Hernando de Soto
Hernando de Soto; drawing by David Levine

No one can tell us with any authority that money makes people happy. But we know that extreme poverty usually makes people unhappy. The World Bank calculates that the number of people in the world living in poverty increased by more than one hundred million since 1987 to approximately 1.2 billion in 1998. This is based on a low threshold of poverty, the equivalent of $1 a day. While the absolute number of poor in the developing world has risen significantly by this measure, the proportion of those in poverty in these nations fell from 28.3 percent in 1987 to 24.0 percent in 1999. Almost all the improvement in poverty rates, however, occurred in East Asia, particularly in China. If we exclude China, the proportion of the developing world living in poverty fell only from 28.5 percent in 1987 to 26.2 percent in 1998. Some progress was also made in reducing the proportion of the poor in South Asia, notably in India. But the percentage of poor people in Latin America and sub-Saharan Africa rose, and there was a huge increase of nearly 25 million poor in Eastern Europe.

If the poverty line is raised to a mere one third of average income in these regions, which I think is a fair measure, the World Bank calculates that 32 percent of the developing world lives in poverty. According to the bank, the proportion of those considered poor rose in Latin America in the last twelve years, and soared in Eastern Europe from 7.5 percent to 25 percent of the population. Poverty in sub-Saharan Africa remained dismally high (in some nations, more than 50 percent), although it did not worsen on average.1

In light of these general trends, it is not surprising that traditional measures of social conditions, such as life expectancy and child malnutrition, improved only slightly over ten years. The percentage of malnourished children fell only a few percentage points to about 28 percent in the developing world. In sub-Saharan Africa, malnutrition among children has actually increased during the past ten years. Adult literacy improved in all regions, but only by a few percentage points, again far less than expected.2 According to the United Nations Development Program, 17 out of 100 of the world’s people have inadequate shelter, 15 are malnourished, 15 are illiterate, 14 have no health services, and 13 will not live past forty.

As we enter the twenty-first century, the third world remains mired in the nineteenth and in some cases the eighteenth century. International agencies such as the World Bank, the International Monetary Fund, and the World Trade Organization have come in for increasing criticism for their failure to deal with poverty. Among scholars and public officials, a new debate has emerged over the emphasis on economic growth itself. Most of the nations in which poverty is widespread have grown slowly, but even when the overall economy is growing, poverty levels in much of South America, several African and Asian nations, and even the US have often not fallen appreciably.

On the other hand, government-run programs have sometimes helped to improve social conditions even when there has been little or no economic growth. Most scholars believe that economic growth remains of paramount importance, but there is a new concern: how to ensure that growth is, in the current jargon, “pro-poor.” The underlying reality is that 20 percent of the world has 86 percent of its Gross Domestic Product, owns 87 percent of all vehicles, and uses nearly 60 percent of its energy. The poorest 20 percent has only 1 percent of GDP, and earns only one seventy-fourth what the richest 20 percent does.3

Despite the increasing sense of futility about the condition of the poor, the respected Peruvian political scientist Hernando de Soto has published a book on economic development that is optimistic in outlook and pragmatic in purpose. De Soto has worked extensively on development projects in the third world, and considerable anger lies beneath the surface of his book, The Mystery of Capital. For de Soto, the rulers of the first world are too readily inclined to attribute the third world’s slow economic development to inherent cultural differences that are alleged to be beyond reform. Racism, colonialist habits, and self-serving superiority, he believes, persist in such Western attitudes. They help to account for the often-cited claims that in the third world, religions such as Hinduism and Catholicism, as well as inefficient agricultural traditions and poor education, make development difficult and maybe impossible.

