EIGHT YEARS ago, a successful expatriate businessman named Hernando de Soto returned to his native Peru from Switzerland for a brief family visit. Trained as an economist, de Soto looked around at the economic decay of Lima and wondered why Peruvians were so poor in Peru but so successful elsewhere. He decided he would stay and try to answer that question.

With a few friends, including novelist Mario Vargas Llosa, de Soto founded the Institute for Liberty and Democracy. Aided by modest grants from some foundations and governments (including the United States), he published his research in 1986 in his book, "The Other Path." Both the name and the findings were a direct challenge to Marxism, and to the insurgent Shining Path movement that was destroying Peru's social fabric.

Concerned only with Peru and aimed at a small audience of Peruvian intellectuals, his book eventually became the top bestseller in every Spanish-speaking country in Latin America. The English version even made bestseller lists in America; bootleg copies circulated here and in South Africa and Asia before official release. Translations are planned into French, Norwegian, Russian and Swahili.

The response surprised everyone, de Soto included. Since the book's appearance in English, de Soto has won a handful of international awards and has been invited to meet with central bankers, economists and government leaders all over the world. Tomorrow, for example, de Soto will host a day-long conference of senior U.S. government officials, academics, analysts and journalists to discuss details of major ILD reform programs currently being implemented by Peru's new president, Alberto Fujimori. Ronald Reagan cited de Soto's work several times as a landmark in understanding development. George Bush noted recently that de Soto's "prescription offers a clear and promising alternative to economic stagnation." What has de Soto said that is so important? De Soto describes an underground economy in Peru (he calls it an "informal" economy to distinguish it from an illegal one) that employs 60 percent of the population and produces 40 percent of the gross national product. Unlike the formal economy, this informal counterpart is an open market, is self-regulated and sustains a society that is run in a completely democratic manner.

The poor are driven into these economic shadows by the heavy hand of the state and its bureaucracy, which control the formal economy largely for the benefit of the privileged elite politicians and their businessmen allies. As a consequence of being excluded from the formal sector (with its credit, its legal protections, its recognized land titles and so on) and being forced to operate illegally (though for legal ends), the informal sector is only half as productive on a man-hour basis as even the grossly inefficient Peruvian state sector.

Contrary to the Marxist view of the poor as a faceless, disenfranchised proletariat, de Soto sees them as an active economic force. For example, the poor own and control 95 percent of the largely informal public transportation network in Peru, worth, perhaps, $1 billion, and have urban land and housing worth $17 billion. Yet none of these holdings can be used as collateral for loans or combined as assets within a corporation since the state considers the related economic activity "illegal" and so subject to confiscation.

Clearly the trick for developing countries is to reform their economies so as to capitalize on the assets and industriousness of their informal economies -- not by bringing them into the tightly controlled formal sector, but by liberalizing the entire economy. In other words, don't formalize the informals so much as informalize the whole economy.

The challenge that emerges from "The Other Path" is not just aimed at leaders of developing countries but also at leaders of the Western democracies who are providing aid. In this horserace of development, we have been backing the wrong horse. One disquieting lesson we learn is that those "private" sectors we help are hardly capitalist allies. De Soto jokes that conservatives in Latin America want to preserve the principles of Francisco Pizarro, not Thomas Jefferson.

This wry observation hits the crux of our problem: In Peru, and indeed all of Latin America, capitalism hasn't failed, it has never been tried. As the West circled its wagons to defend against Marxist attacks on capitalism, we put aside our critical judgment about the nature of those we let into the circle. In fact, the capitalist West's Third World ally in this contest with Marx has not been capitalism but its European predecessor: mercantilism.

True, a modified form of mercantilism has guided the astonishing growth of the Pacific Rim countries. But in the Asian model, highly competitive corporations, while largely shielded from foreign competition in home markets, compete fiercely among themselves for market share both at home and abroad, and the fruits of their productivity are relatively broadly shared. Latin American mercantilism, by contrast, is "capitalism" for the privileged few. De Soto's perspective on poverty and development has profound implications for our foreign-aid policies, for debt relief, for issues of national security and for our notions on the rule of law: Foreign aid and debt. Aid programs, for example, cannot effectively promote economic development when 60 percent of the population functions outside the law and our bilateral aid normally flows through governments or institutions sanctioned by them. Similarly, debt-relief programs focus on macroeconomic issues -- tax policy, trade policy, fiscal policy. Such policies can encourage -- or discourage -- sound growth, but in the end private economies are the aggregation of millions of individual economic decisions or transactions. Until our debt policies, particularly those of the IMF which has only a few microeconomists, take account of the needs of the microeconomy, we will never have serious solutions to the debt problem, only financial collapse on the installment plan. Security. De Soto's more complete understanding of poverty and of the roots of violence in Peru has broad implications for our security interests as well. As the superpower confrontation fades, we are increasingly turning our attention to regional conflicts, such as in Kashmir and the Middle East, and to internal conflicts or insurgencies, such as in Peru and the Philippines.

