The Mystery of Capital by decree

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The Mystery of Capital
21st Annual Morgenthau Memorial Lecture on Ethics and Foreign Policy

Hernando de Soto

Developing countries stand to realize $10 trillion in "dead capital" if they transform their political and legal
practices into systems compatible with Western norms, argues Peruvian economist Hernando de Soto.




                           Online transcript of lecture delivered on May 8, 2002, at the Harmonie Club in
                           New York City.

                           DR. ROSENTHAL: Welcome to the 21st Annual Hans Morgenthau Memorial
                           Lecture on Ethics and Foreign Policy. This event is the highlight of the Carnegie
                           Council's programming year. I am delighted that there are so many of you here to
                           enjoy it.

                           The English critic Samuel Johnson said that great literature should serve two
                           purposes: it should delight and instruct. We like to think of this lecture program in
                           that vein, as an occasion to gather together to delight in good fellowship and to
                           learn from our distinguished lecturer. This program also affords us the opportunity
                           to recommit ourselves to addressing the most urgent moral problems of our time,
                           and in doing so to honor the memory of Hans Morgenthau. Hans Morgenthau was
                           not only an important figure in the life and development of the Carnegie Council;
he was a central figure in the intellectual life of America and in the lives of all who care about ethics, politics,
peace, and social justice.

In his recently-published biography of Professor Morgenthau, Christoph Frei explains that when Hans
Morgenthau fled from Europe in 1937, an unrecognized young scholar with few worldly possessions and few
useful connections, he came to America as a frustrated idealist. "For Morgenthau," Frei writes, "the world
was not a friendly place. In his native Germany he had no professional prospects as the Nazis rose to
power. He went on to Switzerland, then to Spain, Italy, and France. At the end of his odyssey, he arrived in
the United States, where he was forced to begin completely anew."

Begin anew he did, overcoming hardship to land a professorship at the University of Chicago, where he
taught and wrote his master work Politics among Nations, first published in 1948. In Politics among Nations
and other writings, Professor Morgenthau warned of the hazards of moral crusading, the self-righteous
moralizing that characterizes the rhetoric of so much foreign policy; and of the dangers of its opposite,
cynical amoralism, where politics is seen as nothing more than an arena where the strong do what they will
and the weak do what they must. The objective was to find a middle ground, a place where moral clarity and
moral commitment could be acted upon without becoming either counterproductive or insignificant.
Professor Morgenthau's realism, known so well for its emphasis on power and interests, was a moral
concept at its very essence. It was the realism of an idealist who had seen the worst of human experience.

Our speaker this evening understands this view of the world. He begins with the insights and experiences of
a realist and the aspirations of an idealist. If I may quote from last year's New York Times Magazine profile
of him by way of introduction:

Hernando de Soto didn't start out planning to save the world. Born in southern Peru, he left early, after his
father, a diplomat, took a post abroad, eventually ending up in Geneva. Returning to Peru, he was deeply
struck by the overwhelming poverty. The gulf between Europe and his homeland was inexplicable, he
thought, when the quality of the people was the same. After returning to Switzerland for his master's degree,
Hernando de Soto went to work for the GATT. By age thirty, he was chief executive of an engineering firm



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with worldwide business reach.

In 1983, Hernando de Soto founded the Institute for Liberty and Democracy (ILD), headquartered in Lima,
Peru, whose purpose was to study the informal economy of Peru and to push for reforms to help the poor.
The Economist magazine has deemed the ILD as one of the two most important think tanks in the world,
and the German magazine Entwicklung und Zusammenarbeit [Development and Cooperation] has called
Mr. de Soto one of the most important development theoreticians of the last millennium.

Hernando de Soto is the author of two major books on economic and political development: The Other Path,
published in 1986, and The Mystery of Capital, published in the year 2000. A thinker, a doer, an adviser to
world leaders, Hernando de Soto has shown great vision, creativity, persistence, and personal courage in
his quest for social justice. We are fortunate to have him as our 21st Annual Morgenthau Memorial Lecturer.

MR. DE SOTO: Thank you. I am delighted to be here. Professor Morgenthau taught me in Switzerland many
years ago, when I studied at the Graduate School of International Studies. I thought at that time that I would
be a theoretician. But then I went on to spend my life in business, doing practical things. Occasionally,
however, the temptation has come to synthesize what I have learned from everyday life.

My primary interest is in development. I come from a developing country, and I am extremely concerned with
why we do not make it. Talking with my friend, Francis Fukuyama, the other day, I asked him, "What
separates the 5 billion people in the developing world from the 1 billion people who have made it?" His reply
was, "Of course, trust. People in developed countries have a network of trust. They trust each other."

A recent statistical survey carried out in many countries asked citizens: Do you trust the people that you
meet? As it turns out, 60 percent of Scandinavians trust each other; about 45-50 percent of North Americans
trust each other; but only 7 percent of Brazilians trust each other and 5 percent of Peruvians. I was very
depressed about this, but then was able to cheer myself up remembering that I would soon be traveling to
the United States, where most people trust each other.