De Soto argues that culture matters less than many observers believe. He claims that relatively poor people, if given a chance, are as adept at commerce as anyone else, as is shown by the unregulated and energetic “informal” economies in one third world nation after another. Unfortunately, de Soto does not define his terms very well. What is an informal economy? The least ambiguous definition is that it is composed of businesses that do not report their income to the authorities—the underground economy. A better definition can be found in de Soto’s widely cited 1989 book, The Other Path, in which he describes various aspects of the informal economy in his native Peru. These include “informal housing,” where people squat on land they do not own and build illegal houses and stores, and also workplaces where people make everything from shoes to electronic devices. “Informal trading” includes street vendors and open-air markets that bypass government regulation and taxes. An “informal transportation” network also typically develops, in which people with cars and station wagons and bicycles supply services to those who live in informal housing or run informal businesses ranging from hairdressing to small factories. These activities have become important sources of income and innovation. De Soto now writes that such informal economies are estimated to account for 50 to 80 percent of income in many developing nations.


In The Other Path, de Soto was determined to show how valuable these informal economies were. The Mys-tery of Capital argues that the infor-mal economies should now be given legal status; the people who run them must be granted elementary “property rights,” by which de Soto means the ownership of their land and homes as well as official permission to pursue their businesses, with all the legal rights that come with such recognition. If such rights were granted, de Soto claims, developing nations could achieve faster rates of economic growth that directly benefit the poor—the very “pro-poor” growth the international agencies are trying to promote.

Nations would grow faster, de Soto argues, because people could legally put their illegal capital to work. Once they had titles to their homes they would be able to borrow money against their value more readily and inexpensively. They could use that capital to start or invest more in businesses, educate themselves, and generally improve their lives—and provide themselves and their progeny a sense of optimism that can release still more energy. They could openly raise equity capital for their businesses from domestic and foreign investors and borrow from banks and other institutions. If they could have the protection of limited liability laws, such as traditional companies enjoy, this would enable them to take risks without fear of personal ruin. They could buy insurance for their cars and their buildings.

There would be less obvious advantages as well. Informal businesses often manufacture goods in several locations to avoid notice, and they cannot take advantage of economies of scale. If the owners could expand their businesses, they could run them more efficiently. Similarly, if they could come out into the open, free from harassment and prosecution by authorities, they could market their goods and services more effectively. They would no longer have to pay officials to look the other way. “In Peru, for example,” de Soto writes, “the cost of operating a business extralegally includes paying 10 to 15 percent of its annual income in bribes and commission to authorities.”

De Soto maintains that the informal economies have not arisen simply to avoid taxes. He wants the West to understand that, for the most part, those in the informal economy are not outlaws, any more than settlers in the early United States were outlaws when they found a fertile piece of property to call their own. This is a persuasive argument. Some development economists agree, for example, that legalizing currently illegal housing would provide security and capital to otherwise poor people and could give more than a few of them the start they need. Even if the standards of these houses do not meet minimum requirements, it could well be worth the risk. Allegedly legal housing is also often built below standards anyway, as January’s earthquake in India tragically made apparent.

De Soto argues that without property rights much of the capital that already exists in the developing nations is “dead.” It follows that the first world’s obsession with making these nations qualified to import capital, in particular by maintaining strong currencies, should not be the first priority. Strong currencies, the conventional wisdom goes, enable outsiders to invest without fear of loss should the value of the currency fall. To maintain a currency’s value, however, often requires tighter credit, a lower rate of government spending, and restraint on wage increases in order to keep inflation low. And the effects of such stringency are hardest on the poor. De Soto is arguing not only that the capital and the businesses are already there, but that there are ways to make them more productive at very low cost.

De Soto does not, however, provide adequate evidence that his perspective is realistic. The strength of The Other Path was that it was based on real-world examples. The Mystery of Capital is a theoretical tract. De Soto wants us to believe that property rights are the principal source of economic growth, and that they always have been; but he has written an abstract book about a problem that is decidedly down to earth:


It is the unavailability of these essential [property rights] 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.

