HOW TO MAKE POOR COUNTRIES RICH Hernando de Soto is pushing a new idea: Legalize the underground economy. Entrepreneurs now working off the books could then make the Third World strong.
By Jeremy Main REPORTER ASSOCIATE Sarah Smith

(FORTUNE Magazine) – THE underground economy, also called the informal, invisible, or black economy, is regarded around the world as a refuge of drug traffickers, smugglers, and tax evaders. Now a new view is taking hold: At least in the Third World, the underground economy is mainly good, not bad. It embodies the entrepreneurial energy of ordinary people striving in admirable ways to break out of poverty. It comprises thousands of craftsmen, storekeepers, truck and bus drivers, and food vendors whose operations would be perfectly legal in the U.S. but whose governments force them to ply their trades illegally. The underground economy is part of the solution, not the problem. If this entrepreneurial spirit were legalized and nurtured rather than fettered and suppressed, goes the argument, a burst of competitive energy would be released. Living standards, which have been dropping in much of the Third World, would start rising. International trade would increase, and developing countries could service their huge and debilitating external debts more easily. The champion of this new idea is Hernando de Soto, 47, an ebullient Peruvian economist and businessman. He argues that in order to realize their full economic potential, inhabitants of the underground economy need such basic things as titles to land and homes, the right to go into business, and the ability to borrow money and enforce contracts. Son of a diplomat who once chose exile from the country, de Soto studied in Canada, the U.S., and Switzerland. He is fluent in English and French in addition to Spanish. De Soto earned a graduate degree in international economics and law at the University of Geneva and eventually became a managing director of Universal Engineering Corp., a Swiss consulting firm. In 1979 he returned to Peru to manage a placer gold mine, but found himself more interested in the informal economy. The next year he established the Institute of Liberty and Democracy. Though he is hardly the first to study the underground economy, no one has delved into it more thoroughly or heralded its possibilities more enthusiastically. His book, called The Other Path to contrast with the Maoist revolutionary group known as the Shining Path that has murdered thousands of Peruvians in recent years, has been a best-seller in Latin America since it was published in 1986. It has already stirred controversy among leading economists, and an English translation will appear in the U.S. soon. De Soto devotes most of his attention to Peru, where what he prefers to call the informal economy adds 29% to official GNP. But he says the same conditions of overwhelming bureaucracy, regulation, and favoritism exist in various degrees in much of Latin America and Africa. In Argentina, according to Marcos Victorica of the Institute of Contemporary Studies, an economic research % organization, the unreported, informal economy last year produced $50.4 billion, vs. the official GNP of some $70 billion. It is more upscale than Peru's, including most of Argentina's professional and managerial classes. In Kenya the lethal minibuses called matatus that cruise around Nairobi are the most colorful expression of the unofficial economy, which the ministry of planning says contributes about 35% to the country's GNP.

Because he challenges conventional economic thinking, de Soto has plenty of critics among economists. Jaime Mezzera, a Latin American specialist with the International Labor Organization, thinks de Soto exaggerates both the size and potential of the underground economy. He concedes that it creates jobs cheaply, but he believes it adds no more than about 15% to any Latin American nation's GNP. Unless the formal sector grows too, he says, the informal part won't have a market for its goods. A harsher critic is Rudiger Dornbusch, professor of economics at MIT, who worries that de Soto is encouraging tax evasion. Says Dornbusch: ''Economic stability is being destroyed by a dramatic decline in revenues.'' Tax collection in Peru, he says, fell from 14% of official GNP in 1984 to 7% in 1987. De Soto responds that since ordinary Peruvians are shut out of the legal economy, they have no choice but to scratch out a living underground: ''These are people using illegal means to achieve legal objectives.'' FOR ALL the criticism, de Soto has set imaginations aflame. Pedro-Pablo Kuczynski, a managing director of First Boston Corp. in New York and a former Peruvian cabinet minister, believes de Soto overstates his case but is pushing the most interesting economic idea to come out of Latin America in years. Adds James Fox, an economist at the U.S. Agency for International Development (AID): ''What's exciting about de Soto is that he makes you think outside the boxes of traditional development economics.'' Richard Nixon, Ronald Reagan, and Bill Bradley have all picked up de Soto's themes in speeches or writings. AID underwrites much of de Soto's budget, and with the Center for International Private Enterprise, an affiliate of the U.S. Chamber of Commerce, sponsored a worldwide conference last year on informal economies. Research organizations similar to de Soto's have been established or are planned in half a dozen Latin American countries and Kenya. Says de Soto: ''We've become a movement.'' In Peru novelist Mario Vargas Llosa is running for President on a platform based largely on de Soto's ideas. In an eloquent introduction to de Soto's book, Vargas Llosa wrote: ''The informal economy is the people's spontaneous and creative response to the state's incapacity to satisfy the basic needs of the impoverished masses. The people have often shown more daring, effort, imagination, and dedication to the country than their legal competitors.'' For an idea of what Latin American entrepreneurs confront, take a look at the New York City taxi system. To own a cab in New York, you need a license from the city, known as a medallion. No new ones have been issued in the past 51 years, so newcomers have to buy one of the 11,787 existing medallions that trade for around $140,000 each. As a result, the city doesn't have enough cabs. An informal