The Mystery of Capital

This article appeared in Finance & Development, March 1, 2001.
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Walk down most roads in the Middle East, the former Soviet Union, or Latin America, andyou will see many things: houses used for shelter; parcels of land being tilled, sowed, andharvested; merchandise being bought and sold. Assets in developing and former communistcountries primarily serve these immediate physical purposes. In the West, however, the sameassets also lead a parallel life as capital outside the physical world. They can be used to put inmotion more production by securing the interests of other parties as "collateral" for amortgage, for example, or by assuring the supply of other forms of credit and public utilities.

Why can't buildings and land elsewhere in the world also lead this parallel life? Why can't theenormous resources in developing and former communist countries, which my colleagues atthe Institute for Liberty and Democracy (Lima) and I estimate at $9.3 trillion of dead capital,produce value beyond their "natural" state? My reply is, dead capital exists because we haveforgotten (or perhaps never realized) that converting a physical asset to generate capital—using your house to borrow money to finance an enterprise, for example—requires a verycomplex process. It is not unlike the process that Albert Einstein taught us whereby a singlebrick can be made to release a huge amount of energy in the form of an atomic explosion. Byanalogy, capital is the result of discovering and unleashing potential energy from the trillionsof bricks that the poor have accumulated in their buildings.

Clues from the past
To unravel the mystery of capital, we have to go back to the seminal meaning of the word. Inmedieval Latin, "capital" appears to have denoted head of cattle or other livestock, whichhave always been important sources of wealth beyond the basic meat, milk, hides, wool, andfuel they provide. Livestock can also reproduce themselves. Thus, the term "capital" beginsto do two jobs simultaneously, capturing the physical dimension of assets (livestock) as wellas their potential to generate surplus value. From the barnyard, it was only a short step to thedesks of the inventors of economics, who generally defined "capital" as that part of acountry's assets that initiates surplus production and increases productivity.

Great classical economists such as Adam Smith and, later, Karl Marx believed that capitalwas the engine that powered the market economy. In The Wealth of Nations, Smithemphasized one point that is at the very heart of the mystery we are trying to solve: foraccumulated assets to become active capital and put additional production in motion, theymust be fixed and realized in some particular subject "which lasts for some time at least afterthat labour is past. It is, as it were, a certain quantity of labour stocked and stored up to beemployed, if necessary, upon some other occasion." What I take from Smith is that capital isnot the accumulated stock of assets but the potential it holds to deploy new production. Thispotential is, of course, abstract. It must be processed and fixed into a tangible form before wecan release it—just like the potential nuclear energy in Einstein's brick.

This essential meaning of capital has been lost to history. Capital is now confused withmoney, which is only one of the many forms in which it travels. It is always easier toremember a difficult concept in one of its tangible manifestations than in its essence. Themind wraps itself around "money" more easily than "capital." But it is a mistake to assumethat money is what finally fixes capital. Money facilitates transactions, allowing us to buyand sell things, but it is not itself the progenitor of additional production.

Potential energy in assets
What is it that fixes the potential of an asset so that it can put additional production intomotion? What detaches value from a simple house and fixes it in a way that allows us torealize it as capital?

We can begin to find an answer by using our energy analogy. Consider a mountain lake. Wecan think about this lake in its immediate physical context and see some primary uses for it,such as canoeing and fishing. But when we think about this same lake as an engineer wouldby focusing on its capacity to generate electrical energy, by means of a hydroelectric plant, asan additional value beyond the lake's natural state as a body of water, we suddenly see thepotential created by the lake's elevated position. The challenge for the engineer is finding outhow he can create a process that allows him to convert and fix this potential into a form thatcan be used to do additional work.

Capital, like energy, is a dormant value. Bringing it to life requires us to go beyond looking atour assets as they are to actively thinking about them as they could be. It requires a processfor fixing an asset's economic potential into a form that can be used to initiate additionalproduction.

Although the process that converts the potential energy in the water into electricity is wellknown, the one that gives assets the form required to put in motion more production is notknown. This is so because that key process was not deliberately set up to create capital but forthe more mundane purpose of protecting property ownership. As the property systems ofWestern nations grew, they developed, imperceptibly, a variety of mechanisms that graduallycombined into a process that churned out capital as never before.

