The Mystery of Capital

by Hernando De Soto

  The United States, Canada, Japan, and Europe—the twenty-five developed nations of the world—have prospered so much more than those without their kind of accessible, integrated formal property systems that today no one would seriously propose economic solutions that disregarded the need for formal property. That is why most developing and former communist nations today recognize the principle of universal access to property rights as a political necessity as well as an implicit ingredient of their macroeconomic and market reform programs.

  The political intention to legalize the assets of the poor has been consecrated in Latin American law for nearly two centuries. The first Peruvian constitution, written in 1824, just two years after independence from Spain, clearly stated that the poor, then mostly Peruvians of native origin, were the legitimate owners of their land. When it nevertheless became obvious that Peru’s elites were gradually dispossessing the indigenous poor, the government enacted over the years a series of laws reinforcing the intent of the Peruvian constitution. None of them worked. The indigenous people got statutes that generally confirmed that their assets were legally theirs. What they did not get were the mechanisms that would have allowed them to fix the economic rights over their assets in representations protected by law.

  The reason is now very clear: In Peru (and many other countries outside the West), most legal procedures to create formal property are not geared to process extralegal proofs of ownership that lack any visible chain of title—which, of course, is the only kind of proof the poor have. Nor can existing law follow and record subsequent changes in an asset’s title as transactions continue to modify property relationships over time. As we saw in Chapter 2, today, in the best of circumstances, with modern maps, computers, human rights organizations standing by, and all the best intentions in the world, legal procedures for recording titles and changes to them can take twenty years. From the evidence we have uncovered, it seems that Peruvian natives in the nineteenth century faced delays that were no better and probably worse. For people up against such obstacles, creating extralegal rules to protect their assets was the only rational thing to do.

  When it became clear that the mandatory laws were not helping the indigenous people of Peru concretize their rights, the economic elites swung back into action, dreaming up new tricks to circumvent the laws’ intent. Where official titles did not exist, the well connected and their lawyers began inventing them, reconstituting the documentary evidence and getting local authorities and notaries to issue legal titles in their favor (títulos supletorios, as they were called). Once again the elite dispossessed indigenous Peruvians or forced them to sell on the cheap. The government, instead of investigating why the poor were not able to use the law efficiently for their benefit, assumed that the law was not the problem but that the poor were inherently inferior. So instead of improving the law, they extracted some of the poor and built firewalls around their land. In 1924, Peru enacted a major law to protect natives from further legal ploys by packing thousands of them into rural farming communities where the transfer of rights to any land was expressly prohibited. In thus protecting the natives from the scheming and swindling elites, they also deprived them, albeit unintentionally, of the basic tools for creating capital.

  These rural enclaves, however, could hold only a small percentage of the native population. By the late 1960s and early 1970s, the remaining majority were still vulnerable and unhappy and, consequently, a potentially volatile class, especially with the sudden emergence of strong and well-organized leftist movements. To defuse this new threat, the Peruvian government, like those of many Third World countries, instituted agrarian reform programs that expropriated massive tracts of lands from large farms and ranches (haciendas) to create more than six hundred government-run agrarian cooperatives for farmers. Again the aim was noble: to make sure that natives had access to real estate. What turned even these efforts into failures was that many of the indigenous people disliked working inside imposed bureaucracies. They broke up the cooperatives into smaller and private parcels of land and turned once again to more familiar and flexible extralegal arrangements to protect their newly established rights. What the government had not taken into account was that when people finally acquire property, they have their own ideas about how to use and exchange it. If the legal system does not facilitate the people’s needs and ambitions, they will move out of the system in droves.

  Peruvian history offers an important lesson for reformers of all political stripes. Government programs to give property to the poor have failed over the past 150 years whether they followed the bias of the right (private property rights through mandatory law) or of the left (protecting poor people’s land in government-run collectives). The crippling political agendas of “left versus right” are largely irrelevant to the needs of most people in developing countries. These people move out of the law not because the law has privatized or collectivized them but simply because it does not address what they want. Their wants may vary. Sometimes they need to combine their properties and sometimes they need to divide them. If the law does not help them, then they will help themselves outside the law. What characterizes the enemies of property and capital formation in developing and former communist countries is not whether they are leftists or rightists, but whether they are the friends of the status quo. Governments in developing countries need to stop living on the prejudices of Westerners hung up on the cruelty of enclosure and the creation of property in Britain centuries ago or on the bloody dispossession of Native Americans throughout North America. Those moral debts have to be paid in the West, not abroad. What governments in developing countries have to do is listen to the barking dogs in their own communities and find out what their law should say. Only then will people stop living outside it.

