My most memorable experience on a trip to Peru in the early 1980s was the "markets tour" organised by the Institute of Liberty and Democracy in Lima. This showed the path that the typical poor migrant from the Andes took in the metropolis. Travelling across Lima one got a living picture of the process: how migrants organised "invasions" of public land to build their shacks with pilfered supplies of electricity and water, and eked out a living in "informal" activities, including whole illegal covered markets the size of shopping malls. The striking thing was the enterprise of poor people and the ubiquitousness of the trading instinct. Hernando de Soto wrote a famous book, The Other Path, about these informales and about how they were forced into illegality because of the mercantilist system of licences and controls which made it impossible for them to become legal. This meant that they had to create an informal system of law often manned by judges and lawyers from the official system. Their property rights nevertheless remained insecure.
In his latest book The Mystery of Capital (Bantam), de Soto has extended his research to quantify the hidden capital held-mainly in the form of housing-by these informales in the Philippines, Egypt, Haiti and Peru. His estimates are staggering. They are many times all the foreign aid and foreign investment these countries have received since 1945. He therefore, rightly, concludes that, it is not a shortage of capital per se, or lack of entrepreneurship that keeps these countries poor. His panacea is to unlock this hidden capital in the informal sector by making it-in particular the shanty housing-legal, by analogy with the granting of land rights to squatters in the frontier states of the US. This would allow the informales to make their capital liquid so that they could use it as collateral for loans to make wider investments.
There are two problems with this idea. First, unlike in the early years of the US, where there was no infringement of other settlers' rights by squatters, in many parts of the third world the squatters are encroaching on private land or public land designated for parks, drains and other developments. Why should they be granted rights to their shacks at the expense of the rightful owners? Second, much of the illegality of the informales is forced upon them by the "Permit Raj" established in these countries in the name of planning. If these dysfunctional control systems were removed, the informales could operate legally, by converting some of their income into legal housing. But this is not a new finding, and hence there is no real "mystery of capital."
But why do poor countries create and maintain such dysfunctional protectionist economies which keep them-and particularly their poorest-poor? To provide an answer we need to understand what the state is up to in these countries. The state has to have a monopoly of coercion within its territory in order to provide the public good of law and order. As Hobbes described in Leviathan, any state that ends anarchy will raise the incomes and welfare of its citizens. From the viewpoint of the citizen, the state should seek to provide this and other public goods at lowest cost. But such a benevolent Platonic guardian state attempting to maximise the common weal is a historical oddity. Most states through history have, by contrast, been predatory-their objective being the extraction of the maximum flow of resources, including intangibles such as prestige and power for the government and its associates. Predator states share an interest in the enlargement of the incomes of their prey through the provision of public goods, but only so far as this raises the flow of the state's income. So, unlike the benevolent state, the predatory state's citizens' welfare is a by-product of, rather than an objective for, its policies.
What will limit the takings of the predatory state? As a state must have a monopoly on coercion, the only constraint on its exactions is the plausible threat of external or internal competitors contesting this monopoly. This depends on the barriers to entry facing competitors. In The Political Economy of Poverty, Equity and Growth (Clarendon Press), which I co-wrote with Hal Myint, three types of "autonomous" state-which are indifferent to the pressures from their citizens-are contrasted with the "factional" state. This latter type, which often includes democracies, serves the interests of the factional groups who have captured it. Such states can be just as self-serving and predatory as the non-benevolent autonomous states. In particular two-party majoritarian democracies, by and large, serve the interests of the median voter by direct and indirect redistribution from both ends of the spectrum to the middle, (consider the "middle class capture" of welfare states).
The late economist Mancur Olson, in his posthumously published book Power and Prosperity (Basic Books) found his own way to this model of the predatory state. Olson was an original thinker as he showed in his classic The Logic of Collective Action. When he published his article on "roving and stationary bandits" (on which the new book is based ) I told him that he should look at my predatory state model as it encompassed his own model and filled in some of its gaps. Unfortunately Olson died before doing so, which for me makes his new book doubly unsatisfactory, in leaving some obvious holes in the argument and in the spurious claim of originality for its thesis.
Be that as it may, Olson's great insight into democratic capitalism was to note that only small groups could succeed in organising effective collective action, because of the problem of monitoring and controlling "free riding"-getting something for nothing-among larger groups. Thus, in providing, say, law and order, it is in the interests of each member of the community to hope that someone else will pay the costs of provision and they will obtain the benefits for nothing. (All social contract based theories of government are therefore pure fantasies.)
The same Olsonian insight also explains why small pressure groups will succeed in using the political process to redistribute income to themselves from the unorganised majority. There is no reason, therefore, to expect, as Olson admits, that democracies will "take" less than autocracies. In fact the dynastic predator is likely to take a longer view of the costs and benefits to him and his heirs from his "takings" than a typical democratic politician primarily concerned with the outcome of the next election.