Until, that is, I went through immigration in Miami. The immigration official said, "Would you please identify
yourself?" I said, " I'd be delighted to. My name is Hernando de Soto. I am the son of Alberto de Soto of
Arequipa and Rosa Polar Moquegua; and they have two children." He said, "Would you mind just showing
me your passport?" Which I did, as I realized that he did not trust me about my identity, but what he did trust
was my passport. I said, "Interesting. I thought my identity was with me, but obviously it is not associated
with my physical presence; it has been transferred to and is represented in a uniform and standardized
written document, which provides information and is based on rules that allow me to travel globally."

Then I came here to my hotel where I have been staying for about fifteen years.

"It's good to see you again, Mr. de Soto."

I said, "Great to see you as well, Herb."

"Tell me how you will be paying."

I said, "Promptly, as usual."

But then his next question was, "Mr. de Soto, will you please show me your credit card?"

Here is a man I have known for fifteen years, he is a member of one of the New York tribes that I am familiar
with, and he still does not really trust me. At that point I realized that neither the commercial credibility nor
the track record I had established at the hotel was valid. What made me financially credible was the
representation of my status in a plastic card, allowing me to prove to anyone around the globe that I pay my
debts.

That reminded me of Immanuel Kant, who said that people only know about other things through
representations; nobody really knows anything directly. Both of these Americans that I had met in just a few



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hours were able to trust me through two forms of representation -- passports and credit cards -- that your
society has, while mine does not.

By now you may have noticed that I came in with an apple. I hope you understand that this is my apple. I've
got various witnesses to prove that this is my apple. But no matter where I look on this apple, there is
nothing on it or in it that shows it is mine. Nowhere does it say, "This is Hernando's apple," or "This is Mr. de
Soto's apple." It doesn't tell you whether I can transfer it, pledge it, lend it, deposit it as a guarantee, use it as
collateral, nor does it say whether I can export it, import it, or cut it up into segments and divide among
partners.

What that means, therefore, is that property, like my identification or my reputation, is essentially a man-
made construct. It has nothing to do with the physical world. The documents I have mentioned indicate
whether we can be trusted, whether we can be identified, and whether our possessions belong to us and
what we can do with them and how we can leverage them. In other words, all of the elements that make
market economies work are not really physical things; they are constructs about physical things. There
would seem to be two worlds: the world of apples, of physical things; and the world of manmade constructs,
of representations, which come through law and which allow us to communicate among ourselves about
physical things -- myself and the apple.

When someone goes to the Chicago Mercantile Exchange to sell 10,000 head of cattle, he doesn't drive the
cattle into the building. He brings along documents proving he owns the 10,000 head of cattle, and these
documents tell you things you could not see if you looked each cow in the eye.

If you go to the London Metal Exchange, people are trading nonferrous metals, but nowhere does a forklift
take bars of gold from one side of the room to the other when somebody trades. Rather, the traders move
paper that represents these bars in the form of property. Transactions take place by transferring property
rights to these bars; and such rights are concretized on legal paper or computer blips. The only assets that
can efficiently travel locally -- or interationally in the global economic system -- are those legally represented
on paper, subject to rules that enforce property rights. The foundation of the economy, of capital, is property
law.

This point was made some time ago by both Adam Smith and Karl Marx. They both said that the most
important thing you could have in economics was capital. Whether or not they knew they were living during
the Industrial Revolution, they could see that something was happening whereby one could draw from
objects and from human actions a variety of things to create wealth that would not have otherwise been
possible. Capital, they said, is what makes the world go around and what makes economics function.

Tellingly, the word "capital" comes from the Latin word capita, meaning "head." It appears to have originally
stood for "head of cattle" or other livestock. Livestock have always been important sources of wealth beyond
the basic meat, milk, hides, wool, and fuel they provide. Livestock can also reproduce themselves. Thus the
term "capital" begins to do two jobs simultaneously -- capturing the physical dimensions of assets (livestock)
as well as their potential to generate surplus value.

First Smith and then Marx were very explicit that capital is not money; capital is a value that is very difficult
to capture. Marx even called capital the "hen that lays the golden eggs." Without it, the economy would not
function; and it was worthwhile to get normal people to control capital, because otherwise it would be
controlled by an exclusive minority that could exploit the world.

Likewise, Smith said that capital meant the accumulation of physical wealth -- but could only promote growth
provided it was appropriately fixed. What did he mean by "fixed"? Nobody who dealt in the worlds of politics,
economics, and law ever thought about the world as only physical things -- apples. They always thought
about objects with their metaphysical attributes.

Thus, when Adam Smith talked about fixing the value of things, he meant fixing as property, which meant
attaching that property to a legal document -- just as my identity is fixed in my passport and my capacity to
pay, in my credit card.

For Smith, economic specialization -- the division of labor and the subsequent exchange of products in the
market -- was the source of increasing productivity and therefore "the wealth of nations." Smith said that if



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products are not fixed, they remain dead; they have no life for the world of economics. One of the examples
he gave was of the pin factory, where, if you couldn't divide the tasks involved in making a pin among the
workers, productivity would suffer. What made this specialization and exchange possible was capital, which
Smith defined as the stock of assets accumulated for productive purposes. Entrepreneurs could use their
accumulated resources to support specialized enterprises until they could exchange their products for other
items that were needed. The more capital that was accumulated, the more specialization could occur, and
the greater the society's productivity.


Privatizing the Compañia Peruana de Teléfonos
Around 1990, Peru decided to go down the path established by the Washington Consensus. This meant that
we would:

    1.   stabilize our currency;
    2.   promote fiscal stability; and
    3.   unburden the state from its management functions -- in other words, privatize everything that
         belonged to the state.

