Revised Estimates of the Underground Economy: Implications of US Currency Held Abroad

Edgar L. Feige   --  The writer wishes to acknowledge the cooperation of FinCEN, the Financial Crimes Enforcement Network of the Department of the Treasury, and the Board of Governors of the Federal Reserve System in providing data and research support for various aspects of this study. I am also grateful for the continuing dialogue and cooperation I have received from Richard Porter on all aspects of my work. The views expressed are those of the author and do not represent the views of FinCEN or the Board of Governors of the Federal Reserve or its staff.Note

A number of important public policy decisions now call for analytical and empirical knowledge of the nature, size, growth, causes, and consequences of the "underground economy." Our purpose here is to clarify the meaning of underground activity, update various discrepancy and fiscal estimates of its size and growth, and examine the empirical implications of new evidence on the growing use of US currency throughout the world for monetary estimates of the underground economy within the US itself.

The popular term "underground economy" is inexact, encompassing a wide range of economic activities including the production and distribution of illegal goods and services as well as legal activities whose concealment from or misrepresentation to government authorities involves tax evasion or benefit fraud. Given the diversity of hidden activities, it becomes necessary to develop a taxonomy of "underground economies" that identifies specific types of underground behaviours and suggests appropriate methods for estimating their prevalence.

The general penchant for hiding underground economic activities often precludes direct observation of their occurrence and leaves us to use indirect measures to detect the footprints of hidden activities in the sands of the observable economic continuum. Currency, as an anonymous medium of exchange, is viewed as the preferred means of payment in transactions that economic actors are trying to conceal. This makes cash stocks and flows a natural starting point in our search for the underground economy. The total amount of currency in circulation   --  "Currency in circulation" refers in the US context to the amount of the national currency held outside the Treasury and Federal Reserve. Except for small amounts of currency that may have inadvertently been lost or destroyed by the public (Laurent, 1974), currency in circulation includes the holdings of financial intermediaries and the public. Reliable data on financial intermediary holdings of vault cash are readily available, and it is therefore possible to obtain ccurate estimates of the total stock of currency outside the banking system. For a complete description of the cash payments system, see Feige (1994b). Note  --   is one of the best-measured macroeconomic indicators, since the production and distribution of currency by governments is strictly monitored and carefully recorded.

However, our knowledge is meagre when it comes to the location and circulation of the public's US currency holdings. Without reliable estimates of the varying amounts of US currency circulating overseas, we have no way of determining the size of the domestic money supply or its change over time. Our intention here is to demonstrate alternative ways of estimating the amount of US currency held domestically and overseas and present some temporal estimates of net US currency outflows. New estimates of domestic US currency holdings will then be used to reestimate the size and growth of the domestic US underground economy.

A puzzling macroeconomic anomaly is the huge amount of US currency outstanding-$390 billion-and its surprisingly persistent growth. Despite widespread predictions of the advent of the cashless society and decades of cash-saving financial innovation, per-capita holdings of United States currency increased from $160 in 1961 to $1,450 by the end of 1994. Adjusting for inflation, real per-capita currency increased by 70 percent and the proportion of the M1 money supply composed of currency rose from 20 percent to 30 percent. More than 60 percent of the outstanding stock of currency is now in the form of $100 bills. --  Surprisingly large per-capita currency holdings are not limited to the United States. In 1993, per-capita currency holdings in Switzerland, Japan and Germany amounted to (expressed in US dollars) $3,060, $2,944 and $1,579 respectively.Note

The suggestion that the average American family of four now holds $5,800 in currency, of which $3,480 is in the form of $100 bills, appears implausible. The number of notes in circulation is no less surprising than their value. There are presently some 17 billion common denomination notes in circulation. On a per-capita basis, this implies that each person holds, on average, 63 notes of which 9 are in the form of $100 bills. Adult US residents admit to holding only 12 percent of the nation's currency in circulation outside the banking system (Avery et al. 1986,1987). Allowing for US business holdings of currency, the whereabouts of more than 80 percent of the nation's currency supply is presently unknown.

These anomalous findings give rise to the "currency enigma" (Feige, 1990b, 1994a) which consists of a stock and a flow component. Our inability to identify the holders and locations of a large fraction of the US currency stock gives rise to a $300 billion "missing currency" problem (Sprenkel, 1993). This missing stock of currency is used as both a store of value and a means of payment for goods and services. If half of the missing currency were hoarded and the other half turned over at the rate estimated for domestic currency use, this missing currency would generate a flow of "missing payments" roughly equal to the United States' GDP.

Two complementary hypotheses are put forward as possible explanations for the currency enigma. Some fraction of the missing currency may in fact be held by US households for conducting unreported transactions in the US underground economy. A considerably larger portion of the missing currency is more likely to be held abroad in the form of co-circulating currency. US dollars will be a co-circulating currency when they are routinely used by foreigners to effect payments in their own countries. Co-circulating currency (Krueger and Ha, 1995) is also used as a store of value and, in some instances, a unit of account. We will examine the extent to which the currency enigma can be resolved by appeal to both the underground economy hypothesis and the "world dollarization" hypothesis.

We begin with a taxonomic framework for defining different types of underground activity, review alternative methods of estimation, and update available estimates of various "underground economies" in the United States. Our second section presents direct estimates of US currency inflows and outflows derived from Currency and Monetary Instrument Reports (CMIRs) collected by the US Customs Service. Section 3 presents evidence on foreign US currency holdings derived from indirect methods that include a monetary demography model (MDM) and a note ratio model (NRM). Section 4 combines direct and indirect methods to obtain a factor model composite measure of overseas currency flows. To anticipate the results, direct measures of overseas holdings suggest that no more than 25 percent of US currency is presently held abroad: indirect methods yield a wide range of estimates of between 30 and 70 percent held abroad, and the composite estimate is roughly 40 percent. A final section looks at the implications of oversas currency holdings for the measurement of the domestic underground economy.

Defining and measuring underground economies

The early literature on the underground economy lacked an accepted taxonomy for classifying various underground activities. These activities were variously described as subterranean, irregular, informal, hidden, grey, shadow, clandestine, parallel, and black, but these modifiers were rarely augmented by explicit definitions to support analytical and empirical investigation. It is now well understood that there exists a variety of underground economies spanning both planned and market economies, be they developed or developing. Agents engaged in underground activities circumvent, escape, or are excluded from the institutional system of rules, rights, regulations, and enforcement penalties that govern formal agents engaged in production and exchange. Different types of underground activities are distinguished by the particular institutional rules they violate. With this criterion, we can identify four specific types of "underground" economic activity: illegal, unreported, unrecorded, and informal. The metic for measuring the dimension of each underground activity is the aggregate income generated by that activity. Table 1 presents a taxonomy of underground economies.

Click here to view Table 1

The illegal economy consists in the income generated by economic activities pursued in violation of legal statutes defining the scope of legitimate forms of commerce. The most notable illegal activities are the production and distribution of prohibited substances (drugs, for example) and such services as prostitution, pornography, and black-market currency exchange. Estimates of income produced from illegal activities are typically derived from crime-related statistics and range from $70 to $100 billion. In 1982, unreported income from drugs and gambling was estimated at roughly $26 billion (AbtAssociates, 1984), and the 1990 retail value of drugs sold in the US has been estimated at around $40 billion.  --    "What Americans Users Spend on Illegal Drugs": US Office of National Drug Control Policy, Technical Paper, June 1991, p. 5. Reuter (1996) describes the limitations of estimates of the size of the illegal economy.Note

The unreported economy consists in economic activities that circumvent or evade fiscal rules as set out in the tax code. A summary measure of the unreported economy is the amount of unreported income-namely, the amount of income that should legally be reported to the tax authorities but is not. Since illegal income is taxable, the unreported economy includes both legal and illegal source income that is not properly reported. A complementary measure of the unreported economy is the "gross tax gap," the difference between the amount of tax revenues legally due the fiscal authority and the amount of tax revenues paid voluntarily. Since the "net tax gap" represents the difference between the amount of revenue due and the amount actually collected, the difference between the gross and net represents the revenues collected as a direct result of enforcement activities. Benefit fraud, false claims to benefits (welfare or unemployment payments) or subsidies to which the claimants are not legally entitled, should beformally included in "tax gap" measures.

The unrecorded economy consists in those economic activities circumventing the institutional conventions that define the reporting requirements of government statistical agencies. A summary measure of the unrecorded economy is the amount of unrecorded income-namely, the amount of income that should, under existing rules and conventions, be recorded in national accounting systems such as National Income and Product Accounts but is not. Unrecorded income represents a discrepancy between total income or output and the actual amount of income or output captured or enumerated by the statistical accounting system designed to measure economic activity. Since national accounting conventions differ with respect to the inclusion of illegal incomes, unrecorded income may or may not include components from the illegal sector.

The informal economy encompasses economic activities that circumvent the costs and are excluded from the benefits and rights of property relationships, commercial licensing, labour contracts, torts, financial credit, and social security systems. A summary measure of the informal economy is the income generated by economic agents operating informally.

Estimating the size of these various underground economies remains an inexact science at best. However, more precise definition of alternative underground economies has reduced the tendency to compare disparate measures, while improvements in tax compliance and monetary methodologies are narrowing the range of comparable estimates.

Updated estimates of unreported income in the US

Since underground economic activity typically exposes the participant to a risk of penalties if discovered, anyone engaged in such activity has an incentive to conceal that involvement. This propensity for secrecy creates special problems for the social scientist attempting to observe and quantify underground behaviours. Direct and indirect measures of various types of underground activity have been proposed, and each has well-known limitations (Feige, 1989).

Earlier empirical efforts to measure the extent and proliferation of these activities had revealed underground economies that were large enough to be economically significant and expanding considerably in the latter 1960s and through much of the 1970s. Costly regulation, rising tax rates, and a growing distrust of government were cited as the primary causes of increased underground activity. The conservative politics of the 1980s sought to reverse these trends by reducing government regulation, lessening the tax burden, and restoring a greater sense of trust and confidence in government by overhauling the tax system and reducing what were perceived as wasteful government expenditures. What we want to know is whether these efforts had any real effect on cutting the size and growth rate of the underground economy.

Various macroeconomic measures have been advanced as possible indicators of underground activity. These include the adjusted gross income (AGI) gap discrepancy measure produced by the Bureau of Economic Analysis (BEA); the audit-based discrepancy measure of unreported taxable income produced by the Internal Revenue Service (IRS), and estimates of unreported income derived from various specifications of monetary models. These measures are reviewed and updated below.

Discrepancy measures

The US Government produces two discrepancy measures that are cited as indicators of underground activity. The first of these, compiled by the BEA, calculates the difference between adjusted gross income (AGI) as reported to the IRS and an independent estimate of AGI derived from National Income and Product Accounts (NIPA) estimates of personal income.

This "AGI gap" is not officially acknowledged as a measure of the underground economy: however, with a few qualifications (Carson, 1984; Feige, 1989), the AGI gap can be interpreted as a lower bound measure of non-compliance in the reporting of taxable income-i.e., a measure of unreported income.

Figure 1 sets the AGI gap estimates published by the BEA in 1985 beside the most recently revised estimates. The latest government figures showed that the earlier gap estimates had been much too low, and had to be expanded by $115 billion in 1983: by 1992, the AGI gap had risen to $500 billion. As a percentage of AGI,  --   A common error in presenting estimates of unreported income is to display unreported income as a percentage of GNP. Since GNP includes non-taxable government and private expenditures, the appropriate scale measure for presenting estimates of unreported income is AGI, which forms the basis for assessing taxable income. Note  --   the gap reached its peak of 16.1 in 1987 and then fell to an estimated 14 percent of AGI in 1992.

Click here to view Figure 1: Adjusted Gross Income (AGI) Gap

The IRS prepares an alternative discrepancy measure for unreported income using the data from its Taxpayer Compliance Measurement Program (TCMP). Responding to reports of a large underground economy that were based on monetary estimates, the IRS undertook a series of studies of the extent of non-compliance with US tax laws (IRS, 1979; 1981; 1983). The first study concluded that between $75 and $100 billion in legal source income had not been properly reported on individual 1976 tax returns. The agency estimated the resulting revenue loss to the government at between $12 and $17 billion. At the same time, illegal source unreported income was estimated at $25 to $35 billion, with a further revenue loss of $6 to $8 billion.

The 1983 IRS report increased the estimate for 1976 legal source unreported income by $30 billion: the associated estimate of lost tax revenue more than doubled. On the other hand, the 1983 report slashed the estimate of illegal source income to only $13 billion and cut the corresponding revenue loss from the illegal sector to roughly $4 billion.

Feige (1989) demonstrated the sensitivity of the results from the early IRS TCMP studies to small variations in the questionable set of assumptions used for estimating the magnitude of non-compliance. An IRS admission that 1981 total unreported income amounted to some $283 billion with a corresponding revenue loss of $90 billion led the BEA to undertake a major review of NIPA accounts. The BEA's 1985 "comprehensive revision" included changes in definitions and statistical methods, but its single most important element was an adjustment for income previously unrecorded due to understated tax source data. For 1984, the personal income adjustment for unrecorded wages, salaries, and non-farm proprietor income amounted to $101 billion, demonstrating the empirical connection between unreported and unrecorded income.

The latest IRS estimates of unreported income (IRS 1988) were based on the agency's TCMP audits of tax returns in the years 1973, 1976, 1979, and 1982 and include estimates of unreported income and corresponding losses in tax revenue projected out to 1992. These 1988 IRS estimates are presented in Figure 2 with the projections for the years 1983-1992.

Click here to view Figure 2: Unreported Legal Source Income

For each audit year, a sample of roughly 55,000 tax filers was scrutinized by IRS auditors to pinpoint income that should have been reported and was not. Final estimates of unreported income for filers and non- filers from those years were obtained by combining information from audits, information returns, and special surveys. The IRS projections for the period 1985-1992 were based on Office of Management and Budget forecasts of personal income combined with an assumption of constant rates of non-compliance. The projections also assumed that taxpayer behaviour was unaffected by the tax reforms of 1986. By 1992, actual reported AGI fell more than $500 billion short of IRS projections. The overestimates of projected reportable income and the assumption that compliance rates were unaffected by tax cuts and tax reforms do suggest, however, that the IRS projections of unreported income were overstated.   --  On page A-101 of the IRS 1988 report, the agency acknowleges the major limitations of its unrported income projections: "Because we essentially hold constant rates of noncompliance through 1992, these estimates do not reflect recent trends in noncompliance. Second we assume that tax reform has no impact on individuals' behaviour in terms of either their propensity for noncompliance or the types of incomes individuals will receive in future years. Third, these projections are sensitive to changes in macroeconomic model projections of incomes in future years."Note

Whereas the earlier IRS studies had included estimates of both legal and illegal source unreported income, the 1988 study was limited to estimates of unreported legal source income. This study estimated illegal source income as $34.2 billion in 1981, roughly 15 percent of the revised legal source estimate for that year. If illegal income remained at roughly the same percentage of legal income, it would add an additional $88 billion in unreported illegal source income to the estimated $585 billion of unreported legal source income for 1992.   --  The IRS estimates reported above are based on the recommendations of the tax examiners. Since some of these recommendations are challenged by the taxpayer, the IRS also prepared an alternative set of estimates on an assessed basis (IRS, 1988).Note

Figure 3 reports alternative IRS estimates of the "gross tax gap" on individual and corporate legal source incomes. The gross tax gap overstates revenue lost to the government through non-compliance to the extent that IRS enforcement activities collect some of the amounts due. The yield from these enforcement activities was estimated at $15.4 billion in 1981, $18.9 billion in 1984, and $21.9 billion in 1987.  --   IRS (1990), p. 10, Table 2.Note

Click here to view Figure 3: Estimates of the Gross Tax Gap

On the other hand, the gross tax gap understates the loss of revenue to the government because it excludes revenue lost in illegal source income as well as losses from non-compliance with other federal taxes including employment, excise, gift, and estate taxes and customs duties. For the year 1987, income taxes represented only 56 percent of federal budget receipts: another 36 percent came from employment taxes and 5 percent from gift, estate, and excise taxes. Virtually no information is available on losses from non-compliance with these other important revenue sources and we have no estimates of amounts of public money wasted through benefit fraud.

Currency ratio models

The most common method of estimating the size of the unreported economy relies on some variant of the general currency ratio model described in Feige (1989). The most restrictive specification of the currency ratio model (Cagan, 1958; Gutmann, 1977) assumes that currency is the exclusive medium of exchange for unreported transactions; that the ratio of currency to checkable deposits is affected only by the growth of unreported transactions; that the income velocities of reported and unreported transactions are identical; and that in some base period, unreported income was zero, so that the observed base period currency deposit ratio serves as a proxy for the desired currency ratio in the official economy.   --  As described in Feige (1989), the foregoing restrictions imply that the ratio of unreported (Yu) to reported income (Yo) can be estimated as follows: Yu/Yo = (C-ko+D)/(ko+1)D, where: C = Currency; D = Checkable Deposits; ko = Co/Do.Note

Figure 4 shows estimated unreported income as a percentage of recorded AGI as obtained from the simple currency ratio model under the assumptions that in 1940 there was no unreported income and all currency outside the banking system was then held by the domestic public. As pointed out in earlier studies, the ratio of unreported income rose sharply during World War II and then declined to remain relatively stable until the early 1960s. Unreported income then spurted upwards from less than 5 percent of AGI in 1960 to 15 percent by 1980. The percentage of unreported income reached a plateau during the early '80s, and it actually declined around the time of the 1986 tax reform act before rising steeply between 1987 and 1991.

