Given the rancorous debate unleashed by the UK electorate’s decision to depart the European Union – in particular, regarding the damage to the UK economy that independence might bring – it seems wise to re-examine the foundations of economic prosperity and its relationship to political and legal factors. I do so by examining Hernando de Soto’s seminal book, The Mystery of Capital, which goes to the heart of the relationship between political framework, legal framework, and economic development.
The “mystery of capital” is the intriguing title of one of the most important books of the new millennium. Written by the Peruvian economist Hernando de Soto, it breaks with the tradition of dealing with capitalism as a system established of, by, and for the rich, by looking at it from the bottom up: from the lowest levels of society. De Soto finds capitalism even at that level, albeit in a stage of dormancy, as it were. His treatise is intended to help us understand that capitalism is nothing esoteric – despite its being a “mystery” – but rather something down to earth, active in the lowest levels of society, and only waiting for a proper legal and political framework to become an equitable system, in the service of all, not just the well-to-do.
De Soto first made a name for himself with his path-breaking work in Peru, which culminated in the best-selling book The Other Path. In order to show an alternative route to a better society, De Soto developed a unique investigative method. At the time – the 1980s – the better society was being promised by radical revolutionary groups. In Peru, such a group was El Sendero Luminoso, the “Shining Path” – the path to the enlightened society, the workers’ paradise. Officially, this was the Communist Party of Peru, and throughout the 1980s it engaged in violent revolution. De Soto proposed El Otro Sendero, the “other path,” which would render the revolution irrelevant by integrating the real-world economies of the poor within an all-embracing economic framework that left no one out.
What De Soto and his colleagues at the Institute for Liberty and Democracy had discovered was that, at the poorest and most basic levels of society, a vibrant economy was already in existence. It functioned in spite of, rather than because of, the formal institutional and legal structures provided by the state. For in Third-World countries such as Peru, there was not one economy but two: the formal economy, the economy of the wealthy and middle class, connected with the rest of the world; and the informal economy, the economy of the poor, the “off the books” economy, comprising the residual and peripheral denizens who happened to make up the vast majority of the nation. Essentially, the legal and political institutions functioned within and for the benefit of the formal economy, while the informal economy ran on its own, ignored and neglected by the powers that be, kept by the phalanx of rules and regulations from ever graduating from the shadows into the sunlight of the economy proper.
De Soto’s book highlighted this situation and the potential that it held, if it could be harnessed, both for the benefit of the poor and for the nation as a whole. Mainly, the regime of bloated regulation and official corruption needed to be exchanged for the rule of law, specifically the institutions of property and contract. If this would occur, the chains would come off of the poor and they could become full-fledged participants in a functional rather than dysfunctional social order.
De Soto’s second book, The Mystery of Capital, is the culmination of the work done in the wake of, and building on the foundations laid in, The Other Path. It is the product of the transfer of the method pioneered in Peru into many other Third World countries facing similar problems. De Soto took his show on the road, making the Institute for Liberty and Democracy into a globally active entity.
Unlike The Other Path, however, The Mystery of Capital is more than an exposition of the findings of investigative field work. In fact, it transcends the empirical method altogether: it sets forth a philosophical outworking that is both result and foundation of those empirical findings.
In making this leap from practice to theory, De Soto had penned a most important book on the subject. He was enabled to do this precisely because of the empirical basis: the book went beyond economic theory to the real world in which economic practice is embedded, a world that economic theory studiously ignores; it takes into account the real-world framework within which economies function.
The recognition of the two-tiered economy led De Soto to perceive the crucial importance of the legal system. For in his findings, it was the legal system that made the difference between the two economies. This led him to explore virtually virgin territory: the relationship between the legal system and the economy has been largely ignored, except for certain specialty (and rather idiosyncratic) disciplines such as institutional economics, “new” institutional economics, and law and economics. While these latter disciplines have not been entirely fruitless, they have not helped to rework economic theory the way that De Soto had done in his book.
De Soto’s reworking of economic theory starts from a rather crucial distinction that is well known to legal philosophers, the distinction between possession and property. This is a staple of the Western legal tradition (both civil and common). Essentially, the difference between possession and property is physical versus mental – possession is physical holding, while property is an entitlement that stays in force regardless of whether the owner is in physical possession or not. And this distinction depends on a functioning legal order that enforces its arrangements. With possession, enforcement is essentially left to the possessor; with property, it is maintained by a separate entity charged with law enforcement, and hence is not dependent upon the physical strength of the owner in order to enforce possession.
With property arrangements, then, the relations of people and things are elevated to a higher plane than arrangements of pure possession. And they provide for higher-order exploitation of resources than simple possession does. For one thing, property rights can be split up and farmed out any number of ways. For another, property allows for encumbrance in credit contracts, whereby the property item serves as collateral. Without changing its physical status, the encumbered asset engenders a new set of economic advantages. The owner can borrow money against it; and, as Steuart showed back in the 18th century and Schumpeter in the 20th, this is essentially the way in which, in the modern world, money comes into being. At least, in a banking- as opposed to a coinage- or scrip-based system. Credit and debt are the source of money issue. As any bank balance sheet will show you, all money issued has as its counterpart an encumbered economic asset.
