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Homo EconomicusThis is a subject that most people in developed countries probably won't understand, but it is one that people in underdeveloped countries live through every day. Therefore, we will plow away with it. The question is simple. Why is that Capitalism works in the West but it does not seem to work in other under-developed places? Particularly Latin America?

We need to start somewhere, and we will start here. One valiant economist (Hernando de Soto) tried to provide a coherent explanation in his book "The Mystery Of Capital - Why Capitalism Triumphs In The West And Fails Everywhere Else". We sincerely applaud his and his colleague's efforts for they had the courage to get out of the cozy academic environment and plunge themselves into economic reality. For this alone, they deserve our greatest admiration (no, we are not kidding).

However, and there is always a however, his main conclusion is all wrong. In essence, his view is that although poor people have sufficient properties (i.e. capital) to be successful entrepreneurs, this capital, these properties are not legally recognized by governments and this provides an un-surmountable hindrance to the capitalist process and economic wellbeing.

This is, of course, error.

His point of view is that people in poor countries remain poor because they can't get their bureaucratic paperwork in order. Seriously? De Soto should be ashamed of himself having been born in Peru and travel extensively through Latin America; he should know better.

Let's break the problem into small bits.

THE REAL ESTATE PROPERTY ISSUE

It is true that in most old underdeveloped countries anything related to the government bureaucracy is a nightmare. Claiming property rights (such as to un-occupied government land or similar) is a dead end. But let's look at history. There are two lessons:

Lesson #1: what happens when people is given property without having to work for it? We know what happens. Many such experiments have taken place, the most notable one by Peron in Argentina in the 50's. He provided free houses to people. Result? They sold them immediately or dismantled them and sold off bits and pieces and returned to slums. This is a historical fact. In other words, people who receive property without effort do not appreciate it and do not use it for furthering their own financial or economic conditions. They simply do not use this capital but they waste it.

Lesson #2: what happens when people are given property they worked for? Again, we have plenty of historical experiences in this area. Over time, many people in different countries were given the rights to the properties they built on government lands. And what did they do? They simply continued with their lives without using these properties as collateral for loans in order to further their financial and economic conditions. And why would they? They now owned a house or apartment free of debt and still kept the same low paying job they had before. They were far better off than before. Why risk everything?

Giving people capital does not translate into usable capital for entrepreneurial purposes. People want safety first and a property provides just that. They have no incentive whatsoever to use these properties as collateral.

In this sense, whether or not people have legally recognized rights to property has nothing to do with their economic activities.

The real estate property issue is not the root cause of the different economic outcomes from developed and underdeveloped countries.

THE BUSINESS PROPERTY ISSUE

On the same topic, registering a small business is a non-starter. It is for this reason that most small business in underdeveloped countries don't do it. Most small business are indeed extra-legal of sorts. People with the stamina to become entrepreneurs follow the path of least resistance. This path is simple: only register what is absolutely necessary and ignore the rest.

In so doing, they answer the following question: which government entity has the manpower to go after them? The usual answer is: the government entity with the budget to hire people to go after them. Typically this means the tax collector and the municipality. Any other federal or provincial or regional authorities simply lack the budget to follow up on their threats, and so entrepreneurs quite wisely ignore them.

What all this boils down to is simple: the amount of government bureaucracy that one needs to go through to get a legal property claim is actually small to reasonable, because the rest of the bureaucracy is simply non-operational and therefore ignored.

This is, in reality, how a market frees itself, one useless bureaucratic process at the time.

In the end, most small business in underdeveloped countries operate extra-legally in some manner or another and they do this quite successfully. They do so not because they are greedy, evil bastards, but because they either do this or there is no profit to have. No entrepreneur can wait months to get a permit. We need to emphasize that this is not an exception but the rule. At this level, at the level of small business and small entrepreneurs who are proprietor-owned and proprietor-operated they operate just fine without the full blown set of legal property rights. Many of them operate without any property rights at all. They have been doing this for decades without any sign of decrease. And why not? The free market is about… well… marketing stuff; it is not about filling paperwork for useless bureaucrats.

The business property issue is not the root cause of the different economic outcomes from developed and underdeveloped countries.

ECONOMIC ACTIVITY IN CONTEXT

In order to arrive at the correct conclusion, we need to look at the problem in its proper context. Economists tend to look at economic activities as "aggregates" (i.e. everything in the same bag). The GDP of the country is such and such. Un-employment is higher. Poverty levels are lower and so on. This is, of course, the wrong view. Not everything goes into the same bag and not all bags remain static throughout economic cycles.

We need to look at economic activity through these cycles. Doing so is illuminating because through these cycles bureaucratic requirements remain the same as well as property issues also remain unchanged. Yet, somehow, economic activity rises and drops! How strange!