Click here to view Figure 4: Unreported Income as Percent of AGI

The figure also presents the results of a more general specification of the currency ratio model. The general currency ratio (GCR) model   -- The GCR model permits a relaxation of several of the assumptions employed in the simple currency ratio model. In particular, currency need no longer be the exclusive medium of exchange for unreported transactions, and any year can serve as a benchmark for which an independent estimate of unreported income is available. The GCR model can be solved to obtain the equation for the ratio of unreported income, which is: Yu/Yo = (ku+1)(C-koD)/(ko+1)(kuD-C) where ku and ko respectively represent the currency deposit ratios in the unreported and reported economies.Note  --   takes the IRS estimate of unreported 1973 income as its benchmark and assumes that 75 percent of unreported income transactions are made in currency, with the remaining 25 percent made by checkable deposits. The resulting estimates display a time path similar to that of the more restrictive estimates: however, he percentage of unreported activities is considerably higher in all periods.

Figure 5 shows three estimates of total unreported income from both legal and illegal sources for the period 1972-1993.   --  The IRS estimate is the sum of the legal source unreported income estimate in Figure 2 plus a 15 percent imputation for illegal source income. The imputation for illegal source income is based on the estimates reported in the earlier study (IRS, 1983). The currency ratio models yield estimates of total unreported income from all sources.Note   --  The IRS projections are remarkably similar to those obtained with the simple currency ratio model, suggesting that by 1991, total unreported income amounted to roughly $650 billion, or 17 percent of reported AGI. Assuming this unreported income had been subject to a marginal income tax rate of 20 percent, we find that $130 billion in tax revenues-roughly equal to 62 percent of the federal budget deficit-escaped government collection.

Click here to view Figure 5: Estimated Total Unreported Income

The GCR model results suggest that unreported income grew gradually during the first half of the 1980s to decline in mid-decade and then resume growing until the early 1990s: in fact, unreported income appears to have risen to about $1 trillion in the latter years after doubling in the last half of the previous decade. Now all these currency ratio model estimates are predicated on the assumption that US currency exclusively is being used to fuel domestic transactions in both the official and underground economies. There is, however, a growing body of anecdotal evidence to suggest that US dollars also circulate as a medium of exchange in foreign countries. If a large and perhaps variable fraction of US currency is held abroad, conventional currency ratio models employing the total currency supply would be overstating the size of the domestic US underground economy.

Federal Reserve Surveys of Currency and Transaction Account Usage (SCTAU: Avery et al., 1986; 1987) reinforce the notion that a substantial portion of US currency holdings cannot be accounted for by the behaviour of US households. In both 1984 and 1986, SCTAU determined that US households admitted to holding at most 12 percent of the national currency supply. Since business firms are very concerned with efficient cash management to minimize interest losses associated with cash inventories, they are likely to hold considerably smaller cash inventories than households. The scant evidence on US currency holdings by business firms (Anderson, 1977; Sumner, 1990) suggests that domestic firms hold less than 3 percent of the currency in circulation.

A conservative estimate of the stock of currency required to sustain cash payments in the US unreported economy can be obtained with the IRS projection of 1992 unreported income as $675 billion. If we assume that roughly 75 percent of this unreported income is paid with cash, and take currency turnover   --   Also called the income velocity of currency. The methodology for estimating the velocity (turnover) of currency is described in Feige (1990b). The estimates are based on the Federal Reserve Survey of Currency and Transaction Usage, which finds that the income velocity of household cash holdings is roughly 50 turnovers per year. Share-weighted, denomination-specific velocities are obtained by estimating the average lifetime of each note denomination derived from Federal Reserve FR-160 data on currency issues (births) and redemptions (deaths).Note  --   to be roughly 50 times per year, we get a stock of currency used for underground transactions that is less than 4 percent of currency in circulation with the public. In hort, since US households admit to holding less than 12 percent of the nation's currency in circulation, firms hold roughly 3 percent, and underground transactions absorb another 4 percent, the ownership of more than 80 percent of circulating US currency is currently unexplained. This anomaly of missing currency gives rise to the stock component of the "currency enigma" (Feige, 1994a).

The flow component of this currency enigma denotes the volume of cash payments made with the outstanding currency stock. Admitted household holdings give rise to an estimated $1.7 trillion in cash payments for 1992, roughly 41 percent of recorded personal consumption expenditures. Business cash holdings generate some $400 billion, 70 percent of total intermediate payments, and the underground economy accounts for $675 billion in cash payments. If the stock of the remaining "missing" currency circulates at roughly the same rate as currency held by US households, it would generate an additional volume of unaccounted cash payments in excess of $10 trillion.

Several hypotheses have been advanced to explain these monetary anomalies. One holds that the US underground economy is substantially larger than currently estimated and domestic holdings of US currency are much larger than households tell currency surveys.    --  The currency usage survey of US households is likely to understate actual domestic currency holdings for several reasons. The survey undersamples high-income households and may underestimate household hoards. Porter and Judson (1995) suggest that these two sources could add another 5 percent to domestic holdings. The survey may also understate actual domestic currency holdings as a result of self selection bias and underreporting bias, but the extent of these biases cannot be determined.Note  --   The "world dollarization" hypothesis suggests that a substantial fraction of US currency is held abroad by residents of other nations. The complementary "hoarding" hypothesis suggests that overseas hoards are being held as a store of value rather than as a edium of exchange. The dollarization hypothesis requires independent estimates of the fraction of US currency held abroad. The hoarding hypothesis requires evidence confirming that overseas holdings of US currency circulate at slower rates than domestic currency holdings.

Anecdotal reports of US currency circulating in parts of Latin America, the Middle East, Eastern Europe, and Russia are widespread, as are suggestions that foreign demand for US currency can fluctuate quite dramatically. Initial efforts to estimate the amount of US currency held abroad (Feige, 1994) range as high as 45 percent. Since the size, variability, and velocity of foreign US currency holdings have important implications for the measurement of the domestic underground economy and the conduct of domestic monetary policy, we now turn our attention to further efforts to locate this "missing" US currency.

Direct estimates of net outflows of US currency

At present, there is no information system collecting complete data on total amounts of US currency flowing in and out of the country. Large US currency shipments are typically handled by a small number of commercial banks that specialize in the business of wholesale bulk currency transport. These large currency shipments have been informally reported to the Federal Reserve Bank of New York cash office since 1988. Although the period spanned by the confidential estimates is short and the data are not comprehensive, being limited to major wholesale shippers operating largely in the New York Federal Reserve District, they provide useful information on a substantial segment of bulk cash shipments to and from the US.   --  During the interwar period between 1923 and 1941, the Federal Reserve published data on net currency shipments to European countries (Banking and Monetary Statistics: 1914-1941, pp. 417-418). Over the entire period for which data are available, cumulative net inflows from Europe amounted t 4.8 percent of the average outstanding stock of currency during the period. The average annual net inflow of currency from Europe amounted to .25 percent of the average outstanding currency stock.Note   --  We will denote the Federal Reserve bulk shipment outflow series as FSO and the bulk shipment inflow series as FSI. Net bulk outflows (FSN) equal FSO-FSI.

Interviews with Federal Reserve officials suggest that much of the currency for wholesale overseas currency shipments by the major transporting banks is supplied by the New York Federal Reserve Bank in the form of $100 bills. All Federal Reserve banks maintain monthly, denomination-specific records of the number of notes paid into circulation (PIC) and the number received from circulation (RFC). These records, maintained in the Federal Reserve system's FR-160 database, enable us to identify the net injections into circulation (PIC-RFC) of each denomination of currency by each Federal Reserve bank. Feige (1994a) observed a close relationship between the net value of $100 denomination notes injected into circulation by the New York Federal Reserve (NYN) and the net amount of currency shipped overseas as confidentially reported to the New York Federal Reserve Bank (FSN). Feige used NYN as a proxy for FSN, and this proxy was subsequently used by Porter and Judson (1995) as a measure of total currency flows overses.

Although useful as a proxy for the confidential FSN series, net injections of $100 bills by the New York Federal Reserve (NYN) should not be viewed as an accurate measure of overall net currency flows abroad. The NYN proxy will overstate net outflows because some fraction of net injections of New York $100 notes are used to satisfy domestic demand. The proxy will understate true net outflows to the extent that it excludes the net export of smaller-denomination notes. Finally, the NYN proxy takes no account of net currency outflows from other Federal Reserve districts.

The most important direct measure of overseas currency inflows and outflows is collected as part of the regulatory responsibility of the US Customs Service. Enacted in October 1970, the Currency and Foreign Transactions Reporting Act, also known as the "Bank Secrecy Act," requires persons or institutions importing or exporting currency or other monetary instruments in amounts exceeding $5,000 to file a "Report of International Transportation of Currency or Monetary Instruments." Commonly known as "CMIRs," these reports have been collected by US Customs since 1977. In 1980, the reporting threshold was raised to $10,000.

Although the CMIR data system was established to record individual cross-border inflows and outflows of currency and monetary instruments, its micro-records can be usefully aggregated to study the size, origin, and destination of these cross-border movements. Since its inception, the CMIR system has collected 2.3 million inbound filings and more than 300,000 outbound filings. With the cooperation of US Customs and the US Treasury Department Financial Crimes Enforcement Network (FinCEN), the information contained in the millions of accumulated confidential CMIR forms was combined by a specially designed algorithm that aggregated CMIR currency inflows (CTI) and CMIR outflows (CTO) by mode of transportation, origin, and destination. Net CMIR outflows are represented by CTN=CTO-CTI.

The CMIR data system is the most comprehensive source of direct information on currency flows into and out of the US. It differs from the informal reports to the New York Federal Reserve in several important respects. CMIR records contain all reported currency inflows and outflows, including currency physically transported by currency retailers, non-financial businesses and individuals, and currency shipped by financial institutions specializing in wholesale currency transactions. The only transactions excluded are those that fall below the reporting requirements, direct shipments by Federal Reserve banks, and shipments that circumvent legal reporting requirements. [See 31 code of Federal Regulations 103.23(c)]. The CMIR data are thus more inclusive than the Federal Reserve (FED) informal series, which is limited to currency shipments to and from the New York Federal Reserve district by large wholesale bulk shippers.

Comparison of the estimated cumulative net outflows of US currency during the period spanned by each of the foregoing measures (1988-1994) reveals some important empirical differences. Informal FED reports (FSN) suggest that roughly $92.5 billion was added to foreign holdings, while the FR-160 proxy of net injections of $100 notes (NYN) suggests an $118.6 billion figure. The CMIR data as represented by CTN produce a much lower figure of $51.2 billion in cumulative net outflows. To track down the source of these important empirical discrepancies, we turn now to a detailed comparison of the conceptual differences in content and coverage among the three series.

Conceptual and empirical comparisons of direct measures of currency flows

Table 2 presents a conceptual comparison of coverage in the CMIR reporting system and the Federal Reserve informal system. The table reveals major differences in content and coverage between CMIR and FED currency flow data. To derive meaningful comparisons of information content in the two, we had to segregate total CMIR inflows (CTI)and outflows (CTO) by mode of transportation.  --  To maintain the strict confidentiality of individual records in the CMIR data system, aggregations were performed at the offices of the US Treasury (FinCEN). Subsequent analysis was performed on the aggregated data. Since Federal Reserve banks are not required by law to file CMIR statements, the CMIR shipment series was augmented to include direct overseas currency shipments to and by the Federal Reserve Bank of New York. For a more refined breakdown of CMIR inflows and outflows by mode of transportation, origin, and destination, see Feige (1996).Note  --    An algorithm was therefore developed to aggregate the CMIR icrodata into currency flows originated by wholesale bulk shippers and flows stemming from the physical transportation of currency by individuals, currency retailers, and non-financial firms.

Click here to view Table 2: Content Comparison of CMIR and FED Currency Flow Reporting Systems

Table 3 shows the notation used to describe alternative direct estimates of currency inflows and outflows. Total CMIR outflows (CTO) are divided into outflows originating from wholesale bulk bank shipments (CSO) and outflows physically transported by individuals, currency retailers, and non-financial firms (CCO).  --  Non-financial firms include armoured carriers and travel transportation companies such as airlines and cruise ships.Note   --   Correspondingly, total CMIR inflows (CTI) are disaggregated into wholesale, bulk-shipped inflows (CSI) and physically transported inflows (CCI).

Click here to view Table 3: CMIR and Federal Reserve Currency Flow Notation

Since the Federal Reserve data are limited to wholesale bulk shipments, Federal Reserve recorded outflows (FSO) would be expected to be roughly comparable to CSO and, similarly, Federal Reserve recorded inflows (FSI) would be expected to be roughly comparable to the CSI derived from the independently collected CMIR data.   --  The Federal Reserve database excludes currency shipments from or to the 11 non-New York Federal Reserve districts as well as shipments from or to countries other than those in the FED system. The FED data also exclude all inflows and outflows of currency physically transported by individuals or non-financial firms. Feige (1995, 1996) takes account of these finer distinctions.Note  --  The FR-160 proxy flows (NYO, NYI, and NYN) cannot be disaggregated by mode of transportation; nor can we determine what fraction of net injections of $100 bills is used to satisfy overseas demand.

Table 4 shows the means of each of the quarterly flows in Table 3. Comparison of the mean Federal Reserve and CMIR inflow and outflow estimates reveals the CMIR data as considerably more inclusive than the FED. CMIR recorded average quarterly total currency outflows (CTO) exceed Federal Reserve recorded wholesale currency shipments (FSO) by some $1.39 billion per quarter. Similarly, CMIR recorded average total currency receipts (CTI) exceed Federal Reserve (FSI) wholesale currency receipts by $2.86 billion per quarter.

Click here to view Table 4: Direct measures of Quarterly Gross Currency Flows 1988-1994

The finding that CMIR gross flows exceed Federal Reserve gross flows is to be expected because the CMIR data include the physical transportation of currency by individuals, currency retailers, and non-financial firms as well as currency flows with origins and destinations not included in the FED data. The asymmetry in the outflow and inflow discrepancies is due to the fact that individuals, currency retailers, and non-financial firms physically transport only 10 percent of reported total gross outflows but account for 31.8 percent of reported total gross inflows.  --  The series on individual inflows and outflows appear to differ greatly from bulk shipments by financial institutions. There are two possible explanations for this significant disparity. The data for physical transportation by individuals include travel transportation companies such as airlines and cruise ships that generate US currency outside the US and regularly transport it back for deposit in their domestic banks. The discrepancy may also be du to differing levels of compliance with CMIR reporting requirements. Individuals transporting currency out of the country are not monitored as carefully by US Customs as individuals returning to the US. There may thus possibly be a lower rate of reporting compliance for physically transported outflows than for physically transported inflows.Note  --   There is another reason for the discrepancy: though 82.9 percent of wholesale bulk outflows originate in New York, only 50.9 percent of such shipments are returned there.

Given these differences in coverage, we find that the less inclusive Federal Reserve data understate gross outflows less than they understate gross inflows. This asymmetry in underreporting leads to an overstatement of net currency outflows in the FED data. This is even more strikingly true of the shipment proxy (NYN). Any conclusions derived exclusively from Federal Reserve data or from series closely correlated with FED data (such as NYN) are therefore likely to overstate net outflows and lead to the erroneous conclusion that foreign holdings of US currency have increased at a faster rate than is the case.

Table 4 also includes more refined measures of the CMIR flows that are conceptually comparable to the flows captured by the FED data system. CSO* represents CMIR gross reported bulk-shipped outflows originating exclusively from the New York Federal Reserve District and destined exclusively for countries included in the Federal Reserve's informal data collection system. Similarly, CSI* represents CMIR gross reported bulk-shipped inflows headed for the New York Federal Reserve District from countries included in the Federal Reserve data system. CSN* represents the corresponding net outflows (CSO*-CSI*). These adjusted flows are conceptually most comparable to the flows informally reported to the Federal Reserve.

When these refined CMIR measures (CSO* and CSI*) are compared with the conceptually comparable measures obtained from the FED data (FSO and FSI), they are, as expected, empirically compatible as well. The average discrepancy in estimated outflows of bulk shipments from the New York district (CSO* minus FSO) is $.15 billion per quarter and the corresponding discrepancy between comparable inflow measures (CSI* minus FSI) is $.20 billion per quarter. The comparable quarterly net outflow bulk shipment discrepancy (CSN* minus FSN) is only $.05 billion per quarter. CMIR and Federal Reserve data suggest that during the period 1988-1994, wholesale bulk currency shipments from New York resulted in a net cumulative outflow of between $92.1 (CMIR) and $92.5 billion (Federal Reserve). For the longer period covered by CMIR reports (1977-1994), cumulative net currency outflows in wholesale bulk shipments from New York amounted to $97.7 billion.

Table 5 presents the correlation matrix of quarterly inflows, outflows, and net outflows for the period 1988-1994. Examining the relationship between alternate measures of net outflows, Table 5-C reveals that the Federal Reserve bulk shipment series (FSN) is very highly correlated with the proxy series of net injections of $100 notes in New York (NYN). As expected, both series have a much weaker relationship with the broader CMIR measure of all bulk shipments (CSN): however, the refined CMIR estimate of New York net bulk outflows (CSN*) is more closely related to the comparable FSN and NYN measures. This is confirmed when inflows and outflows are examined separately (Tables 5A and 5B).

