Mystifying the concept of capital: Hernando de Soto's misdiagnosis of the hindrance to economic development in the Third World.

• Author: Ahiakpor, James C.W.
• Position: Critical essay

In his well-publicized book The Mystery of Capital (2000), Hernando de Soto claims to have discovered the explanation for poverty in countries of the Third World and the former Soviet Communist bloc. He claims it is the inability of the poor people in these countries to convert their "dead capital" into live, functioning "capital" because of a "legal apartheid" their governments have created. He asserts that the conversion of dead capital into live capital explains the rise of capitalism, which he equates with economic development, in the West. Numerous reviewers of the book have praised de Soto's diagnosis of the cause of underdevelopment and his recommendation of the widespread granting of formal titles to properties owned by the poor as a solution to this problem. In academic journals, the positive reviews include those by Libecap (2001), Buch (2002), Rosenberg (2002), and Pal (2003).

In the process of developing his argument, de Soto refers to the well-known explanation that clearly defined and enforceable property rights reduce transactions costs (Coase 1937) and promote investments, thus earning Ronald Coase's endorsement of the book: "A very great book ... powerful and completely convincing. It will have a most salutary effect on the views held on economic development." Similarly, Milton Friedman endorsed the book, noting: "De Soto has demonstrated in practice that titling hitherto untitled assets is an extremely effective way to promote economic development of society as a whole. He offers politicians a project which can contribute to the welfare of their country and at the same time enhance their own political standing, a wonderful combination" (see the book's back dust cover for both quotations). (1) Comparing de Soto's claims with some of the grand development theories of the 1950s and 1960s, Jagdish Bhagwati (Columbia University) also declares that "de Soto is arguably the most interesting intellectual writing on development today.... [He] is the man with 'big' ideas.... His Mystery of Capital will endure as a work of extraordinary importance" (qtd. in Clift 2003, 10). The Economist hails the book as "the most intelligent ... yet written about the current challenge of establishing capitalism in the developing world" (Clift 2003, 8).

Despite these accolades, de Soto is quite mistaken in his diagnosis of the real hindrance to economic development in the Third World and former Soviet bloc countries. Rather than the lack of titles to property, the problem is the inadequacy of their domestic savings to finance investment. Poor people in these countries hardly own assets, the absence of whose formal titles impairs their ability to borrow funds, or "capital," for investment. Thus, de Soto's suggested solution of a massive titling program by the governments of these countries would be a wasteful diversion from what needs to be done in them to promote their economic prosperity. This point is implicit in Culpepper's criticism of de Soto's property-titling project as "flawed" and "inherently biased against the landless and propertyless tenants," although his book "purports to speak on behalf of, and to empower, the poor and disenfranchised" (2002). Because de Soto's book has received numerous endorsements from high-profile figures, the fundamental errors of its premise need wide publicity in order to spare Third World governments from being misled. (2)

De Soto appears to have arrived at his fundamental misdiagnosis of the hindrance to economic development primarily from his misconception of "capital" and the source from which it derives. He thinks that "an implicit process buried in the intricacies of [the] formal property systems ... creates capital in the West" and that "the formal property system is capital's hydroelectric plant ... the place where capital is born" (2000, 46, 47; hereafter cited by page number only). But this view is incorrect. Rather, it is a community's savings that mainly create the "capital" that may be borrowed by titled or untitled property owners. De Soto compounds his misconception with a confusion between stocks of wealth and the relevant flows of savings, or "capital," to finance investment. He also exaggerates the limited role of titles to property in the economic-development process of the more developed countries and misrepresents the historical causality between economic development and the titling of private property. His misdiagnosis of the principal impediment to economic development also appears to have been driven by his misperceptions of conditions in poor countries, misperceptions that he himself affirms with self-contradictory claims in the book, especially his view that most people there do not have property rights.