This is a bolder contention than de Soto may realize. To support it he offers a few examples of how expensive achieving legality can be in the developing world, and he gives a relevant but oversimplified history of the legal development of land policies in the United States. But in light of the many questions his proposals raise, such arguments are simply inadequate. Can underground business people risk coming out into the open? Is there a sufficient market for their goods or services? What is the quality of schools their children will attend? De Soto does not address such issues because he has loftier aims.

There is no denying that achieving legality is expensive—and often too expensive—in many of these nations. De Soto and his colleagues, for example, opened a clothing factory in Peru with one worker. It took 289 days, working six hours a day, to go through all the processes to acquire the per-mits necessary to make it legal. De Soto’s group also found that to buy a piece of urban property in the Philippines required 168 different steps, including contact with 53 separate agencies, taking thirteen to twenty-five years. Similarly, to register a lot on state-owned desert land in Egypt required going through 77 bureaucratic procedures at 31 public and private agencies.

Eliminating regulations would surely energize commerce, but we are eager to know which of these regulations actually have some value and which do not. De Soto assumes that almost all the obstacles in the way of legalizing business are the unnecessary handiwork of entrenched, usually corrupt, and elitist bureaucracies, whether they are administered by right-wing dictatorships or well-meaning democracies. Such reforms would matter, but we need some demonstration of just how much.

One of de Soto’s central claims is particularly difficult to accept. Are most of the informal businesses he writes about now willing, as he suggests, to pay taxes in order to enjoy the potential benefits of expansion that legality may, or may not, bring? It seems likely that many people will prefer to take a dollar of tax savings today, and remain underground, rather than wait for two dollars of possible but uncertain gains in the future. The basic issue here is not whether legality makes sense or whether everyone would be better off at some future date by legalizing the informal economy, but how people can be persuaded to bring about the changes that de Soto recommends.

Mostly, though, de Soto resorts to history to convince us of his argument. Many early American settlers also had dubious claims to the land they occupied; a large proportion were outright squatters. Like some of the migrants in Peru, they made their illegally owned land into productive farms and they built houses and stores, and eventually entire villages and towns. Along the way, they worked out informal procedures about how to decide who owned what and how property was to be valued. But because state or federal authorities often did not recognize these boundaries, there were continuous battles over who owned property.

What intrigues de Soto is that in early US history the state and federal governments often favored the informal landholders. In the early 1800s, the debt of those who could not meet their payments was often forgiven and the price of land was repeatedly reduced; interest rates were lowered, and squatters were often given legal rights to their property. De Soto could have presented a detailed account of how this happened, but again his purpose is to demonstrate a principle, not provide a comprehensive argument, and he skims the surface of a fascinating aspect of history that is not well understood. For example, as early as 1815 a land rush in Alabama sent prices from one dollar an acre up to $70. With the panic of 1819, many small landowners there could no longer pay their debt. State officials, however, reduced their obligations so that many if not most could ultimately retain the rights to their land.4

Time and again in America, state and local governments redistributed the ownership of land by reducing or canceling debts. During the early nineteenth century, government increasingly sided with the small landowner in other ways. As president in the late 1820s and early 1830s, Andrew Jackson in particular was determined to liberalize property laws in America, and ensure squatters’ legal rights to land. And well after Jackson there was much turmoil over land rights, especially in California during the Gold Rush of 1849. “There were,” de Soto writes, “some eight hundred separate property jurisdictions” in California, “each with its own records and individual regulations established by local consensus.” Eventually, America established one set of property laws, and this no doubt aided its economic development.

But the availability of property rights did not largely account for America’s growth, as de Soto argues. In truth, early Americans brought a strong sense of the right to private property with them from the Old World. What probably made America’s relatively radical policies tolerable to powerful interests was that there was so much land to go around. Moreover, even if early-nineteenth-century economic arrangements were informal compared to later standards, they were highly productive, and far from “dead.” Farms and small businesses were generating income and could be used to secure loans; and those small businesses contributed to the growing market economy of the early nineteenth century. Property rights gave such capital additional life; but before formal property rights were established, this capital was already productive. De Soto fails to see that legalizing informal property rights in the US coincided with the rise of democracy in the Age of Jackson and the establishment of universal white male suffrage. It also coincided with the granting of corporate charters to larger numbers of applicants, legalizing limited liability for corporations, and the spread of publicly financed primary education.