Hidden conversion process of the West
In the West, this formal property system begins to process assets into capital by describingand organizing the most economically and socially useful aspects about assets, preservingthis information in a recording system—as insertions in a written ledger or a blip on acomputer disk—and then embodying it in a title. A set of detailed and precise legal rulesgoverns this entire process. Formal property records and titles thus represent our sharedconcept of what is economically meaningful about any asset. They capture and organize allthe relevant information required to conceptualize the potential value of an asset and so allowus to control it.

Any asset whose economic and social aspects are not fixed in a formal property system isextremely hard to move in the market. How can the huge amounts of assets changing handsin a modern market economy be controlled, if not through a formal property process?Without such a system, any trade of an asset, say a piece of real estate, requires an enormouseffort just to determine the basics of the transaction: Does the seller own the real estate andhave the right to transfer it? Can he pledge it? Will the new owner be accepted as such bythose who enforce property rights? What are the effective means to exclude other claimants?This is why the exchange of most assets outside the West is restricted to local circles oftrading partners.

Developing and former communist countries' principal problem is clearly not the lack ofentrepreneurship: the poor have accumulated trillions of dollars of real estate during the pastforty years. What the poor lack is easy access to the property mechanisms that could legallyfix the economic potential of their assets so that they could be used to produce, secure, orguarantee greater value in the expanded market.

Why has the genesis of capital become such a mystery? Why have the rich nations of theworld, so quick with their economic advice, not explained how indispensable formal propertyis to capital formation? The answer is that the process within the formal property system thatbreaks down assets into capital is extremely difficult to visualize. It is hidden in thousands ofpieces of legislation, statutes, regulations, and institutions that govern the system. Anyonetrapped in such a legal morass would be hard-pressed to figure out how the system actuallyworks. The only way to see it is from outside the system—from the extralegal sector—whichis where my colleagues and I do most of our research.

The formal property systems of the West produce six effects that allow their citizens togenerate capital.

(1) Fixing the economic potential of assets. Capital is born by representing in writing—in atitle, a security, a contract, and other such records—the most economically and sociallyuseful qualities about the asset as opposed to the visually more striking aspects of the asset.This is where potential value is first described and registered. The moment you focus yourattention on the title of a house, for example, and not on the house itself, you haveautomatically stepped from the material world into the conceptual universe where capitallives.

The proof that formal property is pure concept comes when a house changes hands: nothingphysically changes. Property is not the house itself but an economic concept about the house,embodied in a legal representation that describes not its physical qualities but rathereconomically and socially meaningful qualities we humans have attributed to the house (suchas the ability to use it for a variety of purposes—for example, to generate funds forinvestment in a business without having to sell the house—by providing security to lenders inthe form of liens, mortgages, easements, or other covenants). In advanced nations, this formalproperty representation functions as the means to secure the interests of other parties and tocreate accountability by providing all the information, references, rules, and enforcementmechanisms required to do so.

Legal property thus gave the West the tools to produce surplus value over and above itsphysical assets. Whether anyone intended it or not, the legal property system became thestaircase that took these nations from the universe of assets in their natural state to theconceptual universe of capital where assets can be viewed in their full productive potential.

(2) Integrating dispersed information into one system. The reason capitalism has triumphedin the West and sputtered in the rest of the world is because most of the assets in Westernnations have been integrated into one formal representational system. This integration did nothappen casually. Over decades in the nineteenth century, politicians, legislators, and judgespulled together the scattered facts and rules that had governed property throughout cities,villages, buildings, and farms and integrated them into one system. This "pulling together" ofproperty representations, a revolutionary moment in the history of developed nations,deposited all the information and rules governing the accumulated wealth of their citizensinto one knowledge base. Before that moment, information about assets was far lessaccessible. Every farm or settlement recorded its assets and the rules governing them inrudimentary ledgers, symbols, or oral testimony. But the information was atomized,dispersed, and not available to any one agent at any given moment.