Conflicts between sovereign nations will still be the stuff of diplomacy but insurgency typically results from a clash of economic interests rather than ideologies which offer only the veneer of legitimacy. Although revolutionary leaders may be under foreign influence, they will only find soldiers willing to die for change if the economy isn't delivering progress. Thus insurgencies reflect failure of development, not the victory of ideology.

A case in point is provided by the recent reforms announced by Fujimori for Peru's anti-drug efforts. Fujimori intends to build a new rural economy with a massive land-titling program for landless coca farmers as a cornerstone. Once farmers are part of the formal economy, once they have viable alternatives to coca, only then can the harsh legal sanctions of the law against coca cultivation be put into force. The horse, finally, is leading the cart. The ideology of development. De Soto's ideas on reform offer a way to bridge the gap between traditional liberal and conservative views about appropriate economic development -- while contradicting both in important respects.

Liberals tend to focus on those elements of development aid that are primarily resource transfers for humanitarian purposes. Conservatives seek growth, but they often do so without distinguishing between paths that have made growth a social leveler in the West and those that reinforce the concentration of wealth in the hands of the elites in developing countries. Thus efforts to push growth up the wrong path have often intensified the social and economic disparity, which in turn accelerates disintegration and violence. The rule of law. It may come as a shock to economists (and lawyer-bashers) that economic development in a democracy rests on a foundation of sound law with its protection for private property. So before we teach good economics we must help establish good laws and legal systems. If we look towards private enterprise to pull reforming economies into the global system the legal structure must be laid down first. Once firmly instituted, the enabling legal system can drop into the background and we can focus on the engine itself; capital, technology and market access. De Soto's ideas on reform in Peru can be summed up in three elements: reducing the bureaucracy's control, private ownership (aimed more at residential hand holdings than industry), and, most important, making rules democratically.

In the transition to new political economies, sensible constitutions and good statutes are the first step. But, once in place, care must also be taken that they are efficiently and fairly administered. Former Philippines dictator Ferdinand Marcos, a brilliant lawyer in his day, was punctilious about observing the letter of the law but violated its spirit at every turn in order to do what he wanted -- which was to remain in power while he and his friends looted the country.

Not surprisingly there are groups of Western lawyers helping write new laws all over Eastern Europe. White House Chief of Staff John Sununu went to Moscow to teach Mikhail Gorbachev's executive staff how to get organized. Judicial systems, no less than executive, need help in increasing their efficiency and "administration of justice" projects are now a traditional part of our foreign aid.

There must also be a constant democratic process managing legal change lest a sound constitution and sensible statutes be subverted by an autocratic process of application and modification. De Soto notes that former Peruvian president Alan Garcia made hundreds of rules without consulting the people affected or even seeking serious legislature debate or approval. How can any bureaucracy expand so much and intrude so deeply if the rules and regulations are not acceptable to the people? What is the meaning of private property if, once granted, it can be taken away without "due process"?

De Soto likes to quote Einstein, who said, "What does the fish know of the water in which it swims?" And he likens many Western development experts to fish who remain in their North American aquarium and instruct their friends in "parched" Latin America how to swim. It is not that our advice has been bad but more that it is out of sequence.

The question of whether development comes before democracy -- the Taiwan and Korea models -- is no longer relevant. Development by authoritarian fiat is not a viable option in countries where the arrival of democracy and the movement to free markets are contemporaneous. We cannot go to a man like Vaclav Havel, who is building a democracy, and offer him the Korean economic model. New times call for a new model. The West has the right model. Although we have made a few mistakes, our system of open markets based on democratically established and modified laws works. The Magna Charta and then our Bill of Rights say that no one can be deprived of life, liberty or property without "due process," and it is the rigorous application of this notion that underlies the success of the Western economies.

The failure of Western advice in the past stems from development experts who have tended to understand only a part of the development equation. To do better, our policies must, first, reflect an understanding both of the individuals in an economy and the aggregation of those individuals. Reducing transaction costs for the nation is no more important than reducing transaction costs for a self-employed cobbler and all his fellow entrepreneurs. And then the legal profession -- both scholars and lawyers -- must become much more engaged in the development process.

Despite expenditure of hundreds of billions of our tax dollars on development aid, today the developing world has an enormous debt overhang, stagnant government dominated economies, instability, one-sided trade patterns and daunting social and environmental problems such as over-population and deforestation. Small wonder that the popularity of foreign aid in the United States is at its lowest ebb. But we should not let past failure keep us from capitalizing on de Soto's insights. The chance to get it right after so many fits and starts should allow us to suspend skepticism of foreign aid and try to forge a national consensus on the correct path. After all, the Peruvians are doing it.