Click here to view Table 5A: Correlation Matrix of Quarterly Currency Inflows (1988:1-1994:4)

Click here to view Table 5B: Correlation Matrix of Quarterly Outflows (1988:1-1994:4)

Click here to view Table 5C: Correlation Matrix of Quarterly NET Currency Outflows (1988:1-1994:4)

We conclude that when comparable direct measures of inflows and outflows are examined, the CMIR data represent the most comprehensive and accurate estimate of bulk shipment activity to and from the New York district. Moreover, the CMIR data contain direct information on both bulk shipments and physical currency transportation that is not captured by either the Federal Reserve data or its New York $100 injections proxy. Table 5 reveals that the movements in the CMIR measures of physically transported currency (CCI, CCO) are virtually uncorrelated with the narrower New York bulk shipment measures. Indeed, as will be demonstrated below, the additional information contained in the more comprehensive CMIR measures tell a very different story from that suggested by the less comprehensive, New York-centred measures.

Direct CMIR estimates of total netcurrency outflows

Having demonstrated the close correspondence between the CMIR and Federal Reserve estimates of bulk-shipped inflows and outflows to and from the New York district, we now turn to direct CMIR estimates of other flows of US currency for which no other direct information source is available. These include:

     •     wholesale bulk shipments to and from Federal Reserve districts other than New York;

     •     reported currency physically carried into and out of the New York district; and

     •     reported currency physically carried into and out of other Federal Reserve districts.

Table 6 presents a breakdown of the key components of CMIR cumulative net outflows for different periods. The CMIR reports reveal that New York wholesale currency shipments resulted in a $92.1 billion cumulative net outflow of US currency during the period 1988-1994 as compared with a $5.7 billion net outflow for the decade 1977-1987. Wholesale shipments of currency to and from all other Federal Reserve districts produced a cumulative net currency inflow of $12.7 billion during 1988-1994 from $1.1 billion over the earlier decade.

Click here to view Table 6: Direct Estimates of CMIR Cumulative Net Outflows

CMIR reports are the only data source for currency transported by currency retailers, non-financial businesses, and individuals. These sources of physical currency transportation accounted for a cumulative net inflow of currency into the US of $28.2 billion in 1988-1994 and an even larger inflow of $41.5 billion in the previous decade. The combined estimates from all CMIR sources therefore suggest that cumulative net outflows of currency in the period 1988-1994 amounted to $51.2 billion and for the entire period 1977-1994, only $14.4 billion. It appears that failure to take account of physically transported currency and wholesale shipments from districts other than New York will lead to a serious overstatement of the amount of currency transferred abroad.

This conclusion is subject to several caveats. First, it is possible that the CMIR filing compliance rate is higher for currency physically transported by individuals entering the US than it is for currency physically transported by individuals leaving the US, since customs forms are routinely collected from incoming travellers only. The period 1988-1994 shows roughly nine inflow filings for every outflow filing. The average size of each inflow filing for physically carried currency was $39,000, whereas the average size of each outflow filing was $119,000.

The large average size of physically carried inflows and outflows suggests that most of these filings were probably made by currency retailers or non-financial businesses rather than individuals. Inflows mainly represent the physical transportation of currency consolidated from tourist centres and returned to the US by armoured carrier or courier: travel companies such as cruise ships, airlines, and hotel chains routinely collect small amounts of currency from outbound travellers and return these funds for deposit in the US. Businesses that regularly transport currency into and out of the US are aware of the legal filing requirements and liable to penalties if they fail to report. Individuals carrying large sums of currency into and out of the US, however, are more likely to file incoming rather than outgoing CMIR forms. A lower rate of outgoing individual filing compliance would impart a downward bias to physically transported net outflows. Without further analysis of the distribution of incoming an outgoing individual carriers, it is impossible to determine the magnitude of the bias.

Secondly, we must take account of currency flows that fall below the CMIR reporting requirement threshold. Unrecorded inflows include US currency carried into the US by foreign travellers in amounts under $10,000. Similarly, unrecorded outflows include smaller amounts of US currency taken abroad by US travellers and net remittances of US funds sent abroad.

Unrecorded net outflows

Unrecorded net currency outflows from travel are estimated from data on total spending (net of air fares) in the US by foreign travellers and total overseas spending by US travellers going abroad. Net currency outflows from remittances are estimated as a percentage of net remittances sent abroad.   --   The travel data were generously provided by the United States Travel and Tourism Administration, Washington, DC.Note

We have estimated travellers' unrecorded net currency outflows falling below the filing threshold under two alternative scenarios. The first scenario (TR1) assumes that both foreign travellers to the US and US travellers to foreign countries make 20 percent of their purchases of goods and services with US currency and that 20 percent of net remittances are paid in US currency. The second scenario (TR2) assumes respective percentages of 20, 15, and 20. Since foreign travellers to the US will expect to make purchases with US dollars and typically have less access to credit cards than US travellers going abroad, the second scenario appears the more plausible.

Table 7 summarizes the assumptions underlying each of the scenarios and presents our estimates of cumulative net currency outflows below reporting requirements under each set of assumptions. The results suggest that for the period 1977-1994, cumulative unreported net currency outflows below the filing threshold ranged from $2.9 billion to $24.7 billion.

Click here to view Table 7: Cumulative Unrecorded Net currency Outflows from Travel and Remittances ($ billions)

Estimating changes in the domestic stock of US notes

A change in domestic holdings of US banknotes outside the banking system (DNd) can be estimated as the difference between the change in the total note stock in circulation with the public (DN) and the estimated change in overseas holdings (DNo). Then,

         (DNd) = (DN) - (DNo) = (DN) - (CSN + CCN + TR)

where CSN = net bulk shipments of currency abroad as reported on CMIR forms; CCN = net currency physically transported overseas by currency retailers, non- financial firms, and individuals as reported on CMIR forms; and TR = estimated unrecorded net currency outflows arising from travel and remittances falling below the filing threshold.

The stock of US notes in circulation with the public is calculated as the difference between the currency component of M1 minus coins in circulation. Net wholesale currency shipments (CSN) and net currency physically transported by currency retailers, non-financial businesses and individuals (CCN) are obtained from CMIR records. Unreported travel and remittance outflows (TR1 and TR2) are estimated from travel expenditure and remittance data as described in the previous section. All net outflows are assumed to be in the form of notes rather than coins.

Table 8 shows the allocation of net additions to the note supply for different periods under the assumption that a change in domestic holdings will equal a corresponding change in total holdings minus net outflows overseas. Using all available data, the results from direct measures of net currency outflows suggest that between 85.2 and 93.4 percent of the increase in the note stock between 1977-1994 was accounted for by increases in domestic holdings.

Click here to view Table 8: Allocation of Net additions to Note Stock ($ billions)

Direct estimates of the share of US notes held abroad

Given direct estimates of net currency outflows and net additions to domestic stocks between 1977 and 1994, we can now simulate the current percentage of US notes held overseas, given alternative assumptions about the share of notes held abroad in 1977. Table 9 presents a range of estimates of the share of US notes presently held overseas for different starting values in 1977 and different combinations of measures of net outflows going abroad.

Click here to view Table 9: Percentage of US Notes held Overseas, End 1994 (Alternative Estimates)

The results in Table 9 suggest that our estimates for US notes held abroad are sensitive both to CMIR estimates of physically transported currency and to various estimates of net travel and remittance outflows. On the basis of CMIR reports of wholesale shipments alone, the percentage of currency now held abroad ranges between 25.5 and 34.1 percent. However, the inclusion of reported net flows physically transported by currency retailers, non-financial firms, and individuals reduces the estimated range of overseas holdings to between 4.8 and 13.4 percent. The further addition of estimated unreported net currency travel and remittance flows that fall below the filing threshold produces a range of 5.7 to 20.7 percent.

If we entirely ignore the CMIR evidence on reported physical currency transportation but include estimates of unreported travel expenditures and remittances, we obtain an upper-bound estimate suggesting that between 26.4 and 41.5 percent of US currency is held abroad. The hypothesis that from 60 to 95 percent of US currency is held domestically contrasts starkly with evidence from surveys of US currency use that only 20 percent of US currency is so held.

In the light of the substantial range of estimated overseas holdings reflecting combinations of different components of overseas flow estimates, we now turn to the empirical relationship between the known change in the total stock of notes and empirical proxies for domestic and overseas changes. Let change in demand for domestic notes depend on change in domestic personal income (DPI) and the Federal Funds Rate (R). Change in overseas stock is measured by the various components of estimated currency outflows. Change in total note stock (DN) is represented as

          (DN) = f(DPI, R) +g(CSO, SCI, CCO, TR)

Table 10 reports the results of regressing the change in total stock of notes on determinants of the change in domestic note demand and CMIR measures of inflows and outflows. Change in personal income does not significantly affect change in note demand, but the Federal Funds Rate is significant and has the expected sign. All CMIR flow variables have the expected signs, although the coefficient for physically transported outflows is not significant, reinforcing the view that there may be a downward compliance bias in this component.

Click here to view Table 10: Regression Estimates

It is also noteworthy that the coefficient estimates of the flow variables suggest that only some fraction of each dollar of inflow or outflow effects the change in the total stock of notes held outside the banking system. This observation is consistent with the hypothesis that some recorded cross-border flows simply represent a transfer between domestic and overseas currency hoards that are held outside the international banking system. Such transfers would leave the total note stock unaffected. Our results suggest that this is more likely to be the case for physically transported currency than for bulk currency shipments.

Indirect methods of estimating foreign holdings of US currency

As will be demonstrated below, we are able to estimate the share of currency held overseas by a variety of indirect methods. Unlike the direct observations of reported currency flows discussed in the preceding sections, indirect methods require behavioral assumptions about domestic and overseas demand for US currency. Since the US government satisfies all domestic and overseas demand for its dollars, the total amount of currency outstanding is completely demand-determined.

Monetary demography model (MDM)

Consider the general demographic problem of estimating the proportions b1 and b2 of members in two sub-populations C1 and C2, which comprise the total population C, and X1 and X2 the corresponding measured characteristic in sub-populations C1 and C2. The average population characteristic X can be represented as a weighted average of the sub-population characteristics with the weights being the unknown proportions b1 and b2.

      (1)     X = b1 X1 + b2 X2

Since b1 + b2 = 1, it follows that the proportions can be estimated from the measured characteristics:

      (2)    b2 = (X-X2)/(X1-X2)

              b2 = (X1-X)/(X1-X2)

A meaningful solution for parameters b1 and b2 exists so long as the characteristics of the sub-populations are different (X1 ¹ X2) and the calculated proportions lie between 0 and 1.

This demographic framework suggests a monetary demography model (MDM) capable of estimating the proportion of US currency held domestically (bd) and the proportion held overseas (bo). To estimate these unknown proportions, we require measures of characteristics of the overall US currency population and of its domestic and overseas components. Examples of measurable characteristics which might be employed to estimate the MDM are the age, quality, velocity, denomination, series or seasonal characteristics of the US currency population and its domestic and overseas sub-populations.

Given estimates of any currency population characteristic X and the corresponding domestic (Xd) and overseas (Xo) currency characteristics, the proportion of notes circulating domestically (bd) can be estimated as:

     (3)    (bd) = (X - Xo)/(Xd - Xo)

MDM using age and qualitycharacteristics

Applying general demographic concepts to currency populations leads naturally to a consideration of possible differences in the age and quality of denomination-specific notes circulating domestically and overseas. Estimates of the age, quality, and quality by age distributions of the corresponding domestic and overseas sub-populations were obtained from a special study conducted by the Federal Reserve.   -- See the Federal Reserve Soil Level Impact Task Force (SLITF) study entitled "Comprehensive Assessment of US Currency Quality, Age & Cost Relationships" (1990).Note   --  Based on a sample of some 4 million individual notes, note quality was ascertained by recording light reflectivity measures from an optical densitometer that scanned individual notes during routine processing by high-speed sorting machines at the Federal Reserve banks in all 12 Federal Reserve districts.

Individual serial numbers were recorded for a subsample of approximately 150,000 domestic and returning overseas notes to determine the date when the Bureau of Engraving and Printing had sent each note to a Federal Reserve bank. An inventory model was then used to estimate the date when the note had actually been put into circulation, thereby establishing its date of birth. Each note's age was then determined as the difference between this date of birth and the date of sampling. For each denomination-$1, $5, $10, $20, $50, and $100-it was thus possible to construct univariate age and quality distributions for notes sampled domestically and notes returning from abroad.

Casual observation suggests that domestic notes are likely to be used predominantly as a medium of exchange, whereas overseas notes are more likely to be held as a store of value. Accordingly, it was anticipated that the univariate age and quality distributions of domestic and overseas notes and the corresponding bivariate quality by age distributions would differ greatly. Domestic notes sampled on their return to the Federal Reserve were expected to be relatively younger than notes coming back from abroad and generally of poorer quality for a given age. Considering these expected differences in domestic and overseas characteristics, age, quality, and quality by age distributions were thought to be promising characteristics for estimating the percentage of notes held overseas.

Surprisingly, analysis of the quality and quality by age distributions of the domestic and overseas samples revealed that they were not sufficiently different to yield robust estimates of percentages of notes held domestically and overseas. Initial efforts to estimate the MDM were therefore based on differences in univariate age distributions between overseas and domestic notes for each specific note-denomination population. Denomination-specific age distributions for the entire population were derived from FR-160 data on note births and deaths (redemptions) combined with estimates of average note lifetimes.

Given the age characteristics of the relevant populations, the problem is then to estimate the proportions of US currency circulating domestically (bd) and overseas (bo = 1-bd) from the MDM(A) specified for each denomination as follows:

     (4)     A = bd Ad + (1-bd) Ao

              and      bd = (A - Ao)/(Ad - Ao)

where A, Ad, and Ao respectively represent the denomination-specific age distributions for the total, domestic, and overseas note populations. Estimated percentages of notes of different denominations circulating abroad in mid-1989 were then obtained from estimates of the notes' overall, domestic, and overseas age distribution.   --  The estimates for the $1, $5, $50, and $100 denominations are averages from Baselines 1 and 2 of the SLITF study (n. 20). The Baseline 1 model for the $10 denomination and the Baseline 2 estimates for the $20 denomination failed to converge, requiring significant outliers to be deleted from the samples. We therefore report a range of estimates for these two denominations. The similatity of the age distributions for overseas and domestic notes suggests that the reported results are likely to be imprecise.Note

Table 11 presents the resulting denomination-specific estimates of percentages of banknotes held overseas. The MDM(A) estimates for age distribution characteristics suggests that between 45.8 and 53.0 percent of the US currency stock was held overseas in 1989: 68.3 percent in large-denominations-$100s and $50s; approximately 28 percent in mid-sized denominations-$20s and $10s, and 3.6 percent in small denominations-$5s and $1s.

Click here to view Table 11: Estimate of the Demographic Model: MDM(A) age distribution characteristics

MDM using seasonality, series and coin/note ratio characteristics

Porter and Judson (1995) employ several variants of the MDM to estimate the proportion of US currency held overseas by exploiting assumed differences in seasonality, series, and coin/note ratio characteristics of domestic and overseas US currency holdings.

Since the seasonal characteristic of the total US currency population (S) is directly measurable while the seasonal characteristics of the domestic (Sd) and foreign (So) stocks are unobservable, Porter and Judson assume that for the period 1947-1994, seasonal variations in domestic US currency holdings are identical to the observed seasonal pattern for the Canadian currency supply.   --  The assumption is justified by the argument that the US and Canada have similar currency denomination structures and that the Canadian dollar is rarely used overseas.Note   --  They further assume no significant seasonal component in foreign demand for US currency, so that the seasonal characteristic of overseas US currency holdings (So) can be assumed to be equal to unity. The seasonal variant of the MDM(S) can then be estimated with the equation:

     (5)     S = bd Sd + (1-bd) So

where the seasonal characteristics are time-dependent and S = SUS, Sd = SCAN. From (3), it follows that the domestic share of currency holdings (bd) is estimated as:

     (6)     bd = (S - 1)/(Sd - 1)

Table 12 presents Porter and Judson's reported estimates of the denomination-specific share of US currency held overseas in 1989. The denomination-specific MDM(S) yields an overall estimate of 62.4 percent as compared with the 45.8 to 53.0 percent range obtained with the age characteristic model. The MDM(S) results suggest that 67.8 percent of foreign holdings are in large denominations, with 29.7 and 2.5 percent in mid-sized and small denominations respectively.