Developing and former communist nations have not created unified formal property systems.In all of these countries I have studied, I have never found just one legal system but insteaddozens and hundreds, managed by all sorts of organizations, some legal, others extralegal,ranging from small entrepreneurial groups to housing organizations. Consequently, whatpeople in those countries can do with their property is limited to the imagination of theowners and their acquaintances. In Western countries, where property information isstandardized and universally available, what owners can do with their assets benefits from thecollective imagination of a larger network of people.

It may surprise the Western reader that most of the world's nations have yet to integrateextralegal property agreements into one formal legal system. For Westerners today, theresupposedly is only one law—the official one. Diverse informal property arrangements, however, were once the norm in every nation—the West's reliance on integrated propertysystems is a phenomenon of at most the last two hundred years. The reason it is so hard tofollow the history of the integration of widespread property systems is that the process tookplace over a very long time.

(3) Making people accountable. The integration of all property systems under one formalproperty law shifted the legitimacy of the rights of owners from the political context of localcommunities to the impersonal context of law. Releasing owners from restrictive localarrangements and bringing them into a more integrated legal system facilitated theiraccountability.

By transforming people with real property interests into accountable individuals, formalproperty created individuals from masses. People no longer needed to rely on neighborhoodrelationships or make local arrangements to protect their rights to assets. They were thusfreed to explore how to generate surplus value from their own assets. But there was a price topay: once inside a formal property system, owners lost their anonymity while their individualaccountability was reinforced. People who do not pay for goods or services they haveconsumed can be identified, charged interest penalties, fined, and embargoed, and can havetheir credit ratings downgraded. Authorities are able to learn about legal infractions anddishonored contracts; they can suspend services, place liens against property, and withdrawsome or all of the privileges of legal property.

Respect in Western nations for property and transactions is hardly encoded in their citizens'DNA; it is rather the result of having enforceable formal property systems. Formal property'srole in protecting not only ownership but also the security of transactions strongly encouragescitizens in advanced countries to respect titles, honor contracts, and obey the law. Legalproperty thus invites commitment.

The lack of legal property thus explains why citizens in developing and former communistnations cannot make profitable contracts with strangers and cannot get credit, insurance, orutilities services: they have no property to lose. Because they have no legal property, they aretaken seriously as contracting parties only by their immediate family and neighbors. Peoplewith nothing to lose are trapped in the grubby basement of the precapitalist world.

(4) Making assets fungible. One of the most important things a formal property system doesis transform assets from a less accessible condition to a more accessible condition, so thatthey can do additional work. Unlike physical assets, representations of assets are easilycombined, divided, mobilized, and used to stimulate business deals. By uncoupling theeconomic features of an asset from its rigid, physical state, a representation makes the asset"fungible"—able to be fashioned to suit practically any transaction.

By describing all assets in standard categories, an integrated formal property system enablesthe comparison of two architecturally different buildings constructed for the same purpose. This allows one to discriminate quickly and inexpensively between similarities anddifferences in assets without having to deal with each asset as if it were unique.

Standard property descriptions in the West are also written to facilitate the combination ofassets. Formal property rules require assets to be described and characterized in a way thatnot only outlines their singularities but also points out their similarities to other assets, thusmaking potential combinations more obvious. Through the use of standardized records, onecan determine how to exploit a particular asset most profitably.

Representations also enable one to divide assets without touching them. Whereas an assetsuch as a factory may be an indivisible unit in the real world, in the conceptual universe offormal property representation it can be subdivided into any number of portions. Citizens ofadvanced nations are thus able to split most of their assets into shares, each of which can beowned by different persons, with different rights, to carry out different functions.

Formal property representations can also serve as movable stand-ins for physical assets,enabling owners and entrepreneurs to simulate hypothetical situations in order to exploreother profitable uses of their assets. In addition, all standard formal property documents arecrafted in such a way as to facilitate the easy measurement of an asset's attributes. Byproviding standards, Western formal property systems have significantly reduced thetransaction costs of mobilizing and using assets.

