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Tuesday, Feb 19, 2002

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The wealth in the title

Vivek Moorthy

THE emerging markets boom that followed the drive towards liberalisation, privatisation and globalisation (L-P-G) has lost its momentum. World-over, economies were in trouble even before the US began to slow down and well before the events of September 11. So, it would be pertinent to ask why capitalism triumphs in the West and fails everywhere else.

This is has been studied by Mr Hernando de Soto, founder-President of the Institute of Liberty and Democracy in Lima, Peru, in The Mystery of Capital (2000). His analysis involves the law and economics tradition and the paradigm of the London School of Economics and the University of Chicago. Major proponents of this paradigm have been Friedrich von Hayek; Aaron Director, who founded the Journal of Law and Economics in Chicago in 1958; his famous brother-in-law Milton Friedman, Friedman's son, David, author of Law's Order; Judge Richard Posner; and Ronald Coase, who pioneered the analysis of property rights.

In the law and economics paradigm, well-defined private property rights are the overwhelmingly critical condition for economic progress. In contrast, conventional reformers have not paid adequate attention to property rights. The World Bank increasingly talks of governance issues and the importance of the legal framework. But for well over four decades its approach to economic development is best captured by its own slogan, `Get the prices right', instead of `Get the property rights right'.

The emphasis of the Washington Consensus and the World Bank/ IMF allowing for their differences has been on L-P-G and macroeconomic adjustment. The policies recommended and/or implemented have been disinvestment, WTO membership, fiscal deficit and inflation reduction, currency convertibility, financial market deregulation, attracting MNCs, and using capital inflows to bridge the investment-savings gap. Conventional L-P-G reforms have been beneficial but are proving inadequate to ensure sustained, broad-based growth. Since the 1800s, Latin American economies have boomed after episodes of free-market reform, holding out the promise of a sustained increase in living standards for the whole population, only to slip back into stagnation.

Mr de Soto's fundamental insight and arguments set him apart from conventional thinkers. He feels that poor countries are not capital scarce. Though the capital stock is many times larger than their cumulative foreign capital inflow, it is inefficiently tied up in illiquid land and housing without clear-cut ownership rights and title. Hence, these assets cannot be traded outside of narrow circles based on trust or used as collateral to get loans.

In contrast, in the West, every asset is represented in a property document, part of an `implicit legal infrastructure' connecting the asset to the rest of the economy. The single most important originating source of funds for small businesses in the US is a mortgage on the entrepreneur's home. The house address provides a link to the owner's credit history, and facilitates debt collections.

A brick-and-mortar address enables water and electricity meter readings and, when needed, meter shut-offs. Without such shut-offs, any country (and not just the India that V. S. Naipaul had observed so acutely, but without comprehending its economy) is bound to literally remain what Naipaul characterised as An Area of Darkness, the title of his first book about India. The importance of this particular insight power sector reform, which fundamentally involves getting users to pay for electricity, has to start with postal addresses for the entire population cannot be overstated.

Mr de Soto goes beyond the emphasis on property rights to focus on what he labels `meta rights' rights to property rights. He investigates land records from different countries and periods to ascertain how precisely property rights are acquired. Poor countries do have well-developed formal laws, largely inherited from the West, that regulate economic activity. Unfortunately, formal law covers and protects only a small segment of the population those in contact with the West and who benefit the most from LPG. The essence of economic reform, according to him, is to widen the scope of the legal system to cover the entire population. Third World citizens are not inherently lawless. They will abide by law when the benefits of doing so exceed the substantial costs. Firms in the black economy cannot raise low-cost loans from official lenders; they cannot insure against theft, other than by paying the local mafia. Tax-evading manufacturers (some of whom steal electricity as well) cannot achieve economies of scale because they have to shift production facilities across different locations to avoid detection.