Click here to view Table 12: Estimate of the Demographic Model: MDM(S) annual seasonal characteristics

A second variant of the MDM exploits differences in the series composition characteristics (SR) of domestic and overseas notes to estimate percentages of $100s and $50s circulating abroad. In 1991, the Federal Reserve introduced a 1990 series note which was distinguished from the pre-1990 notes in circulation by a polyester strip and micro printing to frustrate counterfeiters. Let the series characteristic (SR) be the proportion of the circulating note population (N) made up of new 1990 series notes (N90) so that:

     (7)     (SR) = N90/N

The series composition of the total currency population is known, but the domestic and overseas components are not. Porter and Judson assume that the series composition of overseas notes is adequately proxied by an estimate of the series composition of notes processed by the New York Federal Reserve, and that an estimate of the series composition of the notes processed by all other Federal Reserve banks adequately reflects domestic composition.   --  Porter and Judson claim that almost all currency sent to and received from abroad is processed by the New York Federal Reserve Bank. The veracity of this assumption can be tested by an examination of CMIR data disaggregated by Federal Reserve district of origin and destination. The CMIR data reveal that only 52 percent of all reported currency inflows for the period 1977-1994 had the New York Federal Reserve District as their point of destination. The New York district was reported as the point of origin for 85 percent of total outflows during the period.Note --   The MDM(SR) can then be represented as

     (8)     SR = bdSRd + (1-bd)SRo

where (SR) = N90/N is known and, by assumption, SRd » SRNon NY and SRo » SRNY.

The proportion of notes held domestically can then be estimated as:

     (9)     bd = (SR - SRo)/(SRd - SRo)/

                       » (SR -SRNY)/(SRNon NY - SRNY)

Porter and Judson use two different procedures for estimating domestic and overseas series characteristics. Table 13 presents their upper- and lower-bound estimates for the $50 and $100 denominations.

Click here to view Table 13: Estimates of the Demographic Models MDM(SR) and MDM(C/N) series and coin ratio characteristics

A third MDM variant uses the ratio of coins to notes as the characteristic distinguishing domestic from overseas currency holdings. The coin/note ratio of the total US currency population is directly observable: it remains to identify the coin/note ratio of domestic and overseas holdings. The domestic coin ratio is proxied by Canada's coin/note ratio, and the overseas ratio is zero with virtually no US coin held overseas.

Let C/N represent the population ratio of coins to notes, (C/N)d the domestic coin ratio, and (C/N)o the overseas coin ratio. If bd represents the fraction of US currency held domestically, then it follows from equation (1) that the MDM(C/N) can be represented as:

       (10)     (C/N) = bd(C/N)d + (1-bd) (C/N)o

By assumption, (C/N)d » (C/N)CAN and (C/N)o » 0. Therefore, (10) reduces to:

      (11)      bd = (C/N)/(C/N)CAN

As shown in Table 13, the MDM(C/N) estimates 20.9 percent of US currency held abroad in 1989. This estimate falls within the range of estimates obtained from the CMIR data.  --   The reported results included an adjustment of the coin/note ratio to take account of the introduction of a $1 coin in Canada in July, 1987. The Bank of Canada continued to issue $1 banknotes until June 30, 1989, at which time there were 246 million $1 coins in circulation. By the end of 1989, the number of $1 coins in circulation had risen to 464 million. The reported results are based on a time series forecast of what the coin/note ratio would have been in the absence of the introduction of the $1 coin.Note

To test the robustness of the Porter and Judson MDM(S) results, we reestimated the model with the X11 ARIMA method for calculating the multiplicative seasonal component of notes in circulation for the US and Canada.   - - Porter and Judson obtained their seasonal components by applying the STL seasonal adjustment procedure to the currency component (coin plus notes) of the Canadian and US M1 series. In our replication, we used the X11 ARIMA procedure on the Canadian and US notes in circulation series, since neither Canadian nor US coins are assumed to circulate overseas.The results reported by Porter and Judson are based on the ratio of seasonal amplitudes of the US and Canadian series, derived by taking the difference between the December and February seasonals (Porter and Judson, 1995, pp. 16-17). Our replication suggests that the results are relatively insensitive to the use of different seasonal adjustment procedures and the substitution of the note series for the currency component series. However, the time eries estimates of the share abroad is quite sensitive to the use of the seasonal amplitude metric employed by Porter and Judson. In particular, when the MDM(S) is estimated on a monthly or quarterly basis and the estimated monthly or quarterly overseas share are estimated as the ratio of each of the seasonal components minus one as suggested by equation (6), the estimated monthly and quarterly shares abroad fluctuate wildly within a year, often yielding estimates of the share abroad that exceed 100 percent.Note  --   Our reestimate of the MDM(S) confirms the Porter and Judson finding that the model is incapable of producing sensible monthly or quarterly estimates. Indeed, monthly and quarterly estimates of the overseas share of US currency reveal a strong seasonal component, suggesting that the assumption that (So » 1) may be unsustainable. Even annual time series estimates of overseas share obtained from the annual average of monthly seasonal components are quite different from Porterand Judson's result with their seasonal amplitude metric of the difference between the December and February seasonals.

Figure 6 presents the Porter/Judson time series of estimated overseas share, MDM(S):DEC-FEB, and the corresponding estimate based on average monthly seasonal components: MDM(S):Monthly Average. The figure also includes the range of 1989 point estimates from the age characteristic model, MDM(A1) and MDM(A2), the overseas shares derived from the coin ratio model, MDM(C/N), and the average share of $100 notes obtained with series characteristic model MDM(SR).

Click here to view Figure 6: Share of US Currency Overseas

As shown in Figure 6, the monetary demographic models produce a wide range of estimates of the overseas share of US currency and different temporal patterns for change in overseas holdings. Given the diversity of these results and the strong assumptions required to produce them, it is difficult to view them with much confidence. The age characteristic model required the elimination of sample outliers before convergence could be obtained. The coin ratio model produces negative overseas shares for the period 1972-1982, and the seasonal characteristic estimates yield implausible results at monthly and quarterly frequencies. Both the seasonal and serial characteristic models require strong assumptions concerning unobserved domestic and overseas characteristic specifications. Given these difficulties, we turn to some alternative approaches for estimating the share of US currency held abroad.

Note ratio models

The Note Ratio Model (NRM) provides an alternative means of indirectly estimating the currency percentage held abroad. The known amount of US notes in circulation (N) can be broken down into unknown quantities of notes in domestic and overseas circulation (Nd and No). Let Z denote any scale variable assumed to affect the demand for notes. Then:

     (12)     N / Z = Nd / Z + No / Z

As with the MDMs, we assume that the domestic US ratio (Nd/Z) can be proxied by the same ratio in Canada, so that:

     Nd / Z » (N / Z)Can

Substituting the Canadian ratio (N/Z)Can into equation (12), multiplying through by Z and dividing both sides by N yields a solution for the unknown fraction of notes overseas (bo):

     (13)    (bo) = No / N = [N - (N / Z)Can.Z]/N

The simple note ratio model (NRM) is estimated for several variants where Z alternatively represents:

      •      personal consumption expenditures (PCEs),

      •      personal disposable income (PDI), or

      •      population (POP) x the Consumer Price Index (CPI).

Figure 7 presents the estimated share of US currency held overseas obtained from each variant of the note ratio model: NRM(PCE), NRM(PDI), and NRM(POP). The results suggest that the overseas share declined for almost a decade between the early 1960s and early '70s, then rose significantly over the following two decades. The peak in overseas holdings appears to have come in 1990, when roughly 30 to 35 percent of US notes in circulation are estimated to have been held abroad. The time series of estimated shares of overseas currency derived from the NRMs are markedly lower than the results from the seasonal MDM and higher than the MDM(C/N) results.

Click here to view Figure 7: Share of US Currency Overseas

Table 14 presents the correlation matrix of overseas currency share estimates obtained by each of our indirect methods. This matrix shows relatively close correlations among all the NRM estimates and the MDM(C/N) estimate. Comparison of the MDM(S) estimate with the MDM(S-PJ) estimate reveals that the two alternative methods of computing the seasonal estimates yield very different results. The correlation between the two seasonal estimates is only .393, suggesting that the model is quite sensitive to the arbitrary choice of a metric. The MDM(S) shows low and negative correlations with the other estimates, whereas the smoothed MDM(S-PJ) series displays positive correlations with the others.

Click here to view Table 14: Correlation Matrix of Indirect Annual Estimates of Overseas Currency Shares, 1962-1994

Indirect estimates of net outflows of US currency

Given the wide range of overseas share estimates produced by our various models, we now turn to estimate the net currency outflows implied by each of the MDM and NRM variants. Given the known total stock of notes in circulation and indirect estimates of the share of currency abroad, we can develop year-end estimates of the total stock of currency held abroad.  --   Throughout the analysis, we assume that all US coin is held domestically.Note   --  The difference in these estimated year-end overseas stocks yields estimates of annual net outflows of currency from the US.

Table 15 shows the correlation matrix for estimated net outflows derived from each of the indirect methods. The net outflow estimates from the different models appear to be more highly correlated than the share estimates, suggesting that the indirect methods may produce more accurate estimates of outflows than shares abroad.

Click here to view Table 15: Correlation Matrix of Annual Indirect Estimates of Net Outflows of Currency Overseas: 1962-1994

Comparing direct and indirect estimates

Table 16 summarizes the cumulative net outflows for different periods as estimated by direct and indirect methods. For the period 1977-1994, cumulative outflows obtained with NRMs fall within the range produced by summing CMIR bulk shipments and unreported travel and remittance outflows. The two significant outliers are the CMIR estimates of the sum of reported bulk shipments and reported physically transported currency (CTN) and the MDM(S-PJ) estimate. The CTN estimate puts cumulative net outflow for the period at only $14.4 billion, while the MDM(S-PJ) estimates a cumulative outflow of $209.0 billion.

Click here to view Table 16: Cumulative Net Outflows of US Currency ($ billions)

Two hypotheses may explain the divergence between the indirect methods and the direct methods that include physically transported currency flows. The first stems from the possibility already mentioned of a downward compliance bias in reported CMIR outflows of physically transported currency. In such a case, physically transported outflows will be underestimated and so will the share of US currency held abroad. An alternative hypothesis is that physically transported net currency flows represent offsetting changes between domestic and overseas currency hoards that do not affect the total currency supply. Since each of the indirect methods is based on changes in the total currency supply, these methods would be incapable of reflecting currency hoard shifts from overseas to the US. While such hoard shifts do affect the proportion of currency held abroad, they will not affect the total stock. If we accept this interpretation, indirect measures will overestimate the share of currency held abroad.

To test the sensitivity of the estimated percentage of US currency held overseas, we turn now to the implications of the alternative estimates of net outflows to different beginning and terminal assumptions about this percentage. Table 17 presents percentage estimates based on different net currency outflows and assuming that 30 percent of US currency was held abroad at the end of 1976. Table 18 presents percentage estimates that reflect the assumption that the terminal share of currency at the end of 1994 was 30 percent.

Click here to view Table 17: Estimated Percentages of Currency Abroad: 1976 = 30%

Click here to view Table 18: Estimated Percentages of Currency Abroad: 1976 = 30%

The starting assumption that 30 percent of US currency was abroad in 1976 leaves us with a range of estimates of 11 to 69 percent for the current situation. All estimated percentages except the CTN result are within the permissible 0-100 range. However, when a terminal share of 30 percent abroad is assumed, only CMIR1, CSN, and PDI yield estimates within the permissible range. What these simulations reveal is that the alternative estimates have a "knife edge" characteristic in the sense that plausible temporal estimates exist only for narrow ranges of terminal conditions. The full CMIR direct estimates give plausible results only for terminal conditions in the 20 to 25 percent range, whereas the NRMs give plausible estimates for terminal conditions between 35 and 50 percent. The MDM(S-PJ) yields plausible results only for terminal conditions in the range of 60 to 80 percent.

Composite estimates

Given the diversity of indicators of unknown net flows of currency overseas, we will now combine these measures to obtain a single estimate based on all available information. One approach here is to use a factor analysis model to estimate the common signal or latent variable (Lt) associated with different indicators of net overseas currency flow (Mit). In the factor model

     (14)     Mit = di Lt + eit, (i = 1, 2, ... N)

each of the Mi indicators of net outflow   --  A general discussion of factor analysis models can be found in Mulaik (1972). Bollen (1989) contains a review of factor analysis in the context of latent variables.Note   --   is linearly related to the latent common factor (Lt). The dis represent the factor loadings and the eit are the temporal measurement errors in each of the N measures of net currency outflow. The latent factor Lt is computed as a weighted average of the observed indicators with the weights constrained to sum to unity.

Since different estimates of net outflows are available for different time periods and different frequencies, we estimated several factor models for both annual and quarterly frequencies to test the stability of our results. The variables used and periods covered by these estimates are described in Table 19.

Click here to view Table 19: Factor Model Specifications

Figure 8 shows maximum likelihood estimates of annualized net outflows as derived from each of the foregoing factor models. The temporal patterns are broadly similar in all estimates, which suggests a rising level of net outflows during the decade of the 1980s and a significant upward shift in net outflows during the early '90s associated with increased use of US currency as a co-circulating medium of exchange in Eastern Europe and the newly independent republics of the former Soviet Union. The seven-variable annual factor model AF(1) produces the highest estimated net outflows for recent years, while the four-variable quarterly model QF(1) produces the lower-bound net outflow estimates.

Click here to view Figure 8: Estimated Factor Model Net Outflows

Simulations employing the factor model outflows for different beginning and terminal values reveal that the most plausible estimate of the share of US notes presently held abroad is roughly 40 percent, which implies that something like 36 percent of all US currency (notes plus coin) is held abroad. Using this current value, Figure 9 displays the implied time series of the share of currency held overseas between 1973 and 1994 for each of the factor model net outflow estimates.

Click here to view Figure 9: Foreign Holdings of US Currency

Implications for the domesticunreported economy

These provisional estimates of overseas dollar holdings suggest that earlier currency ratio model estimates of the unreported economy were erroneous in assuming that the entire stock of US currency was held domestically. We are now able to reestimate the currency ratio models with our new alternative estimates of the domestic US currency stock.

Figure 10 displays estimates of total unreported income obtained from a GCR model using alternative factor model estimates of the domestic US currency stock. Figure 11 shows GCR estimates of unreported income as a percentage of AGI.

Click here to view Figure 10: Total Unreported Income

Click here to view Figure 11: Unreported Income as a Percent of AGI

Total unreported income appears to have grown secularly until 1985, declined briefly around the time of the 1986 tax reform, and then peaked in 1991. The temporal pattern of the alternative GCR estimates of unreported income as a percentage of AGI tell essentially the same story. Unreported income appears to have grown rapidly from 1966 and peaked as a percentage of AGI in 1980. The percentage of unreported income then declined until 1987, rose again until 1991, and fell again to a level approximating levels last observed in the early 1970s.

Of the three factor model estimates of the domestic currency supply, the QF(2) may be the most reliable, being based on quarterly frequencies and the largest amount of direct and indirect information concerning net currency outflows. Employing the QF(2) estimates in the GCR model suggests that total unreported income in 1994 was roughly $700 billion, or approximately 20 percent of AGI.

The main conclusion to be drawn from these revised estimates of unreported activity is that once account is taken of foreign US currency holdings, the range of uncertainty about the magnitude of unreported income is substantially reduced. The difference between the unadjusted GCR estimates of unreported income and the IRS estimates for 1992 amounted to more than $400 billion. The revised estimates in Figure 10 reveal that the difference between the IRS and the QF(2) estimates is now reduced to roughly $100 billion.

Figure 11 reveals that unreported income as a percentage of AGI varies considerably over time. The two most plausible explanations for these fluctuations are changes in average tax rates and variations in levels of dissatisfaction with government.

Figure 12 shows the relationship between the QF(2) revised estimates of unreported income as a percentage of AGI and the average effective federal tax rate, and Figure 13 displays the relationship between unreported income and an index of dissatisfaction with government.   --  The average effective federal tax rate is simply the sum of federal government tax receipts divided by AGI. The dissatisfaction with government index is constructed as an equally weighted average of three normalized indices representing answers to the University of Michigan's Institute for Social Research (ISR) surveys on whether government officials can be trusted, whether they are crooked, and whether the government is wasting taxpayers' money. I am indebted to the ISR for providing the underlying data.Note   --   As we can see in the first of these figures, tax evasion does appear to rise in response to higher average taxes and fall when incentives to cheat are reduced by lower rates. Similarly, Figure 13 confirms the expected relatonship between tax evasion and level of dissatisfaction with government. The dramatic fall in the level of dissatisfaction with government between 1980 and 1984 coincided with a drop in the relative level of tax evasion. Conversely, increases in the level of dissatisfaction with government observed in the later 1980s are associated with a relative surge in evasion. It seems that when taxpayers perceive their public representatives as dishonest and see benefits from their tax dollars decline, they are more likely to engage in tax evasion.

Click here to view Figure 12: Unreported Income and Tax Rate

Click here to view Figure 13: Unreported Income and Dissatisfaction

The finding that a substantial portion of US currency is held overseas provides a partial resolution of the currency enigma. It will be recalled that Federal Reserve surveys showed that US households admit to holding only 12 percent of the nation's currency, firms account for roughly 3 percent, and the unreported economy employs about 4 percent. We now find that another 35 to 40 percent is held abroad and believe that the percentage held domestically is larger than admitted.

Porter and Judson (1995), who place considerable emphasis on the MDM(S-PJ) and MDM(SR) results, have suggested that as much as 50 to 70 percent of US currency is held abroad. We are more inclined to believe that surveys of currency usage are subject to self-selection and underreporting biases which result in a substantial understatement of the actual amount of currency held at home. Whether these domestic cash hoards are derived from underground activities that we continue to underestimate or from legitimate activities that are simply underrecorded in our NIPA accounts remains to be resolved.