This "taking" by the state has various forms. Most forms of state intervention can be reduced to explicit or implicit taxes on, and subsidies to, various groups in the economy. Politics of every kind is by its nature a redistributive game. Where direct taxes are difficult to administer and collect, as in most developing countries and in developed countries in the past, the rulers have to find alternative means to maximise their amount of "take." The licences and controls, which are the hallmark of the mercantilist economies of Europe's past and their descendants in today's second and third worlds, provide the alternative. Hence the "dirigiste dogma" of development economists in the first two decades after the second world war.
One particular feature of dirigisme is the creation of politically determined entitlements to current and future income for various favoured groups in the economy (the poor, small businesses, pensioners, or just political cronies). These entitlements have to be paid for by explicit or implicit taxation of other groups. But in non-totalitarian societies there is bound to be a reaction against these takings. As the tax burden rises, it leads to tax resistance and to the growth of the parallel economy. De Soto's contribution is to document its staggering size in some developing countries.
The predatory state finds that, as many of its victims seek to escape its depredations-in the "suburbs" of 18th-century England, or the informal sectors of the contemporary third world-its tax base shrinks. (In parts of Africa people literally flee, disappearing into the bush to undertake subsistence cultivation.) With unchanging expenditure on the politically determined entitlements and declining tax revenues to finance them, the state faces a fiscal crisis. Economic reform is then undertaken to restore the fiscal base by rescinding the now unviable political entitlements. In some cases the changeover can only occur via revolution. The French Revolution began with the calling of the Estates General to deal with the chronic fiscal crisis faced by the French state. Economic liberalisation was thus undertaken both in the 19th-century Age of Reform, and in the late 20th-century Age of Reform to regain government control over increasingly ungovernable economies.
The most original and valuable part of Olson's book is his model of the Stalinist economy and its denouement. This was a predatory state which found a way to extort more from its prey than any other in history by confiscating the entire capital stock of the country, and then preventing the collapse of investment by directly controlling the level of consumption and thus investment. Stalin came by a canny system of taxation in which all the profits of state enterprises accrued to the state with no explicit taxation of individuals. But by setting basic real wages at fairly equal but very low levels and allowing workers to keep whatever they earned outside normal working hours, the system created a "confiscatory tax on the normal amount of work and little or no taxation of extra or bonus income." This increases the incentive to work, particularly for the ablest. With high savings and increased working hours, it is not surprising that, even with the inefficiencies associated with the suppression of market signals, the growth of the Soviet economy was so dramatic for a few decades.
But this growth performance could not be maintained for two reasons. First, the suppression of markets also removed the incentives for technical innovation. Second, to overcome the inefficiencies of a marketless controlled economy, the Stalinist central planners used various forms of bureaucratic competition allied with terror to elicit information from, and to control the performance of, state enterprises. But given the small number of managers involved there was always the danger of collusion rather than competition among these subordinate units. Given the perils of the gulag, at first this collusion could only be covert. But over time, as personal trust is built up and the collusions reach down to lower levels of subordinates, a devolution of both power and the implicit tax take occurs. Whatever modicum of efficiency the initial bureaucratic competitive bidding provided disappears with these collusions, leading to economic sclerosis. These collusions also involve rising corruption. As Olson puts it: "If no one but the centre owns property, and if no one but the centre has the legal right to claim the implicit tax receipts, then everyone except the centre has an incentive to induce these officials to become part of the countless conspiracies to take back some of what the state has stolen... It is a law of motion of Soviet-type societies that they must not only run down over time but also become increasingly corrupt."
The dissipation of the state's tax base through the above process faces it with the fiscal crisis that necessitates reform, which in the Soviet case meant its demise. Despite the emergence of markets, the transition in many post-Soviet type economies has been rocky. The reason, Olson argues, is that in many of these countries, the previous collusive alliances have not been dissolved. Instead they have become overt, publicly funded insider lobbies. By contrast, he says that China's cultural revolution had the unintended bonus that, being aimed at the cadres, it destroyed these collusive special interest lobbies, much as the second world war did in Germany and Japan, so that when Deng Xiaoping switched to the market there was not the same resistance to change as in Russia..
So the general lesson is clear. The ideal for promoting the wealth of the nation is to prevent state predation so that the tax take is limited to providing the necessary public goods. Most government interventions to improve the functioning of imperfect markets are disguised forms of predation. However, there are some circumstances in which there are structural reasons why such predation will be limited. One of the themes of the Lal-Myint book was the connection between economic performance and land-labour endowments. Countries which have no land or natural resources, say "rocks" like Hong Kong or Singapore, have only one resource their states can exploit-their citizens. So no matter how predatory the state in such countries, the only way it can obtain any revenues for itself is by raising the incomes of its citizens through policies to develop its human resources (education and so on). And being small economies with labour as the only resource, they have to remain open to foreign trade and capital. Wealth-generating policies are thus forced upon even the most predatory state on these "rocks." By contrast, in natural resource-rich countries, the predatory state will seek to grab the rents associated with these resources for itself through various dirigiste means with an adverse effect on the economy. This explains the different outcomes even among predatory states in the so-called "gang of four" in east Asia, and the many natural resource-rich countries in Africa, Latin America and the Soviet Union itself.
