CHAPTER ONE
The Mystery of Capital
Why Capitalism
Triumphs in the West and Fails Everywhere
Else
By HERNANDO DE SOTO
Basic Books
Read the Review
The Five Mysteries
of Capital
The key problem is to find out why that sector of society of the
past, which I would not hesitate to call capitalist, should have lived
as if in a bell jar, cut off from 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 only in certain
sectors and not in the whole market economy of the time?
—Fernand Braudel, The Wheels of Commerce
The hour of capitalism's greatest triumph is its hour of crisis.
The fall of the Berlin Wall ended more than a century of political
competition between capitalism and communism. Capitalism
stands alone as the only feasible way to rationally organize a modern
economy. At this moment in history, no responsible nation has
a choice. As a result, with varying degrees of enthusiasm, Third
World and former communist nations have balanced their budgets,
cut subsidies, welcomed foreign investment, and dropped their tariff
barriers.
Their efforts have been repaid with bitter disappointment.
From Russia to Venezuela, the past half-decade has been a time of
economic suffering, tumbling incomes, anxiety, and resentment;
of "starving, rioting, and looting," in the stinging words of
Malaysian prime minister Mahathir Mohamad. In a recent editorial
the New York Times said, "For much of the world, the marketplace
extolled by the West in the afterglow of victory in the Cold
War has been supplanted by the cruelty of markets, wariness
toward capitalism, and dangers of instability." The triumph of
capitalism only in the West could be a recipe for economic and
political disaster.
For Americans enjoying both peace and prosperity, it has been
all too easy to ignore the turmoil elsewhere. How can capitalism
be in trouble when the Dow Jones Industrial average is climbing
higher than Sir Edmund Hillary? Americans look at other nations
and see progress, even if it is slow and uneven. Can't you eat a Big
Mac in Moscow, rent a video from Blockbuster in Shanghai, and
reach the Internet in Caracas?
Even in the United States, however, the foreboding cannot be
completely stifled. Americans see Colombia poised on the brink of
a major civil war between drug-trafficking guerrillas and repressive
militias, an intractable insurgency in the south of Mexico, and
an important part of Asia's force-fed economic growth draining
away into corruption and chaos. In Latin America, sympathy for
free markets is dwindling: Support for privatization has dropped
from 46 percent of the population to 36 percent in May 2000.
Most ominously of all, in the former communist nations capitalism
has been found wanting, and men associated with old regimes
stand poised to resume power. Some Americans sense too that one
reason for their decade-long boom is that the more precarious the
rest of the world looks, the more attractive American stocks and
bonds become as a haven for international money.
In the business community of the West, there is a growing concern
that the failure of most of the rest of the world to implement
capitalism will eventually drive the rich economies into recession.
As millions of investors have painfully learned from the evaporation
of their emerging market funds, globalization is a two-way
street: If the Third World and former communist nations cannot
escape the influence of the West, neither can the West disentangle
itself from them. Adverse reactions to capitalism have also been
growing stronger within rich countries themselves. The rioting in
Seattle at the meeting of the World Trade Organization in
December 1999 and a few months later at the IMF/World Bank
meeting in Washington, D.C., regardless of the diversity of the
grievances, highlighted the anger that spreading capitalism
inspires. Many have begun recalling the economic historian Karl
Polanyi's warnings that free markets can collide with society and
lead to fascism. Japan is struggling through its most prolonged
slump since the Great Depression. Western Europeans vote for
politicians who promise them a "third way" that rejects what a
French best-seller has labeled L'Horreur économique.
These whispers of alarm, disturbing though they are, have thus
far only prompted American and European leaders to repeat to the
rest of the world the same wearisome lectures: Stabilize your currencies,
hang tough, ignore the food riots, and wait patiently for
the foreign investors to return.
Foreign investment is, of course, a very good thing. The more of
it, the better. Stable currencies are good, too, as are free trade and
transparent banking practices and the privatization of state-owned
industries and every other remedy in the Western pharmacopoeia.
Yet we continually forget that global capitalism has been tried
before. In Latin America, for example, reforms directed at creating
capitalist systems have been tried at least four times since independence
from Spain in the 1820s. Each time, after the initial
euphoria, Latin Americans swung back from capitalist and market
economy policies. These remedies are clearly not enough. Indeed,
they fall so far short as to be almost irrelevant.
When these remedies fail, Westerners all too often respond not
by questioning the adequacy of the remedies but by blaming
Third World peoples for their lack of entrepreneurial spirit or
market orientation. If they have failed to prosper despite all the
excellent advice, it is because something is the matter with them:
They missed the Protestant Reformation, or they are crippled by
the disabling legacy of colonial Europe, or their IQs are too low.
But the suggestion that it is culture that explains the success of
such diverse places as Japan, Switzerland, and California, and culture
again that explains the relative poverty of such equally
diverse places as China, Estonia, and Baja California, is worse than
inhumane; it is unconvincing. The disparity of wealth between
the West and the rest of the world is far too great to be explained
by culture alone. Most people want the fruits of capital—so much
so that many, from the children of Sanchez to Khrushchev's son,
are flocking to Western nations.