Some of the young researchers in my institute were invited to serve on the legal team given the job of
privatizing the Peruvian telephone company, the Compañia Peruana de Teléfonos. Though run by
government, the company was in fact owned by the people who used the telephones; their shares, in the
Lima Stock Exchange, were valued at $53 million. But as soon as we tried to sell the company, nobody
would buy it. The legal team went all the way to New York to talk to AT&T and BellSouth -- but neither
company would hear of it. Likewise, France Télécom wouldn't so much as consider it. Why? Because the
company wasn't properly titled -- it wasn't correctly represented.

For the privatization process to succeed, we had to re-title the Peruvian telephone company. In other words,
we had to give it a passport that allowed it to travel and to spell out the law for settling any conflicts over the
company's ownership with the private sector or the national government. Peru spent $18 million simply on
redefining the Peruvian telephone company in such a way that people in New York, Paris, London, and
Shanghai could look at it and say, "Ah, I recognize what I'm buying, what my rights are."

In 1993, once the title was clear, the team went abroad again, held an auction, and the company was bought
by the Telefónica of Spain for $2 billion. $2 billion is thirty-seven times the value of $53 million, which as you
may recall was what the company was worth when we first began the privatization process.

We didn't paint the company, we didn't repair the broken windows, we didn't touch any physical parts. We
just refigured its passport. We touched the way it was defined by law such that interested parties throughout
the world could concentrate on the value of the company and understand it in similar terms.

In essence, we had created capital. The difference between the $53 million and the $2 billion had nothing to
do with the apple. All we did was change the property law and standardize it in terms that the global market
could understand so that the title could travel around the world accomplishing multiple functions. We
connected it with the larger market, with the larger global division of labor, making it easier for people to
identify the company, assess its value, settle disputes over its ownership, and issue shares and bonds
against its worth.

This is what happens when things are inserted into the world of law. People can then recognize them and
see a value that would not otherwise be obvious, just like the man who received me in immigration and the
man who knows me so well after so many years in my New York hotel but needs the identification that
comes through law and through a card that is an acceptable device for transferring value. The capitalist
system relies on rules and symbols.

Some nations do not have the capacity through their legal systems to represent economic value in such a
manner that it

    •    can increase the information about the commodity in question;




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    •    has mobility -- I can travel all over the world with my credit card; and
    •    can be seen as fungible -- meaning it can be split into different parts or have various functions
         attributed to it.

What allows the apple to act as collateral is not something intrinsic within the apple itself but the law
assigning it a particular function.

This means that the capitalist system is a system of representations, which when working correctly, converts
-- as Adam Smith would have said -- dead into live capital. When it doesn't go smoothly, these things have a
much smaller value than otherwise. Returning to the issue of underdevelopment, the question now
becomes: do developing countries suffer from the problem that most of their assets are unrepresented? That
is to say, their assets have no passports, no credit cards, thus no way of being symbolized and of traveling
in the larger market.

Imagine yourself walking down a street in New York City. You see parks, land, and buildings. Now think of
going down a street in Mexico City. You also see parks, land, and buildings. But how much of what
surrounds you in each of these cities is live capital?

When President Fox asked for my institute's advice, we gave him a list of 100 things a building does in New
York that it does not do in Mexico. When you are in Mexico, buildings give you shelter and allow you to work
and live in them. But buildings in New York further allow you to mortgage and rent them, and to have an
address where you can collect electricity or water bills. When it has all of these other functions assigned to it
by law, an asset becomes live capital, as Adam Smith would have said; when it does not, it is dead capital.

My institute assists heads of state all around the world with investigating how much dead capital their
countries have. To what extent are the nation's assets and the work of its people represented in legal
documents? To what extent are these assets and labor governed by rules that allow them to act as
collateral, fetch credit, and encourage the owners of goods to issue shares against which a nation can foster
investment? We investigate the country's law books and find out how many of its buildings are titled; how
many of its cows are represented in such a way that you don't have to drive them to the mercantile
exchange.


Cairo's Tilting Buildings
< it?? about us to talk come you can So isn?t. it and is law the where capital, live versus capital dead
classifying of way your that understand I market. black sector informal large a have we because relate Peru.
in doing been what seen I?ve>

We said, "Yes, but we'd like to talk to you in Egyptian terms so that we are quite clear about what we are
conversing, because if I give you just Peruvian figures and maps, you will say, 'Oh, these poor Peruvians.
I'm sure that it's bad in Egypt, but probably not that bad.' So we have to talk about Egypt."

After a year-long project involving some six Peruvians and fifty Egyptians, my institute presented a four-
volume report to the Egyptian cabinet. Nobody was going to read four volumes, so we also gave them one
sheet of paper with five pictures. (If you can't sell your argument to a politician in ten minutes, you can't do
it.)

The first picture we showed them was a map of Cairo. One minister said, "I recognize the map and I
recognize that it is Cairo because of the way the Nile twists and turns. But what I don't recognize is the color
coding."