  Formal law is increasingly losing its legitimacy as people continue to create property beyond its reach. Our data from abroad indicated that from the 1960s to the 1990s, the extralegal sector had grown larger not only in Peru but also in other developing and former communist nations. Presuming that the failure of mandatory law was not only a Peruvian phenomenon, in 1994 I put together a special research team to find out if in the last thirty years international financial institutions had reported carrying out any successful and massive “formalization” program in the Third World—one where all assets were properly represented and integrated into one system so as to produce capital. Despite months of methodically sifting through the records of the U.S. Treasury and international organizations, we found nothing even remotely resembling the success of advanced nations.

  What we did find was that over the past four decades various governments had started many such programs by earmarking billions of dollars to finance a huge array of property-related activities such as surveying, mapping, and computerized recording systems. These projects had two main features in common: An extraordinary number of them had been prematurely aborted because of poor results (“lots of new maps and computers, but few new formal owners,” reported one government project manager in Brazil); and with the exception of some rural Thai property certification programs, none of these efforts succeeded in turning extralegal assets into legal ones. We certainly found no evidence that assets were being transformed into capital.

  Was it because governments did not really care? Certainly not. In Peru, for instance, the government had tried to formalize property at least twenty-two times in the four hundred years since the Spanish conquest. Their success rate: zero. We called on titling authorities from other developing countries and obtained similar replies: Major programs had failed or had only a marginal impact. Again, and significantly, nobody we talked to in those countries could claim that any consequential number of titles issued were fungible and fixed in such a way as to be part of an integrated network where capital formation could take place.

  The evidence is overwhelming: No matter how hard developing and former communist nations have tried, no matter how good their intentions, there remains an enormous dist
ance between what mandatory law commands and what has to be done for the law to work. Mandatory law is not enough. As Andrzej Rapaczynski has pointed out:

  The notion that simply instituting an appropriate legal regime will establish a set of property rights that can undergird a modern economic system is deeply implausible, because most property rights can only be marginally enforced by the legal system. The core of the institution of ownership is a matter of unquestioned and largely unconscious social and economical practices that must be rooted in non-legal developments. This is the old Hobbesian problem: when most people obey the law, the government can enforce it effectively and [relatively] cheaply against the few individuals who break it. But when obedience breaks down on a large enough scale, no authority is strong enough to police everyone. In such a setting, with enforcement becoming less and less effective, individuals have an incentive to follow their own interests, regardless of any paper constraints.5

  Throughout recent history, developing and former communist countries have not lacked political will, budgets, international manifestos, or mandatory law drawn up with the explicit purpose of giving rights over assets to the majority of citizens. The problem is that when governments set out to ensure the property rights of poor people, they behave as if they were traveling to a place where there is a property vacuum, as if they were landing on the moon. They presume that all they have to do is fill this vacuum with mandatory law. In most cases, however, there is no vacuum. People already hold a huge amount of property through extralegal arrangements. Although the assets of the poor may be outside the official law, their rights to those assets are nevertheless governed by social contracts of their own making. And when the mandatory law does not square with these extralegal conventions, the parties to those conventions will resent and reject the intrusion.

  Rooting Law in the Social Contract

  Extralegal social contracts on property underpin nearly all property systems and are part of the reality of every country, even in today’s United States.6 As Richard Posner has reminded us, property is socially constructed.7 This means that property arrangements work best when people have formed a consensus about the ownership of assets and the rules that govern their use and exchange. Outside the West, extralegal social contracts prevail for a good reason: They have managed much better than formal law to build on the actual consensus between people about how their assets ought to be governed. Any attempt to create a unified property system that does not take into account the collective contracts that underpin existing property arrangements will crash into the very roots of the rights most people rely on for holding onto their assets. Efforts to reform property rights fail because officials in charge of drafting new legal rules do not realize that most of their citizens have firmly established their own rules by social contract.

  The notion that social contracts underlie successful laws goes all the way back to Plato, who thought that legitimacy had to be founded on some type of social contract. Even Immanuel Kant, in his statements against Locke, wrote that a social contract has to precede real ownership; all property rights spring from social recognition of a claim’s legitimacy. To be legitimate, a right does not necessarily have to be defined by formal law; that a group of people strongly supports a particular convention is enough for it to be upheld as a right and defended against formal law.