Our overseas finding raises another monetary puzzle. Are foreign holdings of US currency being used solely as a store of value or do they function as a co-circulating medium of exchange? An investigation of the age and quality of a large sample of individual banknotes (Feige, 1994b) suggests that the age/quality distributions of domestically circulating notes and notes returning to the US from abroad are quite similar. This suggests that the average velocity of domestically held currency is not that different from the velocity of currency held abroad. If foreign US currency holdings circulated at the same rate as US household holdings, they would generate a flow of annual cash payments approaching the size of the United States GDP.

Thus, the partial resolution of the currency enigma for the US merely creates another monetary anomaly for the rest of the world. The world economy appears to subsume a US-sized unrecorded economy which employs US currency as its medium of exchange. This global currency enigma deepens when we consider that our revised estimates of US per-capita currency holdings are still modest compared with the per-capita currency holdings of other developed European and Asian nations. The missing currency problem is not limited to the US dollar: it extends to other major currencies, most importantly the German mark and the Japanese yen.

Conclusion

In an effort to mitigate uncertainty about the size of the domestic underground economy, we have examined a variety of measures of net US currency outflows to determine what percentage of US currency is held abroad and thus the amount of US currency circulating in the domestic economy. While alternative methods of estimating overseas US currency holdings still yield a wide range, we conclude that the most plausible estimates are in the range of 25 to 45 percent. Given the importance of forming a more accurate estimate of the domestic US money supply, both for the purpose of gauging the size of the domestic underground economy and for more refined monetary policy analysis, it seems necessary to continue research into the matter of the precise amount of US currency held domestically and overseas.

The introduction in 1996 of a newly designed US currency series with modern counterfeit protection provides a unique opportunity to establish a currency census system which, like the population census, would aim at precision concerning amounts of US currency circulating domestically and overseas. A currency census system would not require the burden of human reporting: all necessary information on banknote life cycles could be electronically captured as notes are routinely and anonymously processed by high-speed sorting machines at the times of their issue and return to the Federal Reserve banks. A currency census system would fully preserve the anonymity of currency use by individuals and firms while maintaining automated records of a note's age, quality, birthplace, location, and final redemption. Such a system would provide the data required to construct currency migration matrices and all other demographic characteristics of the note population.   --  The application of demographic theory and methods to crrency populations is developed in Feige (1990b), which includes estimates of age-specific currency mortality and survival rates. Feige (1994b) presents a full demographic model describing the life cycle of the individual note and the dynamics of note populations and cohorts.Note   --  In short, the establishment of a currency census system would provide us with reliable estimates of the domestic money supply and so enhance our ability to conduct domestic monetary policy.

References

Abt Associates (1984), "Unreported Taxable Income From Selected Illegal Activities": US Government Printing Office, September 1984, p. 62;112.

Anderson, P. (1977), "Currency in Use and in Hoards," in New England Economic Review, Federal Reserve Bank of Boston, March/April, pp. 21-30.

Avery, R.B., G.E. Elliehausen, A.B.Kennickell, and P.A. Spindt (1986), "The Use of Cash and Transaction Accounts by American Families," in Federal Reserve Bulletin, vol. 72 (February 1986) pp. 87-108.

----- (1987), "Changes in the Use of Transaction Accounts and Cash from 1984 to 1986," in Federal Reserve Bulletin, vol. 73 (March 1987), pp. 179-196.

Bollen, K.A. (1989), Structural Equations with Latent Variables: New York, John Wiley and Sons.

Cagan, P. (1958), "The Demand for Currency Relative to Total Money Supply," in Journal of Political Economy, vol. 66 (August), pp. 303-28.

Carson, C. (1984), "The Underground Economy: An Introduction," in Survey of Currency Business, US Department of Commerce-Bureau of Economic Analysis, vol. 64, no. 5, (May and July).

Federal Reserve System (1990), A Comprehensive Assessment of the U.S. Currency System, Quality, Age and Cost Relationships: Federal Reserve System, 1991.

Feige E. L., ed. (1989), The Underground Economies: Tax Evasion and Information Distortion: Cambridge, Cambridge University Press.

------ (1990a), "Defining and Estimating Underground and Informal Economies: The New Institutional Economics Approach," in World Development, vol. 18, no. 7 (July), pp. 989-1002.

------ (1990b), "Currency Velocity and Cash Payments in the US Economy: The Currency Enigma," Department of Economics, University of Wisconsin-Madison, unpublished.

------ (1994a), "The Underground Economy and the Currency Enigma," in Public Finance and Irregular Activity, Werner W. Pommerene, ed., supplement to Public Finance/Finances Publiques, vol. 49 (1994), pp. 119-136.

------ (1994b), "The Cash Payment System: Monetary Demography," report prepared for the Board of Governors of the Federal Reserve System and the Financial Crimes Enforcement Network.

------ (1995) "The Cash Payment System: The International Migration and Location of US Currency," Report prepared for the Board of Governors of the Federal Reserve System and the Financial Crimes Enforcement Network.

------ (1996), "Overseas Holdings of US Currency and the Underground Economy," in Susan Pozo, ed., Exploring the Underground Economy: W.E. Upjohn Institute for Employment Research, Kalamazoo, Michigan.

Gutmann, P. (1977), "The Subterranean Economy," in Financial Analysts Journal, vol. 33 (November/December 1977), pp.24-27.

Internal Revenue Service (1977), "Estimates of Income Unreported on Individual Tax Returns," Department of the Treasury Publication 1104 (9-79), Washington, DC.

----- (1981), "Study of the Information Returns Program": Department of the Treasury, Internal Revenue Service, Research and Operations Analysis Division, Washington, DC (July).

------ (1983), "Income Tax Compliance Research": Department of the Treasury, Washington, DC (July).

------ (1988), "Income Tax Compliance Research": supporting appendices to Publication 7285, Department of the Treasury, Internal Revenue Service, Research Division Publication 1414 (7-88).

------ (1990), "Income Tax Compliance Research-Net Tax Gap and Remittance Gap Estimates": Department of the Treasury, Internal Revenue Service, Research Division Publication (1415 (4-90).

Krueger, Russell and Ha, Jiming (1995) "Measurement of Co-Circulation of Currencies," working paper 95/34, International Monetary Fund.

Laurent, Robert (1974), "Currency in Circulation and the Real Value of Notes," in Journal of Money, Credit and Banking.

Muliak, S.A. (1972), The Foundations of Factor Analysis: New York, McGraw-Hill.

Porter, R. (1993), appendix to "Nominal Income targeting with the Monetary Base as Instrument: An Evaluation of McCallum's Rule": Federal Reserve Board, Finance and Economics Discussion Series, Working Study No. 1.

Porter and Judson (1995), "The Location of U.S. Currency: How Much is Abroad?": Board of Governors of the Federal Reserve System, unpublished.

Reuter, Peter (1996) "The Mismeasurement of Illegal Drug Markets," in Susan Pozo, ed., Exploring the Underground Economy: W.E. Upjohn Institute for Employment research, Kalamazoo, Michigan.

Summer, S. (1990), "The Transactions and Hoarding Demand for Currency," in Quarterly Review of Economics and Business, vol. 30, no. 1 (Spring 1990), pp. 75-89.

Sprenkel, C. (1993), "The Case of the Missing Currency," in Journal of Economic Perspectives, vol. 7, no. 4 (Fall 1993), pp. 175-184.

Department of the Treasury, Internal Revenue Service, Research and Operations Analysis Division, Washington, DC (July).

------ (1983), "Income Tax Compliance Research": Department of the Treasury, Washington, DC (July).

The Underground Economy in Britain

John Burton

Public disquiet versus academic quietude

There is a yawning gulf in Britain between the public perception of the underground economy on the one hand and the academic and official evaluations of this phenomenon on the other.

It is impossible to open either a tabloid or a serious newspaper in the UK without reading about various aspects of the underground economy that range from the nefarious, often murderous activities of crack cocaine dealers through benefit fraud and moonlighting to the ongoing growth of the theft industry.

UK newspapers, like media everywhere, report these matters because they are of consuming public interest. We now have an immense volume of personal and anecdotal evidence on the underground economy. Everyone in the UK knows of-and commonly deals with-"cash only" entrepreneurs, be they window cleaners, builders and painters, or small business people. With disgruntlement, everyone in Britain will talk about their experience of burglary over recent years, and more and more commonly, the car theft they have suffered.

Given this widespread public interest and concern about the underground economy in contemporary Britain, it might be assumed that there are plenty of up-to-date estimates of its size. Such, however, is not the case. There was a flurry of research in the first half of the 1980s attempting to quantify the British underground economy, and which harked back to earlier decades, particularly the 1960s and 1970s. --    For surveys, see Heertje, Allen, and Cohen (1982); S. Smith and S. Wied-Nebbeling (1986); and Pyle (1989)Note   --  Since that time, however, academic economic interest in the topic seems to have disappeared entirely.

This is probably not due to genuine lack of interest: economists are reputed to be human beings and must at least occasionally be aware that the rest of the British population are very much concerned about these matters. In fact, the decline or disappearance of up-to-date research on the UK underground economy is more probably due to the difficulties and frustrations of this particular field. The studies published in the first half of the 1980s used a wide variety of techniques to quantify the phenomenon and came up with a wide variety of estimates, ranging from a low of 3 percent of UK national income (Dilnot and Morris, 1981) to a high of 22 percent (Feige, 1981). Others, using yet other techniques, came up with figures that fell somewhere in between, such as 14 percent (Matthews and Rastogi, 1985).

It does seem that no particular strategy for estimating the size of the underground economy was able, in the studies of early 1980s vintage, to demonstrate a convincing "win" over other approaches. Apparently this is still the case even today. There also appears to be a quietly deployed rule of thumb in the contemporary economics profession that "if you can't (convincingly) estimate something, it is best to ignore it." More charitably, it may be that British economists recognize that the task of estimating the significance of the underground economy is, like the quest for the Holy Grail, likely to be without conclusion.

The 7.5 percent solution

In this contemporary academic vacuum concerning the extent of the UK underground economy, a sort of conventional wisdom has emerged that it is in the order of around 7.5 percent of UK national income.

The history of this magical figure bears some recounting. In 1979, Sir William Pile, a former chairman of the Board of Inland Revenue giving evidence to the British House of Commons Expenditure Committee, estimated the possible extent of tax evasion at something like 7.5 percent of UK national income. Neither Sir William nor the Inland Revenue, at that time or any subsequent time, has ever presented any methodology or basis for this particular figure. As Matthews and Rastogi would comment (1985, p. 21):

A cynic might be forgiven for thinking that the figure of 7.5 percent is a particularly comfortable one. It is large enough to cause official concern and warrant further manpower resources to the Inland Revenue. However, it is not so large that it would give the impression that the Board of Inland Revenue is not effective in this area.

The Conservative Party Election Manifesto of 1979 pledged that an incoming Conservative government would review the powers of both the Customs and Excise and Inland Revenue departments. This had been a matter of considerable public disquiet during the 1970s-especially among Britain's small traders-following the passage of the Finance Acts of 1972 and 1976 that gave the taxing agencies extensive powers of search.

In July 1980, having gained office in late 1979, the new Conservative government of Mrs. Thatcher announced the establishment of a Committee on Enforcement Powers of the Revenue Departments under the chairmanship of Lord Keith of Kenkel, subsequently known as the Keith Committee. This inquiry began publishing its conclusions in 1983, eventually issuing four volumes with a total of some 1,378 pages.

The Association of Her Majesty's Inspectors of Taxes gave evidence to the Keith Committee in April 1981 (Keith Report, 1983, n. 41). The tax inspectors accepted that the size of the black economy (tax evasion component) was "debatable," but once again plumped for the 7.5 percent figure as probably correct. In all its deliberations, the Keith Committee failed to consult or discuss any other estimate of the UK underground economy apart from one by a Central Statistical Office employee (Macafee, 1980). It grandly ignored the application of Feige's transactions approach to the UK situation as it did all other work by academic economists on this issue. The only "evidence" referred to in the Keith Committee's published report is the Sir William Pile "guesstimate" noted above.

The outcome of all this was that "the [Keith] Committee eventually announced that it felt 7.5 percent was probably the level of unofficial activity in the country" (Heertje et al., 1982, p. 63). Thus, by a process of bureaucratic reiteration combined with selective avoidance of alternative views, the idea that the tax evasion component of the UK underground economy stands at or around 7.5 percent of British national income was to become entrenched as the semi-official view (Matthews and Rastogi, 1985, p. 21).

This figure-which seems to have been plucked out of thin air-has taken tenacious hold and survives to this day as the most commonly quoted statistic of the "probable" size of the UK black economy. In early 1994, for example, the Economist, a journal not normally given to much truck with official figures when it is discussing the size/growth of the UK formal economy, quoted a 7.5 percent figure to represent the UK black economy as a percentage of GDP. We can only presume that on this occasion the Economist-possibly lacking, like the rest of us, any better ideas-decided to plump for the convenient, conventional "wisdom."

Reflections

If-and that is a very big "if"-we were to accept the "semi-official" figure of 7.5 percent of UK GDP as representing the extent of tax evasion in the late 1970s and early '80s, two observations follow.

In the first place, the total size of the UK underground economy would have been very considerably larger than this, as the Pile guesstimate referred only to what Feige (1993) calls the "unreported economy." The full underground economy-or what Smith and Wied-Nebbeling (1986) call the "shadow economy"-also includes the "illegal economy" (drug trafficking, alien smuggling, theft, fraud, arson, prostitution) and the "self-service economy" involving housework, DIY home repairs, gardening, child care, volunteer work for charities and clubs, informal aid to friends and neighbours, etc.

This full underground economy may also be taken to include what I have elsewhere called the "grey economy" (Burton, 1993) composed of economic activities that may be largely captured in the national income figures but which are either technically illicit or else stand in a grey area legally. An example of the latter in the Britain of the early 1980s was the substantial volume of Sunday trading conducted in England and Wales in contravention of the 1950 Shops Act.

Finally, there is a "very good question"-in the absence of up-to-date quantitative studies-as to how the underground economy has waxed (or waned) in the UK since those times. The writer's somewhat subjective impression as a Briton is that the UK underground economy is even more extensive now than it was in the 1970s and '80s.

Frey and Weck-Hanneman (1984), in their "soft-modelling" approach to the black economy, suggest four major determinants of underground activity:

     •     the burden placed on individuals by both taxation and regulation,

     •     the extent of tax morality,

     •     the incentives to black economy activity created by unemployment, and

     •     the level of economic development.

On the first three of these counts, incentives to participation in black economy activity have probably multiplied in the UK over the past two decades.

Taxation and regulation: while some significant cuts in the marginal rate of income taxation were made in 1988, the overall burden of British taxation went up under Mrs. Thatcher in that decade from approximately 41 percent of GDP at factor cost to 43 percent. This trend continued as sharp tax increases were introduced in 1994.

There was much talk of deregulation during the Thatcher years, but the practical realities were very modest, one example being the deregulation of bus transportation. There has also been an enormous pile-up of regulation coming into Britain at the behest of the Brussels Eurocracy. It is impossible to quantify this tidal wave-suffice it to say that the "curvature" of British cucumbers is now under EC regulation (Boyfield, 1993).

Tax morality: there is no time-series UK evidence on this. The writer's impression is that there has not been any remarkable surge in British tax morality over the past 15 years: if anything, we have seen the reverse.

Unemployment: the measured British unemployment rate at the time of the conference was a sliver under 10 percent of the workforce. This may be a low figure compared with some other European countries-Spain has averaged 18 percent over the last decade-but it is high by UK standards from the 1960s or '70s. Many more people may be being pushed into the black economy than, say, in the seemingly halcyon '60s. Unlike previous postwar recessions, this one includes a large contingent of redundant managerial/professional workers, many of whom have turned to "self-employed consulting," an activity notorious for underreporting income to the tax authorities.

The illegal economy: there can be little doubt that the illegal economy component of the underground economy has grown significantly in Britain over the past two decades, notably in such areas as car theft, burglary, and drug trafficking. The last pursuit got a boost with the completion of the Internal Market on January 1, 1993. The Internal Market features a new British Customs "blue channel" through which most travellers from the EC pass without a check. It is estimated that 65 percent of illegal drugs enter Britain from other EC countries.   --  "One expert estimates that the [UK] street price of cocaine, having stayed at about £70 a gramme for several years, has fallen to £65 over the past six to nine months, a sign that there is more of the stuff about." The Economist, "Crime Without Punishment," June 26, 1993, p.27.Note

All in all, it would seem that the Frey/Weck-Hanneman determinants of black economy activity have been on the increase in the UK over the past decade. It will not be surprising to find, when up-to-date economic studies are eventually undertaken, that the UK's underground economy proves to be significantly larger than it was at the end of the 1970s.

References

Boyfield, K. (1993), The Regulated Society: London, Aims of Industry.

Burton, J. (1993), Whither Sunday Trading?: London, Institute of Economic Affairs.

Burton, J. and Parker, D. (1991), "Rolling Back the State?: UK Tax and Government Spending Changes in the 1980s," in British Review of Economic Issues, vol. 13, no. 31 (October), pp. 31-66.

Dilnot, A. and C.N. Morris (1981), "What Do We Know About the Black Economy?" in Fiscal Studies, vol. 2, pp. 58-73.

