Journal Issue

Hernando De Soto: Integrating the poor into official legal system can unleash their economic potential

International Monetary Fund. External Relations Dept.
Published Date:
January 2000
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The hour of capitalism’s greatest triumph is its hour of crisis.” This warning comes not from Jubilee 2000 or Das Kapital, but from Hernando De Soto in The Mystery of Capital. The Peruvian economist and author of the best-seller The Other Path repeated his warning on September 28 at an event organized by the American Enterprise Institute-Brookings Joint Center for Regulatory Studies.

De Soto suggested that capitalism is at risk because it does not fully utilize the tremendous potential of its largest constituency, the poor. The poor save and accumulate assets like everyone else. What they lack are widespread property rights that would allow them to readily convert their assets into capital. Copying the property rights and formal laws of the West, as some developing countries have done, does not provide the poor with true access to the fruits of capitalism. Why this is the case is the “mystery” De Soto solves in his new book.

Dead capital

Why can’t the poor participate in capitalism? According to De Soto, the poor hold their resources in the form of “dead capital”—that is, capital that cannot be used to its fullest. Though the poor in these countries—a majority of their populations—do save and accumulate assets, their property rights to these assets are not adequately protected, because these rights are recognized only within the limited informal (“extralegal” to use De Soto’s favored term) economy within which the poor operate. The assets therefore cannot be readily turned into capital, cannot be widely traded, and cannot be used as collateral for a loan. In short, the wealth of the poor cannot easily be used to produce additional value.

And why don’t the poor try to enter the legal economy? The obstacles are daunting, according to De Soto and his research team. They have been crisscrossing the globe documenting the hurdles the poor face in finding a legal job, entering formal business, or acquiring legal housing. The examples are shocking:

  • In Haiti, it takes two years to meet the bureaucratic requirements needed to obtain a five-year lease on government land.

  • In Peru, the research team spent nine months of nearly full-time work to obtain all the certifications required to register a small-scale garment workshop. The cost of legal registration was over $1,200—30 times the monthly minimum wage.

  • In Egypt, registering a lot on state-owned desert land involves over 75 bureaucratic procedures at some 30 public and private agencies. The process can take anywhere from 5 to 14 years.

Faced with these obstacles, the poor develop an alternate extralegal economy using informal arrangements to protect and mobilize their assets. Though such economies are often vibrant, they nevertheless do not make fullest use of the capital that the poor manage to accumulate. De Soto argued that it was a shame to waste the tremendous potential of the poor, people who have shown they have the talent and enthusiasm to eke out an existence from practically nothing.

The U.S. experience

The advanced economies went through a similar stage in their history, De Soto suggested, when the property rights of the poor were ill defined. Take the case of the United States. During its colonial period, English common law proved woefully inadequate to guide the emerging nation. In England, occupying land without having a title to it—“squatting”—was against the law. In the United States, however, squatting on available land quickly became a common practice. George Washington himself, De Soto observed, complained about the banditti who had taken over some of his property. The squatters began inventing their own forms of property titles. These extralegal rights were traded, just like official titles (and became the source of legal titles decades later).

Politicians struggled to keep pace with these developments, De Soto said. They tried to dislodge squatters by sending in troops. De Soto noted that in describing one such attack, an observer reported that though the troops “burnt the cabins, broke down the fences, and tore up the potato patches...three hours after the troops were gone, these people returned again, repaired the damage, and are now settled upon the land in open defiance of the Union.” When violence didn’t work, piecemeal reform of the formal property system was attempted through the passage of more than 500 different laws to reform the property system. But, according to De Soto, the complicated procedures associated with these laws hampered the goal of putting property into the hands of private citizens.

Over time, sympathy for the rights of squatters increased and forced the U.S. Congress to draft legislation absorbing them into the legal system. One important legal innovation, De Soto explained, was to allow squatters to buy land they had improved before it was offered for public sale. This principle, known as “preemption,” became the key to integrating extra-legal property arrangements in the United States. In 1862, Congress passed the celebrated “Homestead Act,” giving 160 free acres to any settler willing to live on the land for five years and develop it. According to De Soto, this “was less an act of official generosity than the recognition of a fait accompli...” But the Homestead Act had great symbolic value, because it signaled that by embracing the extralegal arrangements of the squatters, “formal law had legitimized itself, becoming the rule for most people in the United States rather than the exception.” The experience of many other advanced nations is no different. For instance, De Soto noted that in Switzerland at the turn of the twentieth century, Eugen Huber integrated into one codified law the disparate conventions that protected property in different parts of the country.

Resurrecting dead capital

What are the lessons of the U.S. experience for developing countries? In many of these countries today, the official law has not been able to keep up with popular initiative, and government has lost control, according to De Soto. Thus, the primary lesson of the U.S. experience is that ignoring extralegal arrangements or trying to stamp them out—without a plan to channel these arrangements into the formal legal structure—is a strategy doomed to failure. Instead, De Soto said, the governments in these countries should uncover the existing social contracts on property established by the poor and integrate them into the official law.

This is painstaking work. De Soto and his research team spent months uncovering informal property rights in Haiti’s urban areas, where some of the poorest people in the world live and where over half the population is illiterate. Contrary to the predictions of experts on Haiti, De Soto’s team found that every owner of an extralegal plot of land, shack, or building had “at least one document to defend his right—even his squatting rights.” In other countries as well, the research teams found informal social contracts under-girding property owned by the poor.

Once governments have uncovered information on existing social contracts, they can begin the work of organizing the contracts into temporary formal statutes, comparing informal arrangements with existing formal law, and deciding how each has to be adjusted to build a common regulatory framework for all citizens. According to De Soto, this is how Western law was built, “by gradually discarding what was not useful and enforceable and absorbing what worked” It is also the path followed by Peru between 1984 and 1994, when “formalization” of the assets of the poor became part of the country’s political agenda, and legislation and regulations drafted by De Soto’s organization were approved by the Peruvian Congress.

Role of the IFIs? Iffy, at best

De Soto was dismissive of the role played by international financial institutions (IFIs) in helping the poor acquire property rights. With respect to the work of the IMF, De Soto agreed that stability in foreign exchange markets, free trade, foreign investment, and other remedies in the “Western pharmacopoeia” were beneficial in expanding the formal market sectors in developing countries. But he complained that far too much emphasis was placed on allowing legal businesses and foreign investors to prosper and not enough on making sure that the poor had the means to participate in the expanded market system. De Soto was also critical of the role of the World Bank. Though the Bank funds “titling projects” in countries such as Brazil, De Soto argued that these projects end up as “maps of the physical locations of shanty towns rather than maps of the informal property rights” of the poor. It is the latter that are needed to carry out the task of organizing the formal law around the existing social contracts of the poor.

De Soto concluded that capitalism should be more than an economic system that benefits only the elites “who live inside the bell jars” of developing countries, and globalization should be more than a process of connecting the bell jars across countries.

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