The Mystery of Capital by Hernando de Soto: A book review.

When I read this book for the first time, back in the early 2000’s, it left an indelible impression. The themes and thesis of this modern classic come to mind repeatedly over the last few years, especially in light of the recent financial crisis.

Not only does it give a view of where we have come from, it demands constant questioning of where we are going and how our economies are evolving. In light of our recent history, I felt the book offered enormous value in this respect alone.

The Mystery of Capital is an examination of what constitutes capital and how it is created, developed or suppressed. It explores the mysterious development of a thriving capitalist tradition in certain regions of the world and contrasts those findings in places where it does not develop effectively.

Written at the beginning of the internet age, his thesis seems almost prescient in terms of the development and impact of the World Wide Web. The value of networks in property rights, capital formation and transfer along with the representative aspect of capital are all the more interesting in our modern internet based context.

The most valuable contribution in this work is the careful examination of how capital is transformed from a basic organic bricks and mortar object, to a more transformative concept that can be changed, explored and developed. This is referred to as representation.

Representation means that assets move from a house as simply a shelter where you live to a conceptual, measurable, tradable, collateral entity. One with expanding potential.

The Mystery of Capital: Why Capitalism Triumphs in The West and Fails Everywhere Else was written by Hernando de Soto, who is a well-respected Peruvian economist. He has written several books and articles and received numerous accolades for his work. He is currently the President of Lima based think tank called The Institute for Liberty and Democracy which he founded in the late 70’s.

The basis of his thesis is that poor people have numerous assets that are locked outside of the official system for a variety of reasons. These assets have a value, but cannot be recognized and subsequently transformed into capital due to their unofficial status.

They are essentially dead money because they lack legal title and official status.

The system that they operate in is referred to as the extralegal system. It is no less sophisticated than a modern society, but the rules are a patchwork based on tradition, location and custom. In other words each jurisdiction has its own unique and distinct organizations and legal framework.

Diverse and plentiful extralegal organizations, traditions and rules are the equivalent of using a different operating system in every given jurisdiction that are subsequently unable to communicate with each other. The extralegal patchwork therefore makes transfer and fungibility of property and assets outside of these extralegal jurisdictions impossible or at least extremely difficult.

It makes transforming an asset to a representation and capital, impossible.

People in the extralegal system are outside the “official” or legal system because the legal system is too complex, onerous and expensive as to make it almost impossible for them to participate. It takes literally years and hundreds of bureaucratic steps to achieve legitimacy thereby effectively excluding anyone wishing to participate in the system but a select few.

They may not pay taxes, but the receive none of the benefits afforded by being a legal, named, taxpaying citizen. No insurance. No public services. No official protection. No legal rights. No access to credit or capital.

What we take for granted as an everyday transaction, for them is a nightmare of literally endless bureaucracy, red tape and expenses.

By examining the lives of the poor in various developing countries, de Soto came to a number of interesting insights about these people and the economies in which they participate.

The poor have extensive savings and assets that are estimated to exceed all the foreign aid ever provided and often surpass the official assets in the countries in which they reside. These assets, estimated to be in the trillions worldwide at the time, are stuck in an extralegal quagmire and excluded from the transformative power of representation because of a lack of a system of registration.

The term registration is what we call a property rights system. It is characterized by being clear, well organized and standardized to include all of the people and jurisdictions in a nation. A system that most importantly sanctifies and standardizes transfer and title.

Property rights therefore developed through a strong registration system into a way of turning property (and assets) into representations rather than simply dwellings. In this way an asset is transformed into capital, a representation, with infinite potential.

A house is not merely a shelter but rather a concept that can be used as collateral, developed for a business etc. as part of an official legal system tied in a network with everyone else.

The network and the expansiveness of its ties provides value and legitimacy.

In many developing nations, this system of registration and representation exists for very few, and sometimes not at all.

By exploring the evolution of property rights and capital formation, he delves into the histories of developed nations like England and France, followed by a detailed examination of the United States.

The role of squatters is extremely important in the understanding of modern western property laws. Squatting in many ways is the basis for extralegal arrangements that were subsequently combined and developed into modern property rights.

The book explores the development of legal and extralegal arrangements in a social context. At the time of the books’ publication (2000), many developing and former communist nations were grappling with problems faced and overcome by many western nations a mere century or two earlier.