We had used nine different colors to identify the way real estate assets are held in Cairo. We had
discovered that as in Peru, most Egyptians work outside the law. It doesn't mean these people have no law.
Rather, they have rules that they themselves have created -- similar to what Americans did during the 19th
century. In the United States of 150 years ago, fines for disobeying the law were very different from village to
village; the sheriff basically established what the fine was. California, for instance, had 800 types of rules in
the mid-1880s, known as the Mining Claims Association.



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What America experienced then is similar to the Cairo of today. Cairo residents have nine different ways of
holding assets that are determined not by the government but by the people's own law. We told President
Mubarak that the gold band on the map represented buildings that have been built on agricultural land, thus
are extralegal. To which he responded, "But that's not only extralegal, that's unconstitutional, because our
national constitution clearly establishes that you can build only on desert land. We've got little agricultural
land and only one river to irrigate it. That's a crime."

I said, "It's outrageous. We can't have that. However, my team has used photogrammetry to measure the
number of buildings on agricultural land, of which there are 4,700,000. At $10,500 per building, established
by a surveyor that your government trusts and respects, I calculate that you've got about $50 billion of dead
capital in just the agricultural sector."

I told him that one of the other colors indicated buildings erected on cemeteries and that the color in the
center indicated public housing. His Minister of Housing immediately recognized this. He said, "The
government built that housing, so how can it be extralegal?"

I said, "Yes, I'm sure that you built them legally, but as you may recall, these buildings are in Nasser City,
where you built only two-story buildings. These are six stories. So you need to ask: Who built the other four
stories? Obviously, it was the people who lived in story number one and in story number two. They made a
deal and built stories number three, four, five, and six; I could show you other places where they even went
up to ten. You can see that in the Cairo horizon, where some of the buildings tilt slightly to one side or the
other."

All of a sudden, our Egyptian friend started realizing, as we had in Peru, that a large part of the enterprise in
his country was functioning outside the law right under his own nose, but until now he didn't have the
categories with which to distinguish one extralegal enterprise from another.

So what is the value of all the buildings that are owned extralegally, especially by the poor, in Egypt? The
reply is $241 billion. What percentage of Egyptians own real estate outside the law? The reply is 92 percent.
What proportion of Egyptian enterprises provide extralegal employment? It's 88 percent. Roughly 90 percent
of all Egyptians live outside the legal system.

How much is $241 billion? It's fifty-five times bigger than all foreign direct investment in Egypt over the last
200 years, including the Suez Canal and the Aswan Dam, thirty times greater than the market value of all
the companies recorded on the Cairo Stock Exchange, and roughly sixty-eight times the value of all foreign
and bilateral aid received by Egypt, including World Bank loans. In other words, the group in Egypt with the
largest accumulation of assets that could be converted into capital are the poor, but they're not inside the
legal system, they don't have "passports," and you can't create a market economy out of them until they are
governed by the rule of law.

Why does Egypt have so much illegality? Maybe there is something behind the Samuel Huntington "clash of
civilizations" theory that people who are not as pink and as Protestant as others not being able to create
capitalism. We Latin Americans have been thinking about this, wondering if Professor Huntington may be
right. But before we consider his theory, let's look at the obstacles to obtaining property in Egypt by legal
means. My institute examined Egyptian legal precedents to see how long it normally takes someone in
Egypt to build on a sand dune outside agricultural land. According to our findings, they need to do seventy-
seven contracts with government, which means visiting thirty-two government offices -- a process that
usually takes about seventeen years.

By this time my Egyptian friends were getting depressed. I said, "Don't get depressed. When we first got
started in Peru, the process of buying land legally took twenty-one years. And when we got depressed about
this figure, we said to ourselves, 'Don't be so depressed. In the Philippines it's about twenty-five years.'"

As mentioned earlier, we recently finished a study with President Fox to begin a large project to redesign the
property system in Mexico. The number of Mexicans living outside the law constitutes 78 percent of the total
population -- less than in Egypt, but still substantial. Mexicans hold extralegal assets of appproximately $315
billion, which is seven times the size of the country's total oil reserves, or twenty-nine times the size of its
foreign direct investment.




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Thus in Mexico you get the same picture as you do in Egypt and Peru -- I suspect you would also get it in
Russia or Montenegro. The industrial revolution has begun, but the instruments that allow capital to travel
and the market to function are simply not in place. When we do the sum total of what we believe are the
assets held in dead capital throughout the developing world -- including the former Soviet Union -- it
comes to about $10 trillion.

What seems to have happened in places like the United States and Western Europe is "exaptation." It's a
word -- the evolutionary biologist Richard Dawkins uses it to describe the evolution of language -- indicating
that species sometimes invent things for one purpose, and then it evolves a second purpose. Birds
developed feathers for insulation, but then feathers also helped them to fly. Let's see what happens when
we apply this principle to Western definitions of ownership, During the 18th and 19th centuries, the West
defined its property system. Originally, that system was developed to protect ownership, but through
representation it became the process that produces capital; the same process that Adam Smith and Karl
Marx were talking about.

The industrial revolution has now arrived in developing countries. Port-au-Prince in Haiti has grown
seventeen times in the last thirty-five years. Lima has grown seven times. Guayaquil in Ecuador has grown
eleven times. All over the world, from Egypt to the Philippines to Lima, there have been large migrations in
the last forty years, and many of the people one used to know about only through the Discovery Channel or
National Geographic have now, like Oliver Twist, advanced from presenting themselves at the desk of
charity run by the First Lady of the country to introducing themselves to the head of state as budding
entrepreneurs. You can't walk half a block in Cairo without somebody trying to make at least three deals with
you. These people are all entrepreneurs, yet they don't have the law on their side.

