## Saturday, March 17, 2007

### The mystery of capital' by Hernando de Soto

I must be the last guy in the world to read the famous book The mystery of capital: Why capitalism triumphs in the West and fails everywhere else' by Hernando de Soto.

He says that the institutional and legal infrastructure surrounding the ownership of land and property makes possible a great deal of sophisticated things, far beyond the apparently mundane question of being clear on who owns what land. It becomes possible to borrow against land/property. I would go far beyond him in emphasising the vast sophistication of spot and derivative financial markets that can be built, which are ultimately founded on clarity of title and ease of transactions. Without clarity on title, and frictionless transactions, the great wealth that land ownership constitutes is frozen; transactions only happen with neighbours and family. Further, friction in transactions inhibits speculation and thus market efficiency.

I was witness to a similar transformation in India - the shift from share certificates printed on physical paper to ownership information maintained in a computer database. This eliminated the counterfeiting and theft, and made possible a superstructure of sophisticated finance. I am very much in tune with this first point of the book, that of emphasising the importance of clarity of property ownership and frictionless transactions. The task of maintaining these databases and ensuring frictionless transactions is a core State function, right up there alongside the police and judiciary.

I was recently in Ahmedabad and asked about the frictions of purchasing flats. Apparently they are used to paying 5-7% to a lawyer who does a title check' and a bribe of roughly 2% in order to get the government to register the ownership in the name of the new buyer. These payments add up to 7-9%!!! Such a barrier to transactions and speculation is sure to yield a horribly inefficient market. Since land is one of the biggest asset classes, such inefficiency is costly.

The book then goes off into a fascinating ramble, which was fun to read. He asks the question: Where did the intricate systems of property ownership in the West come from? The practitioners of today have no idea about the rationale that led up to present institutions, and the compulsions that shaped present practice. I agree with this notion completely. As Lant Pritchett says, to ask a first world practitioner who operates a certain institutional infrastructure to then go on to design institutions is like asking a New York cab driver to design a car. To understand where first world institutions come from, one has to go delve in history, and think about incentives from first principles. Talking with contemporary practitioners is useful for obtaining a description of the present institutional structures, but not much beyond that.

There is a very interesting chapter about the history of land and the US. The basic story of the US appears to be one where settlers took what land they could, and the State later legitimised the facts on the ground as property rights. The book projects this experience as carrying important lessons for third world countries, who (the book suggests) should do as the US did when it was a developing country. Yes, this is certainly how the US evolved - but that is a very singular story in human history. It was perhaps like that in Canada and Australia also, where a tiny group of settlers faced quasi-infinite land and where State capacity was negligible. In a third world country there is no empty land to expand into. All land is owned by someone. I simply don't see how it is possible to make this analogy: squatters were legitimised in the early history of the US, hence there is a case for a benign treatment of squatters in the third world today.

If anything, there's a strong contradiction between the previous point (clarity of title) and this one (giving squatters rights). I personally do not dream of buying land in (say) Kanpur, since I'm not there in the neighbourhood to watch over it and ensure that squatting does not take place. The squatting equilibrium ensures that a national market does not develop, that a complex financial superstructure does not develop on the land market. With squatting, each person only thinks of owning land in an epsilon neighbourhood or in the epsilon neighbourhood of trusted family.

A side battle taken up in the book is the history of guilds and the extra legal sector'. We all know the broad story - that the development of capitalism led to the breakdown of the guilds, which were anti-competitive. The book paints this as part of the saga of heroic squatters taking on entrenched wealth. I am quite unpersuaded. Yes, taking on the guilds was very important, but it is just a question of competition policy. (As an example, see this recent edit in Business Standard about allowing an extra legal sector' of heroic small telecom companies to take on the guild of Indian telecom companies). Yes, I perfectly agree that at every possible turn in policy thinking, we must enshrine competition. But I don't see how singing paeans to the gritty entrepreneurs in the informal sector is consistent with supporting land grab.

The book draws on examples from a few countries like Egypt and Haiti and argues that Capitalism has failed. It ignores the history of country after country in Asia where Capitalism has worked. First Japan, then Korea and Taiwan, then China and now India are achieving a takeoff based on market-oriented economics, and many small countries have also done splendidly. The book may perhaps be excessively influenced by information from a few countries where Capitalism did fail. But the lessons are less general than meet the eye.

He makes much of the bell jar' analogy, of a modern sector of a poor country inside a bell jar with the great unwashed masses outside clamouring to get in. His belief is that this bell jar will not grow by itself. Well, the data shows that in countries like Japan, Korea, Taiwan, China and India, the bell jar has grown wonderfully. A modern sector takes root in the country, plugs into globalisation, and then reshapes it's surroundings: we have seen this over and over, and have pretty much understood this process ever since Adam Smith, David Ricardo and Karl Marx.

