The Mystery of Capital

by Hernando De Soto

  The sheer size of most of these cities creates its own opportunities. New business owners have emerged who, unlike their predecessors, are of very humble origins. Upward mobility has increased. The patterns of consumption and exclusive luxuries of the old urban society have been displaced by other, more widespread ones.

  The March to the Cities

  Migration is, of course, the key factor in urban growth in most developing and former communist nations. Its causes, however, are hard to pinpoint. Commentators in each country offer various explanations: a war, an agrarian reform program, the lack of agrarian reform, a foreign embargo on international trade, the opening of international trade, terrorism and guerrillas, moral decay, failed capitalism, failed socialism, even bad taste (It is so much prettier in the countryside, why don’t they just stay there?).

  Lately, however, opinion has been converging around a few general causes. The most visible explanation for the wave in migration throughout the developing world is better roads. The building of roads and bridges and the transformation of unconnected paths into proper highways awakened the rural population to the possibility of travel, and they began moving to the cities. New means of communication provided an additional incentive. Radio, in particular, aroused expectations of increased consumption and income. From thousands of miles away came radio broadcasts publicizing the opportunities, amenities, and comforts of urban life. Modernity sounded within reach of anyone with the courage to head down the road after it.

  There is also now fairly widespread agreement that agricultural crises in many countries were also decisive factors. The modernization of agriculture and the uncertain market for some traditional crops following World War II triggered massive layoffs of farm laborers on traditional estates and unleashed vast contingents of people prepared to search for new horizons.

  There was also the problem of property rights in the countryside. The long, complex process of agrarian reform only compounded—and ultimately exacerbated—the traditional difficulties of acquiring land suitable for farming. Unable to own land or find work in the countryside, many people migrated to the cities.

  Another powerful attraction was the lower infant mortality rate in most principal cities. This gap between infant mortality in the cities and rural areas widened as medical services in the cities began improving after World War II. Better wages were also an important incentive. In Latin America, for example, by 1970, people leaving the countryside to take up semiskilled employment in capital cities could double or triple their monthly income. A salaried job might quadruple their previous income, and professionals or technicians could earn six times as much. Higher pay offset the risk of unemployment: A migrant who had been unemployed for a year could recoup the lost income in two and a half months in the city. Life in the far-off cities not only seemed better; it was better.

  Even the growth of national bureaucracies became an incentive for migration. The centralization of power in the hands of government officials meant that most of the government offices competent to provide advice, answer requests, issue permits, or provide jobs were located in the cities. And any migrant seeking a brighter future for his children knew that the opportunities for education were much better in the cities. To underemployed peasants with little in the way of resources other than their own ingenuity, education was an increasingly valuable and productive investment. Cities contained most of the secondary school graduates as well as students enrolled in vocational training centers, schools and institutes of higher education, and university applicants and entrants.

  Migration, therefore, is hardly an irrational act. It has little to do with “herd instinct.” It is the product of a calculated, rational assessment by rural people of their current situation measured against the opportunities open to them elsewhere. Rightly or wrongly, they believed that migrating to larger markets would benefit them. The move, however, was not an easy one.

  Poor People Go Home

  Migrants to the cities encountered a hostile world. They soon realized that although urban people had a romantic, even tender image of the farmers and were quick to acknowledge that all citizens had a right to happiness, they preferred that the good farmers pursue their happiness at home. Peasants were not supposed to come looking for modernity. To that end, virtually every country in the developing and former communist world maintained development programs to bring modernity to the countryside.

  The greatest hostility toward migrants came from the legal system. At first, the system could easily absorb or ignore them because the small groups who had arrived were hardly likely to upset the status quo. As their numbers grew, however, to the point where they could no longer be ignored, newcomers found themselves barred from legally established social and economic activities. It was tremendously difficult for them to get access to housing, enter formal business, or find a legal job. The legal institutions of most Third World countries had been developed over the years to serve the needs and interests of certain urban groups; dealing with the peasants in rural areas was a separate matter. As long as the peasants stayed put, the implicit legal discrimination was not apparent. Once they settled in the cities, however, they experienced the apartheid of formal law. Suddenly, the bell jar was visible.

  Some of the nations of the former Soviet Union also face disarray in their property systems, and at least some elites are recognizing the economic benefits of sorting it out. According to a 1996 report,

  Mechanisms…to protect land rights are in their infancy in Russia…. In many regions land must be registered with an agency distinct from the one that registers buildings. Moreover, the legal protections that registration provides are unclear…. Procedures and customs for protection and use of land rights must be created from scratch…. Land is probably Russia’s most valuable resource, a resource upon which an entire economy and a democratic society can be based.11

  We have found that throughout the Third World, extralegal activities burgeon whenever the legal system imposes rules that thwart the expectations of those it excludes. As we saw in Chapter 2, many countries make the obstacles to entering the legal property systems so daunting and expensive that few migrants could ever make their way through the red tape—as many as fourteen years and seventy-seven bureaucratic procedures at thirty-one public and private agencies in Egypt, and nineteen years and 176 bureaucratic steps to legalize the purchase of private land in Haiti.