Those in the hidden economy pay hidden taxes. Mr de Soto claims that his team's programme to legalise small businesses in Peru was a huge success, with almost three lakh voluntarily doing so without any promise of tax avoidance. For legal reform to work, a bottom-up, rather than a top-down approach, is required. The only effective way to develop property rights is to identify the inchoate bits of prevailing `extra legal law', reflecting social customs and conventions and then codify, ratify and unify these pieces into a whole. The law is something to be discovered more than it is to be enacted. Formal law is much easier to enforce when it builds upon what already prevails. A long chapter, `The Missing Lessons of US History', assembles facts and figures that illustrate and lend credence to this bottom-up approach to legal empowerment.

Shortly after gold was discovered in California in 1848, sparking enormous, uncontrolled migration, there were as many as 800 separate mining jurisdictions, each with its own rules. In 1866, when the US Congress, well after the migration, officially declared the land open to all. It nevertheless ruled that exploration would be subject to "...local customs, or rules of miners, in several mining districts", and the wording of its Bill was taken directly from prevailing lode mining regulations of certain Nevada counties. Less than 40 years after the California Gold Rush started, all separate mining district rules were brought under one uniform law. The history of America's legendary Homestead Act, although less clear-cut, is also a case in point.

In 1862, Congress allotted 160 free acres to all potential settlers in the Prairie States who satisfied certain conditions, such as a minimum period of occupancy. The Act is generally credited with enabling agriculture to take off in the US. But the relatively small number of claims under the Act between 1862 and 1890 (under four lakhs, when the US population grew by 30 million) suggests that the Act largely ratified settlement that had already taken place. By then there were evidently other ways to obtain title. Contrast the above situation with Indonesia over a century later. Despite World Bank-assisted L-P-G policies since the 1970s, proper land laws are still not in place. In 1995, The Economist (of London) stated that not even 10 per cent of the land in the entire archipelago had a clear owner. Without an easy source of good collateral, it is not surprising that banks made so many bad loans in Indonesia, and that the banking system collapsed in 1998 during the Asian currency crisis.

What role can information technology (IT) play in creating land and title records and thus enable legal reforms? Not much.

While digital mapping and global positioning systems facilitate accurate, centralised collection, safe storage and easy transmission of records, IT is neither necessary nor sufficient for the task. "Property is not a physical thing that can be photographed or mapped... but the legal expression of an economically meaningful consensus about assets (p. 140)." Registry offices in Japan have recorded land holdings based on 300-year-old maps.

Yes, K is W. That slogan of some knowledge management guru is correct. But knowledge by itself is not wealth. Rather, as Mr de Soto convincingly argues, title is wealth. He follows that up by outlining a practical strategy and a list of procedures for (en)titling property owners in the unorganised sector. In modern parlance, he is not a mere change-agent, but a champion of change!

Implementing legal-economic reform along the lines suggested by Mr de Soto may be easier said than done. Creating property rights is not enough; preserving and enforcing them is a perennial problem, as those with titles to land and real estate are clearly aware of. The process of creating and formalising titles, like many other government welfare schemes, can and does get subverted by the powerful and well-connected for their benefit.

Lastly, Mr de Soto's pro-squatter bias could backfire in situations of conflict between squatters and bona fide land owners. Indiscriminately entitling squatters can weaken the basic incentives needed for capitalism to function. What worked in the vast, sparsely populated US may not succeed in crowded poor countries, with many claims to property.

These qualifications notwithstanding, Mr de Soto has made one of the most original contributions since Adam Smith to understanding what determines the wealth of nations. Two renowned politicians, Mr Bill Clinton and Mrs Margaret Thatcher, despite their sharp political differences, have endorsed his views.

Mrs Thatcher, in a jacket blurb, says that this book should be compulsory reading for all in charge of the wealth of nations. Mr Yashwant Sinha should take note of Mr de Soto's central point: As in other poor countries, there is ample unutilised capital in India.

Therefore, tax sops on savings are not needed to foster capital accumulation and growth.

(The author is Professor in Economics and Social Sciences Area, IIM, Bangalore. Feedback can be sent to

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