Commentary

Advancing Liberty

By Hernando de Soto
May 27, 2004

Thank you, Fareed (Zakaria, editor of Newsweek International), for your very kind words. And thank you very much, Cato, for making me a hero in this country.

Fareed said very nice things. What he forgot to say at the beginning is that the person who opened our intellectual inquiry in Peru as to why things hadn’t been working, especially in 1979, after essentially 12 years of a leftist military government, were Rose and Milton Friedman, who were my first guests.

And I would like to hereby confirm that Milton Friedman and Rose are two rock stars in Peru since then. I remember quite clearly also how Milton Friedman came in and started off the conference. He had guessed what they were all going to say — what does he know about Peru? He asked, “Well, if you had a sick child, would you ask for a doctor who knew the child or who knew the sickness?” And he shut everybody up. So I’m delighted to be awarded a prize that has Milton’s name. I couldn’t think of a greater honor.

One of the things Milton taught us when he was in Lima ‑‑and that was 1979, which, just think, is already a quarter of a century ago‑‑ was that there was no free lunch. What he didn’t say is that there are free books. About five years later, Milton and Rose sent me a book, called “The Tyranny of the Status Quo,” gratis, via Federal Express. And it was about the “iron triangle.” That book impressed me very much, because, by that time, all those street vendors that Fareed was talking about were already hundreds of the people associated with our institute, which was organized to find out what people needed and to convert it into political policies.

And the Iron Triangle was the book that Rose and Milton had written, to say, after a few years of Reagan government, how difficult it is to make transformation and how important it is to have a strategy. And that made me think very much about what it is that one had to do to be able to break that Iron Triangle of beneficiaries, politicians and bureaucrats, who hold on to the status quo and resist needed change. And though they may be a minority, you have to break the triangle, break that grip, otherwise things are not going to go well.

And what we discovered and what is the key to our success, especially in political terms, is that there was in fact a very large constituency for change in developing countries. Although labeled as “the poor,” we understood that these poor wouldn’t be surviving if they weren’t also entrepreneurs. They just needed something more in order to prosper.

And while people, as Fareed was pointing out, were saying there are a billion people that are living on a dollar a day and maybe there are 3 billion people that are living on $2 or $3 a day, nobody said there are 4 billion people who are poor, who are entrepreneurs, and who are completely excluded from the global economy and even the national economy. Why? Because of lack of law.

This is one of the primary insights of the work that my colleagues and I have been carrying out. This is not the rural 1960’s anymore in the Third World. The population of Port‑au‑Prince has grown 17 times in the last 35 years. The population of Algerian cities has grown 15 times. Ecuadorian cities, 11 times. And countries that were in their majority rural when we were talking with former Secretary of State George Shultz (sitting in the audience), today are urban. And these people have moved to become businessmen through the division of labor that cities offer.

As Professor Friedman said in his remarks, the sorts of solutions that poor countries need are the kinds of things that developed countries did in the 19th Century, not the 21st Century. In other words, what occurred in the West in the 19th century is now occurring in developing countries. “Oliver Twist” has come to town. But Oliver Twist and his friends haven’t yet been recognized by international financial institutions or by most bilateral programs from developed countries. And even worse than that, he hasn’t really been recognized by most of the people in developing countries who think that street vendors are a problem, that illegal manufacturing creates faulty products. But the truth is, the industrial revolution has come in.

And so to us what is very important is that the more people are aware of the real conditions in developing countries, where there are 5 billion of the world’s 6 billion population, the more politicians are going to find out that their biggest constituency for change are poor businessmen. And that is what will eventually make them move because that increases their legitimacy.

And we now know that these reforms are important to solve various of the world’s problems. For example, my country, Peru, had for 10 years a president of Japanese origin. His name was Alberto Fujimori. The Fujimoris were one of 1 million families that came from Japan to Peru and to Brazil in the 1930’s and 1940’s.

Now, the fact that the Fujimoris came to Peru and the Yoshiyamas went to Brazil isn’t what’s important. What is really important to understand is why didn’t the Toledos and the Lulas go to Japan? And the reason they didn’t go to Japan was because Peru had a GNP per capita of 25 percent above that of Japan’s in 1940, and Brazil had one 50 percent above that. And so what happened was obviously that Japan did something in the last 50 years that has made it today, now that Alberto Fujimori has returned for reasons I will not mention back to Japan, 10 times richer than Peru. What happened? Why are Peruvians now eager to go to Japan?

Well, the fact is that after the Second World War, a plan was implemented that was begun in Honolulu in 1942, under MacArthur’s supervision. His team, also under Wolf Ladejinsky, planned the postwar regime. Like Mao Zedong in China, they basically destroyed the feudal system, which they thought was at the heart of all the evil and the problems of Japanese expansionism within Asia. But unlike postwar China, they created the basis of a widespread private property system.

By breaking the feudal system down and creating a large constituency for a market economy, they transformed Japan and its two colonies, Taiwan and South Korea. In 1978, Deng Xiaoping turned around and said, “You know, I don’t care what color the cat is as long as it catches mice.” And now the giant of Asia is turning around by means of property.