  If there are costs to becoming legal, there are also bound to be costs to remaining outside the law. We found that operating outside the world of legal work and business was surprisingly expensive. In Peru, for example, the cost of operating a business extralegally includes paying 10 to 15 percent of its annual income in bribes and commissions to authorities. Add to such payoffs the costs of avoiding penalties, making transfers outside legal channels, and operating from dispersed locations and without credit, and the life of the extralegal entrepreneur turns out to be far more costly and full of daily hassles than that of the legal businessman.

  Perhaps the most significant cost was caused by the absence of institutions that create incentives for people to seize economic and social opportunities to specialize within the marketplace. We found that people who could not operate within the law also could not hold property efficiently or enforce contracts through the courts; nor could they reduce uncertainty through limited liability systems and insurance policies or create stock companies to attract additional capital and share risk. Being unable to raise money for investment, they could not achieve economies of scale or protect their innovations through royalties and patents.

  Blocked from entering the bell jar, the poor could never get close to the legal property mechanisms necessary to generate capital. The disastrous economic effects of this legal apartheid are most strikingly visible in the lack of formal property rights over real estate. In every country we researched, we found that some 80 percent of land parcels were not protected by up-to-date records or held by legally accountable owners. Any exchange of such ex
tralegal property was therefore restricted to closed circles of trading partners, keeping the assets of extralegal owners outside the expanded market.

  Extralegal asset owners are thus denied access to the credit that would allow them to expand their operations—an essential step toward starting or growing a business in advanced countries. In the United States, for example, up to 70 percent of the credit new businesses receive comes from using formal titles as collateral for mortgages. Extralegality also means that the incentives for investment provided by legal security are missing.

  Cut off from the legal system, the migrants’ only guarantee of prosperity lay in their own hands. They had to compete not only against other people but against the system as well. If the legal systems of their own countries were not going to welcome them, they had no alternative but to set up their own extralegal systems. These extralegal systems, in my opinion, constitute the most important rebellion against the status quo in the history of developing countries since their independence, and in the countries of the former Soviet bloc since the collapse of communism.

  Growing Extralegality

  The populations of most major Third World cities have increased at least fourfold in the past four decades. By 2015, more than fifty cities in developing countries will have 5 million or more people,12 with most living and working extralegally. The extralegal sector is omnipresent in the developing and former communist countries. New activities have emerged and gradually replaced traditional ones. Walk down most streets and you are bound to bump into extralegal shops, currency exchange, transport, and other services. Even many of the books for sale have been printed extralegally.

  Entire neighborhoods have been acquired, developed, and built on the fringes of, or in direct opposition to, government regulations by extralegal settlements and businesses. For every one hundred homes built in Peru, only about thirty have legal title; seventy have been built extralegally. Throughout Latin America, we found that at least six out of eight buildings were in the undercapitalized sector and that 80 percent of all real estate was held outside the law. According to most estimates, the extralegal sectors in the developing world account for 50 percent to 75 percent of all working people and are responsible for one-fifth to more than two-thirds of the total economic output of the Third World.

  Consider Brazil: Thirty years ago, more than two-thirds of housing construction was for rent; today rentals constitute scarcely 3 percent of Brazil’s construction. Most of that market has moved to the informal parts of Brazilian cities—the favelas. According to Donald Stewart,

  People are not conscious of the volume of economic activity that exists in a favela. These informal economies were born of the entrepreneurial spirit of peasants from the North East of Brazil who were attracted by urban centers. They operate outside the highly regulated formal economy and function according to supply and demand. In spite of the apparent lack of resources, this informal economy functions efficiently. In the favelas there are no rent controls, rents are paid in U.S. dollars and renters who do not pay are rapidly evicted. The profitability of investment is good and as a result there is an abundance of supply of housing.13

  The Wall Street Journal reported in 1997 that according to the group Friends of the Land, only 10 percent of land occupied in the Brazilian Amazon jungle is covered by property titles.14 In other countries, extralegality is on the rise.

