The Mystery of Capital
By Hernando De Soto 
Basic Books, 2000 - 276 pages

The book, in case you don't know, is socio-economic in nature as Mr. DeSoto discusses economics, philosophy and economic development throughout the world. The book is well written and easy to read while it is, in my opinion, highly repetitive in chapters 1-4.

I read The Mystery of Capital in September of 2001 and this book, along with three others I read that month, caused a light bulb to go of in my head. More specifically, I have rethought how individuals coexist in our global economy and, more specifically, how economic development will be altered in the next century due the impact of representational systems. To this day I continue my reading on related subjects so that I may publish a report by the end of the year that is definitely economically oriented. I am currently reading about 3000 pages dealing with economic history, philosophy, political thought, economics and science / technology to get more information in preparation for the report.

Here are the key elements of this book, as I see it:

1. Mr. DeSoto tries to explain why capitalism is working in the West and not in many former communist nations. He points to property rights as the key element to launching economic growth in these nations. For those that aren't aware, communist nations are government-controlled and they own and control the assets such as property. Private property doesn't exist for the most part so when a nation departs from a communist philosophy / economic situation the entire social, legal and economic structure must be altered to help the nation stimulate economic growth.

2. The author provides an excellent description of property and how it is "created of the mind." In the West we take private property for granted but in much of the world there are wars and arguments that go back thousands of years about who owns what land and what it can be used for.

3. The book reminded me, once again, about the term "social contract" and how law evolves out of this. The roots of such philosophy go back to the 18th Century with Rousseau and his famous work published in the 18th century entitled Social Contract.

4. There is an EXCELLENT chapter on the evolution of property laws in the United States. I personally have always found history to be interesting and I was typically the individual busting the curve in that class throughout high school and college. While I love the subject it is tougher to generate income with such a degree so you can see my reasons for choosing another career path. For the record, I NEVER considered it because of the monetary implications but I find myself reading more and more about world history on a daily basis so that I can learn about the evolution of politics, economics, philosophy and law. For those that are interested, you will find the topics HIGHLY RELATED.

5. Mr. DeSoto states that many of these former communist nations have yet to establish and normalize the invisible network of laws that turns assets from "dead" into "liquid" capital, specifically as it pertains to property and ownership of land. In the West, standardized laws allow us to mortgage a house to raise money for a new venture, permit the worth of a company to be broken up into so many publicly tradable stocks, and make it possible to govern and appraise property with agreed-upon rules that hold across neighborhoods, towns, or regions. Mr. DeSoto backs this up with data from his think tank's years of experience. For example, in Egypt , the wealth the poor have accumulated via real estate/property is worth 55 times as much as the sum of all direct foreign investment ever recorded there. He also provides data in the countries of Haiti and Peru .

6. Mr. De Soto provides insights as to how these countries are currently organized/operate via an "extra legal" sector. Rather than operating under a formal code of law local cooperatives enforce and provide dispute resolution and he argues that, since law evolves out of social contract that property laws/organizations could be made a part of the law to help unleash capital through the economy.

Now here is where I strongly disagree with Mr. DeSoto:

1. The nations he mentions in his book, which he has done consulting work for and who could turn their illiquid property into capital, rank amongst the most corrupt nations in the world! The nations evaluated are mentioned right at the top!

Source: David Nile's book on Macroeconomics (his source was Business Intelligence, a part of Economics Intelligence Unit)

Don't get me wrong folks. Mr. DeSoto's work truly inspired me but I find it nothing short of appalling how he, who is quite the intellectual heavyweight (based on the sources he quotes), fails to mention time and time again how the proper "superstructure" must be put in place for ANY economy to maximize its growth potential. Instead, Mr. DeSoto actually poses the question "Is capitalism a private club, a discriminatory system that benefits only the West and the elites who live inside the bell jars of poor countries."

The reality to this question is YES!

Until people vote and then hold their congresses and President's accountable corruption and inefficiency will loom large. We must not forget economists and lawyers as they too must choose to implement laws and evolve the economy so that creative ideas and innovative entrepreneurs or existing businesses can generate economic wealth.