And just as advanced countries once learned that they had to change the law to give the poor property rights
-- that was the only way to harness the growing tide of energy from a new society that was sprouting up
spontaneously in response to the Industrial Revolution -- the developing world, too, needs to adapt its laws
to give the vast majority of people the property they require to participate in the standardized global
economy on an equal basis.


Lessons from Germany and Switzerland
As mentioned already, part of the answer could be cultural. Some cultures are capable of creating, over
time, a functioning legal system, whereas others are not. But in that case, the only way the legal system
could develop would be spontaneously. According to the findings of my institute, that is not the case. We
combed through the history books to see, for example, how Germany got its property system. It came as a
result of war. A law protecting property was created after Germany was defeated by Napoleon in 1807.
Having tried unsuccessfully to recruit troops, the Kaiser was looking for ways to recruit people and came up
with the idea of offering them property titles as a way of increasing the pool of those eligible for military
service.

500 years had passed since the Bauernkrieges, or European peasant wars, had begun, with the goal of
toppling the feudal system and giving property to ordinary people -- Martin Luther joined the struggle in 1520
with his writings condemning the tyranny and greed of the pope and his cardinals. By the early 19th century,
the German bourgeoisie could no longer resist the peasants' demands. The Stein-Hardenberg reforms were
introduced in 1833, enabling peasants to purchase the land they occupied by paying in installments. This
increased the pool of Germans who could go to war. The Prussians finally defeated Napoleon in 1870 -- and
in the process got a property system.

Something similar happened with the Swiss. At the end of the 19th century, Switzerland was one of the
poorest countries of Western Europe; but then the Swiss decided, when they saw their prosperous German
neighbors, to reform their property system. At that time, Switzerland was so poor that even travel agencies
were regulated under the newly-drawn up Swiss Federal Constitution. This was not because the Swiss were
traveling with phony pesos to Cancun but because they were being exported as cheap labor to Latin
America and as cannon fodder to Southern Europe.

Prodded by the Swiss Federal Council, the Swiss entrusted a civil lawyer, Eugen Hubert, to find out how
many of their citizens lived outside the law so that they could live within the law by possessing their own
property. After twenty years of study, Hubert concluded that the Swiss actually had 179 different forms of



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holding assets. It took another twenty years before the Swiss found a way of bringing these assets under
one code -- the Civil Code of 1908 -- and creating a solid Swiss property system. This still survives today.

But to us Latin Americans, the discovery of what the Americans and Europeans had done throughout the
19th century, how they had organized their property, would mean talking to dead Europeans and Americans,
where there's not much of a dialogue. And so we said: Isn't there somebody who is still alive whom we can
talk to about this?


The Japanese Experience
We decided to talk to the Japanese. Until 1945, Japan was, economically speaking, organized like a feudal
country. Under the occupation of General MacArthur, this changed. How? How do you take a system where
only a few people have access to the law and make sure that everybody has the same rights? Where is the
key to the lock?

We first perused the American history books, where we found some insinuations, as well as some data, but
not the details of what we needed to know. We looked at the Japanese books, but they were just too
technical. Ultimately, we managed to get some funds from a European foundation to locate the Japanese
who had executed the transformation -- seven surviving octogenarians who had overseen the process. We
invited them to the International House of Japan, and we Peruvians came over and said: "We're starting to
title Peru. We get all of our information from the bottom up. We find that there is a large informal extralegal
sector supporting various rules of law, and what we aim to do is bring all of these rules together under a
single legal system, one that meets international standards. Have you found a shortcut?"

Within two weeks, we had our answers. In fact, the Japanese had not used a shortcut. Our Japanese guests
showed us a poster from 1946, when the government was announcing to the population that Japan was
about to become a property economy. The problem is, the poster explained, that the government doesn't
know how property or assets are held.

The feudal system had a mechanism whereby the lords collected taxes and rents from people, but what the
Tanakas and the Sugiharas did with their assets was not the government's business. Ordinary citizens
traded amongst themselves -- bought, sold, redivided, and organized their assets. The feudal class wasn't
very well informed of what assets the Tanakas or the Sugiharas held and in what form. And as long as this
didn't threaten the social order, no one seemed to mind very much.

By the time General MacArthur arrived, Japan had a thriving informal sector. The basic organizational units
were groups of local residents that kept records of their members' landholdings and other assets. At the end
of World War II, there were 10,900 such organizations, indicating which parcels of land, buildings and
businesses each family in a particular neighborhood owned. In most of their ledger books, you see pictures
of individual Japanese sitting or standing on a plot of land with a sign saying, "I am Mr. Fujimoto; I own this."

Under MacArthur, the decision was taken to create a property system for Japan from the bottom up. The
aforementioned neighborhood organizations were officially recognized as land commissions and authorized
to transmit information on the holdings of the Tanakas and the Sugiharas to the prefectural authorities. They
told the prefectures who owned what and how that property should be determined. The prefectures then
reported to the Japanese government, which faced the task of codifying, professionalizing, and
systematizing the law.

