Did the Great Recession inflate the shadow economy?

August 13th, 2010

The Economist highlighted a paper yesterday, with the headline “shadow economies have grown since the financial crisis began.” The magazine noted that for the first time in a decade the world’s shadow economies are increasing as a percentage of GDP.  A shadow economy, in this sense, does not mean a drug market or bribery ring.  Rather it is the sum of businesses with unrecorded activities, perhaps in order to avoid taxes or to skirt labor regulations.

As noted on this blog, this increase makes sense. Those who cannot find employment in the official economy may look to the unofficial economy for work.  They may be particularly inclined to do so if they have remained unemployed for an extended period. In the U.S. for example, the long-term unemployed–those who have been without a job for over 27 weeks–make up more than 45% of the unemployed population.  Such a dismal state may lead a worker, who otherwise would not have been inclined, to participate in the unofficial economy.

This report has prompted headlines worldwide, including this one from Germany:

“Recession driving workers into underground economy”

Or in Brussels:

“Recession spurs growth in EU shadow economy.”

Even the author of the study, the Austrian economist Friedrich Schneider, told one newspaper that “The stronger the country is hit by the economic crisis, the more the shadow economy will grow.”

It is almost certainly true that some businesses and workers move underground when profits or incomes take a hit. But it’s a mistake to infer from this paper that the shadow economy is more resilient than the official economy or that it is growing in absolute terms.

The paper only finds that the shadow economy is larger relative to the official economy; that is, it’s growing as a percent, not absolutely.  It is far more likely that both sides of the summation are shrinking, but that the official economy is shrinking faster.  This difference in pace may be attributed to some of the factors I already discussed, but not because the informal economy is stronger.

In other forums, Schneider has suggested that the black market could shield certain countries from a downturn.  He noted that “People earn extra money, and nobody works in the shadow economy in order to pay into a savings account – so the money is spent on consumer goods, boosting demand…Greece’s large black economy was welfare increasing. The only loser is the state.”

There are a lot of flaws in this argument.  First of all, the Greeks are in their current crisis because the state cannot pay its loans, as a result of rampant tax evasion and its shadow economy.  If Greece defaulted on its loans—as a result of those shadow economies—and the EU system crumbled with it, those extra “consumer goods” workers are earning illegally would be of little consolation to the Europeans.

Second, as Schneider says, this money will not go into a savings account; it will stay in cash.  This does not help banks who—worldwide—are facing tight budget sheets and cannot make loans.  It does not help businesses and entrepreneurs and home owners who are looking to those banks for credit.  And it doesn’t help the unemployed who might have gotten a job from a new business with a new loan.

Third, much of this money spent on consumption may stay in the underground economy, where it will never reach the official economy.  It may also induce businesses to maintain unfair labor practices or skirt even more taxes, fueling more government budgetary problems.

No, it’s not fair to say the shadow economy is on the rise, though it may be increasing as a share of GDP.  And it’s not fair to say that this phenomenon is good for the world.  In fact, it’s flat out wrong.  But that just makes Schneider another Austrian economist who’s too infatuated with the free-market Hero to see its Achilles heel.

Written by Ann Hollingshead

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