The cities of the Third World and the former communist countries
are teeming with entrepreneurs. You cannot walk through a
Middle Eastern market, hike up to a Latin American village, or
climb into a taxicab in Moscow without someone trying to make a
deal with you. The inhabitants of these countries possess talent,
enthusiasm, and an astonishing ability to wring a profit out of
practically nothing. They can grasp and use modern technology.
Otherwise, American businesses would not be struggling to control
the unauthorized use of their patents abroad, nor would the U.S.
government be striving so desperately to keep modern weapons
technology out of the hands of Third World countries. Markets
are an ancient and universal tradition: Christ drove the merchants
out of the temple two thousand years ago, and Mexicans were taking
their products to market long before Columbus reached
America.
But if people in countries making the transition to capitalism
are not pitiful beggars, are not helplessly trapped in obsolete ways,
and are not the uncritical prisoners of dysfunctional cultures, what
is it that prevents capitalism from delivering to them the same
wealth it has delivered to the West? Why does capitalism thrive
only in the West, as if enclosed in a bell jar?
In this book I intend to demonstrate that the major stumbling
block that keeps the rest of the world from benefiting from capitalism
is its inability to produce capital. Capital is the force that
raises the productivity of labor and creates the wealth of nations.
It is the lifeblood of the capitalist system, the foundation of
progress, and the one thing that the poor countries of the world
cannot seem to produce for themselves, no matter how eagerly
their people engage in all the other activities that characterize a
capitalist economy.
I will also show, with the help of facts and figures that my
research team and I have collected, block by block and farm by
farm in Asia, Africa, the Middle East, and Latin America, that
most of the poor already possess the assets they need to make a
success of capitalism. Even in the poorest countries, the poor save.
The value of savings among the poor is, in fact, immense—forty
times all the foreign aid received throughout the world since 1945.
In Egypt, for instance, the wealth that the poor have accumulated
is worth fifty-five times as much as the sum of all direct foreign
investment ever recorded there, including the Suez Canal and the
Aswan Dam. In Haiti, the poorest nation in Latin America, the
total assets of the poor are more than one hundred fifty times
greater than all the foreign investment received since Haiti's independence
from France in 1804. If the United States were to hike
its foreign-aid budget to the level recommended by the United
Nations—0.7 percent of national income—it would take the richest
country on earth more than 150 years to transfer to the world's
poor resources equal to those they already possess.
But they hold these resources 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, by contrast, 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 that 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. By this process the West injects life into assets
and makes them generate capital.
Third World and former communist nations do not have this
representational process. As a result, most of them are undercapitalized,
in the same way that a firm is undercapitalized when it
issues fewer securities than its income and assets would justify.
The enterprises of the poor are very much like corporations that
cannot issue shares or bonds to obtain new investment and finance.
Without representations, their assets are dead capital.
The poor inhabitants of these nations—five-sixths of humanity—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 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.
This is the mystery of capital. Solving it requires an understanding
of why Westerners, by representing assets with titles, are able
to see and draw out capital from them. One of the greatest challenges
to the human mind is to comprehend and to gain access to
those things we know exist but cannot see. Not everything that is
real and useful is tangible and visible. Time, for example, is real,
but it can only be efficiently managed 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, from the creators of integrated title systems and corporate
stock to Michael Milken, were able to reveal and extract capital
where others saw only junk by devising new ways to represent
the invisible potential that is locked up in the assets we accumulate.
At this very moment you are surrounded by waves of
Ukrainian, Chinese, and Brazilian television that you cannot see.
So, too, are you surrounded by assets that invisibly harbor capital.
Just as the waves of Ukrainian television are far too weak for you
to sense them directly but can, with the help of a television set, be
decoded to be seen and heard, so can capital be extracted and
processed from assets. But only the West has the conversion process
required to transform the invisible to the visible. It is this disparity
that explains why Western nations can create capital and the
Third World and former communist nations cannot.
The absence of this process in the poorer regions of the
world—where two-thirds 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.
How could something so important have slipped our minds? It
is not uncommon for us to know how to use things without
understanding why they work. Sailors used magnetic compasses
long before there was a satisfactory theory of magnetism.
Animal breeders had a working knowledge of genetics long
before Gregor Mendel explained genetic principles. Even as the
West prospers from abundant capital, do people really understand
the origin of capital? If they don't, there always remains
the possibility that the West might damage the source of its own
strength. Being clear about the source of capital will also prepare
the West to protect itself and the rest of the world as soon
as the prosperity of the moment yields to the crisis that is sure to
come. Then the question that always arises in international
crises will be heard again: Whose money will be used to solve
the problem?
