Of course capitalism is in trouble, because, as usual, it is only catching among the top 20 or 10 percent of the population in Latin American countries that have got their property rights paperized in a way that they can enter the market. Capitalism is in trouble in the sense that it isn’t working for the majority. I insist that capitalism doesn’t work without universally accessible property rights. Capitalism definitely did not win the battle against communism: what happened is that communism collapsed. The main ideas or concerns held by the early communists and socialists are still around.

Do you agree with libertarians that plead for a minimal state? What is your position with regard to libertarianism and liberalism?

Hernando de Soto: I think that some of the most resourceful sophisticated thinking comes from libertarians. To me, they are the ‘avant garde’ because, among other things, they point out the dangers of concentrated power. They are a continual source of inspiration to me but it is the gap between their proposals to do a way with government and reality. I am not too sure they understand that government is important to enforcing freedom and democracy - maybe this is because they do not know what it is like to live without any government like some of us in the Third World. The rule of law has to be managed and enforced by strong government if it is to prevail.

In my case, I would say that I am a classical liberal, corresponding to the liberal ideas of the 18th and 19th centuries, which were characterized by being radically opposed to the concentration of power and the causes of the poor.

The reason I study the 18th and 19th centuries of Europe and North Ame3rica is not because I like the past, but because they provide me with lead to understand the present with regards to developing countries. There is a sense that individualism becomes clearer with the Renaissance. Before, people could not envisage themselves as being anything other than part of a whole. That phenomenon of individualism is now starting to take shape in Latin America. In Mexico, for example, where we are currently doing our biggest project, one of the areas we have to focus on is the ejido, which is an indigenous collective property system. We found out that the average age of the Mexican farmer is 65, which means that most of the young people have already left to the city and are becoming individuals. In other words, we are at that stage of individualization that you in Europe were at a couple of centuries ago. Europe’s 18th and 19th centuries intellectual debate are very relevant to developing countries and former Soviet Union nations in the 21st century.


Interview by Dirk Verhofstadt


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