fleet of some 40,000 limousines and so-called gypsy cabs -- often inadequately insured and unsafe -- has sprung up. Now imagine that the entire U.S. economy works like New York's cab system. That's the economy of Peru and most of the Third World. De Soto argues that Peru has never escaped the weight of mercantilism established more than 400 years ago by Spanish colonizers to control all economic activity. Though the country now has a socialist government, he points out that much of the economy remains in the hands of a privileged few who can use connections or bribes to cut through the bureaucracy. TO ILLUMINATE the problems, four student researchers from de Soto's institute set up a small garment workshop and then went dutifully from government office to government office collecting all the required permits and signatures. They vowed to pay no bribes unless absolutely blocked. Working full time, it took them 289 days and two bribes to get the new business approved. Later they went to New York to get authorization to open a similar business. It took four hours and no bribes. No one in Peru, of course, would do what the researchers did. Real Peruvian entrepreneurs would use whatever influence they had and pay lots of bribes. Or, more commonly, they would just go into business illegally. De Soto and staffers at his institute discovered that food retailing in the city is dominated by some 90,000 illegal street vendors. Most bus and taxi transportation in Lima is informal. The government never bothered to develop a system because of its grandiose plan -- never carried out -- to build a subway. ALTHOUGH they often win some recognition from the authorities through bribery or negotiation, underground businesses have no access to the courts and cannot enforce business contracts. Unless they have spent years haggling with bureaucrats, they have no title to their property and can't get mortgages or insurance. They stay small to escape official attention and so never achieve the economies of scale that lead to higher productivity. While underground entrepreneurs evade all the taxes they can, bribes can exceed what they would pay legally. The problem is that, unlike taxes, bribes support no government services. Even if the underground economy were legalized, it would still be tangled in bureaucracy. De Soto claims the Peruvian government produces an average of 27,400 new laws and regulations a year. Only 360 are passed by Parliament. The rest are produced by bureaucrats and politicians, in alliance with privileged businessmen, and without accountability, public participation, or even the knowledge of most of the people affected. In order to buy or build a house according to the law, a person would have to spend a decade waiting for the government to complete the paperwork. As a result, de Soto estimates, nearly half the people of Lima -- a city of about six million -- live in illegal housing. These homes are created in a remarkable fashion. While the government looks the other way, thousands of settlers swoop down on the edge of the growing city, usually on vacant public land, to create so-called young towns. The invaders are well organized and thorough. Planning begins with meetings of neighbors, families, or regional groups who need the housing. They often hire politicians, labor leaders, or professors to help them plan. On the day of the invasion, they arrive in trucks and buses accompanied by temporary kitchens and security guards to keep order. Elected leaders walk around laying out streets and property lines with powdered chalk. The settlers quickly put up crude shelters of straw matting. Gradually the shelters become more solid, and some evolve eventually into elaborate houses with basic conveniences. De Soto calculates that between 1960 and 1985 informal housing worth $8.3 billion went up in Lima. The trouble is, the homesteaders have no title to their homes. Appalled by this kind of irrationality, de Soto has moved beyond research and writing into advocating reforms that will help illegal workers, homeowners, and entrepreneurs. Peru's socialist President, Alan Garcia, decided last year to nationalize the banks that were still private -- about a fifth of the country's total -- on the ground that they weren't providing credit for the common people. De Soto seized the opportunity to point out that Peru's nationalized banks weren't making loans to poor people either. The real problem, he argued, was lack of collateral because so many people had no title to their homes. Garcia dropped the nationalization plan and adopted de Soto's idea of a streamlined system for registering homes built by squatters. The registration can be used to back a small loan. Garcia signed the law in July, and de Soto expects the credit to begin flowing this year. Small as they may be, the loans could do wonders for an impoverished economy. As little as $800 could give a furniture maker some working capital. CAPITALISM IS STILL a tainted word in Latin America, and de Soto is careful to avoid it. Inhabitants of the underground tend to blame their troubles on foreign exploiters and equate capitalism with the mercantilist privileges they see all around them and have rightly come to hate. They have never experienced a true free-market economy that encourages risk taking and enterprise regardless of class. De Soto and other advocates of reform have taken center stage. Their task is to demonstrate conclusively that small-scale free enterprise can create jobs and prosperity even amid the ruins created by uncontrolled inflation. They have opened up a new way of thinking about solutions for the Third World. Robert Litan, a senior fellow at the Brookings Institution, argues that ''development economists have been missing the boat by concentrating only on capital, technology, and labor.'' As for the Dornbusch argument that he is glorifying tax evasion, de Soto replies that nothing would make his constituents happier than switching to the right side of the law. They operate illegally not by choice but because regulations -- and sometimes taxes -- are so oppressive. If they could enter a legal free market, they would gladly do so and kick off the restraints that now restrict their growth. ''Small is not beautiful,'' says de Soto, and nobody knows that better than those who have been kept small against their will.