In essence, these legal reforms constituted an anti-poverty program. Poor people -- of which there were
many in Japan after World War II -- were able to procure titles to their homes and businesses. The upshot
was a market economy that nearly all of the Japanese could participate in.

Our Japanese friends showed us another poster from that time that tells the bare bones of this story in a
series of three illustrations. During the Meiji Restoration, Japan imported mostly German as well as some
French law to consolidate the property rights of the Japanese ruling class. This law was torn up eventually,
as we see inside the first circle. Inside the second circle, we see farmers and neighborhood organizations
reporting on their local rules to the government. The third circle shows the new law of Japan, which still
stands today. This was all done by legalizing the informal law, the law that came from the bottom, with the



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active participation of Japanese people themselves.


No Law, No Capitalism
Why is all of this important? Since the fall of the Berlin Wall, the Russians, the Peruvians, the Egyptians, the
Filipinos, and the Mexicans have decided that we're going for capitalism. Yet none of the standard
macroeconomic recipes helped to create the rule of law.

When you look at the generous bilateral assistance the United States gives to our countries, there is very
little -- if any -- requirement for a rule of law. Same for the World Bank, which sees the rule of law as a
country's own internal matter. Yet capitalism can only take place where you are able to get a rule that allows
you to form capital, because capital can't be picked up except through a legal document. You can't issue
credit without the rule of law.

I don't know if you remember Donald Duck's billionaire uncle, who dives into a big swimming pool full of bills
and coins. In my organization, the Instituto Libertad y Democracia, we speak of the "Scrooge McDuck
syndrome" to describe the mentality that says that the world of money is distinct from the world of apples,
when this is simply not the case.

As you may know, banking got started in Holland over 400-500 years ago. Chambers of commerce issued
property titles on goods, which bankers were then able to use as collateral for issuing credit. Property came
first, money second.

We Latin Americans have the highest inflation rates in the world, so obviously money isn't the problem. The
problem is property and the rule of law -- that is where capitalism begins. In most developing countries, there
is no property. In essence, property provides the rules and symbols of orderly development. It also gives you
the possibility of enforcing the law peacefully.

You had a dramatic event less than a year ago here in New York, but three days after 9/11 you were able to
find out where thirteen of the terrorists had been because, thanks to your property system, you had the
paper trails necessary to trace their movements. But you still haven't gotten Osama bin Laden because he
lives in a country without property trails.

Some of you may remember the popular 1980s television series Miami Vice. It's about two very good-
looking American cops who are trying to get a bad Colombian or Peruvian, someone who looks very much
like myself. At the start of a typical episode, they talk to a beautiful blonde and ask, "Where is that cad
Hernando?" She says, "That Hernando, he is no longer here. He has gone to 353 Stewart Street." So they
get in their red convertible and go to 353 Stewart Street, where this beautiful brunette comes out and says,
"Hernando, that rat, he is not here anymore; he's at 101 Ocean Drive." They get back in their red convertible
and go off to 101 Ocean Drive. About forty-five minutes later, they catch the poor Peruvian. They have
succeeded at what the New York police call "skip tracing" -- using property information to get the man in
question without killing too many people around him (just one or two!).

The property system allows you not only to create capitalism, capture value, and settle property rights; it is
the basis for order. Likewise in international relations or relations with indigenous peoples, property gives
you the tools to settle disputes peacefully.

Since the Carnegie Council is interested in international affairs, I imagine that many in today's audience
have heard of Alsace Lorraine, the piece of land between Germany and France that has continually gone
back and forth from Germany to France, from France to Germany. But the reason it's not so contentious --
unlike what happens in border disputes within the Middle East or Latin America -- is that it doesn't matter
which nation has sovereignty. Monsieur Dupont gets to keep his property and Herr Schmidt to keep his.
Property ownership depends on who made the original deal. It is much more solid than sovereignty.

We are all brothers and sisters in this world, but there are too many of us to be able to recognize each other
by face. We need the rule of law, the system of passports. My book, The Mystery of Capital, describes how
Americans of about 150 years ago came to develop a formula for the rule of law. This gave your nation the
means for people to live peacefully and to generate wealth. Now the developing world needs to do the



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same. Globalization requires us to think about world order, but there can be no order without the rule of law.
Then -- and only then -- can we have true global justice.


Question & Answer Session
Q: I'm wondering about how property gets transferred to poor people in Peru or Egypt: From whom
it was transferred, and why did they allow the transfer to take place peacefully?

MR. DE SOTO: Let's take the example of Haiti, the poorest country in the Western hemisphere. Haiti
occupies the Western half of the island of Hispaniola, next to the Dominican Republic (see map). My
institute had a contract with President Jean-Bertrand Aristide to advise on how to convert dead into live
capital. To do that, we had to walk the shantytowns. There was no problem about defining what was illegal
and what was poor. It was all clearly visible.

We didn't find one shack in all of Haiti that doesn't have a property title; but not a single one of these titles
had been issued by government. What that means is that while their government attended to other issues,
Haitians went ahead with forming their own laws and settling their financial affairs. Somebody could of
course come back and say, "Wait a second. When there was a French colony, all of that belonged to my
family, Les Duponts." But possession is nine-tenths of the law, and it's obvious that Haitians have been able
to organize the territory and represent their apples in a way that most everybody in the neighborhood
accepts.

