The Formal Economy is protected by law, property rights, and contracts. This is what Westerners are used to. When you go into a shop, you engage in an economic contract with the businessman. You trade money for merchandise. This exchange is recorded by government and there is recourse within the legal system if the contract is violated.

The Informal Economy is unregulated, untaxed and unmonitored by the government. This is sometimes called the gray market – the goods are legal, but it is not under the protection of the law. The Informal Economy makes up the majority of economic activity in the poorer states of the world. It’s one of the major structural restrictions on development.

Hernando de Soto deserves credit for popularizing this structure. Here’s a recent article in Time by de Soto and Madeleine Albright.

In Kibera-and in thousands of other urban settlements around the world-poor citizens like Margaret have no legal identity: no birth certificates, legal addresses or deeds to their shacks and market stalls. Without legal documents, they live in constant fear of being evicted by local officials or landlords. Joseph Muturi, 33, who runs a small clothing business in Toi market, says, “We live with the thought that bulldozers can flatten our stalls anytime. I know that in a matter of hours, all this can disappear.”

The lack of security and legal protections inhibit stable generation of wealth. This forces individuals to live day by day. They must favor instant gratification over long-term payoffs. They cannot “save” their money because the money and property is not secure.

This is widespread in the Third World:

We are well into the 21st century, yet roughly half the world’s people live in makeshift homes in squatter settlements and work in shadow economies. In many countries, more than 80% of all homes and businesses are unregistered; in the Philippines, the figure is 65% and in Tanzania, 90%. More than one-third of the developing world’s GDP is generated in the underground economy, a figure that has increased steadily over the past decade.

People who live in the Informal Economy are not exactly poor. They have capital and work very hard, yet they cannot get rich either. Their capital is inert and non-fungible.

Take property. Most people live as squatters on land they do not formally own. They claim land by building on it. They cannot leave their property without a different group of squatters moving in or the government tearing down their homes. Since they lack property rights, they cannot get a mortgage on their home to get start-up capital to start a business.

Likewise, many of these poor are enthusiastic capitalists. They run small businesses as street venders for instance, but do business without contracts. They cannot stop abuse by criminal gangs or stop theft of their goods.

The Informal Economy encourages cheating and defections rather than the upholding of contracts. This is a bad situation, since it leads to a low-trust environment. This is a source of corruption. Bribery is the only way to get anything done.

The fact is, half or more of the Third World production does not show up in GDP measurements.

Powerlessness and poverty go hand in hand, yet neither is inevitable. As co-chairs of the Commission on Legal Empowerment of the Poor, we believe there is a better way. The commission, a U.N.-affiliated initiative made up of some two dozen past and present world leaders, is exploring ideas to extend enforceable and fungible legal rights to impoverished people in societies across the globe. Our goal is to bring about a consensus on what needs to be done and find incentives for national and local leaders to do it.

Hernando de Soto wants governments to expand “squatter rights” by formally recognizing their property. Once this is done, new property holders will get access to micro-credit banks, police protection, and development resources.

Socialists noted a problem with land distribution but had a bad solution. They correctly saw that most of the land was owned by a few absentee landlords. They believed they should confiscate that land and collectively allocate it to poor farmers. Bad idea. The landlord was absent, but the squatters were already there. Instead of redistributing land, they should have just allowed squatters to keep what they already owned. The socialists attacked squatters instead, as if they were the problem.

There are groups today that push for formal economy reforms, including a new UN committee. The World Bank also encourages reforms, and has published an estimate of the size of informal economies.

The average size of the informal economy, as a percent of official GNI in the year 2000, in developing countries is 41%, in transition countries 38% and in OECD countries 18%. A large burden of taxation and social security contributions combined with government regula tions are the main determinants of the size of the informal economy.

Here’s the catch. De Soto’s theory is correct, but his idea are not producing miraculous results in practice. Why? I don’t know. He identified one of many poor structures which inhibit development, but without solving the others there has been little progress. Corruption may inhibit the formalization of the economy, for instance, as does authoritarianism in many Third World countries. It seems de Soto identified a problem without giving us a good solution.

Or, maybe we are barking up the wrong tree, just as the Socialists did 20 years ago.

Poverty in the Third World seems intractable. Identifying the problems they face is a good first step, even if we cannot create a solution. We know that legal and institutional reforms in the West provided the foundation for the Enlightenment and Industrial Revolution. But we really do not understand the process of how the Europeans reformed or how we can accomplish similar reforms elsewhere.

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