  That is why property law and titles imposed without reference to existing social contracts continually fail: They lack legitimacy. To obtain legitimacy, they have to connect with the extralegal social contracts that determine existing property rights. The problem, of course, is that these social contracts are dispersed throughout hundreds of extralegal jurisdictions in scattered villages and city neighborhoods. The only systematic way to integrate these social contracts into a formal property system is by building a legal and political structure, a bridge, if you will, so well anchored in people’s own extralegal arrangements that they will gladly walk across it to enter this new, all-encompassing formal social contract. But this must be a bridge so solid that it does not crack and send everyone stampeding back into extralegal arrangements, a bridge so wide that no one falls from it. That is how, over hundreds of years, the West did it. Harold Berman reminds us:

  The systematization of law within various communities…was possible only because there had previously developed an informal structure of legal relations in those communities…. The Western legal tradition grew—in the past—out of the structure of social and economic interrelationships within and among groups on the ground. Behavioral patterns of interrelationship acquired normative dimensions: usages were transformed into custom…and custom into law.8

  Building a legal and political bridge from social contracts scattered “on the ground” into one national law is what Eugen Huber did in Switzerland at the turn of the twentieth century. Huber adjusted the Roman doctrines of Swiss statutory law to the customs, rules, and behaviors dispersed throughout the cities, towns, and farmland of his country. He pulled together all conventions on property into one codified law that secured the rights and obligations of people in line with the local norms to which they were accustomed. Huber liked to quote an old German saying, “Das Gesetz muss aus dem Gedanken des Volkes gesprochensein,” which, loosely translated, means, “The law must come from the mouth of the people.” American law, as we saw in Chapter 5, showed the same respect for existing social contracts. Its strength was not its doctrinaire or professional coherence but its usefulness in the hands of authorities who wanted to transform undeveloped assets into productive ones.

  The transitions from extralegal relations to unified formal property in advanced nations were not built on thin air. The systematization of the laws that underpin modern property rights systems was possible only because authorities allowed preexisting extralegal relationships among groups on the ground sometimes to supersede official laws: “Law both grows upward out of the structures and customs of the whole society,” wrote Berman, “and moves downward from the policies and values of the rulers of society. Law helps to integrate the two.”9

  By rooting formal property law in social contracts to which people were already committed, the governments of the West achieved the widespread popular acceptance required to overcome any resistance. The result was one legal system for property. With that in place, they were able to begin integrating dispersed conventions into one national social contract. And where once only the owner of a house and his neighbors could confirm whether the house belonged to him, with the advent of formal property the whole nation knew he was the owner. Formal property titles allowed people to move the fruits of their labor from a small range of validation into that of an expanded market. Western nations had thus laid out the energy plant to power a modern market and capitalist system.

  Shifting the recognition of ownership from local arrangements into a larger order of economic and social relationships made life and business much easier. People no longer needed to rely on burdensome parochial politicking to protect their rights to assets. Formal property freed them from the time-consuming local arrangements inherent to closed societies. They could now control their assets. Even better, with adequate representations in hand, they could focus on their assets’ economic potential. And because their real estate and businesses could now be located easily and identified nationally, owners lost their anonymity and became accountable. Gradually, these mechanisms of legal property set the stage for expanded markets and the creation of capital involving a huge number of players.

  The Solidity of Precapitalist Social Contracts

  Are the extralegal social contracts that prevail in developing countries today a solid enough foundation for creating official law? Without a doubt. There is a mountain of evidence that government officials implicitly and explicitly comply with the extralegal social contracts when they operate in the undercapitalized sector. Reports of international donor organizations refer continuously, albeit obliquely, to extralegal conventions. How could governments have developed agric
ultural and urban renewal projects in the poorest sections of their countries without coming to terms with extralegal beneficiary organizations? The fact that governments and international financial institutions help squatter settlements put in public services (roads, electricity, water, and schools), in defiance of property law, is an implicit recognition of extralegal property arrangements. As Robert Cooter and Thomas Ulen have noted, “the terms [of property rights] are often more efficient when people agree upon them than when a law-maker imposes them.”10

  Extralegal social contracts rely on a combination of customs, ad hoc improvisations, and rules selectively borrowed from the official legal system. In the absence of legal protection from the state in most developing nations, it is extralegal law that regulates the assets of most citizens. This may sound oxymoronic or even subversive to Western readers who have come to believe there is only one law to obey. But my experience visiting and working in dozens of developing nations has made it clear to me that legal and extralegal laws coexist in all of them. As Margaret Gruter succinctly puts it: