Spotlight: Underground Observer

When Hernando de Soto talks about Peru, he describes a land of Incan legends, of mountains, jungle, and desert, of Indians with high cheekbones and haunting eyes. A classic image of his country.

But de Soto adds a twist. He goes on to talk about Peru as the home of a bustling free-market economy: a dirty, developing El Dorado in which impoverished Indians have become urban entrepreneurs. While many people look at the sprawling slums of Lima and see only despair, de Soto sees a system with great promise for the poor.

With its mind-boggling network of government regulation, Peru is not generally regarded as a free-market mecca. But the free market de Soto describes is not the official economic system; it is Peru's immense underground economy, which the 42-year-old de Soto has been exploring for the past five years as president of the Institute for Liberty and Democracy (ILD), a free-market think-tank in Lima, the capital.

Born in the city of Arequipa, on the southern coast of Peru, de Soto studied in Europe and spent much of his adult life there. In 1967 he received a masters in economics from the Institut des Hautes Etudes Internationales in Geneva. He began working toward his doctorate but was lured into a job with the international agency the General Agreement on Tariffs and Trade (GATT), where he worked until 1971. Later he worked for firms in Paris and Switzerland. By 1978, homesick for his own country, he returned to Peru.

In 1980 de Soto founded the ILD, close on the heels of his hosting a symposium, "Democracy and the Market Economy." The left-wing military dictatorship governing Peru had agreed to bow out to an elected civilian government, and de Soto saw a need for broad public discussion of the available economic options.

The 1,200 people who attended that symposium were mostly members of the Peruvian elite, but a few unusual guests participated as well: de Soto invited about 20 chiefs of the street vendors' guilds of Lima. During the conference, he called attention to these street vendors. He told the audience that these people, many of them working outside the law, without state protection or subsidies, were the real entrepreneurs of the country, from whom the rest of the country would have to learn.

"This shocked people," says de Soto. But it delighted the street vendors, who asked de Soto if they could do anything to thank him. "Introduce me to the underground economy," he replied. Thus de Soto began to establish contacts in the underground who trusted him enough to talk about their businesses. After two years gathering information, he decided to proceed with a comprehensive study of the underground economy.

In 1981 de Soto organized a second symposium, persuaded Milton Friedman to attend, and threw him in with, among others, newly elected president of Peru Fernando Belaunde Terry, UN Secretary-General Javier Perez de Cuellar, and Peruvian novelist Mario Vargas Llosa. Having explained at this symposium his plan to study the underground, or "informal," economy, de Soto then put together a team of 55 researchers with varying backgrounds. They spent the next two years investigating the underground economy and by the end of 1983 had accumulated 22,000 pages of reports detailing the story of the informal economy.

This inside story turned out to be a shocker. The ILD found that two out of every three urban Peruvian workers are employed in the underground. Most of these workers are Indians, poor newcomers to the cities who lack the connections and funds to cut through the red tape required to set up a legal business in Peru. Instead, they go into business outside the law. Their efforts account for 90 percent of the clothing business in Lima, 75 percent of the furniture business, 60 percent of construction, and 95 percent of public transportation. All this activity substantially raises average per capita income in Peru above the government figure of $900 and has been achieved without state planning or financial help and despite the high costs of evading the law.

The informal sector has its own legal code, which is sufficiently powerful and efficient to enable businessmen to enforce deals that would be impossible to enforce in government courts. Keen competition makes it essential that businessmen uphold their contracts to preserve their reputations. Even off-duty judges hired to arbitrate disputes don't take bribes—if word got around that they were dishonest, they wouldn't be hired.

Armed with his study, de Soto is trying to convince his countrymen that these underground entrepreneurs have created a huge, native market economy that is in many respects more efficient than the legalized sector. Unlike many Latin American advocates of the free market who rub their countrymen the wrong way by pointing to "imperialist" developed countries as role models, de Soto is asking Peruvians to look to themselves to recognize the benefits of the marketplace. "The character here is Peruvian," he says, "but the overall definition is a market economy." De Soto hopes the Peruvian government will cut back the legal jungle and confer formal status on the native market economy.

Although de Soto has set himself a tough marketing job, his efforts are worth watching. Along with his evidence that free enterprise is actually the Peruvian way, he is providing Peruvians with a vision of their own dignity and abilities. Though an unusual approach to the problem of poverty in Latin America, it just might catch on. It has the merit of offering a solution.

Claudia Rosett is a research fellow at the Manhattan Institute.