R&L: In the first sentence of your book, The Mystery of Capital, you write, “The hour of capitalism’s greatest triumph is its hour of crisis.” The great triumph, of course, is capitalism’s victory over communism. What is the great crisis?
De Soto: Everyone had high expectations at the fall of the Berlin Wall, when we thought that the “end of history” was in sight because market economies would allow all to flourish, but now there is a general feeling of discontent. This is certainly the case in Latin America; most are discontent, though they have not lost hope. So the crisis, as I see it, is that the economic systems that were established throughout the Third World and former Soviet Union to replace past patrimonialist and collectivist systems have not benefited the large majority of the population. My argument is that this failure does not indicate that market economics does not work but, rather, that something is missing in the capitalist formula as it exists in five-sixths of the world.
R&L: And finding this missing thing is the mystery of capital.
De Soto: That’s right. What the book tries to convey is that the traditional reforms associated with establishing a capitalist system—monetary stability, fiscal equilibrium, privatization—are definitely not enough. What makes the capitalist system function well in the United States, Western Europe, Japan, and the four Asian tigers is a very good property and transaction legal system. As both Adam Smith and Karl Marx explained, what gives the market economy system its power is essentially the wide-spread division of labor, what we today call specialization. Specialization has been possible in the Western world throughout these last two centuries because of the ability of specialists to create and exchange capital among themselves, and that ability exists because the West has good property law, which allowed for good market transactions. For at least 70 to 80 percent of the world’s population, for former communist nations and developing countries, a legal system allowing for the definition of property rights and their transaction in an orderly market is not in place.
R&L: What is this property and transaction legal system?
De Soto: It is what you in the United States have right under your noses. Every asset, from a bicycle all the way up to a nuclear plant, is essentially titled within the law. Every act inside your legal system is done according to written rules and can be followed within up-to-date records, where transactions, debts, and investments can be tracked. Every company is owned by people represented in its shares. Every home and automobile has a recorded property title or deed, which allows the identification of who owns what and where. All developing and former communist nations, with the exception of maybe 10 to 20 percent of their population, do not have such records or rules.
R&L: What do they have?
De Soto: They have what you in the United States used to have about two hundred years ago: The majority of people own things outside the legal system, under customary devices that I call extra-legal law, which encompasses all forms of arrangements that are not codified or do not operate within the law. If you go to any village in the Amazon or any small town in Egypt, it is very clear who owns what and who has transacted with whom, but only at the level of the town. It is a little market economy that ranges maybe no more than five or ten city blocks. There is no way for transactions to occur on a national—much less, global—scale. In other words, throughout the Third World and the former communist nations, there are thousands of little market economies that cannot be interconnected and, therefore, cannot join that larger market economy within which the division of labor is possible.
Let me give you an example. In the mid-nineteenth century, California was divided by the Gold Rush miners, some three million Americans, into eight hundred jurisdictions, each governed by local law created by the miners themselves. Most of the assets in California did not abide either by the rules dictated by the Mexicans, who used to own the territory, or by United States federal law; they abided by local arrangements that grew in customary ways. That is the situation of most of the former communist nations. The result, of course, is not chaos but anarchy—not one single order but many hundreds or thousands of little orders unable to cooperate on a large scale, form capital, or create a prosperous market economy.
R&L: Why is capital mysterious?
De Soto: Something seems to have escaped us in the course of the last one hundred fifty years. Capital was a big issue for economists of the eighteenth and early nineteenth centuries, Smith and Marx included. These economists said that the most important aspect of capital, what distinguishes it from any other physical good, is the fact that it is metaphysical. Capital is not money. It is not a physical asset. It is value. And it is the most important part of economy. (The word capital always refers to something that is important, such as a capital city or capital punishment.) What is interesting is that all the classical economists—and that includes Smith and Marx—said the new capitalist system was creating metaphysical value. But none of them really described it, and what I try to indicate is that there are values to things that are hard to see but that the West’s legal system, with its rules and titles, manages to capture. That is the mystery.
And that is why when you buy or sell a car in the United States, you exchange a piece of paper that abides by certain rules. That is what gives you not just physical possession but also metaphysical right over the car. If you look at the capital markets of the West, you see markets where property titles in the form of shares or bonds transport value. In other words, capital is essentially metaphysical but is captured in documents that represent value. And failing to understand that real value is captured by the legal system and its symbols is why most of the attempts of five-sixths of the world to establish working market economies have failed.