If de Soto were to make explicit the consequences of his own argument in The Mystery of Capital, he would call for broad-based land redistribution policies that are decidedly democratic and even radical in nature. But he fails to discuss who owns the land he would like to distribute to members of the informal economy. Some of the land is owned by the government, but probably most of it is owned by rich, well-entrenched gentry and investors. De Soto proposes the abrogation of contracts and the forgiveness of debt, as was the case in early America. These amount to violations of what economists generally now think of as property rights. De Soto’s book has strong endorsements from Milton Friedman, Margaret Thatcher, and Walter Wriston, the former head of Citigroup. Do these people endorse ignoring legal contracts and widespread forgiveness of debt? It seems more likely that they have been beguiled by de Soto’s faith in entrepreneurship and unfettered markets and haven’t quite realized that he is also arguing for the cancelation of certain property rights that they hold sacred.

What probably gives de Soto confidence in his claims is that it is consistent with growing attention to property rights among economic scholars. Economists usually mean something broader than the rights to land when they discuss property rights. They are essentially talking about the enforcement of all contracts, and the development of such institutions as the stock market and credit cards that depend on the protection of investments and private savings and on honest accounting. A well-known theoretical case for the central importance of property rights was made by the Nobel Prize– winning economist Ronald Coase (who has also endorsed de Soto’s book).

Academic research is also being undertaken in support of property rights. A widely cited study, for example, concludes that the primary factors in determining how rapidly nations will develop are the security of their property rights and the amount they trade with other nations.5 But critics of these findings point out that while a correlation may exist between measures that would establish property rights and economic growth, the advance of property rights also typically coincides with many other factors that promote growth, including improvement in education, wider markets, technological progress, and the commercial tendencies of an acquisitive culture. China’s remarkable economic growth during the past few decades has occurred without conventional property rights.

Academic claims that property rights matter more than anything else have apparently encouraged de Soto to treat government only as an obstacle in his book. He does not discuss education, health care, or the relative benefits of democracy or authoritarianism. He has nothing to say about government programs to build low-cost housing or about the importance of education for women, which is now seen by many economists as a crucial condition of growth in developing nations.

Even de Soto’s contention that capital itself is the main ingredient of growth is a disturbing oversimplification. Referring to Adam Smith, he writes, “Capital is the force that raises the productivity of labor and creates the wealth of nations.” But Smith himself did not go this far. Capital is essential to growth, no doubt, but it is not a sufficient condition for it. Smith’s views are often misinterpreted. A pin factory, Smith wrote, could manufacture one hundred times as many pins in a day by dividing the process of pin-making into nineteen separate tasks. But the factory owners did not create this division of labor simply because they had the capital to buy the needed machines; rather, they believed they could sell many more pins in a large and rapidly growing marketplace. To Smith, a large and expanding market for goods was critical to the increased specialization of labor. De Soto’s informal economies also need markets.6

The debate over the true sources of economic growth has long suffered from a misguided emphasis on finding a single cause, and de Soto suffers badly from the same single-mindedness. When we consider the sources of US economic growth apart from property rights, we have to recognize that there were countless technological advances, from water mills to the steam engine to electricity. Capital could be imported from Europe; Americans were highly literate and had free early education; natural resources were available and, despite de Soto’s skepticism about culture, many settlers brought with them from England highly commercial habits; new religious tendencies reinforced incentives to make money. Most important, in my view, was the existence of an enormous, continent-wide market that, especially as the railroads were built, provided growing demand for the goods and services that business could produce, as well as incentives for continuing technological advance.