Samuelson (2001), Woodruff (2001), Gilbert (2002), and Miranda (2002) have offered criticisms and warnings about the illusions of de Soto's proposal. Woodruff notes that the amount of "capital" that may be "unlocked" from the poor's assets "might be only a small percentage of that suggested by de Soto" (2001, 1221). He also reports from a study of rural Thailand that "owners of untitled land are as likely to receive credit as are farmers with titled land, even from banks," and that "titles have little effect on credit obtained from non-bank sources such as traders" (1219). Samuelson faults de Soto for his neglect of the cultural dimension of the pursuit of economic development, adding: "Property rights are not the be all and end all of progress but a simple reflection of the larger culture.... [De Soto's] story of property rights is only an interesting sideshow" (2001, 211). (3) Gilbert reports that the granting of titles in Bogota, Colombia, has made little difference in people's access to credit, and Miranda notes that "after six years work and more than 1 million registered land titles [in Peru], a very small percentage of the people in the target population have credit, which in most cases is from the Banco de Materiales, a government credit system that provides credit to those with secure incomes and which is not based on those who have formal titles" (2002, 263, emphasis added). Miranda's report answers Thomas's query about the outcome of the land-titting project to which de Soto was appointed by President Alberto Fujimori of Peru in the 1990s, but of which de Soto says nothing in the book to explain "why this programme failed to generate credit for those who were registered" (2002, 191). A recent study of a poor suburb of Buenos Aires, Argentina, by Galiani and Schargrodsky also finds "only ... modest effects on access to credit markets as a result of [property] entitlement" (2005, 3). The land had been bought by the Argentine government and distributed to squatters.

However, the preceding criticisms do not focus on de Soto's misconception of "capital" and of its source--namely, savings--or consider that titles may only increase the demand for loanable savings in the formal credit market without necessarily increasing the total supply. (4) Meanwhile, such notable textbook commentators as Perkins, Radelet, and Lindauer (2006, 85,414) and Gwarmey and colleagues (2006, 38) repeat without criticism de Soto's claims that the absence of formal titles to property is a hindrance to economic development. I here follow up Woodruff's suggestion that "policy makers ... be alerted to the limitations of de Soto's proposals" (2001, 1223). I also clarify Adam Smith's concept of capital, which de Soto misrepresents. (5)

De Soto is reported to have admitted the insufficiency of his titling project to promote economic development, but insists on its primacy: "I'm not saying that other reforms aren't necessary. I'm simply saying that a property rights system is a principal reform, without which other reforms are difficult to manage. It's quite clear that property law alone does not resolve the other problems. But to me, what is also quite clear is that without property law, you will never be able to accomplish other reforms in a sustainable manner" ("Hernando de Soto" 2007). In view of this insistence, his mistaken diagnosis requires correction, particularly for his free-market admirers who have been touting his program.

Mystifying Capital and Its Source

When a businessperson says he is looking for some "capital" to invest or set up an enterprise, he has in mind a sum of money (funds), typically to be borrowed at interest. Some of the funds may be used to purchase or rent machinery or equipment, rent space for the enterprise, purchase raw materials, and pay for the services of workers. Some of the funds will also be kept on hand to pay incidental costs that the enterprise incurs or to provide change to customers before revenues start to flow in. Thus, borrowed "capital" is a larger sum of money than the value of the physical assets an entrepreneur purchases, which modern economists call capital goods--machinery, equipment, raw materials, or produced goods yet to be sold. It goes without saying that income earners first must save if businesspersons are to borrow capital. Thus, "capital" is intimately connected with savings and interest rates. The greater the demand for "capital" relative to its supply (savings), the higher the rate of interest, and vice versa.

This meaning of the term capital is the one that the classical economists and several early neoclassical economists employed; see, for example, Adam Smith's Wealth of Nations([1776] 1976, 1:294-301); David Ricardo's Works and Correspondence (1951-, 1:363, 2:331, 3:89-94); J. S. Mill's Collected Works(1963-88, 2:chap. 6, 3:chap. 23); Alfred Marshall's Principles of Economics ([1920] 1990, 60-69); A. C. Pigou's Industrial Fluctuations (1927, 120-22, 131-34); Frank Knight's essay "Professor Hayek and the Theory of Investment" (1935) and book The Economic Organization ([1933] 1967, 113-17); and J. B. Clark's The Distribution of Wealth (1938, 116-56). Marshall argues that "economists have no choice...