Let's take a more complicated case, that of Cairo. About forty-fifty years ago, President Nasser established a
policy of rent control. But once there was rent control, tenants created their own legal system to sell, buy, or
rent their apartments outside the law, and to ensure property inheritance. And this practice, though widely
established, has nothing to do with the official law that says that the friends of Mr. Farouk who rented the
apartment fifty years ago are still the tenants, paying rent of just $1.00 a month.

It's quite clear that the poor have already taken over much of the property in the developing world. Yet you
will get into trouble if you go down the paper trail to another generation and a generation past that. To
institute the rule of law, you must go to the people who currently have a system, and once you are able to
identify it, bring that system into a common legal framework. At the same time, you have to strike a deal to
clear the books. This is a political decision that can be accomplished relatively easily.

Q: Do you have any broad-spectrum analysis showing that some developing countries work very
differently from others -- for instance, because of having been colonized?

MR. DE SOTO: To be honest, I find it remarkable how similar most developing countries are today -- with
their massive informal sectors -- rather than how different they necessarily were in the past. Indonesia, for
instance, developed under Dutch law, but when you go into Indonesia today, 92 percent of the country is
outside the law.

My previous book, The Other Path, talked about the informal sector in Peru. It was translated into Bahasa
Indonesian. When visiting Bali some time ago, I got a call from the Suharto government through U.S.
Ambassador Monjo, a friend of mine. President Suharto and his cabinet said, "This is very interesting. Peru
seems to resemble what we have here in Indonesia. Can Mr. De Soto come and visit?"

I sat down with them, and they said, "Don't give us all of this stuff about why property is important. We know
that. 92 percent of the country is not titled. We just don't know who runs the factories, who runs the
businesses, who owns the land. That is our main problem. Tell us how we can find out who owns what."

So I said, "Here is what you have to think of. I have just been to Bali. It's a beautiful place. We walked from
one rice paddy to another, crossing wonderful terraces surrounded by palm trees, showing rice crops at
different stages of maturity. But we knew every time we were changing property because a different dog
would bark. So what you have to do is listen to Indonesian dogs: they've got the whole story."

Whether we're in Indonesia, Egypt, or Peru, it's no different.



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Q: The rights of the individual are quite inbred in the American way of life, so that when one speaks
of law, one is always conscious of individual rights. Now, with your system, individual rights have to
be protected somehow. It comes back to the "barking dogs." But can developing countries achieve
this?

MR. DE SOTO: There may have been factors present in the United States that engendered growth in this
direction, which simply aren't present in some of the countries I've mentioned. Start reading what Thomas
Jefferson had to say over 200 years ago. It's completely different from what Peruvian people were writing
then. You had better forefathers than we did!

From my understanding of U.S. history, when you began your conquest of the West, your common law
system regarding property rights collapsed to the point where Congress had to pass thirty-seven preemption
acts that said: "The common law no longer prevails. By statute, the people of California shall have this; by
statute, the people of Little Miami River shall have that; by statute, the people of Kansas shall have that."
This was because your law couldn't keep up with the reality of property ownership.

In Peru we have found that, on average, every parcel of land has twenty-one titles. In other words, the
Peruvian government tried to determine property rights twenty-one times, whenever there was a peasant
revolt. We did try your methods, but we had less success.

Rather than look to the past, it is much more interesting to start "listening to the dogs" -- talking to people --
about what they are willing to accept today. This puts us much closer to the truth than if we just looked at the
past. For instance, let's say I'm allowed to operate a bakery in Cairo. How much time does it take me to get
authorization to operate my bakery legally? It takes 549 days, working eight hours a day. How long does it
take me to transfer a property title in Peru, if I live in the area of Ayachucho? It takes three years and six
months.

Most Latin American countries are like Peru. In Peru about 30,000 rules are being made per year -- or about
106 per working day. With that flood of rules, you can put rights in, but you can also take rights out.

Our congresspeople are not like yours, elected by district and, therefore, accountable to District Number 32
in New Jersey or District Number 3 or 4 in New York. We are elected by lists and we are accountable a la
nación -- ergo, to no one whatsoever.

So yes, there is something in your tradition that has made it much easier to create a property rights system
that is sensitive to poor people.

Q: What steps can be taken in certain countries like Argentina, where law and capital are ersatz, and
corruption is essential?

MR. DE SOTO: About three months ago, a friend of mine in New York asked me, "How exactly do you get
your information?" I told him that in developing countries like mine, the informal sector is where you buy, it's
where you sell, it's where you do everything." In every developing country, we talk to that informal sector.
We have a very orderly way of going about this. First, we locate the most representative elements. Then we
find out how they see the law, how they make their deals. This enables us to recommend corrective
measures.

One of the last interviews I had in the Middle East was with a member of the informal sector -- as usual, I
was talking to the people so that we could make maps showing who is running what business and in which
part of town. Anyway, we had finished our questionnaire and were getting along very well, so I decided to
seek his views on corruption. I said, "Sir, could you tell me what you think of baksheesh, paying off people?"

The reply was "Baksheesh? Oh, I love baksheesh."

I said, "Tell me, why do you love baksheesh?"

He said, "If I have to deal with the law of my country -- about a hundred things coming at you every day -- life
is not very predictable. But if I pay off five key policemen, who are poor, I am helping them and I can get


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something done. I could also pay off a judge, but I don't recommend judges; they're shifty, they're unreliable,
and they're expensive. With baksheesh I've got predictability."