  Unlike the situation in advanced nations, where the “underclass” represents a small minority living on the margin of society, in some countries extralegality has always been the mainstream. For example, in most countries we have surveyed, the value of extralegal real estate alone is many times greater than total savings and time deposits in commercial banks, the value of companies registered in local stock exchanges, all foreign direct investment, and all public enterprises privatized and to be privatized all put together. This should not, on reflection, be surprising. Real estate accounts for some 50 percent of the national wealth of advanced nations; in developing countries, the figure is closer to three-quarters. Extralegal settlements are often the only avenue for investment in developing and former communist countries and therefore represent an important part of the savings and capital formation process. Moreover, the growing contribution of cities to GNP suggests that a great deal of potential capital and technological know-how is being accumulated mainly in urban areas.

  The Extralegals Have Come to Stay

  This explosion of extralegal activity in the Third World, the massive squatting in rural areas, and the sprawling illegal cities—Peru’s pueblos jóvenes, Brazil’s favelas, Venezuela’s ranchos, Mexico’s barrios marginales, and the bidonvilles of the ex-French colonies as well as the shantytowns of the former British ones—are much more than a surge of population, or poverty, or even illegality. These waves of extralegals crashing up against the bell jars of legal privilege could very well be the most important factor forcing authorities to welcome the industrial and commercial revolution that is upon them.

  Most governments in most nations are in no condition to compete with extralegal power. In strictly physical terms, extralegal ventures have already overtaken government efforts to provide housing for migrants and the poor. In Peru until the end of the 1980s, for example, government investment in low-income housing hovered around 2 percent of the housing investment in the extralegal sector. Including middle-class housing raised the government share to only 10 percent of total informal investments. In Haiti in 1995, the value of extralegal real estate was nearly ten times greater than all the holdings of the Haitian government.

  This extralegal sector is a gray area that has a long frontier with the legal world, a place where individuals take refuge when the cost of obeying the law outweighs the benefit. The migrants became extralegals to survive: They stepped outside the law because they were not allowed inside. In order to live, trade, manufacture, transport, or even consume, the cities’ new inhabitants had to do so extralegally.

  The extralegal arrangements they cobbled together are explicit obligations between certain members of society to provide security for their property and activities. They represent combinations of rules selectively borrowed from the official legal system, ad hoc improvisations, and customs brought from their places of origin or locally devised, and they are held together by a social contract supported by the community as a whole and enforced by authorities the community has selected. The disadvantage to extralegal arrangements is that they are not integrated into the formal property system and as a result are not fungible and adaptable to most transactions; they are not connected into the financial and investment circuit; and their members are not accountable to authorities outside their own social contract.

  These arrangements are run by a large variety of organizations, including urban development associations, farming conventions, small merchant associations, small business organizations, micro-entrepreneurial communities, transport federations, miners’ claim clubs, agrarian reform beneficiaries, private housing cooperatives, settlement organizations, residential boards, communal committees, beneficiary committees in state-built housing, native communities, small farmers’ associations, and village organizations. These organizations also run building extensions on desert land, building extensions on agricultural land, special arrangements for historic parts of the cities, subdivisions of public housing, settlements with private contracts, settlements with public contracts, appropriations through subleasing with owner’s consent, state housing with incomplete titling, illegal tenancy contracts declared before a notary and not recorded, settlement contracts recorded but not declared before a notary, settlements recognized by “national peace processes,” relocated settlers, and settlements recorded with suppliers of basic services or tax authorities but not recorded with the official property custodians.

  Extralegality is rarely antisocial in intent. The “crimes” extralegals commit are designed to achieve such ordinary goals as building a house, providing a service, or developing a business. Far fr
om being the cause of disarray, this system of extralegal law is the only way settlers have to regulate their lives and transactions. As a result, nothing could be more socially relevant to the way the poor live and work. Although their “laws” may be outside formal law, they are, by and large, the only laws with which these people are comfortable. This is the social contract by which they live and work.

  The extralegal settlements the migrants inhabit may look like slums, but they are quite different from the inner-city slums of advanced nations. The latter consist of once-decent buildings falling apart from neglect and poverty. In the developing world, the basic shelters of the poor are likely to be improved, built up, and progressively gentrified. Whereas the houses of the poor in advanced nations lose value over time, the buildings in the poor settlements of the developing world become more valuable, evolving within decades into the equivalent of working-class communities in the West.

  Above all, the extralegal settlers, contrary to their lawless image, share the desire of civil society to lead peaceful, productive lives. As Simon Fass wrote in the eloquent conclusion of his book about the economy of Haiti,

  These ordinary people are extraordinary in only one respect. Their incomes are very low, so low that one serious error of judgment or one unfortunate act of providence can often threaten survival of a household as a corporate entity, and sometimes also threaten survival of its members as corporeal entities. What is extraordinary is not so much the poverty itself, but rather the ability of these people to survive in spite of it…. Nothing they do in this process is anything but a productive contribution to survival and growth, and the simple items they obtain have concrete functions as factor inputs to the production process.15