The Mystery of Capital

Introduction
“The Mystery of Capital” by Hernando de Soto is an amazing book. It seeks to answer the question, “Why Capitalism Triumphs in the West and Fails Everywhere Else”, which is also its subtitle. The question, as you can imagine, is too complex and deep but de Soto does his work very well. He approaches this thorny question from several angles. This and the articles are my humble attempts to summarize the findings of one of the greatest economists (and of his research team) of our age.
What is capital?
Let’s first define capital. If we want to find out why capitalism won in the West and failed in other regions in the world, we should first look at its backbone, which is capital. In medieval Latin, the word “capital” meant, among several other definitions, head of cattle. Though the cattle and other livestock provided meat which can be considered their chief advantage, they also were a significant source of wealth through the ages. Not only livestock are important possessions because they are countable and measurable, but also they provide additional wealth or “surplus value”. Beyond meat, they can provide milk, skin, and wool among other things. If all of these don’t make livestock an important source of wealth, consider that they can also reproduce thus generating additional wealth.
After introducing the idea of livestock being a source of surplus value, we can now generalize from this and define the word “capital”. The term “capital” captures two dimensions of assets: the physical dimensions of the assets (such as livestock), and their ability to generate surplus value. For the classical economists, the term denoted a country’s assets generating surplus production and increasing productivity of labor.
Classical economists wanted to understand what capital is, how it is produced and how it can be used to increase productivity. Adam Smith, the father of modern economics, regarded specialization — the division of labor — as the force increasing productivity. Thus, it was also the source of “the wealth of nations”. For Smith, capital, which he defined as the stock of assets amassed for productive purposes, was what made economic specialization possible. The more accumulated capital paved the leads to more specialization of labor which raises productivity across the economy.
One aspect of the capital that Smith emphasized is so important to the message of the book that we’ll mention it here. Smith thought that accumulated assets are not converted to active capital automatically; for assets being useful in increasing productivity they should be fixed and realized in some tangible form. Therefore, stock of assets in itself is NOT capital, it is its potential to be used in raising productivity. For their potential to be released, accumulated assets should be expressed in a tangible form.
However, this important meaning of capital has been forgotten eventually. Now capital is almost always associated with money which is only one tangible form into which can be converted. But as de Soto points out it is erroneous to think that money is what finally fixes capital. For Smith money was an important “wheel of circulation” because it made economic transactions more convenient. But money in itself cannot capital because “those metal pieces” and banknotes don’t raise productivity; thus, don’t have any intrinsic value. Money is useful and convenient because it is an important benchmark against which we can value different items which are not similar to each other. That’s why it facilitates the valuation of businesses in monetary terms; without money it would be very challenging to assess the value of buildings, equipment, and land. Money facilitates the estimation of dissimilar goods and their exchange. This is what makes money useful — it is a medium of exchange and unit of account. But money is not what fixes capital.
Capital is the lifeblood of the modern economic system. It raises productivity across the economy. Without it, we wouldn’t have progress we have; the poverty would have ruled all over the world. As de Soto puts it, capital is the force creating the wealth of nations.
So, if capital is such an important force without which economic progress is almost impossible, then why many countries in the world cannot produce it? Why many poor regions of the globe cannot create capital which would get them out of poverty?
And if it is not money that fixes the potential of an asset, what is? What makes it possible to convert the potential energy of accumulated assets so that they can put more production in motion?
I’ll answer these questions in the next post.