So when governments ask us, "What is the challenge we face when trying to create a new law that helps
poor people?," my reply is, "It's got to be more predictable and accessible than the current official law
because if it's not, the extralegal system will win out. People are reasonable, they are rational, and they will
become squatters if it takes twenty-one years to get a sand dune legally."

The way to form the new law is to make sure that it is cost-efficient, for which you have many mechanisms in
the United States that are not written into the Argentine constitution. We Latin Americans are very good at
writing constitutions that look like yours but aren't the same thing.

When we bring out a new rule, there is no Office of Management and Budget that looks at it from a cost-
benefit perspective. There are no "comment-and-notice" periods giving people the opportunity to comment
on the first draft. There are no congressmen elected by districts that consult with their constituents. There
are no sunset procedures.

Japan looks like a bureaucraticized system, but when you go there, you find out that when the Diet wants to
make a law, it passes it to the bureaucracy, and the bureaucrats then bring together a consultative group, or
shingikai, composed of all the key elements of society. The shingikai debates the law over a year or two.
These debates are supervised by a press club, which is given office facilities for the purpose.

Once the law is drafted in a form approved by the press, it goes before a popular assembly meeting in at
least thirty-eight places in Japan. Then it goes back to the Diet, and congressmen have access to the
primary schools in their districts on Saturdays and Sundays so that they can canvass people on their views
about new laws.

Whether it's Japanese popular assemblies, Swiss referendums or cantonical laws, or British
parliamentarians and their surgeries, Western law is generally much more accountable than law in
developing countries. Somehow or other, you are always in contact with your "dogs."

This is not, of course, to say that there's only one system. The Swiss system is completely different from
yours. They've got seven presidents who take turns, while your president gets elected through chads in
Florida. But one thing all of you in the West have in common: the rule of law is the rule of law because,
generally speaking, people see it as fair.

Now let's get back to Argentina. Before we go through another revolution in Argentina or any other country in
Latin America, we should know why the system failed. My general sense is: 1) legal property is not
widespread, so there is no vested interest in keeping the legal system in place; and 2) we do not have real
democracy. In my country we elect a dictator every five years who literally can issue 150,000 rules during
that period (that's 30,000 executive decrees per year).

This naturally results in no small amount of corruption and mayhem. You can talk about macroeconomics all
you want, but until we get the politics right and the property rights systematized, capitalism will not take hold.

Q: You hold up the United States, North America and the rest of the developed world as your ideal,
yet it is hard to find two states within the U.S. that have implemented our Uniform Commercial Code
in exactly the same way. What about the Cayman Islands? They have codified to an extreme extent
the way in which property and other assets can be transferred. How far does the developing world
actually need to go to get the benefits you are describing? Does the West have even further to go?

MR. DE SOTO: Regarding how much further the United States has to go: I really have little to say, not only
because I am the son of a diplomat, but also because the work of my institute is dedicated to assisting poor
people in a practical way. We don't want the poor to fall into the hands of dreamers who say, "No, we can do
much better," or "Let's try something else." Rather, we prefer to test what actually works. The broad lessons
that I draw from observing both Americans and Europeans is that when you really want to help a country,
you don't throw money at it; you assist with creating a legal framework.




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I tried to illustrate that through the case of Japan. After World War II, the United States wanted to break the
back of Japan's feudal system, which had supported and financed its military expansion into Formosa, now
Taiwan, and Korea. But there were other reasons as well for breaking Japan's feudal system. General
MacArthur was concerned that Mao Zedong was coming down from Manchuria and titling collectives, a
system that could have proved even more effective than feudalism.

Interestingly enough, Americans didn't remember what Mao had done when they started fighting in Vietnam,
because otherwise they would have countered Ho Chi Minh much more effectively. Guerrillas and terrorists
excel at titling; that is also what Ho Chi Minh did. Peru found that out with Abimael Guzman of The Shining
Path. We had to out-title Guzman in the course of putting down his insurgencies. That was the only way we
could win the local war. When you really want to help a nation, you have to address its legal practices.

The European Union is also interesting. In 1979, Spain was still receiving foreign aid. Then it started
preparing for entering the European Union, and what happened? The European Union said: "You have to go
through accession procedures, which doesn't mean we want you to change your law. We want the dogs to
continue barking. We just want to make sure your law is conversant with ours."

So they said: "Okay, Frankfort will do twinning with Madrid, which means that Frankfort will advise you until
such a point that we in Brussels are satisfied that a businessman from Germany, Belgium or France, when
he comes to Madrid, gets the same deal that he would get as if he went anywhere else in Europe." These
accession procedures can last from ten to fifteen years. Spain and Portugal went through it, and today
Romania is going through it. And you know what? Romania is becoming developed.

Likewise with the Unified Commercial Code in the United States: each state has its own way, but they can
talk to each other.

In closing, I would like to say that if you care about improving our world, you have to address the rule of law.
I am not saying that no one is writing about the importance of the rule of law. I have read an enormous
amount of literature from the United States, which has been extremely beneficial to the work of my institute.
But not enough people are dedicated to putting these thoughts into practice. The Europeans have been
making efforts on behalf of their union, and the United States made efforts in Asia about fifty years ago. The
time has come to give the rest of the world its chance.




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