Commentary

Why Capitalism Works in the West but Not Elsewhere

By Hernando de Soto
This article appeared in the International Herald Tribune, January 5, 2001.
Imagine a country where nobody can identify who owns what, addresses cannot be easily verified, people cannot be made to pay their debts, resources cannot conveniently be turned into money, ownership cannot be divided into shares, descriptions of assets are not standardized and cannot be easily compared, and the rules that govern property vary from neighborhood to neighborhood or even from street to street.

You have just put yourself into the life of a developing country or former Communist nation. More precisely, you have imagined life for 80 percent of the population, which is marked off as sharply from the country’s Westernized elite as black and white South Africans were once separated by apartheid.

This 80 percent majority is not, as Westerners often imagine, desperately impoverished. In spite of their obvious poverty, even those who live under the most grossly unequal regimes possess far more than anybody has ever suspected.

Five years ago my research organization, Instituto Libertad y Democracia, and hundreds of professionals from various countries went into the streets of developing and former Communist nations to learn what real people are achieving inside and outside the underground economy. We closed our books and opened our eyes, and the results of our findings have been dramatic.

The data we have collected demonstrate that the world’s poor and lower middle classes have accumulated all the assets needed for successful capitalism. The value of their savings is immense - many times all the foreign aid and investment received since 1945. In Egypt alone the assets of the poor are 55 times greater than all foreign investment ever recorded, including the funding of the Suez Canal and the Aswan Dam.

Why then are these people so underdeveloped? Why can’t they turn their assets into liquid capital, the kind that generates new wealth by increasing production and productivity?

For a very simple reason: To be useful in an expanded market, capital must first be represented in a property document where it can then be assigned a status that allows it to produce additional value. What most people possess outside the West is not “paperized” in such a way as to produce capital.

When you step into an airplane in New York to fly to Jakarta, what you are leaving behind is not the high-tech world of fax machines and ice makers, television and antibiotics; many people in the Third World also have those. What you are leaving behind is the world of enforceable legal representations.

Assets outside the West are held 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 readily be turned into capital, cannot be traded outside of narrow local circles where people know and trust each other, cannot be used as collateral for a loan and cannot be used as a share against an investment.

In the West, every parcel of land, every building, every piece of equipment or store of inventories is represented in a property document that is the visible sign of a vast hidden process which connects all these assets to the rest of the economy. Thanks to this representational process, assets can lead an invisible, parallel life alongside their material existence.

They can be used as collateral for credit. The single most important source of funds for new businesses in the United States is a mortgage on the entrepreneur’s house.

These assets can also provide a link to the owner’s credit history, an accountable address for the collection of debts and taxes, the basis for the creation of reliable and universal public utilities and a foundation for the creation of securities (like mortgage-backed bonds) that can then be rediscounted and sold in secondary markets.

Third World and former Communist nations have been unable to give the overwhelming majority of their citizens access to this representational process. The inhabitants of these nations 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.

It is the unavailability of these essential legal representations that explains why people who have adapted every other Western invention, from the paper clip to the nuclear reactor, have not been able to produce sufficient capital to make their domestic capitalism work.

One of the greatest challenges to the human mind is to comprehend those things which we know exist but cannot see. Time, for example, is real, but it can be efficiently managed only when it is represented by a clock or a calendar.

Throughout history, human beings have invented representational systems - writing, musical notation, double-entry bookkeeping - to grasp with the mind what human hands could never touch. In the same way, the great practitioners of capitalism were able to reveal and extract capital by devising new ways to represent the invisible potential locked up in the assets we accumulate.

The absence of this process in the poorer regions of the world - where five-sixths of humanity lives - is not the consequence of some Western monopolistic conspiracy. It is rather that Westerners take this mechanism so completely for granted that they have lost all awareness of its existence.

Although it is huge, nobody sees it, including the Americans, Europeans and Japanese who owe all their wealth to their ability to use it. It is an implicit legal infrastructure hidden deep within their property systems, of which ownership is but the tip of the iceberg.

The rest of the iceberg is an intricate man-made process that can transform assets and labor into capital. This process was not created from a blueprint and is not described in a glossy brochure. Its origins are obscure and its significance buried in the economic subconscious of Western capitalist nations.

The challenge to leaders in developing and former Communist nations, from Russia’s President Vladimir Putin to South Africa’s President Thabo Mbeki, is to address the fact that most of the citizens they govern do not have property rights.

They have to face the fact that macroeconomic stabilization programs that their governments have carried out have performed only a fraction of the work required to create a democratic market economy.

The fundamental shortcoming of these macroeconomic programs is that they forgot to focus on the poor. The time has come to take the issue of the poor away from the charitable agendas of the first ladies and insert it into the working agendas of the heads of state.

As capitalism falters in five sixths of the world, the time is ripe to take the subject of property away from conservative legal establishments and put it in the hands of politicians committed to progress.

Hernando de Soto is president of Institute for Liberty and Democracy and winner of the 2004 Milton Friedman Prize for Advancing Liberty.