The actions of governments, moreover, made a huge difference. The federal government built the roads and canals of the early United States, not to mention the highway system constructed after World War II. State and local governments provided free education throughout the nineteenth and twentieth centuries, from primary school to high school, and they subsidized loans for college. And US governments not only frequently favored the small landholder over the large and powerful, but also reinforced competition by refusing to allow elitist monopolistic control over markets. By 1913 the federal government created a stable financial system with the creation of the Federal Reserve. More than in the developing coun-tries today, the government protected workers from abuse and consumers from fraud. Finally, the US was a democracy whose spirit by the Age of Jackson was openly sympathetic with “the little guy.” Because there was so much to go around, democracy in those years typically meant more for most people—except for African-Americans.

De Soto has something important in common with these Jacksonian principles, as much as he hides it by using language congenial to Milton Friedman and Margaret Thatcher. There is common ground between de Soto’s ideas and the recently formed consensus among some international agencies that poor people have talents and often know better what they need than outside consultants do. De Soto, the World Bank, and the United Nations all say they want to give more power to the poor. They also say they now believe that local citizens themselves must have a part in devising new policies. In the current idiom of the World Bank, the people must “own” the recommended policies.

I suspect, moreover, that de Soto’s ideas are especially appropriate in some developing nations—possibly, for example, Egypt and Peru—where informal economies may now be large and well-established enough to take substantial advantage of insurance, limited liability, sophisticated marketing, and equity markets. De Soto’s proposals for giving more people more property rights could help many of these communities mature still further. They seem to have affinities with early informal economies in the US: they are already economically vital; their capital is far from “dead”; and they have a good chance to compete in the legal economy.

Still, what de Soto fails to recognize in his advocacy of property rights is the ways that unfettered markets can solve some problems but by no means all. In my view, fast economic growth still remains the best social welfare policy. The most progress against poverty in the past two decades has been made in the fastest growing nations of the world—notably in East Asia, including China. As rates of growth in South Asia have improved, nations such as India, which has increasingly opened its borders to trade and international capital, have also made progress toward reducing poverty.

Moreover, fast growth provides tax revenues from which to develop useful social programs, if governments have the will to do so. Botswana, for example, grew swiftly from 1970 to the mid-1990s and was able to raise its social expenditures significantly, resulting in a rapid reduction in infant mortality. The Sudan grew slowly over this period and was unable to raise its social expenditures to the same level or enjoy the same results.7

But rapid economic growth can be misleading, and may be inadequate to help many poor people. In the developed nations of the West, income inequality has worsened in recent decades, especially in the US. Economic growth in Latin America in the 1990s did not reduce the widening inequality that occurred during the troubled 1980s. Even in China, recent economic growth in the sophisticated cities on the coast has not reduced inequality substantially. It was rural development in the 1980s that cut the poverty rates.8

Similarly, countries with only moderate rates of growth have been able to raise life expectancy and reduce infant mortality significantly by allocating social resources to these tasks. Several poor countries, including Jamaica and Cuba, rank high in health care and education, thanks to government expenditures. That health has improved in Cuba is only one aspect of life in a despotic country; but genuine accomplishments there should not be ignored.

One need not renounce the benefits of fast growth, then, to recognize that social programs, higher education levels, and the participation of women in the labor market are important sources of social well-being and that they need government funding and direction. Moreover, public investment, far from being economically inefficient, can promote future economic growth by building human capital and providing transportation and improved communications. In particular, the reduction of poverty enables people to invest in themselves, and promotes that most intangible if important of benefits, a sense of optimism about the future. Thus the poor may not merely start and sustain businesses but also send their children, male and female, to school rather than to work.

Hernando de Soto has done useful work in alerting the world to the energies of informal economies that are too often ignored or dismissed as disreputable. It would be unfortunate if his single-minded advocacy of property rights obscured the genuine perceptions of daily economic life on which his work is based. As he probably knows better than most other experts, just insisting on one general principle or another is not enough.

This Issue

May 31, 2001