2. Mr DeSoto points out that only 25 of the world's 200 countries produce capital in sufficient quantity to benefit fully from the division of labor in expanded global markets. The lifeblood of capitalism is not the Internet or fast-food franchises. It is capital. Only capital provides the means to support specialization and the production and exchange of assets in the expanded markets. It is capital that is the source of increasing productivity and therefore the wealth of nations. I completely agree with Mr. DeSoto but, until the legal system is revised and CORRUPTION is dealt with people will have to rely on what Mr. DeSoto term's the "extralegal" society, where people increasingly rely on informal relationships within the community and amongst individuals. It is a shame because many people have no financial assets in banks, no accrued wealth as we see in the Western World.

3. At least 80% of the population in these countries cannot inject life into their assets and make them generate capital because the law keeps them out of the formal property system. They have trillions of dollars in dead capital. As Mr. DeSoto states, "Perhaps economists have concentrated their focus on policies that deal with the aggregates rather than with individuals. They are the ones that participate in the market system, the ones that elect officials. Many nations forget that people are the fundamental agents of change. Aggregates don't operate with the concept of class in mind."

This insight, in my opinion, is quite on the nose and he brings up a good point....

In discussing capital and how it is created here are some of the interesting/highly correlated quotes I found in the book and who he quotes them from. Many are EXCELLENT points.

o "Karl Marx - The production of the human brain appeared as independent beings endowed with life. Capital was "an independent substance…in which money and commodities are mere forms which it assumes and casts off in turn."

o In talking about representational systems… the philosopher Daniel Dennett has called "prosthetic extensions of the mind."

o Through representational systems we bring key aspects of the world into being so as to change the way we think about it, according to Viviane Forrester in L'Horreur Economique "capitalism has invaded physical as well as virtual space…it has confiscated and hidden wealth like never before, it has take it out of the reach of the people by hiding it in the form of symbols. Symbols have become the subjects of abstract exchanges that take the place nowhere else than in their virtual world."

o Margaret Boden put it "Some of the most important human creations have been new representational systems."

The basic point of the above comments is that capital is not necessarily a monetary amount. Capital is an invisible thing. The importance of a representational system is that it transforms assets (money) from a less accessible condition to a more accessible condition, so that they can do additional work. Representations, unlike physical assets, can be easily combined, divided, mobilized, and used to stimulate business deals. By uncoupling the economic features of an asset from their rigid, physical state, a representation makes the asset "fungible" - able to be fashioned to suit practically any condition.

The classic example, in my opinion, is financial innovations that have occurred during the 20th century that have led to an explosion of different financial vehicles. Mr. Desoto states, "As representations become less ponderous and more virtual, people are understandably skeptical. New forms of property derivatives (such as mortgage-backed securities) may help form additional capital, but they also make understanding economic life more complex."

So, think about this within the context of home equity loans, collateralized loans, mortgage-backed securities. From a Federal Reserve or IMF report I recently read I recall the comment that the number of asset categories within the financial markets had multiplied from roughly 2,500 to 25,000 during the years 1990-2000. If I recall correctly, and I know I am quoting fairly accurately, this truly is an amazing number. We have learned how to have money create additional money because some people want risky assets and others don't. Now if you want to own mortgage notes (defaults are historically low) you can own any class of risk you choose from those with pristine credit ratings and tons of cash on their balance sheet to those who are taking out a 2nd mortgage to finance additional spending or to pay down other debts.

Like all of us Marx was influenced by the social conditions and technologies of his time. Much of today's surplus value in the West has originated not in the scandalously expropriated labor time but in the way that property has given minds the mechanism with which to extract additional work from commodities.

I believe it is also important to note that Karl Marx did not fully understand that legal property is an indispensable process that fixes and deploys capital and that without property mankind cannot convert the fruits of its labor into fungible, liquid forms that can be differentiated, combined, divided, and invested to create surplus value. (quote from Mystery of Capital)

So Mr. DeSoto's conclusion is essentially that the West set up a legal framework that gave most people access to property and the tools of production and other nations haven't. Western nations should help communist nations recognize this and evolve their legal and financial institutions so that capital is not only freed up but created from the capital unleashed.

