Lessons from Hernando De Soto on the Informal Economy

Hernando De Soto’s Theory on the informal economy looks at the reason as to why capitalism is a system that cannot work in developing countries. The theory explains why capitalism has succeeded in particular western countries and failed in other parts of the world. As he aptly puts it, the major stumbling block that keeps the rest of the world from benefiting from capitalism is its inability to produce capital.

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He further adds that in these areas where poverty is prevalent, most of the poor possess the necessary assets to produce capital. The problem in place is that these resources are held in defective forms in terms of a lack of proper documentation, a lack of property rights and basically no form of formal representation hence the reason why they cannot be turned into capital. In this sense, these assets can only be traded in informal circles.

Further, seeing as the broader definition of the informal economy encompasses unregulated economic activities in an environment in which similar ones are regulated, businesses in the informal economy often feel comfortable operating outside the official government regulatory framework. This makes them susceptible to a myriad of risks from which they cannot gain legal protection.

According to De Soto, a country with any proportion of informal economy will never have reliable macroeconomic figures. This is due to the fact that informal economy systems lead to a strong preference of using cash while carrying out transactions. It gives birth to a situation whereby the influence of informal activities on an economy can only be measured by indirect means with a long information delay. This is true in as far as getting data on the informal economy goes. A good example is that of the Micro Small and Medium Sized Enterprises 2016 Survey by the Kenya National Bureau of Statistics which is an estimated projection of the informal economic space in the country. It was compiled using official data that was available on the sector, leaving out a lot of small and micro businesses in their analysis.

Strategic efforts aimed at strengthening informal businesses in a way that they gradually grow from micro, small and medium enterprises into formidable formal enterprises should focus on fixing the systemic legal and policy issues that force these businesses to operate outside the legal frameworks. By doing this, we will be building a society where wealth creation is an aspect that is achieved and felt across the different levels of the socio-economic demographic.

In an interview with McKinsey & Company, a management consulting firm, De Soto demonstrates the relationship between the informal economy and poverty in the following words, “It is very simple if you are poor in a Third World country. If you don’t make an income in the first month, you are dead in the second month. So, it is very hard to be unemployed in a Third World country, because life takes place on another level. The sign of progress that I would like to see is that the body politic basically recognizes that the poor are an enterprising poor. They are not the problem, but the solution”


Informal Economy Analyst