But even in natural resource rich predatory states, as long as the state can maintain economic and civil liberties associated with the protection of clearly defined property rights-but not necessarily political liberty-poverty alleviating growth can occur. It is well known that if markets are to expand beyond purely spot trading to encompass exchanges over time, it is essential that promises are legally enforced otherwise trading will be confined to the small-often kin-based-circles in which there is mutual trust and effective sanctions. With the establishment of a formal system of law in which strangers can sign enforceable contracts with each other, there will be a widening of the market, with big gains in both the volume and efficiency of investment.
A legal system covering commerce for enforcing contracts among strangers is one of the features which set the west on a different path from the rest of the globe. In my book Unintended Consequences (MIT Press) I described how this arose because of Pope Gregory VII's Papal revolution of 1075, when he overturned the ancient Christian doctrine "render unto Caesar the things that are Caesar's...," by declaring "Let the terrestrial kingdom serve... the celestial." As Harold Berman has shown in Law and Revolution, the whole of the western legal tradition derives from the development of canon and secular law during the 11th to 13th centuries under the aegis of the church-state called into being by Pope Gregory VII's declaration of 1075. That in turn arose to protect church property from plunder, following its rapid accumulation in the preceding centuries as a result of the family edicts of Pope Gregory I in the 6th century. (The effect of Gregory's new rules was to reduce the number of families with male heirs so that the church benefited from a big increase in gifts of property.) Once this legal infrastructure has been invented it can be transferred to other regions and civilisations. The only other necessary condition is that there should also be a framework for preserving civil liberty where individuals can expect their property rights to be adjudicated impartially.
It has become a mantra of western-in particular US-political scientists, which has now been taken up by the World Bank, that democracy is required to protect the individual property rights essential for development. Olson, despite seeing the darker side of the predatory special-interest coalitions in a democracy, also makes this claim in favour of democracy. But one just has to think of the example of colonial Hong Kong to realise that all good things do not in fact need to go together. Even without political liberty, the civil and economic liberties assured by the colonial government were sufficient to launch this "rock" on its spectacular post-war development. In fact in the Lal-Myint study we found no link between the form of government and economic performance, despite the many studies which claim to have found such a relationship (in democracy's favour).
Nor is democracy likely to be an inevitable by-product of development, as many hope-especially with reference to China. The polities of ancient civilisations were determined largely by the ecological-geographical environment in which their high cultures were formed. These have given rise to ancient political habits. Thus Chinese civilisation developed in the compact Yellow river valley, constantly threatened by the barbarians from the steppes to the north. To cope with this continual threat to its existence it developed a tightly controlled bureaucratic authoritarianism which continues to our day. It is unlikely to change unless the Chinese cease being Chinese.
By contrast, Hindu civilisation developed in the vast Indo-Gangetic plain, protected to a greater extent by the Himalayas from the predation of barbarians to the north. This geographical feature also accounts for the traditional Indian polity which was notable for its endemic political instability among numerous feuding monarchies, and its distinctive caste system. The latter, by making war the trade of professionals, saved the mass of the population from being inducted into the deadly disputes of its changing rulers. And the tradition of paying a certain customary share of the village output as revenue to the current overlord meant that any victor had little incentive to disturb the daily business of its newly acquired subjects. The democratic practices gradually introduced by the British Raj fitted these ancient habits like a glove. The ballot box replaced the battlefield for the hurly-burly of continuing "aristocratic" conflict, while the populace accepted that its rulers would through various forms of "rent-seeking" take a certain share of output to feather their own nests.
Thus, in contrast with the current conventional wisdom (in the World Bank and IMF), I would argue that law is more important than democracy in engendering prosperity. Despite attempts to conflate different types of liberty, the distinction between economic-cum-civil and political liberty is important, and whatever the intrinsic value of the latter, it is not as vital for prosperity as the former is. This is fortunate, as the political habits of people are difficult to change, but they can all adopt the legal institutions pioneered by the papal revolution of Gregory VII.
In conclusion, what we have rediscovered as the cause of the wealth of nations is a refurbishment of the classical insights of Smith and Hume. What is needed, they saw clearly, was good government, which promotes wealth by establishing laws that guarantee free exchange and peaceful competition. About the form of government they were agnostic. They recognised the natural predatoriness of states, including democratic ones. Even predatory states, as we saw, can have an incentive in certain circumstances to pursue the right policies, but there is always a natural instinct to return to their bad old ways. How such states can be tied, Ulysses-like, to the mast, to prevent their basic instincts from damaging the springs of popular wealth creation, remains the big unanswered question. No one has found the solution-not Hume, not Smith, not de Soto, not Olson-not even me!
