How do Institutions Facilitate Entrepreneurship

ECONOMICREFORMFeature Service

Center for International Private Enterprise

How do Institutions Facilitate Entrepreneurship?

Article at a glance

• Creatingwealththroughentrepreneurshiprequirescombiningdifferentresources(forexample,thepartsofapencilorthoseofawatch).Institutionsarecrucialtofacilitatingthatcombination.

• Todoallthethingsthatentrepreneursindevelopedcountriestakeforgranted–likedividinglabor,usingpropertyascollateral,protectingpersonalassets,expandingmarkets,orcreatingeconomiesofscale–entrepreneursindevelopingnationsneedthestandardsthatonlylegalinstitutionscanprovide.

• Thewealthyindevelopingnationshaveconvincedthepoorthatnomatterhowtalentedorenterprisingtheyare,theywillneversucceed.Infact,theworld’smostsuccessfulentrepreneursjusthaveaccesstosuperiorlegalinstitutions.

March 15, 2013

Hernando de SotoPresident

Institute for Liberty and Democracy

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To comment on this article, visit the CIPE Development Blog: www.cipe.org/blog

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Center for International Private Enterprise How do Institutions Facilitate Entrepreneurship?

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This FeatureService article is based on an interview at the CIPE offices in Washington, DC on February 11, 2013.

Institutions Facilitate Entrepreneurship

Entrepreneurship is all about combiningthings from different resources to create wealth,and institutions are crucial to facilitating thatcombination. What do I mean by “combiningthings”? Consider Leonard E. Read’s famousexample that to build a simple pencil involvesnumerous countries, countless individuals, andhundredsofdifferentingredients:fromgraphitetotheOregon woodwhich sandwiches it in, to thecopperofChileandthezincofPeruandtheblacknickelofSouthAfrica,whichholdtheerasercloseto the pencil itself, to the lacquer that is on thepencil.The wood requires kilning and dyeing. Itmustbecutandshapedandglued.Ortakealookatyourwatch,whichislikelytoinvolvemorethan500parts,alsoprovidedbysuppliersfromallovertheworld.

Tocreatethetrusttocombineallthoseresourcesandpeopletomakeeventhemostcommonobjectsrequires many legal institutions. Good contracts,for example – a clear definition of who has thepropertyrightsoverthematerials,andconfirmationthat you are not buying from a crook. If you donot have the appropriate legal environment, youwill have very poor-performing entrepreneurship.Successful countries have created the rule of lawwithitspropertyandentrepreneurialrights,which,inturn,haveallowedthemtocombineallsortsofthingsandpeopleandtherebycreatewealth.

Wherever I go in theworld, entrepreneurshipis already there – even in developing countrieswhere most of the people are poor. WheneverI walk on a street in Mexico City or Cairo, forexample, I encounter somebody trying to sellsomething or build a business. People are, bynature, very entrepreneurial – particularly thepoor, who typically have no alternative forfeeding their families other than going intobusiness for themselves, as street vendors or

shantytown entrepreneurs. In some places, therearewell-organizedentrepreneurswhohaveverylowtransactioncosts,whocanmakedecisionsquickly,and can combine, recombine, and rethink thecomponents of their business. However, in otherplacesthereareentrepreneurswhohaveabsolutelynone of the contractual support that is necessarytodealwithpeoplefaraway.Andthisdifferenceisonemajorreasonwhysomecountriesarerichandmanymorearepoor.

In otherwords, if you lack that rule of law –allthoselegaldevicesthatallowyoutoconnecttoother people, particularly property and businessrights – youwill be forced to do business on thebasis of customary or constructed agreementsbetween you and your relatives and neighbors.Sucharrangementswilllimityourbusinessactivityto a physical circumference of 25 miles or so.Expanding your markets to areas where you arenot personally known is impossible without theidentitymechanismsthatonlythelawcanprovide.So,while urban areas of developing countries areteemingwith small, informal enterprises,withouttheruleoflawthoseentrepreneurswillneverpullthemselves–ortheircountries–outofpoverty.