So far, Western countries have been happy to take their system
for producing capital entirely for granted and to leave its
history undocumented. That history must be recovered. This
book is an effort to reopen the exploration of the source of capital
and thus explain how to correct the economic failures of poor
countries. These failures have nothing to do with deficiencies in
cultural or genetic heritage. Would anyone suggest "cultural"
commonalities between Latin Americans and Russians? Yet in
the last decade, ever since both regions began to build capitalism
without capital, they have shared the same political, social, and
economic problems: glaring inequality, underground economies,
pervasive mafias, political instability, capital flight, flagrant disregard
for the law. These troubles did not originate in the
monasteries of the Orthodox Church or along the pathways of
the Incas.
But it is not only former communist and Third World countries
that have suffered all of these problems. The same was true of the
United States in 1783, when President George Washington complained
about "banditti ... skimming and disposing of the cream of
the country at the expense of the many." These "banditti" were
squatters and small illegal entrepreneurs occupying lands they did
not own. For the next one hundred years, such squatters battled for
legal rights to their land and miners warred over their claims
because ownership laws differed from town to town and camp to
camp. Enforcing property rights created such a quagmire of social
unrest and antagonism throughout the young United States that
the Chief Justice of the Supreme Court, Joseph Story, wondered in
1820 whether lawyers would ever be able to settle them.
Do squatters, bandits, and flagrant disregard of the law sound
familiar? Americans and Europeans have been telling the other
countries of the world, "You have to be more like us." In fact, they
are very much like the United States of a century ago when it too
was an undeveloped country. Western politicians once faced the
same dramatic challenges that leaders of the developing and former
communist countries are facing today. But their successors
have lost contact with the days when the pioneers who opened the
American West were undercapitalized because they seldom possessed
title to the lands they settled and the goods they owned,
when Adam Smith did his shopping in black markets and English
street urchins plucked pennies cast by laughing tourists into the
mud banks of the Thames, when Jean-Baptiste Colbert's technocrats
executed 16,000 small entrepreneurs whose only crime was
manufacturing and importing cotton cloth in violation of France's
industrial codes.
That past is many nations' present. The Western nations have so
successfully integrated their poor into their economies that they
have lost even the memory of how it was done, how the creation of
capital began back when, as the American historian Gordon Wood
has written, "something momentous was happening in the society
and culture that released the aspirations and energies of common
people as never before in American history." The "something
momentous" was that Americans and Europeans were on the
verge of establishing widespread formal property law and inventing
the conversion process in that law that allowed them to create
capital. This was the moment when the West crossed the demarcation
line that led to successful capitalism—when it ceased being a
private club and became a popular culture, when George
Washington's dreaded "banditti" were transformed into the
beloved pioneers that American culture now venerates.
* * *
The paradox is as clear as it is unsettling: Capital, the most essential
component of Western economic advance, is the one that has
received the least attention. Neglect has shrouded it in mystery—in
fact, in a series of five mysteries.
The Mystery of the Missing Information
Charitable organizations have so emphasized the miseries and
helplessness of the world's poor that no one has properly documented
their capacity for accumulating assets. Over the past five
years, I and a hundred colleagues from six different nations have
closed our books and opened our eyes—and gone out into the
streets and countrysides of four continents to count how much the
poorest sectors of society have saved. The quantity is enormous.
But most of it is dead capital.
The Mystery of Capital
This is the key mystery and the centerpiece of this book. Capital is
a subject that has fascinated thinkers for the past three centuries.
Marx said that you needed to go beyond physics to touch "the hen
that lays the golden eggs"; Adam Smith felt you had to create "a
sort of waggon-way through the air" to reach that same hen. But
no one has told us where the hen hides. What is capital, how is it
produced, and how is it related to money?
The Mystery of Political Awareness
If there is so much dead capital in the world, and in the hands of
so many poor people, why haven't governments tried to tap into
this potential wealth? Simply because the evidence they needed
has only become available in the past forty years as billions of people
throughout the world have moved from life organized on a
small scale to life on a large scale. This migration to the cities has
rapidly divided labor and spawned in poorer countries a huge
industrial-commercial revolution—one that, incredibly, has been
virtually ignored.
The Missing Lessons of U.S. History
What is going on in the Third World and the former communist
countries has happened before, in Europe and North America.
Unfortunately, we have been so mesmerized by the failure of so
many nations to make the transition to capitalism that we have
forgotten how the successful capitalist nations actually did it. For
years I visited technocrats and politicians in advanced nations,
from Alaska to Tokyo, but they had no answers. It was a mystery. I
finally found the answer in their history books, the most pertinent
example being that of U.S. history.
The Mystery of Legal Failure: Why Property Law Does Not Work
Outside the West
Since the nineteenth century, nations have been copying the laws
of the West to give their citizens the institutional framework to
produce wealth. They continue to copy such laws today, and obviously
it doesn't work. Most citizens still cannot use the law to convert
their savings into capital. Why this is so and what is needed to
make the law work remains a mystery.
The solution to each of these mysteries is the subject of a chapter
in this book.
* * *
The moment is ripe to solve the problem of why capitalism is
triumphant in the West and stalling practically everywhere else.
As all plausible alternatives to capitalism have now evaporated,
we are finally in a position to study capital dispassionately and
carefully.
(C) 2000 Hernando de Soto All rights reserved. ISBN: 0-465-01614-6
