What's Wrong with Latin American Economies?

Elections without democracy, regulations without law, a private sector without capitalism

Marxists in Latin America, and others whose ideology is contrary to market economies and democracy, describe the poor as an oppressed proletariat with no interest in entrepreneurship and free markets. Our research in Peru indicates otherwise. While only about 5 percent of Peruvians belong to labor unions, more than 60 percent are entrepreneurs.

These entrepreneurs, however, operate illegal businesses in the black market, the "informal" sector. This raises the question, Why are they illegal? Is that a Latin American characteristic—that half the people are dishonest and are culturally not made for doing deals above the table? Our researchers at the Institute Libertad y Democracia set out to discover why almost two-thirds of the man-hours in Peru have to be worked outside the law.

We set out to measure the cost of the law, especially to the most disadvantaged sectors of society. But instead of asking lawyers what they thought the cost might be, we went out and started firms ourselves. The first was a small workshop on the outskirts of Lima. It had two sewing machines and produced garments.

Four students, including a lawyer, went window to window, complying with the requirements of the bureaucracy. Working six hours a day, it took them 289 days to register the firm and operate legally. We just finished the same experiment in New York City, and it took us four hours. In other words, a Peruvian has to work 433 times as many hours as a North American before he can start a small enterprise.

The same is true with street markets. It takes a group of street vendors, from the time they get organized to the time they are authorized to build a market, more than 12 years to get the necessary authorizations. Of the large retail markets in Lima, 274 were built illegally by "informals," while only 57 were constructed by the state.

When it came to housing, we found similar results. Most Latin American cities are surrounded by small, poor houses, neighborhoods called "young towns" in Peru. Most of these homes are illegal. We discovered the reason why. If I were the secretary-general of a small housing association with 100 families and wanted to legally obtain some abandoned government land and permission to build houses on it, I would have to visit 52 government offices and fill out 207 different forms.

In total, I would have to work 8 hours a day for 6 years and 11 months before the land could be purchased or conveyed for housing purposes. Not surprisingly, in 1985 there were only three legal conveyances of land in Lima and more than 282 "invasions," illegal occupations of government land.

The costs of excessive laws include not only the costs of entering the market but also the costs of remaining legal. Of every $7.00 that a small legal enterprise pays to government, $1.00 is in the form of taxes, and $6.00 is in the form of bribes, social costs, and bureaucratic red tape. The law is a very costly thing for most people in Latin America.

Some critics suspect that Third World entrepreneurs work in the informal market not because regulations keep them from becoming legal but because they want to avoid taxes. But most informals in Latin America do pay taxes. Very little of the tax revenue in a country like Peru comes from direct income taxes. Most comes instead from excise or consumption taxes. One of the Peruvian government's biggest sources of revenue is the gasoline tax. Since 95 percent of public transport is informal, the informal sector is one of the biggest contributors to government.

Also, the government finances itself by running huge deficits, creating a high inflation rate. The people who actually pay for inflation directly are those who have to hold large cash balances. Those who hold large cash balances are, of course, the informals.

There are a variety of excise taxes. Street vendors in most Latin American countries, including Peru, pay an excise tax every day to the police. The municipality of Lima collects twice as much from this tax on street vendors as the government collects for property taxes in the whole formal sector in all of Peru.

The informals do not operate outside the law because they want to, but because the cost of the law is enormous. They are not trying to avoid the law. We have documented what we call the extralegal norms of the informals—the common law of the black market. This common law recognizes property rights. Informal entrepreneurs know how to settle disputes. They have their own register of property ownership, their own torts, and their own insurance system. But, of course, the system is weak because their rules cannot be enforced by government.

Our researchers measured not only the cost of bad law but also the cost of not having good law. Take the example of property rights. We found two young towns in Lima with different degrees of development. One had three-story buildings with television sets lit behind the curtains and Toyotas and Volkswagens downstairs. It had neatly trimmed lawns, and you could reasonably describe it as a middle-class neighborhood.