(5) Networking people. By making assets fungible, by attaching owners to assets, assets toaddresses, and ownership to enforcement, and by making information on the history of assetsand owners easily accessible, formal property systems converted the citizens of the West intoa network of individually identifiable and accountable business agents. The formal propertyprocess created a whole infrastructure of connecting devices that, like a railway switchyard,allowed the assets (trains) to run safely between people (stations). Formal property'scontribution to mankind is not the protection of ownership: squatters, housing organizations,mafias, and even primitive tribes manage to protect their assets quite efficiently. The propertysystem's real breakthrough is that it radically improved the flow of communications aboutassets and their potential. It also enhanced the status of their owners.

Western legal property also provides businesses with information about assets and theirowners, verifiable addresses, and objective records of property values, all of which lead tocredit records. This information and the existence of integrated law make risk moremanageable by spreading it through insurance-type devices as well as by pooling property tosecure debts.

Few seem to have noticed that the legal property system of an advanced nation is the centerof a complex web of connections that equips ordinary citizens to form ties with both thegovernment and the private sector, and so to obtain additional goods and services. Withoutthe tools of formal property, it is hard to see how assets could be used for everything theyaccomplish in the West.

(6) Protecting transactions. One important reason why the Western formal property systemworks like a network is that all the property records (titles, deeds, securities, and contractsthat describe the economically significant aspects of assets) are continually tracked andprotected as they travel through time and space. Public agencies are the stewards of anadvanced nation's representations. They administer the files that contain all the economicallyuseful descriptions of assets, whether land, buildings, chattels, ships, industries, mines, orairplanes. These files will alert anyone eager to use an asset about things that may restrict orenhance its utilization, such as encumbrances, easements, leases, arrears, bankruptcies, ormortgages. In addition to public record-keeping systems, many other private services (escrowand closing organizations, appraisers, etc.) have evolved to assist parties in fixing, moving,and tracking representations so they can easily and securely produce surplus value.

Although they are established to protect the security of both ownership and transactions, it isobvious that Western systems emphasize the latter. Security is principally focused onproducing trust in transactions so that people can more easily make their assets lead a parallellife as capital. The Western emphasis on the security of transactions allows citizens to movelarge amounts of assets with very few transactions. In most developing countries, by contrast,the law and official agencies are trapped by early colonial and Roman law, which tilt towardprotecting ownership. They have become the custodians of the wishes of the dead.

Conclusion
Much of the marginalization of the poor in developing and former communist nations comesfrom their inability to benefit from the six effects that formal property provides. Thechallenge these countries face is not whether they should produce or receive more money butwhether they can understand the legal institutions and summon the political will necessary tobuild a property system that is easily accessible to the poor.

The French historian Fernand Braudel found it a great mystery that at the inception ofWestern capitalism, it served only a privileged few, just as it does elsewhere in the worldtoday:

The key problem is to find out why that sector of society of the past, which Iwould not hesitate to call capitalist, should have lived as if in a bell jar, cut offfrom the rest; why was it not able to expand and conquer the whole of society?. . . [Why was it that] a significant rate of capital formation was possible onlyin certain sectors and not in the whole market economy of the time?

I believe the answer to Braudel's question lies in restricted access to formal property, both inthe West's past and in developing and former communist countries today. Local and foreigninvestors do have capital; their assets are more or less integrated, fungible, networked, andprotected by formal property systems. But they are only a tiny minority—those who canafford the expert lawyers, insider connections, and patience required to navigate the red tapeof their property systems. The great majority of people, who cannot get the fruits of theirlabor represented by the formal property system, live outside Braudel's bell jar.

The bell jar makes capitalism a private club, open only to a privileged few, and enrages thebillions standing outside looking in. This capitalist apartheid will inevitably continue until weall come to terms with the critical flaw in many countries' legal and political systems thatprevents the majority from entering the formal property system.

The time is right to find out why most countries have not been able to create open formalproperty systems. This is the moment, as Third World and former communist nations areliving through their most ambitious attempts to implement capitalist systems, to lift the belljar.

This article is derived from Chapter 3 of the author's book, The Mystery of Capital: Why Capitalism Triumphsin the West and Fails Everywhere Else (New York: Basic Books and London: Bantam Press/Random House,2000).

References:
Fernand Braudel, The Wheels of Commerce (New York: Harper and Row, 1982)
Adam Smith, The Wealth of Nations (1776; reprint, London: Everyman's Library, 1977).