Thursday, February 03, 2011

The importance of a legal system

The Peruvian economist Hernando de Soto writes today in the WSJ about how the lack of a real legal system in Egypt explains so much of why Egyptians cannot improve their own situations. De Soto has participated in a study of the Egyptian economy ordered by one member of the government earlier in the decade. Unfortunately, nothing came of his report's recommendations. But the results are telling for Egypt and so many other countries.
Today, when the streets are filled with so many Egyptians calling for change, it is worth noting some of the key facts uncovered by our investigation and reported in 2004:

• Egypt's underground economy was the nation's biggest employer. The legal private sector employed 6.8 million people and the public sector employed 5.9 million, while 9.6 million people worked in the extralegal sector.

• As far as real estate is concerned, 92% of Egyptians hold their property without normal legal title.

• We estimated the value of all these extralegal businesses and property, rural as well as urban, to be $248 billion—30 times greater than the market value of the companies registered on the Cairo Stock Exchange and 55 times greater than the value of foreign direct investment in Egypt since Napoleon invaded—including the financing of the Suez Canal and the Aswan Dam. (Those same extralegal assets would be worth more than $400 billion in today's dollars.)
So what does it mean to have so much of Egypt's economic activity to be done off the books?
The entrepreneurs who operate outside the legal system are held back. They do not have access to the business organizational forms (partnerships, joint stock companies, corporations, etc.) that would enable them to grow the way legal enterprises do. Because such enterprises are not tied to standard contractual and enforcement rules, outsiders cannot trust that their owners can be held to their promises or contracts. This makes it difficult or impossible to employ the best technicians and professional managers—and the owners of these businesses cannot issue bonds or IOUs to obtain credit.

Nor can such enterprises benefit from the economies of scale available to those who can operate in the entire Egyptian market. The owners of extralegal enterprises are limited to employing their kin to produce for confined circles of customers.

Without clear legal title to their assets and real estate, in short, these entrepreneurs own what I have called "dead capital"—property that cannot be leveraged as collateral for loans, to obtain investment capital, or as security for long-term contractual deals. And so the majority of these Egyptian enterprises remain small and relatively poor. The only thing that can emancipate them is legal reform. And only the political leadership of Egypt can pull this off. Too many technocrats have been trained not to expand the rule of law, but to defend it as they find it. Emancipating people from bad law and devising strategies to overcome the inertia of the status quo is a political job.

The key question to be asked is why most Egyptians choose to remain outside the legal economy? The answer is that, as in most developing countries, Egypt's legal institutions fail the majority of the people. Due to burdensome, discriminatory and just plain bad laws, it is impossible for most people to legalize their property and businesses, no matter how well intentioned they might be.

The examples are legion. To open a small bakery, our investigators found, would take more than 500 days. To get legal title to a vacant piece of land would take more than 10 years of dealing with red tape. To do business in Egypt, an aspiring poor entrepreneur would have to deal with 56 government agencies and repetitive government inspections.

All this helps explain who so many ordinary Egyptians have been "smoldering" for decades. Despite hard work and savings, they can do little to improve their lives.
What Egypt needs is an enlightened government that would devise a legal system to address this situation. That is the only way for its economy to grow - for people to have hope to build better lives while also building the nation's economy. The fact that Egypt has not had such a legal system put in place in the past sixty years is deeply telling. And what are the chances the ElBaradei and his Muslim Brotherhood supporters would address such institutional problems? About as slim as the chances are that Hamas would do the same in Gaza.