In his book, De Soto never explicitly refers to the legal doctrine of possession vis-à-vis property, but despite that, it underlies his entire exposition. He argues that it is the legal system that enables possessions to become property, thus assets, and assets to become capital – resources capable of generating new productivity and income. “Like electrical energy, capital will not be generated if the single key facility that produces and fixes it is not in place. Just as a lake needs a hydroelectric plant to produce usable energy, assets need a formal property system to produce significant surplus value. Without formal property to extract their economic potential and convert it into a form that can be easily transported and controlled, the assets of developing and former communist countries are like water in a lake high in the Andes – an untapped stock of potential energy.”
De Soto’s argument is crucially important – as far as it goes. But it runs into problems when he goes further and highlights a single aspect of the legal system, to which he attributes excessive importance. This in turn causes him to lose sight of other aspects, and indeed, the bigger picture.
De Soto emphasizes the role of record-keeping as the determining factor in creating a cognitive layer overlaying the physical layer of tangible things. Records, titles, data storage and retrieval, allow the things that otherwise exist in isolation to be integrated together into a collective mind map, by which they become a synergistic whole that is greater than the sum of the parts. For De Soto, this is the crucial element of a system of property rights, which enables it to generate productive economic assets – capital.
But this is to overplay his hand. It is not so much record-keeping within a framework of law, but the framework of law itself that is the important thing. The key is the establishment of common law: a law that is valid across the board across the entire territory, which holds for everyone and which establishes at its core, property rights and freedom of contract, uniformly and equally enforced. Historically, this kind of common law was established early on in England, where the king’s writ came to run everywhere. Which is why England became the common-law country par excellence.
Such an establishment of common law, in turn, depends upon the consolidation of sovereignty.
Sovereignty is the power by which the rule of law is established. It is the prerequisite of a functioning legal order. Sovereignty is the power to establish and confirm shared, social value. It does this through legislation and adjudication, establishing laws as standards by which the social order is ruled – the rule of law. These, then, are values, which are universally valid and binding.
But there is more to the establishment of value than this. Valuation has, of course, an economic dimension as well as a juridical one. But does the legal system generate economic value? Yes it does, through the utilization of property and contract. And here we have the intangible, mental, symbolic dimension of the economy that De Soto intuits, but does not quite elucidate, given his focus on record-keeping. Property and contract generate value by the process of credit and debt. When property is harnessed as collateral in a credit contract, it is valued; and this valuation is expressed in the issuance of a monetary equivalent. A deposit is established at the bank, in the equivalent of the loan. Borrowing a metaphor from the days of minting coinage, Steuart called this the “melting down” of property into “symbolical” money. Hence, the regime of property and contract participate in the process of valuation in a very critical way. And out of this valuation comes capitalization – capital.
Now then, the context of this valuation and process issuing forth ultimately in that mysterious entity, capital, is a common legal order, the product of a consolidated and viable locus of sovereignty. Sovereignty, then, enables this whole process of capitalization to take place. What is the locus of sovereignty? Following the German Calvinist statesman and political philosopher, Johannes Althusius, we can answer unambiguously, the nation.
The Industrial Revolution, the “take-off,” as W.W. Rostow put it, did not come about in a vacuum. It came about in nations in which sovereignty had been consolidated; and those nations in which sovereignty had not been consolidated, did not experience it. Nationhood and sovereignty go together. Like a lens out of focus, sovereignty is weak where it does not shine through the prism of nationhood. And, where sovereignty is weak, there also a domestic economy does not materialize; as a result, conditions are rife for an exploitative, colonial or neo-colonial framework. Wallerstein’s center-periphery framework then looms large. None of that is necessary for economic growth: in fact, it only benefits particular interests, at the expense of broad-based, populace-elevating economic growth.
So then, it is sovereignty refracted through nation-states that has enabled the genesis of the capital which De Soto seeks to demystify. Summarizing this state of affairs, I wrote: “Through the institutions of property and contract, credit and debt, the asset base in man (human capital) and through man (tangible and intangible property) becomes capitalized, generating a money supply which, when properly maintained, is the faithful representation of that asset base, no more and no less. The nations of the world have no need of a Wizard of Oz to grant them prosperity. It is in their hands to do so, if they would only recognize it.” That is the mystery of capital explained. In its fullness, only nations can bring it off. Neither inchoate peoples, nor empires, ever have, or ever will.
 Hernando De Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (New York: Basic Books, 2000), p. 48.
 For more on this point see my book Common Law & Natural Rights (Aalten: WordBridge, 2009), pp. 68ff.
 For more on this point see my book Common-Law Conservatism: An Exercise in Paradigm-Shifting (Aalten: WordBridge, 2007), ch. 1.
 For more on this point see this previous post.
 Follow the Money, p. 190.