De Soto and *Shadow* Economics

[A BBC interview yesterday with Hernando de Soto on the problem of shadow banking will be followed by an excursus about his impact on a student of development economics in the early 1980s.]

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BBC interviewer:  Could the next global financial crisis come out of the shadow banking sector, which accounts for more than a quarter of world’s financial companies? These are the companies that raise money and lend it without being a bank. Official banks have felt the regulatory screws tightened, but shadow banks are still virtually unregulated.

Ben Bernanke [on tape]:  Inevitable side effect of new regulations is that the system will adapt in ways that push risk taking from more regulated to less regulated areas.

Hernando de Soto:  I don’t mind small banks or hedge funds. The question is: do we know what they’re producing, do we know what they’re doing? ‘Shadow’ implies missing information. They produce something like $700 trillion of derivatives, financial instruments, which are not recorded. That is ‘shadow’. They have balance sheets off the books that no longer reflect the values. You don’t get to know who is really in control and what the real debts are. The crisis begins where there is a non-correspondence between the financial instruments and the underlying assets they’re supposed to finance. What needs to be done is open the doors and let people who are not financial inside -- because it has to do with truth telling -- it can only be solved at the highest political level. It’s not about getting a new bureaucracy, or just giving the regulators an insight. It’s about giving information for all of us. “Just report” [say this to them]. In the same way I have to report to government what I own so I pay my taxes. All we’re asking of banks and financial institutions is to publish their books. They are the only ones who are allowed a secret life in the shadows. The result is we are all afraid to invest, including them; they’re not investing with each other. You need governments to take a stand. That’s how you brought down kings in Europe and emperors in Asia, you made them report. We’ve reached that revolutionary moment. What was in place has been eroded over the last 15-20 years. There was a western system where everybody was accountable to the law. Whoever took advantage of the law by incorporating, having limited liability, being able to issue paper, simply had to go out and inform and tell the truth. That took a lot of courage. You had to confront privilege.

That is my (inexpert) transcript of parts of yesterday’s interview with Hernando de Soto. You can listen to the whole thing here or download the podcast. In addition, here is an extract from an FT article Hernando de Soto published in January 2012:

The brilliance of western capitalism lies not in providing a formula for wealth creation but in its property memory systems, which are the result of examining, selecting and validating information about who owns land, labour, credit, capital and technology, how they are connected and how they can be profitably recombined. For the past 15 years, the records of western capitalism have been debased, leaving governments without the facts to spot what needs to be fixed and for businesses to know where their risks are. To regain its vitality, western capitalism must bring under the rule of law and public memory hundreds of trillions of dollars now swirling mindlessly out of control in the obscure world of financial innovation.

The sage speaks infrequently. When he does, every piece must be treasured and recorded.

I will blog about Hernando de Soto’s economic ideas in the future. 

Today, being weekend, I want to make a pleasurable journey down memory lane. Let me take you back 30 years to when de Soto’s ideas, his valuable information, his knowledge of development and capitalism, were still confined to the shadows of darkest Peru.

I arrived in Peru in October 1981 with three other English students clutching local council grant cheques (the British state is not so generous now) and letters-of-introduction from the university. Our Instructions for Year Abroad? Find a university, enroll in it, do research, keep out of trouble. We soon scattered in different directions (months later the eldest among us was expelled from the country by the Peruvian Investigative Police for fraternizing with peasant activists in Cajamarca). But while we remained together in Lima we began our research by gaining *free* entry to a Symposium on Development and Dependence organized by Hernando de Soto’s new Instituto de Libertad y Democracia (ILD).

This was a watershed in my life. I attended the symposium for 3 days. I listened in a small auditorium at The Sheraton to Milton Friedman, the novelist Mario Vargas Llosa, historians Hugh Thomas and Luis Alberto Sanchez, the Venezuelan journalist Carlos Rangel, and various Peruvian political leaders. Carlos Rangel was author of one of the most important books ever written about Latin America; I wish I had known that then.

I still have the original conference program booklet! Hernando de Soto later said: “The conference was a huge success. The fees we collected were used to set up an office, and to hire a clerical staff and consultants.”

And, they had the generosity of spirit to let in four unwashed punkish-looking undergraduate students waving only their letters-of-introduction!

What a stroke of luck it was to begin the year with that historic symposium of the ILD in November 1981. De Soto had not yet written The Other Path (1989), a revolutionary book documenting the effects of government red tape on informal sector small-scale business.

But I absorbed quite a bit about the aims and interests of the ILD in 1982; enough to influence how I focused a year of fieldwork in the Peruvian highlands and Lima’s urban fringes for an undergraduate dissertation on the spread of market relations in the artisan sector. If it hadn’t been for that symposium perhaps I would have looked more negatively -- or not at all -- on the expansion of commerce, the movement from communal ethics to ethics of market competition, the unleashing of entrepreneurial spirits and natural ingenuity, the resulting greater equalization of economic opportunity, and the importance of enforceable property and contract rights in securing the benefits of market expansion.

I shall mention a trivial but doubtless representative example of the shadows in which de Soto’s work languished many years. In 1984 I started a 2-year masters in development. Urban small-scale enterprise was the topic of one paper I submitted in the first semester. In it I referenced 25 books and articles, several of them written by my own professors.

But I also included arguments I had found in a newspaper article about the ILD’s research in Peru. What I remember about the essay is not its content, which I’m sure was bad and confused, but rather the fright I got when the relevant professor of development economics initially would not grade the essay. When the grade was not forthcoming I enquired about it. The course administrator said I must make an appointment to discuss the paper with the professor. I have a vivid memory of my encounter with that tall bearded Canadian fellow (so many of them were marxist in those days) in his office. After questioning me about my motives for including the arguments of the ILD -- which I apparently refer to in the essay as “right wing” -- the professor told me in gruff unequivocal terms that the views of Hernando de Soto and the ILD were not acceptable. I must have been a stubborn and unyielding in those days, because the final copy of the essay still contains reference to the ILD findings:

A recent study of the ‘black economy’ in Lima by an influential Peruvian think tank, the Institute for Liberty and Democracy, concluded that small-scale enterprises, family work shops and street vendors are sophisticated operators. Showing a clear admiration for the incipient entrepreneurs of Lima’s shanty towns, the Institute complains of the “high cost” of job stability codes, workers participation directives, and other bureaucratic regulations.

I notice Hernando de Soto continues to provoke outrage among some of my old profs (pdf):

There is a particularly militant and influential variant of legal formalism, associated with Hernando de Soto, that we discuss separately in Annex 1 under the label of ‘property rights fundamentalism’.

Hernando de Soto’s explication of shadow economy is fundamentalist? Don't be ridiculous...;