The problem for these developing nations was that developed western prescriptions for property rights and capitalism were not written in a simple linear easy to find manuscript. It was patchwork of changes. Numerous laws developed based on both a highly developed legal tradition and a blending of legal and extralegal arrangements that brought it all together.

De Soto elaborates that in the west every building, home and asset of any kind is represented in a document. The document is “a visible sign of a vast hidden process that connects all these assets to the rest of the economy”.

“Assets can live a parallel life alongside their material existence”. That means they can be used for credit, collateral, provide an address in order for services to be rendered and taxes paid.

Third world countries don’t have this process. As de Soto notes: “They have houses but no titles; crops but not deeds; businesses but not statutes of incorporation”

He references the impact of Michael Milken’s insights on high yield bonds as an example of the role of representation: (they) “were able to reveal and extract capital where others saw only junk by devising new ways to represent the invisible potential that is locked up in the assets we accumulate”.

The book explores the American development of this representative asset system and examines key pieces of legislation. The development of property rights had some interesting similarities to how the government involved themselves in research and development as noted by Janeway In his book on venture capital.

The laws created were adapted from the extralegal sector to encompass the broadest number of people possible using as many of their existing extralegal rules and traditions. Just like innovations that were favored by the government a great example being the internet, they were careful to include the widest group of people possible.

The legal changes lead to a complex but mostly uniform system where transfer, assessment, history and all information to do with the asset are broadly available. By combining all of this information in a codified way, the system reduced the friction in the information required for transactions and the unlocking of capital potential.

George Gilder discussed the value of this “low entropy” information and its value in reducing friction and hence enhancing efficiency of transactions in his book: Knowledge and Power.

The goal of de Soto’s work was to help people in the extralegal, underground economy, in developing nations join the official legal economy with the least number of encumbrances possible. To move their assets into the official legal sector so that they could use registration to explore the transformative power of representation and access to capital.

The context of the book is the backdrop 1990’s. The Berlin wall had fallen and the dissolution of the Soviet state. Capitalism had triumphed. Western prosperity seemed at its height. Many nations were grappling with the same types of challenges experienced in the west only a century earlier.

The examination of capital and the role that the poor have to play in its subsequent development makes this a worthy read. Especially looking back 20 years.

In reading this book again I was struck by the many questions it brought to mind, particularly since the GFC.

I wondered if you could bring people into the official economy by streamlining laws and making them more inclusive, could you also do the opposite: Increasingly exclude people from a developed economy through onerous laws and increasingly diverse rules on assets.

We see numerous pieces of economic data that move from one extreme to the other, from week to week, in addition incredible number of people who seem not to be participating in the workforce. Has the GFC led to an expansion and redevelopment of the extralegal sector in western nations?

Has the economy become unduly complex? Too onerous for many? Impossible to participate in for a large swath of people due to increasing costs, rules and exclusionary precepts?

Is it possible to destroy the registration system, the very basis of capitalism, through complex financial engineering?

What implications might this have on future capital development?

A recent article looked at some of the leading internet companies and explored a curious notion: Uber owns no cars. Airbnb no rooms. Amazon no stores. Facebook…….multibillion dollar companies who are networks for monetizing assets.

The modern internet era demonstrates the notion of representation espoused in the book in ways de Soto perhaps would not have conceived at the time he wrote it. And yet he is prescient in his belief in the power of unlocking networks by bringing people into the legal economy. The value of assets and their representation strengthened by the size, scale and quality of the networks they are a part of.

The internet does this in profound ways.

The idea that a human represents not just cost to a business but a transformative asset with all kinds of hidden potential has been unleashed by the internet. This takes de Sotos view one huge step further. The leap from “things” to the incredible conceptual power of people in a direct and personal manner.

We can explore how trillions in dead capital may have been liberalized through reforms and property rights into representations. Assets effectively created and made official through registration offering the opportunity to use them as credit, collateral, and all other types of representation that did not exist two decades ago.

The Mystery of Capital is an easy but meaty read. Thought provoking and illuminating.

This book is exceptional and worthy of your time.

 

Interesting thesis by de Soto, it's very clear where he's coming from. I find it rather sad, however, that his whole theory is attached to a tunnel-vision philosophy to examine the inner mechanics of capitalism, only to, explicitly or not, recycle the same old argument.

Colourful TV, colourless Life.
 

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