Well, no, it is not strange at all.

Capital has nothing to do with economic activity, at least not in the manner in which de Soto describes it. Economic activity has to do with price stability. More specifically, entrepreneurial activity has to do with price stability.

If you study (or even better, travel) to underdeveloped countries, you will notice that as soon as inflation drops to meaningless levels (typically under 1% per year), economic activity miraculously flourishes. As soon as inflation begins to grow, economic activity drops like a stone. This is not economic fiction, it is economic reality. It has nothing to do with property rights or with the capacity to release trapped capital because of lack of property rights. It has everything to do with Central Bank printing and the inflation they unleash.

People in underdeveloped countries tend not to respond in the classical manner to monetary stimulus (i.e. print and spend). They do to a degree, but they respond much more extensively to the lack of economic stimulus in the monetarist sense because this stimulus comes with inflation attached to it.

CONTRADICTION

This is all well and honky dory but when we try to apply this to developed countries it looks quite dodgy. Developed countries' economies seem to respond to the classic monetarist theory. Print (or borrow) and spend and the economy goes up, stop this process and the economy goes down. How is this contradiction possible?

ANSWERS

The answers to these problems are, of course, to be found somewhere else. As we have explained many times before (for example see Political Systems Lifecycle), different countries are in different political (and economic) evolutionary steps. People in underdeveloped countries understand that the best opportunity they have to make a profit is when the government is nowhere to be seen. In practice this means the time when short economic stability periods appear between debacles. They fully understand that it is now or never. They could not care less about the legality of property rights nor about the extremes of the extra-legality they operate in. They simply don't care and with good reason because the government can't get them.

The opposite is also true. When people in such countries are confronted with higher inflation rates, they fully understand that strange forces are at work and that as a consequence of this action, economic activities will become progressively worse. Therefore, what do they do? They reduce economic activity because it is a loser's game. Levels of entrepreneurship drop. They fully understand that they cannot go against these forces and win; therefore they simply fold and leave to wait for better time. Or pass the problem to somebody else by getting a job.

People in developed countries, on the other hand, have not yet learned this valuable lesson. Consequently, they expect governments to re-activate the economy. It is the you first credo. It is irrelevant if the inflation is below 1% or over (as long as it is not too high). If the government fails to "incentivize" the economy they won't either. Allow us to ask you this question. Right now, in your country, given the current economic conditions, would you go out and start a business? Of course not. Any why not? Because the economic conditions are depressed. This attitude becomes a self-fulfilling prophecy.

Ask yourself. Why is that USA and EU economies are depressed even though interest rates are the lowest they have been since…well… pretty much ever! When was the last time that ZIRP (Zero Interest Rate Policies) were enacted in those places? Well, this is the first time. Yet, there is no economic reactivation. Why? Because everybody is afraid. And why is so? Because of the debts levels. And why would this make them afraid? Because the economy is flat and those debt levels cannot be sustained. And what are the consequences of this logic? Not to invest in economic ventures. And what is the result of this? Economic depression. Presto! Full circle. Self-fulfilling prophecy.

And what happens in these countries when inflation rises? People invest more heavily to "protect" themselves from inflation. They don't fold and leave economic activities; they simply look for higher ROI deals. And what do we get in these conditions? Bubbles and crashes. It is this mentality, the exact opposite to the undeveloped world mentality that makes all the difference.

ENTREPRENEURS

There is one more concept that we need to explore. Many economists are of the opinion that for some reason, people in underdeveloped countries lack or have less of entrepreneurial skills. This is, of course, rubbish. They are looking at entrepreneurial activities through the distorted lens of Central Bank activities. Entrepreneurial activities raise and fall with the printing and restraining from this activity that Central Banks undertake. However, since printing is pretty much the universal hobby in those places, it is then inevitable that entrepreneurial activities are depressed. In order to see what this people are capable of, you need to look at those brief periods when Central Banks are out of the picture. Then, you will realize that entrepreneurial skills are not a "God given right" of developed countries. It is an inane skill that we all have, pretty much in the same amount, no matter where one goes.

CONCLUSION

People in under-developed countries are poor precisely because of the interventions of Central Banks. It is monetarist economic policies that create poverty, not bureaucratic or legal property rights issues. Sure, rights eventually become an issue, but in general terms, they play a very small role in activating or re-activating economies. It is not that Capitalism does not work in underdeveloped countries; it is that politicians and Central Banks keep wrecking it. In the end, it is a matter of lessons learned. Evolution. Further politically evolved people respond differently to different economic conditions. This is only common sense. Experience matters in the real world and always had. This is, unless you are an economist of the monetarist persuasion, in which case only theory matters… until reality explodes in your face.

Believe this or not. Your experience, your choice.

Note: please see the Glossary if you are unfamiliar with certain words.

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