R&L: In your book, you argue that the economic success of the West is due, in part, to the parallel life that assets are able to lead because of these pieces of paper that capture their value. What is this parallel life, and why is it so important for wealth creation?
De Soto: Maybe I can give you an example. In 1990, the Peruvian Telephone Company, which was managed by the government, though supposedly owned by those who owned telephones, had a value on the Lima Stock Exchange of $53 million. That very year the decision was made to privatize it. In the process, it was discovered that the company was improperly titled, because Western telecommunications companies were not willing to buy the paper that represented it. We Peruvians, like everyone in the Third World, then spent the early 1990s redescribing and retitling the assets of our telephone, electric, and other major utility companies in such a way that the titles were sound and thus could be traded internationally. This retitling cost a lot of money and took a lot of time. Three years and over twenty million dollars later, we produced a title that was acceptable to foreign companies. After bids were solicited, Telephonic of Spain paid $2 billion—thirty-seven times the $53 million that it cost only three years earlier.
So when you have good paper, it is able to capture the value of invisible things. In the case of the Peruvian Telephone Company, paper captured all its goodwill and the rights over possible operations of cellular phones. It allowed whoever owned the company to issue shares and bonds for loans. It immediately increased the price of everything, because not everything that is valuable about a company resides in its physical assets. A company’s value has a lot to do with the way it interconnects with the rest of the system, so when the Peruvian Telephone Company was paperized, it was able to lead a life in the financial and investment sphere that it could not lead when it was simply a physical asset.
R&L: The same thing happens with real estate deeds and titles, correct?
De Soto: Yes. When you apply for a loan and use your real estate for collateral, you do not use the house itself but the paper representing the house. In other words, there is much more in the representation than in the physical asset itself, and that fact allows a house to have a parallel life. When you walk down a New York City street, the buildings are doing the same things physically that they are doing in Lima. But metaphysically, the building in New York is also acting as a form of security to anchor insurance policies, as collateral against some kind of a loan, and as an address to which services can be delivered and from which debts and rates and taxes can be collected. Those metaphysical functions do not exist for the majority in Lima or for over five-sixths of the world’s population. That parallel life, that paperization within the legal system, permits the basis for generating capital.
R&L: Since the Third World cannot paperize its assets for such a parallel life, they suffer the phenomenon of what you call dead capital.
De Soto: That’s right. Over the past fifty years, most of the poor and marginalized have been moving to the cites of the Third World; the population of Port-Au-Prince has multiplied seventeen times, Lima’s population has multiplied seven times, and Mexico City has also multiplied something like seven times so that the city’s population is now over twenty-five million. What these people who are outside the system are telling us is that they want to move into the large division of labor of the capital system, but we are finding out that the systems of these countries have no way of representing these people within the legal order and, therefore, no way of allowing them to leverage the value of the assets.
R&L: Many in the West have argued that the Third World is poor because it does not possess the kind of culture in which capitalism can thrive. You object strenuously to this. Why?
De Soto: Because I do not see any proof. How do you explain the fact that capitalism works in Japan, Hong Kong, Singapore, Taiwan, and South Korea but not in North Korea and the rest of China? If only white Anglo-Saxon Protestants have the right culture, how do you explain that cities such as Venice and Florence actually developed the first basis for capitalism?
Aside from not being based on facts, such an argument does not offer much hope. I think all cultures have the possibility of creating and accumulating wealth, which has to do with legal systems. The argument that poverty is due to lack of good property laws is certainly much more solid than those about culture. Of course, this does not mean that culture is not an important issue. However, focusing only on culture does not tell you how to hold these other aspects together, while focusing on law does allow you to get a grip on the problems that could be of a cultural origin, because law is able to put culture into an order that allows it to serve productivity.
R&L: At the end of your book, you write, “The poor are not the problem but the solution.” In what way is this true?
De Soto: Take the case of Egypt. My research team and I were invited to Egypt by the government to make an inventory of the poor’s assets versus all the other sectors of the economy. We found that since the end of the Second World War the poor accumulated some $245 billion worth of assets, including real estate and small enterprises. How big is $245 billion? Fifty-five times bigger than all foreign investment in Egypt over the last two hundred years, including the Suez Canal and the Aswan Dam. Fifty times greater than all foreign aid received by Egypt. Thirty times greater than the Cairo Stock Exchange. So the poor are the solution. The problem is that they do not have a legal system that allows them to bring together capital, create new enterprises, leverage their assets, and cooperate on a global scale. The poor certainly were the solution in the United States, which was built by poor, entrepreneurial pioneers. And the formula has not changed in the last two hundred years.