Across the road was your typical shantytown: corrugated iron, cardboard walls, poor sanitation. So we assumed, obviously, that these were two towns of different levels of cultural and economic development. But our advisers from the ministry of housing told us that both of these towns had been started together by the same kind of people—as a matter of fact, by migrants from the same Andean village. We spent a year studying them, and we found that the difference between them was that the people in the nicer town had titles to their land and those in the other town had no titles.

The mayor of the first (these towns all have illegal but democratic elections) had dedicated most of his time to obtaining property titles. He had not only walked the long corridors of Peruvian bureaucracy but had also petitioned government in more than one way. For example, he gave this town the name of the wife of the president of the republic, changing the name when the president changed. Then when they got the titles, he gave the town the name of their real hero. Ten years later, the value of the homes was 41 times greater than in the other town. When people are certain that the property belongs to them, when uncertainty is eliminated by a good property right—whether the property is owned by an oil company or a poor Peruvian—they invest. They begin to change their human capital into physical capital.

At the same time, they have collateral for loans. In the United States, about 80 percent of your small enterprises are financed through mortgage loans. Mortgage loans are possible because your land and your homes are titled. Only 3.5 percent of Peruvian homes are titled. One should not be amazed therefore that Peruvians don't get ahead. They have no way of converting secure property rights, even when they've obtained them, into credit—without which it is impossible to conceive a business.

Also, of course, the possibility of renting homes and obtaining additional income is greatly reduced. Nobody wants to have somebody renting the second floor when the building's owner doesn't have a title, because when somebody does come around to grant a title the person renting the second floor will say the home is his.

This lack of property rights accumulates one form of anarchy over another. If you have in the informal sector no property rights, no credit, no courts to settle disputes, no courts in which to complain against bad government action, no possibility of making long-term arrangements on the basis of which to make future investments, if you have no way to secure your labor, if you have no way to capitalize yourself by paying salaries at the end of the month, so you can actually use other people's work as an investment—then your possibilities of being prosperous are largely diminished. It's the law that gives you those advantages, including the law of limited liability.

A Latin American operates with unlimited liability. That is the maximum uncertainty. If a Latin American takes a risk and loses, his liability is totally open. He will lose not only his business, as you do in limited-liability companies, but his car, his home, his mattress, his TV set—practically all his assets. He can't spread the risks around. He has no way of buying insurance.

The two traditional countries that are examples of wealth are Switzerland in the West and Japan in the East. Now, Switzerland has no cocoa, and my country does have cocoa, yet Switzerland produces better chocolate. Japan has no iron. My country does. But Japan produces more and better steel than Peru. Owning natural assets is not sufficient. A country must be able to assemble the necessary resources to develop assets productively. The ability to pool resources is crucial.

Now how can you pool resources? You must have contracts that allow you to combine them in the most fruitful manner possible. Imagine that a friend and I discover ourselves in the informal sector of Peru. We decide we have talent and resources we want to pool together. I have a little button-making machine, and I make the best buttons in Lima. My friend knows how to sell buttons. He knows how to make the contracts, he knows who needs the buttons, he knows people who trust him—he's got that kind of talent. We decide we could start the big button industry of Peru and even become exporters.

We agree that owning this asset of a button machine gives me more rights to the business than my friend, so we'll split the profit 60-40. We shake hands on that. My friend goes very happily to his home and sees his wife. She says, "Now, wait a second. Think it over. This fellow, De Soto, you barely know him. This fellow, De Soto, after a year will know who your clients are, whom to sell to, when to sell, and how to sell to them. After a year, he won't need you. He will no longer keep on giving you 40 percent of your business."

And my friend thinks it over and agrees with his wife. Right now, he thinks to himself, there's a great sort of friendship budding. But within one year, he worries, when it comes time for De Soto to give me 40 percent of the profit, he might think differently.