We admire the grit, determination, and innovation of small entrepreneurs, but we should be wary in judging their economic significance. A lot is made of the size of the informal sector, but when you look at the data, SMEs just don't add up to much. In India, the mere 100 big firms (the firms in Nifty and Nifty junior, which have good stock market liquidity) account for a full 10% of GDP. And this is just the value added within the firms - given Indian labour law, these firms contract-out a large amount of production so as to steer clear of this law. The true economic footprint of these biggest 100 firms, then, well exceeds 10% of GDP. And I've only counted the biggest 100 firms. By the time you get to the top 10,000 firms, which (with the government) inhabit the bell jar, you get to a huge and growing slice of India.

Capitalism has not failed everywhere else'. The bell jar is big; the bell jar is growing. I do not share the message offered by the book that the bell jar is stagnant; the bell jar has failed; that the only way to build a vibrant capitalism is to go outside the bell jar and enshrine the reality of the extralegal sector into the legal system.

The book claims that when law diverges from universal social practice, the law must inevitably give way. What about the campaign against sati? There was a time in India when after a husband died, the widow was urged, encouraged and pushed into the funeral pyre by immediate family. The prevalence of sati was the facts on the ground'. The creation of a modern India critically relied on the Law saying that such practices were unacceptable.

I remember how, ten years ago, there were many fatalists who believed that counterfeiting and theft of physical share certificates was the inescapable reality of India. It was solved by a top-down reformative policy push, not by a process of law accepting theft, or giving partial ownership rights to the counterfeiter. The only way towards making progress on building a mature market economy is to go after these kinds of problems with passion and zeal. In similar fashion, squatting is the norm in India today, and no land is safe, but still there is absolutely no case for benign support towards squatting or encoding the facts on the ground in law'. The success of the Indian development project critically requires achieving frictionless land transactions.

1. Ajay, do you know of any state that has decent and clear land title ownership laws? In a bout of socialism, land ownership became the causality. But now it's mostly political corruption - everyone from CM down to puny bureaucrat, in pretty much every state, has their hand in manipulating land ownership (mostly state land but private too) and profiting from it. So it's next to impossible to reform, following the footsteps of share certificates, unless the centre steps in with clear mandates and clean up states inaction within a specific period of time.

2. There are a couple of issues that havent been scratched here, so here goes my opinion.

In the case of squatters being given rights, I think it is a suggestion to be applied in retrospect rather than in prospect. More importantly, where they squat may be significant in understanding the issue. If the government owns large blocks of undeveloped land, and squatters arise on those parts of land, what then? Another nuance is the government often does not understand that the location of a land might give rise to "natural markets" eg the area near railway stations if one sees will invariably be occupied by makeshift markets. I would rather understand what is it that drives squatting of land. But given that, I agree it is a thorny idea. Even a one-time policy of making squatters on government land legal with fraught with repetition in India.

With respect to the law of Sati, I think the counterfactual is not a "No law on Sati" but maybe laws upholding individual freedom. That begs the question, do you believe in the right to suicide?

And I loved the practitioner analogy.

One has to just see the land market in Delhi based on "power of attorney" to understand the distortion wrought by our land transaction policies.

3. Yes, the history of State control of land is surely part of the problem. If the State will auction off all government land over some years, then it could settle into just focusing on enforcing property rights.

Application of squatters-rights in retrospect inevitably changes the behaviour of would-be squatters in prospect. If you know that by squatting for enough years, the land becomes yours, your behaviour will change to do this.

I don't want to get into debates about Sati and suicide. (Widows are free to commit suicide in most places in the world, very few do). My limited point is that I felt the book was grossly overstating the importance of accepting the facts on the ground' in the extralegal sector into the formal legal system. There is a lot of terrible stuff in the extralegal sector - e.g. the use of violence in grabbing land. I felt the book has an excessively romanticised version of life in the extralegal sector. I see it more like the Wild West, where life was short, nasty and brutish.

4. Interesting take... very important and interesting study. Personally, though, I think the reason why capitalism doesn't work anywhere else but in the West (and I make this observation based on study, not based on my own personal opinion...) that it is all about the way a particular nation or group of people THINK. Capitalism doesn't work in India for many reasons (or at least, not the same as it works in America) because of the way the country thinks (it's philosophy, history etc.)
You can't apply a western thought (capitalism) fully into eastern thinking, and expect it to work. That's pretty much the bottom line, I think.

5. Ajay, I realize I'm about an year late in this comment.

But I feel you are being a bit unfair about the book. I agree with you in that Do Soto, puts a little too much emphasis on the Property rights problems as the single most causative factor of poverty.

But he does not say (as i recall) that the property reform must happen exactly like the way it happened in the west, like recognizing squatter rights.

But don't you think it's logical that the fact that a person without a legal title to claim his property has great difficulty in turning it into productive capital? which is the central thesis of the book.

Please note: Comments are moderated. Only civilised conversation is permitted on this blog. Criticising me is perfectly okay; uncivilised language is not. I delete any comment which is spam, has personal attacks against anyone, or uses foul language. I delete any comment which does not contribute to the intellectual discussion about the blog article in question.

Please note: LaTeX mathematics works. This means that if you want to say $10 you have to say \$10.