When I think about representational systems I think of a lot more than property rights. For example, some other representational systems noted in Mr. DeSoto's book include:

Formal notions such as:
" Arabic numbers, not forgetting zero
" Chemical formulae
" Staves, minims and crotchets used by musicians
" Computer programming languages are a more recent example.
" Representative paper money was resisted into the nineteenth century.

Anyways, I hope to discuss what I believe is the impact of representational systems by the end of the year in a full blown report, probably some 50 pages in length with lots of pictures and graphs so they don't bore everyone to death.

To me Mr. DeSoto's book was extremely refreshing because it highlighted how I take for granted certain rights that I have. Many of these rights have been with the country for hundreds of years but they continue to evolve and were shaped by history and its events.

In the book Mr. DeSoto talks about property rights.

It is my belief that the real estate market, which is much of the accumulated wealth in the Western world, would not be what it is today if it wasn't for property rights. Therefore, think about your home or apartment complex you live in. Many of these homes or complexes wouldn't have been built had property rights not evolved because our growth rates wouldn't have evolved with them.

Additionally, due to economic growth the standard home increasingly has more and more luxuries. Did you know that central air conditioning wasn't invented until the 20th century? Heck, the first air conditioners were the ones that people put outside their windows and it was marketed as a convenience or luxury. The population migration to the southern U.S. wouldn't have occurred had it not been for air conditioning temperatures are 110 in Dallas in the summer - air conditioning saves lives, no pun intended.)

Sorry to stray there folks

I think about Mr. DeSoto's work from a personal perspective and my background in accounting.

Accounting has its own representational system, which most people can't understand. It is the general ledger and overall bookkeeping. Then, on top of that you have specialties in auditing, cost accounting, forensic accounting, tax accounting and non-profit accounting.

Each of these particular parts of accounting utilize the same double column method of recordkeeping but they have their own laws, rules and regulations (notice how law plays a key element?).

Additionally, some auditors increasingly specialize in information technology to better understand how money is transferred via the electronic networks and how it affects the balancing of the books. The key element here is that these accountants learn how to program in a language or learn new skills (another representational system). They then apply their new skills across manufacturing, informational technology, R&D, purchasing, marketing, etc. ie. they apply their new skills across departments within the corporation.

The Key point of the book: Accounting has its own representational systems and so does each specialization within a corporation (computer programmers (languages), finance jocks (EVA, DCF, IRR etc), R&D (perhaps physics or science).

As each field (accounting, finance, manufacturing, IT, etc) within business continues to become more specialized and sub-divided people are learning new representational systems and appying them to other aspects of business. The one thing I notice is that the corporation is increasingly the type of organization that is able to fully utilize the talents and skills that are learned by individuals. For example, the entrepreneur can know alot but can he or she learn all of the skills that 10 people can? More importantly, can the entrepreneur then apply those skills on a full time basis through which they create economic wealth?

I say that each part of business is becoming more specialized. Here is another example. Finance: The # of asset classes apparently rose from 2500 to 25000 from 1990 to 2000. Were high-yield bonds an asset class before Michael Milliken? Were asset-backed securities around in the 18th century? How about being able to separate mortgages into tranches of high risk and low risk mortgages, which can then pay their own respective yields given their different features? The key point here is that in the 19th century one could know most of finance. In today's society you may have an asset manager, who specializes in portfolio optimization, a stock trader who trades blocks via his network of information flow, you may have a stock analyst, you may have an asset backed analyst, you may have a corporate bond guy, a municipal bond guy, an international bond guy, etc. Each of these people at large corporations are applying their tool set learned from years of experience and schooling and utilizing them all the time. Would they apply them all the time at their own small investment shop? Would the economy get the maximum benefit from unused skill sets?

Better yet, think about this...........in our society the individual has their own choice....... Do they become an entrepreneur or work in a corporate setting? The choice is theirs.........

Sincerely,

Dan Ross

P.S. As always, if you have any comments / feedback you can reach me at dan@betterbizbooks.com