Infact,themostimportantpartofthebusinessenvironment is rules. Everybody has rules, eventhose who work outside the legal system. Theyhavebusinesspracticesthattheirfellow“extralegal”entrepreneurs accept; theyhave created theirownnorms to make transactions and protect theirassets.Buttodividelabortoincreaseproductivity,tousetheirpropertyascollateraltoobtaincredit,to protect their personal from business assets, toexpandtheirmarketsorcreatethekindofeconomiesofscalethatgeneratewealth–todoallthethingsthatentrepreneursindevelopedcountriestakeforgranted – they need the standards that only legalinstitutionscanprovide.

Universalstandardsarefairlynew–onlyabout120yearsold.GreenwichMeanTime,forexample,the standard thathas allowedus toestablish timedifferences – and business meetings – across theglobe,hasexistedonlysince1884.Similarly,19th

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Century legal reformers in Europe and the U.S.begantoset thestandards fordoingbusiness thatput theWest on a fast track to economic growthover the next century. As a result of the spreadof such standards, the global economyhas grownmore since the end ofWorldWar II than in theprevious2,000years.

Moving Toward the Rule of Law

IntheThirdWorldandinmostformerSovietnations, the majority of entrepreneurs are stillwaitingfortheirownlegalreformerstogivethemaccess to those standards – the same ones theirelites already have.They are forced to operate inwhatIcallanarchy.Thisdoesnotmeanthattheyare lawless; they have, in fact, too many systemsofrules,differentbusinessstandardseverymileortwointheprocess.

Policymakersneedtopromoteentrepreneurshipby establishing and spreading standards. At thecenterof the ILD’smission is to create awarenessthroughout the developing and former Sovietworldthatentrepreneurshiphasnothingtodowithculture,thattheideathatcertaingroupsofpeopleare incapable of entrepreneurship is amyth, thatreligionisnotafactor.Overthepastthreedecades,theILDhasworkedinLatinAmerica,Asia,Africa,ex-Soviet Europe, and the Middle East. Ourresearchershavefoundthatpeopleeverywherewantbasicallythesamething–toprotecttheirpropertyandgrowtheirbusinessessothattheycanmoveoutof poverty. Once policymakers have understoodthat,wecanbeonourway.

Think of the migrants that flowed into theUnitedStatesfromEurope,orthosecomingfromthehinterlandtocitiesinPeru.Everybodyisgoingto where there are standards andwhere there areeconomiesofscale.InthecaseofPeru,forexample,90 percent of the managers who have industriesoutside Lima actually live in Lima, because it ismoreimportanttobeclosetothestandardsandtothelawmakersthanitistobesupervisingyourownfactory.The issue is, “Howdoeseverybodyget toparticipateinthis?”

Another problem is that most of thelawmakerswhodraft the rulesdonotunderstandthe importance of bringing all their citizens,particularly the poorest among them, into thelegal system. Thomas Jefferson understood. Sodid Washington, Franklin, and Madison. Allthe attention given to constitutions and to rulemaking that benefitted all Americans proves thatthey gave the law a huge amount of importance.That is no longer true among political leaders,in my experience. So, we must start convincinglawmakers that law is important – for everyone.The reason that people behave differently in thePeruvian Amazon than in Lima, for example isnot just cultural; they own things, and they havebusinesses. But discriminatory, burdensome andjust plain bad laws force them to operate in theextralegaleconomy.

Mobilizing Small Entrepreneurs

In order to get the majority of people indevelopingcountriesmovinginthesamedirection,the first thing I’ve found useful to tell them isthat they are “entrepreneurs.” In many countrieswhere I go, I find an entrepreneurial class thatjust does not believe they are entrepreneurs.Thewealthy have managed to convince the poor, nomatterhowtalentedorenterprising theyare, thatthey are inferior, that they need more educationor luck or were born in thewrong ethnic group.Evenpoliticiansontheleftareinclinedtosaythatindigenous peoples are “different” – and are notinterestedinparticipatinginthemarketeconomy.


While urban areas of developing countries are teeming with small, informal enterprises, without the rule of law those entrepreneurs will never pull themselves– or their countries – out of poverty.

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Our researchhaspunctured suchmyths.AfteraviolentconflictinthePeruvianAmazonin2009between indigenous communities and the policeprotecting the interestsofprivatecompanieswithlegal concessions to exploit the region’s naturalresources, the ILD sent a team into the regionto determine the causes.We soon found that thelocal people had their own private property andbusinesses; theywerealready in themarket– justnotthelegalone.Wealsodiscoveredthattheyhadgone to war to protest their lack of legal controloverthepropertyrightsoftheircommunities.