Economist (1994), "Working in the Shadows," February 12, p. 81.

Feige, E. (1981), "The UK's Unobserved Economy," in Journal of Economic Affairs (July), pp. 205-213.

Frey, B.S. and H. Weck-Hanneman (1984), "The Hidden Economy as an 'Unobserved' Variable," in European Economic Review, vol. 26, pp. 33-53.

Heertje, A., M. Allen, and H. Cohen (1982), The Black Economy: London, Pan Books.

Keith Report (1983), The Committee on Enforcement Powers of the Revenue Departments: London, HMSO, Cmnd 8822, 9120, and 9440.

Macafee, K. (1980), "A Glimpse of the Hidden Economy in the National Accounts," in Economic Trends (February), pp. 81-87.

Matthews, K. and A. Rastogi (1985), "Little Mo and the Moonlighters: Another Look at the Black Economy," Liverpool Research Group in Macroeconomics Quarterly Economy Bulletin, vol. 6, no. 2, pp. 21-24.

Pyle, D.J. (1989), Tax Evasion and the Black Economy: London, Macmillan.

Smith, S. and S. Wied-Nebbeling (1986), The Shadow Economy in Britain and Germany: London, Anglo-German Foundation for the Studies of Industrial Society.

The Size and Some Effects of the Underground Economy in Mexico

Raymundo Winkler

Mexico's Underground Economy

The Mexican informal economy is very extensive. According to estimates by the Centre for Economic Studies of the Private Sector, the informal economy in Mexico represents, depending on the method employed, between 25 percent and 35 percent of the formal gross domestic product. The first Mexican study on this subject was conducted by the Centre in 1988, and since then many other studies have been done by both independent researchers- that is, people who do not work for the government-and universities. These studies produced similar results to those of the Centre even though different and finer approaches were used. In general, the methods employed were the monetary approach and the input of generalized use-namely, electricity consumption. More recent studies have focussed on surveys of various kinds with similar results.

The most recent estimates, including our reestimate, show that the global size of the informal economy as a proportion of GDP has never surpassed 35 percent, even though there has been a clear increase in these activities in the main cities. This contrasts with the trend observed over the past two decades, when the informal economy rose very fast-from 10 percent in 1970 to 30 percent in 1988. This could be explained by the recovery of the Mexican economy that began in 1989: it might also be due to the fact that the informal economy has a natural limit to its expansion because of the limited size of the total consumer market and, above all, because many informal companies find that in certain circumstances of size or scale it is necessary to enter the formal economy looking for, say, credit, a better-educated labour force, and other vital services.

As expected, the main causes of the informal economy found in most of the studies were the typical ones: higher taxes, excessive government regulation of economic activities, corruption, and bureaucracy. In Mexico's case, the job shortage during the last decade also markedly influenced the creation of a highly informal economy.

The initial reaction of the Mexican government to these studies was very skeptical, and there was a refusal to see them as worthy of attention. However, during the last few years the government has begun to conduct surveys among the population engaged or employed in informal activities and has also put some measures into effect to attack the underlying causes of the informal economy, especially tax evasion.

According to the national statistical agency, the population engaged or employed in the informal sector numbers 4.5 million people or 22 percent of the labour force. Based on estimates of productivity in that labour force as well as perceived income and sales, the Mexican statistical agency guesses that the underground economy amounts to only 10 percent of recorded gross domestic product. Most of the independent studies show that this figure clearly understates the real size of the informal economy. Nevertheless, this acknowledgement represents a sea change in the attitude of the Mexican government compared to its previous denial of the existence of this phenomenon, and in any case, 10 percent of GDP should be considered a significant proportion.

At the same time, the official figures contradict, or are incompatible with, the numbers the government collects on underemployed people in Mexico. Although the open unemployment rate in Mexico is just about 3.5 percent, the official underemployment rate is 25 percent of the labour force-more than 5 million people. It is felt that practically all that population is engaged in informal activities that do not pay taxes.

Some effects

Some of the main impacts of the informal economy are the following:

     •     A high level of tax evasion, which means a big loss of fiscal revenues: this dictates a need to get higher taxes from a reduced number of contributors or taxpayers. The top marginal tax rate for individuals, 35 percent, is reached by people earning no more than US $8,000 a year. This situation tends to feed back into informal activities and/or tax evasion, creating a vicious circle.

     •     Statistical distortions: for economists, analysts, and for the government itself, it is difficult to know what is really going on with such matters as the actual size of the economy, its growth rate, inflation performance, employment, unemployment, income and expense levels, income distribution, international trade (mainly imports), and so on. The actual effects of some macroeconomic policies are anybody's guess.

     •      Contraband: this activity has been estimated at US $15 billion for 1993, equivalent to 30 percent of the total amount of Mexico's imports in that year.

      •     The informal participants are both strong and unfair competitors for formal market participants. According to some surveys carried out by CEESP among almost 500 companies located in several Mexican cities, between 30 and 40 percent of producers and retailers consider that the informal economy has a big presence in their markets and that they have been partially or totally wiped out of markets by informal business. The formal companies say that this problem is as acute as the phasing-out problem produced by legal imports that is associated with opening up the economy to international trade. According to them, trade liberalization and the informal economy are the main problems they are facing as they attempt to generate higher growth rates in production and sales.

     •     Another important impact is that, due to the fact that the informal economy is a refuge for many unemployed workers, this sector exerts upward pressure on wage levels.

Strategies to combat the informal economy

The Mexican government has undertaken a series of measures to diminish the informal economy that include reducing administrative procedures and general taxes for both individuals and companies and a remarkable effort to punish tax evaders. Law enforcement in this area has recently been very strong-some would say Draconian. However, it has not been enough: participants in the informal economy still continue to think that the perceived risk is not high enough to offset the benefits they can obtain from their informal activities. For millions of people in Mexico, the informal economy does still pay.

The enforcement drive of the Mexican tax authorities has had some dramatic results. The number of active federal taxpayers-as distinct from those considered captive because they work for a formal company which collects their taxes and remits them to the tax authorities-grew from 1.5 million people in 1988 to almost 5 million in 1993. Tax collection has shown an average annual growth rate of more than 8 percent since 1988. This has reduced tax evasion and improved the public finances but, as already mentioned, it has not necessarily reduced the size of the underground economy. At best, the government measures may have contributed to somewhat arrest the expansion of the informal economy.

Conclusion

The underground economy in Mexico is very big compared with what is reported for industrialized nations but fairly "normal" in terms of standards for developing countries. Its causes are similar to those found in most of the industrialized world, but in Mexico the high unemployment rate, and specifically the underemployment rate, play a very important role in determining its size.

The Mexican government has at least begun to acknowledge the existence of this economy and its impacts, and as a result is attacking some of its main causes. For Mexico, this represents an encouraging change of attitude on the part of the government.

The informal economy is a big challenge for formal economic participants, a strong competitor with such cost advantages as less taxes and non-compliance with regulations.

Even though opening up the Mexican economy to legal imports could mean reduced cost-attractiveness for contraband, many products still offer advantages. One important aspect is that the informal economy is becoming the most effective way of distributing products that get into the country through dumping practices. These include clothing, footwear, old machinery, and a host of other products.

What are the prospects for the Mexican informal economy? Well, this sector is one of the very few in Mexico that can look forward to a marvellous future. It will continue to provide a refuge for millions of people who cannot finds jobs in the modern sectors of the formal economy.

The Mexican economy in the context of NAFTA will be looking mainly for a skilled workforce. For unskilled workers, their destiny will be the informal economy and/or emigration to other countries. Certainly the NAFTA will create jobs, but not immediately in the numbers needed to absorb the more than 1 million people annually entering the Mexican labour market.

The Growing Importance of Informality and Possibilities for Integration

Enrique Ghersi

Introduction

Despite the fact it represents a historical problem, its deep causes lie in the countries legal structure and some of its most outstanding aspects have made it very visible during the last few years, only recently has informal economy has become a topic for debate. Nevertheless, in a very short time a new intellectual discipline has developed, so called "informology."

What is informality?

Before analyzing the informal economy, we should define its concept, thus there isn't unanimity regarding it's definition.

The International Labour Organization (ILO) and the Regional Employment Program for Latin America and the Caribbean (REPLAC) understand informality as related to economic activity scale: for them, informality is synonymous to small business.

We find this concept essentially inaccurate. Any definition on economic activities quantitative aspects is bound to be altogether arbitrary, as no objective measure exists to tell the difference between big and small. Economic activity scale is an effect and not a cause: therefore we cannot consider that it defines informality-rather, it is one of its multiple consequences. The small business definition is also inadequate to explain existing qualitative differences. For example, there are more economic differences between a small business that is duly registered, pays its taxes, and is protected by the law, and a small one that is not, than between a midsize company and a small business.

On the other hand, the classic anthropological literature which specializes in this subject identifies "informal" with "marginal." This seems to imply that informal activities are performed as a means of survival or a last resort, which seems to be a criterion of verification more than a definition. Now since, according to research carried out by the ILO itself, informality in our country involves at least 48 percent of the economically active population and 61.2 percent of man/hours worked, it cannot be said that informal workers are marginal. On the contrary, the real marginal individuals are more likely to be the ones commonly considered "formal."

Taking all these difficulties into account, the ILO has tried to develop a concept of informality that conforms more closely to what actually exists in our country. Briefly, this concept considers as informal those economic activities which use illegal means to achieve legal objectives. It is very probable that the people directly involved in such activities, as well as the society in general, are better off if the law nominally applicable is infringed rather than complied with.

It is not the individuals who are informal, but their activities. Informality is not a specific, static sector, but an indefinite borderline with a considerable frontier of contact with legality where individuals take refuge when the costs of complying with the laws exceed the benefits. Thus understood, informality is nothing but an analytical concept that refers us to concrete cases where economic agents cannot abide by government regulations even if they do adapt to socially accepted behaviour.

This criterion applies both to activities that we could call classically informal-street trading, for example-and to the duly recorded production of the formal factories and even the process of informal urbanization, which is typical to emerging small towns or housing associations and cooperative organizations.

Quantifying informality

It was estimated in 1984 that informality in Peru covered 48 percent of the economically active population engaged full-time. However, should part time informals be considered-that is, people who, like "pirate" cab drivers or occasional street vendors, devote only part of the working day to these occupations? With them included, informality would account for an estimated 61.2 percent of total man/hours worked in the country.

Informality also contributes with a highly significant volume both of goods produced and of services rendered in the Peruvian economy. In 1984, informal activity produced the equivalent of 31.7 percent of total GNP. Since a substantial part of it is not considered by official statistics, we estimate that GNP was undervalued by 18.4 percent, This means that in 1984 we were 18 percent wealthier thanks to the informal workers, nevertheless we didn't know it.

Informal housing

This category covers all provisional settlements either acquired, urbanised, or built without abiding by or even against legal provisions, which may eventually benefit from a system of administrative exception to allow them some form of official acceptance. We include here the so called shanty towns, marginal neighbourhoods, emerging small towns, shelters, "popular urbanizations of social interest" (UPIS), urban expansion areas, marginal provisional settlements, municipal provisional settlements, housing associations, and cooperative organizations.

Among all existing houses in the capital city in 1982, 42.6 percent belonged to informal marginal settlements, 49.2 percent to the formal sector, and the remaining 8.2 percent to the poorest sections located in former "formal" areas. Measured in terms of people, these informal settlements have provided lodging to 47 percent of Lima's population. It is estimated that an additional 20 percent lived in the poorest sections, that is in areas of much misery within traditional urban sites, and that only the remaining 33 percent lived in what could be considered formally fit urbanizations. Even so, these indicators cannot reflect the immense proportion of cases in these urbanizations where applicable rules and regulations for accommodations or construction had not been complied with.

Beyond their unquestionable social importance, the informal settlements also have significant economic importance. In 1984 again, to calculate the value of the real property located in such settlements, each house was appraised separately. According to this appraisal, the total value of the informal settlements amounted to $8,319.8 million, equivalent to 69 percent of Peru's external longterm debt.

What is also remarkable about all this is that the value was generated by the informal occupants themselves with no aid or investment provided by the state. As evidence of its significance we only need to say that during the same period when these informal settlements developed-between 1960 and 1984-the state spent only $173.6 million in housing projects: that is only 2.1 percent of what the informals had invested with their own efforts.

Informal trade

Informal trade includes all commercial activities that take place without abiding by or in defiance of the official provisions nominally regulating it. Such activities comprise the ones conducted out in the public road-street trading-and the ones occurring in markets built especially to keep business off the street.

Despite the fact that it is considered to be the informal activity par excellence, official figures on street trading in Lima are unsatisfactory. The only count ever done by the government dates back to 1976 and was based on a limited sample which, given the features of the current crisis, could be used as valid. This made it necessary to take new counts in 1985 and 1986, when the population engaged in street trade and their main specializations were recorded.

As of January 1986, then, 91,455 street vendors were counted throughout the city, distributed in 79,020 stands at a rate of 1.16 per stand. Of the total number of stands, 59.5 percent were selling foodstuffs; 17.5 percent were selling articles for personal use, 13.7 percent, services and 9.3 percent, home and office supplies.

Apart from their social importance, their economic significance was also determined. According to an income survey carried out in 1985, the street traders gross sales totalled $322.2 million a year, which made the per-capita income derived from this activity 38 percent higher than the minimum legal remuneration. Obviously, an unqualified individual would have found it economically much more attractive to work in street trade than to try for a job at the minimum wage.

As for the second type of informal trade, the trade that takes place in informally built markets, it was found that Peru's capital city counted with 274 of these markets as compared with only 57 erected by the state, and that these markets were occupied by some 38,897 individuals who used to be street vendors, distributed in 29,693 stands at an average of 1.31 per stand. These informal markets had an appraised value of $40.9 million.

Informal transportation

Probably the economic activity with the highest index of informality in Lima is urban transportation. This has been the case since at least 1930, when a big strike of group passenger transport drivers paralyzed the city. Since 1965, when the old private bus companies went bankrupt, the growth of informality in this area has been constant. This particular universe has two clearly defined levels. The first, of higher relative legality, is composed of minibus and cab drivers who have government permits in the form of concessions; the second, of lower relative legality, is formed by minibus drivers and "pirates" or provisional cab drivers who conduct their activities without permits.

As to numbers, if we consider minibuses and buses, informality accounts for 91.4 percent of the service: if the universe is expanded to include small group transportation by automobiles and taxis, the informality percentage reaches no less than 94.8 percent. We should consider, however, that these figures will have varied more recently to reflect the government's decision to accept "rural station wagons"-a regulatory euphemism for "pirate" minibuses. The replacement value of this fleet amounts to $620 million, to which $400 million should be added for infrastructure-gas stations, mechanics' garages, and other facilities.

Informal industry

Informality continues to predominate, at least in the same activities where it was already significant according to a study conducted by the UN. Leading categories are shoemaking, apparel manufacture, and furniture. Lima is estimated to have about 8,000 companies engaged in the manufacture of clothing and 2,000 shoe workshops, 90 percent of which have not been registered. At least 85 percent of wooden and metallic furniture originates in informal industries that sell both to the public and to legally approved companies that affix their own trademarks to it.

Possible causes of informality

The underlying cause of informality in Lima can be identified as the formal systems inadequacy to meet the needs of the emerging population. This can be clearly seen in at least two specific instances.

The migrant who leaves the countryside to come to the city is not a neutral economic agent. He needs access to economic opportunities, not only a job but also housing, transportation, commerce, and in general anything he may need. Given the national ruling tradition, however, there is no easy access. The fact that someone wants to sell in a market, build a house, make fit a piece of land, or start a business or industry does not mean that he can just go ahead and do it. First he should obtain licences: he should pass through the screen of the law-and this represents the first step of confrontation between the individual and the institutional system. In our attempt to identify the causes of informality, we shall refer to this first step as the cost of access to formality.

Our second specific instance is once access has been obtained. Our individual wants to do something-build a house, provide a service, work in an industry or in commerce- but he cannot go outside the law to operate officially. His conduct is supposed to be conditioned by the institutional system. Taxes should be paid, the law complied with, job stability respected, concessions obtained, and buildings must be subject to the very particular requirements of the National Rules and Regulations for Construction. Thus, it does not suffice to obtain legal access: legality should be maintained. We will call this second phase, "costs of permanence" within formality.

To quantify these costs, a simulation was conducted in 1984 to cover all the steps required to legally constitute a small clothing workshop on the central highway. The goal was to go through the whole process like any citizen, without either technical information or professional advice and with an eminently honest purpose. Consequently, it was decided not to pay any graft to expedite the procedure.

The final result was that 289 days were required to get the 11 permits required at a total cost of $1,231 between expenses actually disbursed and loss of profits. Graft was demanded about ten times and had to be paid on two occasions: thus, in spite of compliance with regulations, bribery to some officials could not be avoided.

To verify whether the problem might be universal, the experiment was repeated in Tampa, Florida, USA, where it was discovered that processing the legal founding of a small clothing workshop took only three hours. The astounding difference between these results requires no further comment, except that they apparently reflect the two countries' levels of development.

