How do Institutions Facilitate Entrepreneurship?


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

Institutions facilitate entrepreneurship

Entrepreneurship is all about combining things from different resources to create wealth, and institutions are crucial to facilitating that combination. What do I mean by “combining things?” Consider Leonard E. Read’s famous example that to build a simple pencil involves numerous countries, countless individuals, and hundreds of different ingredients: from graphite to the Oregon wood which sandwiches it in, to the copper of Chile and the zinc of Peru and the black nickel of South Africa, which hold the eraser close to the pencil itself, to the lacquer that is on the pencil. The wood requires kilning and dyeing. It must be cut and shaped and glued. Or take a look at your watch, which is likely to involve more than 500 parts, also provided by suppliers from all over the world.

To create the trust to combine all those resources and people to make even the most common objects requires many legal institutions. Good contracts, for example — a clear definition of who has the property rights over the materials, and confirmation that you are not buying from a crook. If you do not have the appropriate legal environment, you will have very poor entrepreneurship. Successful countries have created the rule of law with its property and entrepreneurial rights, which, in turn, have allowed them to combine all sorts of things and people and thereby create wealth.

Wherever I go in the world, entrepreneurship is already there — even in developing countries where most of the people are poor. Whenever I walk on a street in Mexico City or Cairo, for example, I encounter somebody trying to sell something or build a business. People are, by nature, very entrepreneurial — particularly the poor, who typically have no alternative for feeding their families other than going into business for themselves, as street vendors or shantytown entrepreneurs. In some places, there are well-organized entrepreneurs who have very low transaction costs, who can make decisions quickly, and can combine, recombine, and rethink the components of their business. However, in other places there are entrepreneurs who have absolutely none of the contractual support that is necessary to deal with people far away. And this difference is one major reason why some countries are rich and many more are poor.

In other words, if you lack that rule of law — all those legal devices that allow you to connect to other people, particularly property and business rights — you will be forced to do business on the basis of customary or fabricated agreements between you and your relatives and neighbors. Such arrangements will limit your business activity to a physical area within a circumference of maybe 25 miles. Expanding your markets to areas where you are not personally known is impossible without the identity mechanisms that only the law can provide. So, 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.

In fact, the most important part of the business environment is rules. Everybody has rules, even those who work outside the legal system. They have business practices that their fellow “extralegal” entrepreneurs accept; they have created their own norms to make transactions and protect their assets. But to divide labor to increase productivity, to use their property as collateral to obtain credit, to protect their personal from business assets, to expand their markets or create the kind of economies of scale that generate wealth — to do all the things that entrepreneurs in developed countries take for granted — they need the standards that only legal institutions can provide.

Universal standards are fairly new — only about 120 years old. Greenwich Mean Time, for example, the standard that has allowed us to establish time differences — and business meetings — across the globe, has existed only since 1884. Similarly, 19th Century legal reformers in Europe and the United States began to set the standards for doing business that put the West on a fast track to economic growth over the next century. As a result of the spread of such standards, the global economy has grown more since the end of World War II than in the previous 2,000 years.

Moving toward the rule of law

In the Third World and in most former Soviet nations, the majority of entrepreneurs are still waiting for their own legal reformers to give them access to those standards — the same ones their elites already have. They are forced to operate in what I call anarchy. This does not mean that they are lawless; they have, in fact, too many systems of rules, different business standards every mile or two.

Policymakers need to promote entrepreneurship by establishing and spreading standards. At the center of the ILD’s mission is to create awareness throughout the developing and former Soviet world that entrepreneurship has nothing to do with culture, that the idea that certain groups of people are incapable of entrepreneurship is a myth, that religion is not a factor. Over the past three decades, the ILD has worked in Latin America, Asia, Africa, ex-Soviet Europe, and the Middle East. Our researchers have found that people everywhere want basically the same thing — to protect their property and grow their businesses so that they can move out of poverty. Once policymakers have understood that, we can be on our way.

Think of the migrants that flowed into the United States from Europe, or those coming from the hinterland to cities in Peru. Everybody is going to where there are standards and where there are economies of scale. In the case of Peru, for example, 90 percent of the managers who have industries outside Lima actually live in Lima, because it is more important to be close to the standards and to the lawmakers than it is to be supervising your own factory. The question is, “How does everybody get to participate in this?”

Another problem is that most of the lawmakers who draft the rules do not understand the importance of bringing all their citizens, particularly the poorest among them, into the legal system. Thomas Jefferson understood. So did Washington, Franklin, and Madison. All the attention given to constitutions and to rule making that benefitted all Americans proves that they gave the law a huge amount of importance. That is no longer true among political leaders, in my experience. So, we must start convincing lawmakers that law is important — for everyone. The reason that people behave differently in the Peruvian Amazon than in Lima, for example is not just cultural; they own things, and they have businesses. But discriminatory, burdensome and just plain bad laws force them to operate in the extralegal economy.

Mobilizing small entrepreneurs

In order to get the majority of people in developing countries moving in the same direction, the first thing I’ve found useful to tell them is that they are “entrepreneurs.” In many countries where I go, I find an entrepreneurial class that just does not believe they are entrepreneurs. The wealthy have managed to convince the poor, no matter how talented or enterprising they are, that they are inferior, that they need more education or luck or were born in the wrong ethnic group. Even politicians on the left are inclined to say that indigenous peoples are “different” — and are not interested in participating in the market economy.

Our research has punctured such myths. After a violent conflict in the Peruvian Amazon in 2009 between indigenous communities and the police protecting the interests of private companies with legal concessions to exploit the region’s natural resources, the ILD sent a team into the region to determine the causes. We soon found that the local people had their own private property and businesses; they were already in the market, just not the legal one. We also discovered that they had gone to war to protest their lack of legal control over the property rights of their communities.

To demonstrate to indigenous leaders — and Peru — that native peoples were capable of operating in the legal market economy, the ILD brought down indigenous leaders of enterprises in Alaska worth more than $2 billion each. They arrived in full tribal regalia and said that the key to their success was having property rights, which made it possible for them to turn their tribes into multi-national corporations. “I am an Indian of the Kamloops tribe,” declared Manny Jules, the famous activist for Canada’s aboriginal peoples, “and I am proud of my tradition. But I am not a museum piece. Let me tell you why.” Then, his Peruvian audience started to understand.

As I said, I find entrepreneurs everywhere; but too often they need to be convinced of their status. “I only work from my garage,” a man in a Lima shantytown might tell me. Interesting, so did Steve Jobs. And then he adds, “I did go to university, but I dropped out.” So did Steve Jobs. “Well, he had ideas.” You don’t? “Oh yes, I have ideas.” But he can’t patent them or get a loan to turn his garage into a real business — or get any of the 18 other things that Steve Jobs did to turn his idea into Apple. This is the kind of process that it takes to prove to ordinary people that even the world’s most successful entrepreneurs are not culturally superior; they just have access to superior legal institutions.

There is no doubt that people can grow from being small-scale, informal entrepreneurs to largescale entrepreneurs. That is the history of the world. And one cannot foretell where it is going to happen or who is going to do it. Let me offer one final example from my native Peru, where I returned to live 30 years ago. Those who were rich and powerful then are completely different from those who are rich and powerful today. Yes, people grow from struggle to success. I do not know a country where the opposite would be true, provided everyone has access to the legal institutions essential for prosperity and generating wealth.

Hernando de Soto is currently President of the ILD —headquartered in Lima, Peru— considered by The Economist as 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, Entwicklung und 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 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 Other Path, in the mid- 1980s, and at the end of 2000, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. 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 Economic Reform Feature Service provided 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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