Interview: Peruvian Economist Hernando de Soto

Hernando de Soto
Photograph courtesy of the Institute for Liberty and Democracy, Lima, Peru

Few people can boast that their ideas have been praised by George Bush, Bill Clinton, Ronald Regan, and Vladimir Putin, or that their books have been acclaimed by New York’s conservative Wall Street Journal and by Paris’ liberal Le Monde. Peruvian economist Hernando de Soto can.

As president of the Institute for Liberty and Democracy (ILD) in Lima, he works with heads of state to implement institutional reforms that give the poor access to formal property rights for their real estate holdings and businesses along with the tools to release the capital locked up in those assets. De Soto’s work has earned the ILD recognition from the international press. London’s conservative Economist magazine has called the ILD one of the world’s two most-important think-tanks in the world; London’s Daily Telegraph called the ILD the progenitor of one of the four biggest ideas in modern times for improving the lives of the world’s poor; and New York’s Time magazine ranked the ILD as one of the five most-important innovators of the 20th century in Latin America.

De Soto recently spoke with World Press Review correspondent Kenneth Rapoza in a series of telephone interviews from Paris and Tanzania.  

Kenneth Rapoza: What do you mean by the “extralegal” economy? What is its negative impact in the developing world today?
De Soto: Extralegal is something that cannot be readily used as a guarantee to obtain credit, invest, or make accountable by a third party. The “under-the-table” economy is part of the extralegal sector. You have people in developing countries who have a legal home, with all the legal documents they require, but have an “illegal” job. It’s rare to find purity. Seventy-eight percent of the Mexican population is either living or working illegally, which is to say they are working in the informal economy. If they own assets, these assets are not working for them because they are not registered; they cannot borrow against their assets to create wealth. In Mexico, this includes 11 million buildings and 6 million businesses, for a value of US$315 billion. That is equivalent to seven times the value of all known oil reserves in the country and 29 times the value of foreign direct investment. So we’re on to something here. We’re currently working with the Mexican government to reform all this. They understand when you ask them, “What happens when 78 percent of your society doesn’t pay taxes?” It also means if you’re looking for someone like Osama bin Laden, you’re not going to be able to prove he exists.

In 1990, the economist John Williamson, defining the “Washington Consensus” on U.S. Latin American policy, listed the recommendation to secure property rights as one of the 10 items of the consensus. Why do you think this recommendation hasn’t figured more prominently in Western governments’ advice to Latin American countries since?
My own suspicion is that basically the West doesn’t know what to do. Everyone in the West knows that property rights are essential to establishing wealth, but they don’t know the genesis. How did that come about? What laws and institutions enforced it? They don’t know.

What concrete economic results have been attained through this program of formalization?
We ran a project together with the Peruvian government and the World Bank about 10 years ago. It cost about $77 million and had a net benefit of $9.4 billion—or a net return of well over 100 percent—and is one of the most successful projects of the World Bank. We went into towns to legalize housing, evaluate property, and give owners titles and deeds for their properties. More than 400,000 companies moved from the informal to the formal sector. Tax income increased by $400 million a year between 1993 and 1995 and over half a million jobs were created. In towns where people had legal assets, 20 percent more children were enrolled in school. It was one of Peru’s greatest economic growth periods. Then we were kicked out by [President Alberto] Fujimori’s government.

Do these economic reforms lead to greater stability and democratic participation?
The more people that are inside the legal system the better. Once you’re in the legal system, you become more interested in the political system.

Brazil is offering small, low-interest loans for poor families, small farmers, and small businesses. Do you take this as a sign that the banking and political elites are realizing that they have to go “down-market?”
Microcredits are great. Banks have to recognize that the poor know how to use credit and will use it efficiently. Banks and governments are definitely discovering the poor and just how important small- and middle-market enterprise really is. Many companies in this sector are informal and a lot of that has to do with the tax systems in these countries. But in the end, microcredits will only work if the borrower has something to loose by not paying back their loan, and they will only have something to lose if they have title deed, legal ownership of their house, their car, their family farm, whatever.

If Brazil, Peru, and Mexico completely formalized their economy, would they be less dependent on foreign capital?
Yes, of course. They’d finally have national capital and they’d have ways to guarantee investments. It wouldn’t put the International Monetary Fund out of business, though. There will always be international cycles of ups and downs where it will be useful. And there are plenty of projects for the World Bank to invest in.

People in countries like Brazil complain about taxes and that’s why, they say, they operate small businesses in the informal economy because they can’t afford to be totally legal.
So Brazil and countries like it must have more incentives for people to want to be in the formal economy and be legal. It has to be cheaper for them to work within the law. You need to do a total cost/benefit analysis, because trying to bring them inside the law is not easy. One of the first thing illegal immigrants want when coming to the United States is to become legal, because it just makes their lives easier. But in Mexico or Brazil, you can do better working outside the system. Often there are no jobs in the formal sector, so people who aren’t criminals invent their own jobs and become the informal economy, mostly. In the United States, no one wants to work outside the legal system. It just doesn’t make a lot of sense. Not unless you’re on the cast of “The Sopranos,” of course.