For obvious reasons, no simulation could be undertaken for housing, and we decided to study actual legal files. As a result, it was found that the formalities for adjudicating, making ready, and obtaining construction licences-all of which were required for the use of an uncultivated lot owned by the state-take an average of 80 months and involved no fewer than 207 different administrative steps even with the intervention of the President of the Republic. The sole cost of awarding the land to an average residents' association amounted to about $2,156 dollars per member, 52 times the minimum legal remuneration in force at the time of the estimate.

The case of retail trade turned out to be equally pathetic. Costs of access to a formal store and a supply market were examined, since these represent the two most common options for this activity. In the first case, a simulation indicated that the formalities for opening a small grocery store take about 43 days at a cost of $600. As for the second possibility, study of five actual cases revealed that the formalities for legally building a market last an average of 18 years.

In the case of transportation, the matter is much simpler but at the same time dramatic, as there is no access at all. To work in this service, a person has to invade and then either demand or negotiate politically for legal admittance. Only when the transporters have been formally admitted they are allowed to participate in the bidding that is so ostentatiously called for by the municipality.

As to the costs of permanence within formality, these have been found, based on a sample of 50 small industrial businesses, to represent 347.7 percent of their profit after taxes and 11.3 percent of their production costs. Some 21.7 percent of the costs of permanence go in taxes, 72.7 percent are related to labour and bureaucratic expenses, and the remaining 5.6 percent represent costs for the use of utilities. All of this suggests that taxation is a much less important factor than it is commonly considered to be in defining the formality or informality of businesses. Instead, the state-imposed labour and bureaucratic costs for maintaining businesses under protection account for the bulk of our costs of permanence.

Thus, the causes of informality can be determined by examining the costs of access and permanence in various economic areas. The mechanism is simple: given that people are inclined by nature to do what is cheapest and avoid that which is most expensive, compliance with the law-materially speaking-depends on whether its costs are lower than its benefits. Individuals making this evaluation will naturally pursue their own objectives and not those of the state.

If the costs of access are such-considering the onerosity, delays, and other difficulties involved in formality-that they either become unaffordable for people with fewer resources or exceed the benefits of legal access, people will decide to remain in informality. Likewise, if the costs of permanence exceed the benefits of formality, people decide to opt out of the circuit despite having joined it: that is, they decide to go back to informality.

This explains why there are two specific types of informal workers: those who never joined the circuit because they could not afford the costs of access, and those who, having entered, leave it because of the high costs of permanence.

On the other hand, it must not be disregarded that informality has its own costs, in many cases especially high or dangerous, given the significant negative externalities affecting such activities as street trading or popular transportation. These costs of informality-the cost of lack of legal protection, the cost of being unable to apply to the courts, the cost of not having access to credit, the cost of lack of insurance, the cost of invasion, the cost of grafting and bribery, the cost of the definition of property rights, the cost of insecurity in contracts, etc.-are precisely those which argue the need to face the problem of informality as the principal one which the country is currently undergoing.

There is no doubt that modifying the institutional system will improve the effectiveness of the economy to the extent that it reduces its costs. Modification has become indispensable, given the high level of social pressure and frustration that these circumstances cause.

Some alternatives

Frequently, the problem raised by all these circumstances is summed up in the following dilemma: should informal workers be formalized, or should the formal workers become informal?

The dilemma is spurious: it is not convenient to have economic activities going on that do not meet the legal requirements at all, given the considerable costs and incitement to violence that this condition represents. Clearly, whatever is done on behalf of informal workers should benefit formally established activities. Establishing regimes of exception for the exclusive benefit of informal workers would have consequences as harmful to the country's economic organization as reviving the eradication of idolatries.

One alternative that suggests itself is to reduce the costs of access. Since illegality is generally the consequence of difficulties to cope with legal access to the market, it would appear mandatory to lower such access costs. To that effect, a deregulation program would be set up to remove all the hindrances that limit or prevent access to economic activities.

Obviously, deregulation would favour not only new businesses but also existing ones, since it guarantees fast movement of production factors and, as a result, the adequate appropriation of resources according to market incentives. At the same time, an attempt at effective debureaucratization would simplify the process of administration.

Secondly, lowering the costs of permanence would bring the expenses to levels at which they will not be stimulated to return to informality. Two specific measures are called for here.

The first ought to be an administrative simplification process directed, not at the formalities required to enter the market, but at all the others which businesses must satisfy in the course of their normal lives. It has been estimated that such formalities currently require an average of forty hours per work week from the managers of formally established companies. The second measure should be a thorough, simple and stable tax reform to cut rates to levels where the cost of paying the tax is lower than its benefit.

Similarly, an effective process of decentralization could be attempted: this should not be understood in a merely administrative sense but as a real distribution of power towards the provinces so that they can compete with each other as producers of legislation, coupled with the privatization of certain public functions to transfer responsibilities from governments to individuals.

The foregoing suggestions are quite general, but they may open the way for much more concrete proposals stemming from a recognition that the profusion of regulations may have contradictory effects if the poor are discriminated against and formal requirements are excessively expensive.

A package of reforms of this type would produce two types of economic effects. First, eliminating the limitations on informal growth and investment would raise informal productivity considerably-bearing in mind that it is currently equivalent to only one third of formal productivity. In the second place, eliminating superfluous rules and regulations would reduce the costs of formal workers and allow for the productive use of resources that are currently used up in unproductive expenses required to conform with the state. Both measures would finally lead to the growth of the GNP.

Although the real consequences are hard to gauge, an institutional reform eliminating the differential between the two levels of productivity would raise the GNP by up to 54 percent. Even if the differential could not be reduced by more than one half, the GNP would grow by 27 percent. If elimination took ten years, the annual growth rate of the GNP as a result of this single proposal would be 4.4 percent; if it were reduced by only one half in ten years, growth would amount to 2.4 percent. In either case it would certainly exceed the 1.8 percent per annum registered in the period 1973-1983.

It is therefore perfectly possible to use the so called "informality problem" to increase the collective wealth of our country: adequate institutional reform would enable every Peruvian to seek his own benefit and as a result serve and benefit the rest. It is a matter of thorough reform of the institutional framework that makes it more profitable to operate legally and thus stimulates the efficient appropriation of resources without which economic growth is impossible and social progress a farce.

A market cannot operate at its full capacity unless it has a "metamarket" that reduces its costs, internalizes externalities, stabilizes contractual relations, and guarantees property rights. Thus, the problem is being misconstrued when we refer to the growing importance of informality and the possibilities of its integration. Economically speaking, informality is not separate from formality. There is no such thing as the informal sector, autonomous and autarkic. Both formality and informality represent legal conditions of economic activities, not separate activities. In fact, the problem should be viewed from a different standpoint. It is the law that should be integrated; in other words, law must be adjusted to reality.

Law, democracy, and mercantilism

It is clear from the above that our institutional system is inefficient. It restricts legal access to and permanence within the formal economy. Further, its inadequacy imposes a series of expensive charges on informal activity. Through excess or insufficiency, it restricts the development of individual lives, discriminates against the less favoured-by definition, those who cannot afford the costs the law demands for its protection-and it divides markets and limits the movement of production factors. In sum, it gradually forms a legal order which, rather than consisting in general rules, tends to resemble a group of contracts between the state and small interest groups which regulate the different aspects of reality, doing absolutely without the participation of the other members of society.

We are convinced that a legal system like this is no accident in our country: it is bound up with the way the law is produced and, in the end, the nature of our political regimes. In effect, our lawmakers are adhering to a tradition of using the law as an instrument for the redistribution of wealth instead of its creation. The law is conceived as a mechanism that facilitates the distribution of a fixed "stock" of wealth among the various interest groups that demand it.

With legislation being produced in this manner, it goes unnoticed that beyond its immediate redistributive impact, every law affects the functioning of the economic system in its entirety. In fact, it enables our countries to organize themselves to compete, not in the economic marketplace, but in the political one, because Latin Americans know very well that they can obtain much more through a comfortable arrangement with government than through their own labours.

In the long run, all this affects both our means and objectives. In our countries, the laws discriminate against those who do not have either the organization or the resources required to participate in the process. Our countries compete for the benefit and privilege of the state rather than the benefit and privilege of the consumer. In our countries, the law does not limit power: it reflects power.

This is dramatically expressed in the legislative process. Nominally, our countries have a division and balance of powers in the best Western constitutionalist tradition. However, this is not true. In the case of Peru, for instance, the main producer of legislation is not the Congress but the Executive Power: in the last 40 years, an average 98.68 percent of the regulations produced annually came from the president and his ministers, not from the congressmen.

Certainly, in Latin America and Peru we all criticize our parliaments as inefficient, unreliable, and slow. But the executive lawmaking process lacks transparency and the public participation that parliaments are supposed to stand for. Regulations are "cooked up" in the consulting offices of the ministries or the Government Palace and are surreptitiously approved, making it impossible for anybody to oppose them until they are published, already mandatory, in the relevant official newspaper-if they are published at all.

Actually, it is quite usual in our countries for the drafts of decrees and resolutions to be written in the offices of the lawyers who represent interest groups and sent to the government with a calling card. If we coolly examine the historical process, we can see that legislative production by the Executive Power is constant between democratic governments and military dictatorships. In other words, our civilian presidents are as arbitrary as military dictators.

All the evidence tends to belie the democratic pretensions of our societies. Our institutional structures are such that the best we can expect is the right to vote for a president every certain number of years, but not the right to participate in the decisions made by the president or in his administration: we issue a blank cheque to the elected president to administer the country as he wishes.

The only way our institutional structures allow us to participate in decision making is by becoming involved in the political competition held by our interest groups for the redistributive power of the state. This leaves us with the option of trading reciprocal favours with powerful politicians, offering political support and votes in the nominal democracies or the capacity to call for assemblies and legitimacy in the exercise of power in our dictatorships. In any case, it becomes a matter of negotiating for legal regulations which, through different channels, will benefit the powerful by creating income in their favour. An insider licence to enter a market, a tariff raised, the technical modification of a tax calculation...

Looking at it in perspective, however, this way of governing and lawmaking is neither casual nor unique in history. In fact, it was typical of the Western world at least until the Industrial Revolution and the subsequent affirmation of market economy regimes. It is the system which economic historians call "mercantilism."

Now mercantilism has been defined in many ways. Usually, it is associated with more or less strict control of foreign trade. Nevertheless, consensus exists in economic history that it is much more than that.

UNESCO's Dictionary of Social Sciences defines it as the belief that the economic well being of a nation can be guaranteed only by a nationalist government. Other analysts prefer, however, to conceive it as the distribution of monopolistic privileges by the machinery of the state. In such a system, economic competition is transformed into a competition for privileges or revenues to be obtained from the state without the necessary presence of a productive counterpart. This competition for privileges limits access to the economy, segments markets, restricts the movement of production factors, and in general raises the cost of compliance with the law, which mainly affects people with the least resources.

The company as privilege, the law as discrimination, and property as restriction-all are typical of the mercantilism of France under the ancien regime, England under Cromwell, Russia under the Romanovs, and even Spain when ruled by Franco, as well as Latin America.

It is for this reason that Marxist Leninists erroneously believe that we are living in a society that dances to an imperialism which is the highest phase of capitalism. Latin American social democrats are also wrong in their belief, since the time of Haya de la Torre, that on our continent imperialism is not the last but the first phase of capitalism. The fact is that the first phase of capitalism we are living in is a mercantilism to which the informal entrepreneurs of Latin America are peacefully yet steadily offering resistance.

These millions of small entrepreneurs who have recovered the right to do business; these inhabitants of the emerging small towns, the poorest sections, the shantytowns of our cities who have recovered the right to private property; these vendors who invade the streets everywhere to illegally exercise the right to free commerce; these drivers who provide service without being under and protected by the law-all of these people represent a vigorous market economy that is moving right ahead. Informality is nothing less than an industrial revolution occurring in Latin America a hundred years after the European version.

Descriptions of Mexico City, Lima, or Bogota significantly resemble Charles Dickens's descriptions of London. Crowding, human migration, business activity are everywhere, but also the ignoble interventionist state trying to redeem the whole world when all it really does is negotiate the country's "stock" of prosperity in exchange for political profits, and the frivolity of a decaying bourgeoisie unable to realize that each poor individual facing it represents a private entrepreneur.

Of course, each historical experience is different. Mercantilism fell more violently in France than in England; it wore a corporative face for forty years in Franco's Spain; its sway was resolved by the installation of an even worse dictatorship in eastern Europe. There is no reason why we should follow any of these roads, but we cannot ignore the fact that in our countries the state already lacks legitimacy. Legitimacy now dwells in the street: in each poor dwelling where private property is rescued; in each street vendor's stand where free commerce is recovered; in each private enterprise where liberty is maintained.

And it will be only in the modification of our institutions, with the return of sovereignty to the people and the effective democratization of our societies, that the Latin American state will recover its legitimacy. In this process, the definitive fall of mercantilism and the triumph of our industrial revolution will afford all Latin Americans a chance to enjoy the benefits of liberty.

Learning from the Informal Sector

Ignacio Irarrazaval

Our subject here is the main lessons to be learned from the operation of the informal sector in Chile. Most of what follows is based on two empirical studies: the La Granja study of a low-income municipality of Santiago, directed by the author, which weighs the costs and benefits of becoming formal, and the MIDEPLAN study based on a sample survey of 415 microenterprises in the same Chilean city, which examines their operations and levels of regulation obedience.

We begin with a brief discussion of the term "informality" as it pertains to the Latin American setting before proceeding to survey some current estimates of the size of the informal economy in Chile. The final section presents the most important issues and lessons that can be derived from the local operation of the informal sector in Chile. What are the costs and benefits of informality? What has been done to tackle the problem of informality?

Approaches to the informal sector

The concept of informal sector is elusive: the literature offers a variety of interpretations. Since our main purpose here is to identify practical lessons to be learned from the informal sector, we will concentrate on two main approaches.

The International Labour Organization (ILO) approach views the informal sector as a result of the restructuring of labour and production worldwide. In the Latin American context, these processes occur in a situation of labour surplus. Competitive pressure from the labour force reduces wages and creates subsistence activities that are not linked with the dynamic sectors of the economy (Tokman, 1990). The informal sector supplies low-income markets that are incapable of accessing capital, training, and technology. In other words, the informal sector can be defined as the range of economic activities existing outside government regulation.

The ILO approach usually quantifies the informal sector in relation to various groups in the labour force. Traditionally, it views as informal all workers who are self-employed (excluding professionals and technicians), unpaid family workers, and workers in enterprises with fewer than five employees.   -- In some studies, a distinction is made between small enterprises (five employees) in services and trade and small enterprises producing goods. The former cases are considered informal only when the workers have no contract: in the latter, contracts are irrelevant.Note

Our second theory, the neoliberal or De Soto approach, is based on the observation that informal activities in developing countries are a by-product of inadequate legislation and excessive bureaucracy. Illegality and informality arise from difficulties with obedience to regulations and the costs they impose, rather than from any need to reduce production costs or increase production flexibility. According to De Soto (1987), government regulations are a barrier to the development of informal activities, and his well-known example of a potential street vendor having to secure more than 80 signatures or appeals speaks eloquently to this. Access to the more dynamic markets can be gained only through the legal and institutional machine.

The neoliberal approach sees informality, not in individuals, but in activities, which become illegal as a result of excessive government regulation. From this standpoint, informality and illegality are similar concepts. There are three main areas of illegality:

     •     taxing illegality, reflecting the extent that a business is not a registered tax unit and/or is not paying taxes-it is possible here to further differentiate between central and local taxing illegality;

     •     environmental and physical illegality, reflecting non-compliance with health and environmental regulations, particularly important for food establishments, and non-compliance with an urban master plan in an establishment's physical features and layout; and

     •     labour illegality reflecting the absence, not only of contracts, but also of social security and health insurance for workers.  --   In the Chilean case, social security and health insurance are mandatory payments regardless of a firm's size. Both payments are financed by the employee and withheld directly from the employer's payroll.Note

Size and features of the informal sector

No studies exist of Chilean informality at the national level: most have concentrated on Santiago, the capital city of 4.2 million people. The available studies do not use the same definitions and data sources, making it difficult to form time series. In practical, methodological terms, this means that our general picture of informality has to rely on a variety of information sources and is constrained in some areas.

Before describing the Chilean case itself, however, we will need a broader understanding of the informal context in Latin America generally. This will also help to situate the Chilean sector in its regional setting.

Table 1 summarizes the findings of recent informality case studies in Latin America. The approach taken here adheres closely to De Soto's evaluation of the barriers to formality. The main variables assessed are time dedicated to administrative procedures and the financial costs involved. When looking at costs, we have to differentiate between cases in which the law requires alterations in the infrastructure for producing the goods and cases in which such requirements are minimal or nonexistent. Examples of this are regulations requiring special ventilation in kitchens or bathrooms exclusively for employees in industries employing more than three or four people.

Click here to view Table 1: The Accessing Cost of Legalizing Informal Production

How long does it take to formalize an economic activity? Measured in days of work dedicated to administrative procedures, this varies significantly among the countries reviewed. Bolivia, Brazil, Chile, and Uruguay impose relatively shorter periods for access to legality that range from a fortnight to three months. A different situation can be found in countries like Ecuador, Guatemala, Mexico, and Venezuela, where access to legality can take from three to ten months. De Soto (1986) has estimated that it could take as long as 289 days to legalize a clothing industry in Lima. Thus, we can include Peru in the latter, slower group.