Japan is an interesting lesson because when the Americans went to Vietnam, they forgot about it. And they forgot about it in later foreign policy interventions. But they have turned countries around and converted feudal economies and patrimonial economies into modern economies through foreign policy moves before. But there is a tendency, it seems, to forget about these things.

These lessons were not in your books. To find them, I got a grant and managed to bring together in Japan the seven surviving octogenarians who had designed the Japanese reform through the instigation of the United States. These men told us how they had created the property system and so built a modern nation.

So there are ways of doing this. The only way you can create a market economy is literally by engineering it. It’s not going to come through the courts. And the good news is that it has been done before.

Now, we are working for different heads of states throughout the world. We began working, as you saw in that film, in Peru. And now we have been called in by nearly 30 heads of state. So it is not only people from the bottom that are thinking that there is some reason to do the kinds of things we’re talking about and that we learned from you and your own history, but it is also heads of state. It is much easier for a Third Worlder to understand the things I’m saying than it would be for a First Worlder, because First Worlders take things for granted.

[Karl] Popper used to talk about that phenomenon. He used to call it, I believe, the Carl [Adolf] Busch phenomenon. He had once gone to see his favorite violinist in Zurich, who was Carl [Adolf] Busch, with a friend who was also an enormous admirer. They saw him interpreting Vivaldi. When he went from the third to the fourth movement, he did it marvelously, the way nobody had ever heard it. So they visited him afterwards in his chambers and asked, “Maestro, how did you go from the third to the fourth movement?” And Carl [Adolf] Busch said, well, it’s rather simple. He put the violin to his neck and started playing, and he’s never been able to play it again.

You in the West are like the spider that only has eight legs. This spider tells the centipede, “I’ve only got eight legs, and those are hard to organize, so how do you manage to organize 100 legs?” And the centipede said, “Look, it’s easy, you first lift the 25…” and the centipede hasn’t been able to move since then.

The developed countries have showed us the way, but you don’t seem to be remembering, and this has had a profound effect on us. Mainly, you are not putting your money into the real task of nation building. The money goes elsewhere. It means you don’t repeat your past successes and so it means your foreign policy sometimes goes wrong.

I remember in 1988 I was asked to give a speech at the Secretary’s Open Forum, when George Shultz was Secretary of State. And shortly afterwards, Mr. Secretary, you invited me for lunch. The title of the speech was “The United States: Why I Think You’re Talking to the Wrong People.”

In other words most Americans talk to Westernized Third Worlders like myself. But most of us have vested interests. We’re not really capitalists open to competition, we are mercantilists looking for privileges. Still, we have graduated from your schools and we talk your language. But the really interesting guys are the real entrepreneurs. However, they are poor and small and you haven’t made contact with them.

And this is a dangerous vacuum, because vacuums are always filled by somebody. Yet, you do have an enormous number of people who believe in the market system and you can see this by their actions. They have to be reached if you are to help them build a modern nation. And if you don’t reach them, somebody else will get there.

In Mexico, for example, where we’re working with President Fox, we have just finished the numbers. We have found out that roughly 80 percent of the Mexican population — and I did not say 18, it is 80 percent — is in the extralegal economy. They own about 6 million businesses, 134 million hectares, and 11 million buildings. And all of them together are worth $315 billion, which is seven times the size of Mexican oil reserves and 29 times the size of all foreign direct investments since Spain left.

In other words, these pre‑capitalist economies, with capitalist orientations, are emerging all over the world. In Egypt, what the poor own outside the law is 92 percent of all the buildings and 88 percent of all the enterprises, which are worth $248 billion. And $248 billion is equivalent to 55 times the value of all foreign direct investment in Egypt since Napoleon left, including the Suez Canal and the Aswan Dam. And it is 35 times the size of the Cairo Stock Exchange and 40 times the value of all World Bank loans to Egypt, and 70 times all the bilateral aid that they have received.

In other words, the majority of our resources will really not come from you in the West. Of course, you’re very kind, and we accept what you give us, but really you’re a drop of water compared to what we already have. Real wealth grows from the efforts of entrepreneurs who can bring resources together and divide labor efficiently among themselves to raise productivity.

And the other places we’ve been called are places like Ghana. And interestingly enough, not only by President Kufour, but by also the tribal chiefs who, this time, are wiser than the indigenous people of North and South America. They have read our stuff and said, we don’t want sovereignty anymore; we want property rights. Sovereignty is something all people violate, from the white man to the black man. Property rights are much more solid, because they’re based on a social contract rooted in the reciprocity of one person’s interests to another’s, not one nation to another.

If you look at a map of Europe, over time you find that sovereignty is extremely unstable. It starts off with a big Germany that shrinks as the Austro‑Hungarian Empire expands. Then Austria shrinks and the Balkans split into millions of pieces. Very unstable.

But yet, if you look at the Alsace‑Lorraine, which is a territory that has been divided up time and again between the French and the Germans, you will find that, no matter who owned it, Monsieur du Pont still lives where he always lived, and Herr Schmidt lives where he always lived. Property rights are the result of a grassroots contract, and they stick even when sovereignty fragments.

