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  • Overcoming Underdevelopment
  • Hernando de Soto (bio) and Deborah Orsini (bio)

A desire to solve the baffling puzzle of underdevelopment led to the creation of the Instituto Libertad y Democracia in 1980. Our basic question was: why is it that only 22 countries have been able to build successful market economies and functioning democracies, while the other 152 sovereign states in the world, many with similar or better natural resource bases, remain underdeveloped?

The ILD began its investigation by studying the roots of the "informal" economy. This was a prominent phenomenon in Peru, and we thought it held the clue to the underlying causes of underdevelopment. We define the "informal sector" as encompassing those economic activities that operate outside the law but pursue legitimate [End Page 105] objectives—for example, unregistered, "underground" manufacturers or unlicensed street vendors or taxi drivers. We make a clear distinction between these kinds of enterprises and activities such as drug trafficking, which are carried out illegally in order to pursue criminal objectives.

Our research, conducted over more than six years, indicated that the informal sector is remarkably dynamic and enterprising: it includes 60 percent of the economically active population in Peru and produces nearly 40 percent of the country's GDP. In Lima, informals control 95 percent of the public transportation sector, and informal settlements house nearly half the city's eight million people. Our research also showed, however, that the prevalence of "informality" is a symptom of serious institutional failings in Peru, and that these failings are the fundamental cause of the country's economic and social crisis.

Formal institutions have forced most of the Peruvian population into informality for two reasons. First, they produce reams of red tape: inefficient, time-consuming, and needlessly complicated regulations that hinder economic initiative and enterprise. This "bad law" discourages entry into the formal sector. Second, Peruvian institutions fail to produce the "good law" needed to facilitate private enterprise—for example, by securing property and contractual rights or promoting investment. The absence of a sound legal foundation for economic effort discourages entrepreneurs from remaining in the formal sector.

What underlies the numerous inefficient regulations, the excessive red tape, the precariousness of property rights, and the general disincentive to engage in economic activity is the lack of democratic institutions. The country desperately needs institutions that would allow the majority of Peruvians to make their real needs known, that would make government decision makers accountable for their decisions, and that would bring the rule-making system into the light of public scrutiny.

The only element of democracy in Peru today is the electoral process, which gives Peruvians the privilege of choosing a dictator every five years. Rule making is subsequently carried out in a vacuum, with the executive branch enacting new rules and regulations at a clip of 134,000 every five years (an average of 106 each working day) without any feedback from the population.

To explain why our political and economic institutions do not function in Peru, we find it useful to borrow from Marxist terminology. Essentially, the Marxist approach views growth as a linear process over time characterized by successive systems of production, each of which tends to outlive its usefulness. Before passing from one system to another, it is necessary to transform the institutions produced by the old system, and thus to get rid of its inherent contradictions.

We believe that in Peru—as in most developing countries—the contradictions in our political and economic institutions are impeding change. Those contradictions flow primarily from the presence of strong, [End Page 106] entrenched interests, defended by a tiny minority of the population, which effectively prevent the majority from taking part in decision making.

This closed society is dominated by mercantilism. We purposely use this term in order to recall the political and economic systems that preceded democratic, market-based economies in Europe. The comparison is intended to highlight the way that some interest groups use political power to gain unequal economic advantage and benefits (economists call this "rent-seeking" behavior) in the context of a political system that lacks transparency, accountability, and feedback. In particular, mercantilist systems favor closed-door decision making within the executive branch and a...


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