As a result, my friend will choose instead to associate with a relative—someone in his extended family. And that person won't produce buttons as good as mine. So they will have a little company that isn't going to be very prosperous. I'll have to do the same. I'll find somebody to sell buttons who trusts me because he happens to be family of mine. But he just doesn't sell buttons the way my friend can sell buttons. And therefore, the two talents that were required to make a successful industry in Lima will not be able to merge. Then some anthropologists from Cornell University will come to Peru and say, "Look at Peruvians. They like to work in small family units."

It is not that Peruvians, or Salvadorans, or Venezuelans like to work in small family units. Nor are our families any closer than yours. It's that we have no other resources with which to get associated, because the law does not work for enterprise the way it does in your country.

To analyze how good law gets made, and why Peru doesn't have good law, our researchers began to analyze—and count—our laws. We found that the government of Peru makes 27,000 rules a year. That means 111 rules a day. The most extraordinary feature of these 111 rules a day is that 99 percent are made by the executive branch and only 1 percent by the legislative branch.

Consider the contrast with the way you make rules in the United States. First, you have the common law. Thousands of courts spread throughout the United States produce rules through jurisprudence. This lawmaking is not centralized in monopolistic hands. There is not one family or one person who controls it. There are thousands of people. The law is spread around. It is not perfect, but it is not the monopoly of any one person.

The second way you produce rules is, of course, through Congress. To be elected a representative in the United States, you've got to be more popular than whomever you're running against. And if you want to be reelected, you'd better vote the way people think you should vote, because they keep records on you.

In my country, that isn't the way parliamentarians are elected. Parliamentarians are elected according to a system of lists. If I want to be elected, I've got to be in the highest position possible on one of the political party's lists. And the people do not decide who gets high on that list. The leader of the party does. So my incentive is to vote the way the party structure wants me to vote. So even that 1 percent of Peruvian laws that comes from parliament is produced under different incentives from ours. It begins to be clear how 289 days of obstacles to starting a business can be created.

The third way to create laws is through the executive branch. The executive branch in the United States has gotten more powerful each year. But, nevertheless, you have ways of controlling it. First of all, no important regulation comes down without following Office of Management and Budget procedures. Everybody is required to bring out laws not only structured in such a way that they can be easily read but also accompanied by a cost-benefit analysis. And people who don't agree have the opportunity to come in and modify the law through comment and public hearings.

Through the whole process, there is access to public information. Any North American can get public information. The press certainly can. In my country, there is no access to public information. In fact, it is forbidden by law.

Our courts are not governed by equal-access-to-justice laws that let any citizen challenge a rule that is substantially unjustified. We have no General Accounting Office that acts as an ombudsman. We don't have referendums, which the Swiss use to repeal laws. We don't have any of those feedback mechanisms that keep government continually in touch with people and that can prevent them from producing those terrible laws that affect most Peruvians.

Every five years in Peru we have elections. We elect a dictator every five years. You've confused it with democracy, and so have we. But it's only elections. It has none of the accountability and none of the feedback mechanisms that really make a democracy.

When we come to the United States looking for someone who can explain how the feedback and accountability mechanisms actually work, we can't find such a person. It's not just that we don't know how a democracy works; you don't know how democracy works, either. Over 250 years, you have built this system whereby government is more or less under control. And because it's been done spontaneously, you've never made a blueprint.

The terrible result is that you can't teach it. If you can't teach it, then when you start talking about democracy you get satisfied with small things, like when we have elections. But elections really don't mean democracy. Democracy has not failed in Latin America. It's never been tried.

This situation affects the formal sector as well as the informal. The property rights of most Latin Americans even in the legal sector are not secure. Most governments are allowed to expropriate for social needs, and "social needs" are not defined in any of the constitutions. The definition can be chosen arbitrarily by any government.

The definition of property rights in Latin America does not include contracts or credits as it does in your country. So the government can freeze all assets in dollars without having violated anyone's property rights. It's simply called a financial move, a financial transaction. We have no courts in which to fight expropriation. As a matter of fact, we can't challenge expropriation under our law.