Todemonstratetoindigenousleaders–andPeru–thatnativepeopleswerecapableofoperatinginthelegalmarketeconomy,theILDbroughtdownindigenous leaders of enterprises in Alaska worthmore than $2 billion each. They arrived in fulltribalregaliaandsaidthatthekeytotheirsuccesswashavingpropertyrights,whichmadeitpossiblefor them to turn their tribes into multi-nationalcorporations. “I am an Indian of the Kamloopstribe,” declared Manny Jules, the famous activistforCanada’saboriginalpeoples,“andIamproudofmytradition.ButIamnotamuseumpiece.Letmetellyouwhy.”Then,hisPeruvianaudience,startedtounderstand.

AsIsaid,Ifindentrepreneurseverywhere;buttoooftentheyneedtobeconvincedoftheirstatus.“I only work frommy garage,” aman in a Limashantytownmighttellme.Interesting,sodidSteveJobs.Andthenheadds,“Ididgotouniversity,butI dropped out.” So did Steve Jobs. “Well, he hadideas.” You don’t? “Oh yes, I have ideas.” But hecan’tpatent themorget a loan to turnhisgarageinto a real business – or get any of the 18 otherthings that Steve Job did to turn his idea intoApple.This is thekindofprocess that it takes toprovetoordinarypeoplethateventheworld’smostsuccessfulentrepreneursarenotculturallysuperior;theyjusthaveaccesstosuperiorlegalinstitutions.

There is no doubt that people can grow frombeingsmall-scale,informalentrepreneurstolarge-scale entrepreneurs. That is the history of the

world. And one cannot foretell where it is goingto happenorwho is going to do it. Letme offerone final example from my native Peru, where Ireturnedtolive30yearsago.Thosewhowererichand powerful then are completely different fromthosewhoarerichandpowerfultoday.Yes,peoplegrow from struggle to success. I do not know acountrywheretheoppositewouldbetrue,providedeveryonehasaccesstothelegalinstitutionsessentialforprosperityandgeneratingwealth.

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Hernando de Soto is currently President of the ILD —headquartered in Lima, Peru— considered by TheEconomistas one of the two most important think tanks in the world. Time magazine chose him as one of the five leading Latin American innovators of the century in its special May 1999 issue “Leaders for the New Millennium”, and included him among the 100 most influential people in the world in 2004. In its 85th anniversary edition, Forbes named Mr. de Soto as one of 15 innovators “who will reinvent your future”. In January 2000, Entwicklungund Zusammenarbeit, the German development magazine, described Mr. de Soto as one of the most important development theoreticians of the last millennium. In October 2005, over 20,000 readers of Prospect magazine of the United Kingdom and Foreign Policy of the United States ranked him among the top 13 “public intellectuals” in the world from the magazines’ joint list of 100.

Mr. de Soto has served as an economist for the General Agreement on Tariffs and Trade, as President of the Executive Committee of the Copper Exporting Countries Organization (CIPEC), as CEO of Universal Engineering Corporation (Continental Europe’s largest consulting engineering firm), as a principal of the Swiss Bank Corporation Consultant Group, and as a governor of Peru’s Central Reserve Bank.

In recent years, Mr. de Soto and his colleagues at the ILD have been involved in designing and implementing capital formation programs to legally empower the poor in Africa, Asia, Latin America, the

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Center for International Private EnterpriseHow do Institutions Facilitate Entrepreneurship?

Middle East, and former Soviet nations. More than 30 heads of state have invited him to discuss carrying out ILD institutional reform programs to fight poverty and legal exclusion in their countries.

Mr. de Soto has published two books about economic and political development: The OtherPath, in the mid- 1980s, and at the end of 2000, TheMysteryofCapital:WhyCapitalismTriumphsintheWestandFailsEverywhereElse. Both books have been international bestsellers – translated into some 20 languages.

The views expressed by the author are his own and do not necessarily represent the views of the Center for International Private Enterprise (CIPE). CIPE grants permission to reprint, translate, and/or publish original articles from its EconomicReformFeatureServiceprovided that (1) proper attribution is given to the original author and to CIPE and (2) CIPE is notified where the article is placed and a copy is provided to CIPE’s Washington office.

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How do Institutions Facilitate Entrepreneurship