And when President Mkapa invited us to Tanzania, where we’re also beginning work, we interviewed his tribes and found that among the Masai there were 800,000 enterprises. So if anybody comes along and tells you, it’s either the tribe or it’s the enterprise, they are wrong. The real split is the choice between the tribes or government. The enterprise is already born, it’s already in place.

But these very seeds have also been in China and Russia for millennia. If entrepreneurs don’t find their expectations satisfied by their government, they will follow somebody else. And that is open territory for terrorists and it is open territory for all the failed doctrines that we shouldn’t be following.

So what we are trying to do is demonstrate that you can break the iron triangle by showing political leaders that they have an enormous constituency for change to a market economy. But that a market economy is essentially a legal construction and not all those physical things — roads, bridges, airports and ports — that the West seems to want to give them. And this legal construct begins through property rights.

If you look at the laws of a nation, they all look equal; family law, international public law, international private law, criminal law, and then there is property law. But if you’re poor all you’ve got basically is a piece of land and a place where you work, whether you’re street vending or milking a cow. There is nothing more precious for you than your property. But to preserve it without the law you’ve got to satisfy tribal chiefs, crooked cops, corrupt politicians, bad judges, your difficult neighbors and even the terrorists.

But if the law comes in and says those rights are now recognized, not only by your neighbors but by the police and the whole nation, now you can trade them nationally and even internationally and the law will protect you. Then that poor person becomes interested in the rule of law. Then it means something. Then he begins to understand it.

For instance, what happens if they have a dispute and go to court? Well, then they want a good judiciary system. And eventually they will realize that the laws can be changed so they’ll say, hey, who makes the laws? And they will care about the political process.

So the genesis of the rule of law — which will allow a modern nation to grow and so bring peace, stability and prosperity to the world — is property rights. That is where it actually starts.

And it is the rule of law will actually generate prosperity. Adam Smith and later Marx would say that the new productivity was due to the division of labor and this was bringing prosperity to Europe.

Smith’s example is very simple. He said he had seen a couple of people working outside the walls of Glasgow making pins. Taking 18 steps, they were able to make 20 pins each a day. In another place, he had seen 10 people dividing those 18 functions among themselves, and producing 48,000 pins a day. And the way he broke it down is that one bought the wire, another one covered it with tin, and then a third one drew the wire, two other people cut the wire, one other person put points to the wire, somebody to head it, and they made 48,000 pins a day. An increase in productivity of 240 times.

But if you go to developing countries you will see that you don’t really have firms, because the law hasn’t reached there. What you’ve got are families. And families have trouble putting even 10 people to work. They can only put four. And of those four, there is your lazy brother, your alcoholic brother‑in‑law, guys who weren’t made to go for pins. Anybody who is a manager knows that how you combine resources and whom you employ to work is important.

But over 4 billion people don’t have property rights over their assets so they cannot get credit and use collateral and they also cannot create a firm with which they can divide labor. This means they can’t efficiently organize inputs or manage the creation of the outputs. They can’t separate the assets of shareholders from the assets of creditors and from the assets of the workers.

Therefore, of course, with only a few poorly organized people per enterprise, no matter how much microcredit you throw to them, they will never become efficient and so never be able to compete in the global marketplace. They’re only going to become prosperous when the law comes into place.

So the time has come ‑‑and that’s what we’re trying to do as we go around the world — to indicate that value is not only raw manpower but the power of man to divide labor. Even though Adam Smith was a great man, many of these early liberals left us with an inheritance that we’ll have to get rid of, which is the labor theory of value. Value doesn’t just come from simple labor. It comes from intelligent political and economic solutions that can raise productivity enormously. We need to get that theory out of my book and into the real world.

So the choice is simple. To build modern nations, we have to learn how the poor work and then structure law that fits their needs. In the end, Peruvians, Chinese, and Americans want essentially the same things: life, liberty, and property. And to get it, you have to build on a market economy based on the rule of law. Our real enemies are not Marx and others, but are essentially the people who do not believe in the potential of human beings liberated by the rule of law.

The enemies of the Enlightenment are the romantics who become the kind of nationalists, who don’t know how to talk about civilization in singular, that always believe in many civilizations at the same time. But because they’re romantic nationalists, they draw people away from the universal laws of progress. They are people like Samuel Huntington, who is really a moderate when compared to our romantics who believe that we shouldn’t follow your model because Max Weber convinced them that it was an Anglo‑Saxon model.

So I am here at Cato, proud to be the second foreigner to receive your prize, surrounded by fellow Latinos and introduced by a former citizen of India. You are clearly on the path to enlightenment because you believe in the potentials of all people of the world. So I am proud to receive this prize from Cato, named after the great Milton Friedman. And I am humbled by the honor bestowed upon me, which reflects the work of my colleagues.

Hernando de Soto is the 2004 recipient of the Cato Institute’s biennial Milton Friedman Prize for Advancing Liberty. Mr. De Soto’s speech below was given at the award dinner in San Francisco on May 6.