As a result, our researchers have found some very interesting statistics on Peru's formal sector. We found out, for example, that 85 percent of all entrepreneurs or managers who work in the provinces at firms with more than 100 employees live in Lima, not in the provinces. It is much more important to be close to where the law is decided than to be close to the factory. How much time is wasted? How much productivity? How much inefficiency is due to the necessity to be close to the lawmakers?

We also found out that general managers in Lima spend 45 percent of their time involved in politics of one form or another. As a result, Latin Americans are slick. We usually become presidents of business conventions because we know how to deal with people. To be successful in Peru, the way the law is formulated obliges us to spend at least half our time cultivating politicians.

This is not a Latin American characteristic. This is the way that most of the world was before the democratic revolutions occurred in the course of the last 250 years. That's why we at the institute refer to the existing system of government in Peru as a mercantilist system. It is a system of predemocratic capitalism. It is a system that predominated in Europe 100 or 200 years ago, depending on the country. It is a tightly privileged system of capitalism where only those who have access to political power can actually do business.

In the old days of mercantilism, a private sector existed. But private companies did not necessarily have to compete. What was important was to have a charter from the king. And if you had a charter from the king, you could then operate. You needed political permission to do so, as you do in Peru.

So an important distinction has to be made between the private sector of a country like Peru and the private sector of the United States. Let's imagine we are French, living back before the American Revolution. We decide that the objective of our foreign policy is to protect private enterprise in North America. Then we hear about the Boston Tea Party, a demonstration against King George. Who backs free enterprise? Both the leaders of the Boston Tea Party and King George. If that is the only criterion, we will develop excessive contact with King George and forget about the Boston Tea Party. The fundamental distinction is that King George does not want free access to markets and the leaders of the Boston Tea Party do.

Many of our "private sectors" in Latin America are, in effect, King George's entrepreneurs. The informals are the budding Boston Tea Parties of the Third World. Any association with King George will be short-lived. The mercantilist system can no longer hold these people who were supposed to be the other side of the dual economy. They have come into the city and they want the same things we do—and they've got rising expectations sufficiently strong to disrupt the system.

If you open the doors to them, you get Hong Kong—a prosperous country in which entrepreneurship flourishes and all people feel they have opportunity and can participate. Peace comes about gradually. If you close the doors, you get Vietnam. If you close the doors, you get Nicaragua. You get Cuba. If you open the doors, you might get England. But these are the alternatives.

It's very difficult to negotiate this with King George III. It's much easier if one establishes direct contact with the Boston Tea Party. Democracy and entrepreneurship have not failed in Latin America. They haven't been tried. There is a constituency for change. It happens to be the majority of the country. They seem to have the same ideals as you do, but nobody has made contact with them—except the Marxist-Leninists, who do cater to them, while you cater to the private sector.

The informals do not see themselves as the private sector. We did a very interesting survey among some of the informals in Lima, the most eloquent and representative of them. We asked them three basic questions. The first was, Are you the private sector? In 98 cases out of 100, the reply was no. The second question was, Are you the public sector? The reply was also no, the public sector is the government. So the third question was, Who is the private sector? And the reply was, those who have the privileges. So you can't use the word private in Peru.

In this context, we have made many mistakes—for example, when a North American conservative thinks that a Latin American conservative stands for the same principles. A North American conservative wants to conserve the principles of Benjamin Franklin and James Madison and Thomas Jefferson. A Peruvian conservative wants to conserve Francisco Pizarro. Very different things.

Most problems in Latin America can be solved. They all involve structural adjustment. But structural adjustment is not what the Baker plan calls it. It's not what the Bradley plan calls it. It's not what the IMF calls it. And it's not what the World Bank calls it.

Structural adjustment is taking away the 289-day barrier. Structural adjustment is really seeing what gets in the way of people and markets, and what gets in the way of people controlling their own government. That is structural adjustment. Once we get those terms right, there is no reason why Peru shouldn't also be a prosperous country.

Hernando De Soto is president of the Instituto Libertad y Democracia in Lima and author of The Other Path: The Invisible Revolution in the Third World (Harper & Row). This article is adapted from a Reason Foundation Forum speech.