Regarding the financial costs of accessing legality, we again find important variations in actual amounts spent and their relation to profits. The previous country groupings hold here. In the first group of countries, Chile among them, the financial costs of access to legality are relatively low relative to annual profits. In the second group, average financial costs are twice as large. However, when the law requires alterations, accessing costs become increasingly high and in most cases prohibitive, since they can absorb more than the annual profits of the business. It is important to note that Chile places a high financial price on legality.

To summarize, we may conclude that Chile presents relatively low accessing costs for legality relative to other Latin American countries. However, this situation can be reversed if alterations costs are considered. As a result of this, many Chilean businesses fall into a "gray area" in which they have taken the initial steps towards legalization but have not incurred the additional and high costs of completing the process. In most cases, an entrepreneur's decision not to proceed will be related, not only to financial costs per se, but also to individual assessments and estimates of the areas in which the business can be more easily fined.

Informality in Chile

In analyzing the patterns in Chile over the last few years, we have used the ILO approach for measuring informal employment (see Figure 1). The figure highlights three main points:

Click here to view Figure 1: The Informal Sector, Unemployment, and Labour Force Participation in Chile, 1986-1993

     •     the Chilean informal sector measured by the ILO approach is about one third of total employment (32.5 percent in 1992);

     •     informal participation in total employment was very stable around the early 1990s and appears to be a structural constant in the Chilean economy.

     •     there seems to be no relationship between a country's informal sector and level of economic activity: It is even possible to think of a positive relationship between GDP/PC and informality.Note a decrease in unemployment is not echoed by a decrease in the informal sector. As Leiva (1992) has pointed out, the urban informal sector is not necessarily a "refuge" for people becoming unemployed.

La Granja study

The Municipality of La Granja is one of the poorest in Santiago. Forty percent of its households are below the official poverty line. Per-capita municipal revenue is only half of the average for Greater Santiago. In 1991, La Granja had an estimated population of 151,681.

Our study was possible by an agreement between the municipality and the University of Chile's economics department.   --  The bulk of the information in this study can be found in the B.Sc. Economics thesis of Ms. Aura Escudero, directed by the author (Faculty of Economics, University of Chile, 1991).Note   --   The La Granja municipal tax inspectors first put together a list of the addresses of all businesses located within the municipal boundaries. This information was then cross-tabulated with municipal data on industrial and commercial licensing fees and Internal Service Tax (IST) data on businesses that had initiated commercial operation (corporate and value-added tax). This simple cross-tabulation was possible because our three information sources recorded the owners' national identity numbers. Despite the obvious beneficial relationships that can be built up between the IST and the municipal finance department for collection purposes, this information is never shared due to special regulations. The La Granja case isin this sense a pilot study.

One important caveat is that our information relied on the "visual knowledge" of local tax inspectors and thus excludes a number of economic activities that have no "facades" or addresses, namely the small street vendors. This means that a significant proportion of small business was not considered in the study. Our information enabled us to define three categories of formality in La Granja:

     •     formal, referring to businesses paying municipal and IST taxes;

     •     informal to municipality, referring to businesses paying only IST taxes; and

     •     informal, referring to businesses paying no taxes.

Table 2 presents the results of our cadastral survey of businesses in La Granja. It can be seen that of 1,635 businesses surveyed, almost 30 percent were totally informal and a further 12 percent were informal as classified by the municipality. This means that 42 percent of all known economic activities in this municipality were informal.

Click here to view Table 2: Municipality of La Granja Type of Formality by Economic Activity (%)

As noted in Table 2, by far the most common economic activity in this municipality was retail trade, followed by wood industries (furniture and carpentry), repair services, and services in general. Levels of informality varied among economic activities. Wood industries presented the highest level of informality, a situation stemming from zoning requirements in the urban master plan. In most cases, carpenters located their industries in the backyards of their residences, bypassing a residential land use requirement. The same situation also applied to repair services. In the cases of retail trade and other services, the most important constraint to formality related to environmental and health regulations (e.g., requiring a refrigerator for food). It is interesting to note that our "other services" included educational services. According to our information, La Granja had 13 informal schools. Although mostly small nursery schools, they did pose a question about the relevance of the regulatory requirements in ths case.

The second part of the La Granja study was devoted to the costs and benefits of becoming formal. For this purpose, we conducted in-depth interviews with 10 businesses, questioning them about their perceptions of these costs and benefits. The project was evaluated over a period of 11 years, and we differentiated between accessing costs (period 0) and operating costs (periods 1 to 11).   --  The 11-year assessment of the formality project reflects previous studies showing that the expected lifespan of informal urban businesses is that period. See Corvalan (1983).Note

A summary of costs and benefits can be found in Table 3. On the benefits side, we worked with four main fields. Penalty savings reflected the avoidance of fines for not complying with tax regulations. VAT absorption was the facility available to formal businesses of deducting VAT from the purchase of inputs for production and using this as a credit for the VAT to be paid on the sales of production. Informal businesses do not have this VAT facility, resulting in higher prices for inputs and thus higher final prices and probably less demand for production. The other two benefits were access to credit and access to markets. Some businesses perceived these as benefits, but it was impossible to estimate them monetarily.

Click here to view Table 3: Costs and Benefits of Formalization

Table 4 summarizes the results of the cost-benefit analysis of the "becoming formal" project. It is important to remember that this exercise considered costs and benefits as the businesses perceived them. This marked a departure from other cost-benefit estimates of informality. In our case, most owners repeatedly expressed no fears about municipal or IST penalties: we found only one tax penalty and shop closure experience.

Click here to view Table 4: Municipality of La Granja Internal Rate of Return: Project "Becoming Formal"

As can be seen, there is no clear relationship between the assets of a business and the profitability of the project. The study required an IRR of at least 18 percent to consider a project viable, as this is the estimated inflation level for the period studied.

The MIDEPLAN study

The MIDEPLAN study was a semiprobabilistic sample survey of 415 microenterprises in Greater Santiago conducted by DESUC-the Institute of Sociology, Catholic University of Chile-at the request of MIDEPLAN, the Ministry of Planning. An important feature of this study is that it considered businesses with no external identification, finding them by interviewing all the households in a randomly chosen block about the presence of businesses in their area.

In terms of the socioeconomic features of the microentrepeneurs, DESUC found the gender distribution of businesses strongly related to traditional occupations. Males tended to dominate wood and repair microenterprises, while women led in clothing and food microenterprises. At the same time, the study found no significative differences between the entrepreneurs' educational levels, even when controlling by area of economic activity and size of the business. Microentrepreneurs are not necessarily poor-only 28 percent of them reported incomes below the poverty line   --   The national estimate of population below the poverty line is 33 percent.Note   --  -but higher concentrations of poverty were found in clothing and textile and food businesses, which exceeded the national average. An initial explanation for the subjects' relative prosperity is that a large proportion of microentrepeneurs, 43 percent, were former employees-an indication that these businesses tend to be created with an accumulation of previous experiece. Again, this is less clear in the areas of clothing and food, which are basically subsistence or complementary activities.

Formality levels for Greater Santiago, reckoned with the ILO approach, can be seen in Table 5. More than two thirds of the microenterprise employees had contracts and social security payments.

Click here to view Table 5: Microenterprise Labor Formality

Table 6 shows formality levels by economic sector according to the De Soto approach. It can be seen that 40 percent of the microenterprises interviewed were in total informality, with an additional 12 percent in partial informality. It should be noted that clothing and textiles and food presented higher levels of informality.

Click here to view Table 6: Informality By Economic Sector and Tax Compliance

The final table of this section shows the features of informal and formal businesses according to their ages, assets, and monthly sales. In contrast to the La Granja study, the MIDEPLAN study found initial evidence of a direct relationship between microenterprises' assets and sales and their levels of formality. In both variables, businesses in the higher brackets presented higher levels of formality. However, the table does not show a significant relationship by age: formality levels observed in the older group of businesses (55 percent of the sample) are not significantly higher than in the younger businesses.

Click here to view Table 7: Formality According to Age, Assets and Monthly Sales ($)

Lessons from the informal sector

One of our intended contributions here is to relate perceptions of problems rather than their official definitions, thus providing a fresh view of traditional issues in the informal sector. Our brief review of the features of Chile's informal sector leaves us with seven major lessons from its experience.

The informal sector is relatively stable

Contrary to the conventional wisdom, the informal sector has maintained its share of total employment. At the same time, the MIDEPLAN study showed that more than 50 percent of the microenterprises included in the Greater Santiago sample had been operating for more than six years. Since the informal sector is apparently "here to stay," we can plan ahead with real incentives to help them become formal. A possible result of this suggestion might be an increase in the collection of municipal fees and the economic activities in which they are involved.

Accessing costs: bringing theworkplace up to code

Accessing costs in terms of municipal licences or IST are not perceived as significantly discouraging formalization. The prohibitive costs are the ones involved in bringing the workplace up to code. This especially affects people working in the food and the furniture and wood sectors. Prohibitively priced though they may be, however, some of these requirements are unavoidable for safe working conditions or quality of production.

However, there is ample room to revise these regulations to consider the size of the economic unit. Regulations must be adjusted to reflect the scale of the hazard or problem that might be created. Is it possible to decentralize some standards? Can a bicycle workshop be treated the same as a car garage?

Operating costs might even createadditional expenses

In general terms, the operating costs of being formal are not perceived as high, though an exception to this is added rent for a workplace. However, due to their severe lack of information, knowledge, and practice, most businesses had to ask for guidance in filling out tax returns and tax forms. In the MIDEPLAN study, of the few individuals paying income tax, over 90 percent hired an accountant to fill out the forms.

Municipal fees not perceived asbenefits

An interesting example of popular knowledge arose in discussions about the importance of paying some municipal fees. People showed a clear perception of the concept of public goods and the impossibility of the municipal government excluding them. In only one case was an individual able to identify waste collection as a benefit to his business.

Benefits of becoming formal are not always perceived as such

In connection with penalty savings, we found only one case in La Granja of a business actually being fined by a tax inspector, closing the business for three days. The municipality has no enforcement policy and few tax inspectors, who concern themselves with the more profitable businesses, i.e. big industries. In addition, business permits form a small proportion of overall municipal receipts. Most municipal expenses are financed from central government transfers. The real incentives are to obtain those grants instead of disturbing local taxpayers (Irarrazaval and Scarpaci, 1994).

VAT absorption is also a theoretical benefit, but only one business was able to appreciate this as a potential gain. Most purchases are made in the informal market, so there is not much to absorb.

Intangibles remain intangible

Nearly three quarters of the microenterprises in the MIDEPLAN study had never applied for a loan. The most important perceived constraint is lack of collateral rather than lack of formality. Additionally, more than a third of respondents mentioned having fears of indebtedness. In fact, NGOs working with microenterprises have been awarding credit regardless of formality. However, the credit problem places a severe constraint on the growth of the sector.

According to the same study, more than 70 percent of sales were made in the place of production, with an additional 20 percent made at the client's address. These facts challenge the need for publicity. As is well known, most informal businesses are geared to local niche markets and show a poor integration with the modern sector of the economy. Even when this occurs, publicity is not needed because the whole business has been created as a result of a relationship with the purchaser.

Latin American solution: provisional licences

One interesting alternative for coping with informality would be provisional licensing. The strategy would allow tax inspectors to issue provisional municipal licences to most businesses except ones that presented clear dangers, for example in some areas of food processing and in cases of severe violations of zoning ordinances.

In this way, businesses could gain some of the benefits of being formal. When the firm became consolidated, the inspector could start to press for compliance with the rest of the requirements.

References

Ahumata, G. (1992), "Encuesta nacional de empleo y tamano de establecimiento," in Revista Estadistica y Economia, no. 5, INE Santiago.

De Soto, H., et al. (1987), El otro sendero: La revolucion informal: Buenos Aires, Editorial Oveja Negra.

DESUC-MIDEPLAN (1993), Microempresas e informalidad: Santiago, MIDEPLAN.

Irarrazaval, I. and J. Scarpaci (1994), "Decentralizing a centralized state: Local government finance in Chile within the Latin American context," in Public Budgeting and Finance.

Leiva, X. (1992), "El sector informal en Chile: analisis de sus componentes y mediciones posibles," in Revista Estadistica y Economia, no. 5, INE Santiago.

PREALC (1990), Mas alla de la regulacion: el sector informal en America Latina: Santiago, PREALC.

Tokman, V. (1990), "Sector informal en America Latina: De subterraneo a legal," in PREALC (1990).

The Russian Underground Economy in Transition

Michael Alexeev   --   The writer is grateful to Jim Leitzel and Vladimir Treml for their valuable comments and discussion. All remaining errors and omissions are entirely the author's responsibility.Note

Introduction

Even prior to the introduction of market-oriented reforms in the late 1980s, a great deal of genuine market-economic activities used to take place in the Soviet Union. While some of these markets were legal, examples being the so-called kolkhoz markets for agricultural products, many were technically outside the law. Law enforcement, however, was generally lax and the risks of small-scale operation in many of these markets were negligible. For example, despite their commonplace occurrence, crimes of "speculation"    --  Speculation was defined essentially as resale of goods at a profit.Note   --  accounted for fewer than 2 percent of all reported crimes in the 1980s.  --    Rossiiskaia (1993), pp. 135-136.Note  --    According to Kozlov (1990), the Soviet researchers believed that only 1 percent of all crimes of speculation was reported to authorities, and even this estimate appears to be on the high side.

The Soviet underground economy was not, of course, limited to the resale of goods purchased or stolen from official vendors. Illegal economic activities permeated the entire Soviet system. In fact, the official system probably could not have survived for as long as it did without help from the underground economy. Besides greasing the wheels of the official economy and correcting its mistakes, the Soviet underground economy was also responsible for significant amounts of waste and distortion. As the official economy stagnated and the illegal sector grew rapidly during the 1970s and '80s, both the productive potential of the underground economy and its negative impact on the rest of the economy were becoming more and more apparent.

The market-oriented reforms that began, albeit haltingly, in the late 1980s and turned radical in 1992 were intended in part to bring these illegal economic activities above ground. Instead, however, the reforms further accelerated the growth of underground activities even though the main causes of this growth had changed from price controls to excessive regulation and high tax rates. In today's Russia, the underground economy continues to exert both positive and negative influences on the rest of the economy. It does appear, though, that in the current environment the negative effects of the illegal sector may have begun to overshadow its benefits.

The next section outlines the size and growth pattern of the underground economy in the USSR prior to market-oriented reforms and analyzes its impact on the traditional Soviet economy. After this, a brief description of the major developments concerning the Russian underground economy in the late 1980s and early 1990s is followed by a look at the role of illegal economic activities in the current environment and their implications for the future of reforms.

The underground economy in the traditional Soviet system

The underground economy was always an important part of the Soviet system. According to Shmelev and Popov (1989), even during the height of the war, when private trade was prohibited and could be punished by summary execution without trial, black marketeers provided as much bread for Russian cities as state procurement did. Black markets continued to function in the postwar Stalinist period as well. They began to grow with particular rapidity in the mid-1960s, and by the mid-1970s the underground economy had permeated all areas of Soviet economic life.   --   These illegal economic activities, as well as the so-called "second" economy in the USSR, have been extensively studied by Western economists since the pioneering works of Grossman (1977, 1979). By Grossman's definition, the Soviet "second" economy included all economic activities which were either performed directly for private gain, or illegal, or both. The illegal economy thus formed a major part of the second economy.Note

Comprehensive price controls accompanied by chronic shortages and the interdiction of most private economic activities were the main reasons for the growth of the Soviet black markets. Other incentives for turning to black markets included high taxation and excessive regulation of allowed private economic activities, the existence of a large amount of impersonal state property kept under inadequate custody, and the need of poorly paid individuals to supplement their incomes.

One of the commonest types of illegal activity in the USSR was theft of socialist property-i.e., property of governments, collective farms, "social organizations" such as trade unions, and so forth. This type of theft used to be taken for granted by the public and did not arouse serious social censure. Even the late Soviet President Brezhnev was quoted as saying to his aides: "You don't know life. No one lives on wages alone. I remember in my youth we earned money by unloading railroad freight cars. So, what did we do? For every three crates or bags unloaded we'd take one for ourselves. That's how everybody in the country lives." Burlatskii (1988), p. 14, quoted in Treml (1990).Note

A variant on the theft of socialist property was stealing time off work. Apparently this too was a Soviet commonplace. As a reflection of the importance of theft in the Soviet economy, wages in various occupations seemed to be vary inversely as opportunities to steal from the workplace. Treml (1990) has estimated Soviet workplace theft of materials at approximately 63.7 billion rubles in 1975 and 70.4 billion rubles in 1980, or between 3 and 5 percent of the Soviet Gross Social Product-defined as the value of output of all material goods, intermediate and final, valued at current buying prices.

Perhaps just as common was the phenomenon of "speculation," the technically illegal resale of goods for personal gain. Despite its illegality, speculation was practised virtually in the open. Large markets reminiscent of American flea markets existed in most large Soviet cities. Officially, their function was to allow individuals to sell unwanted goods, but in reality they became major outlets for selling stolen property and products from the underground economy as well as the resale of goods purchased at low state-controlled prices.

Significant amounts of production by individual artisans as well as entire underground factories also took place in the black economy. Workers often produced goods on their own account on company time, using equipment in their state-owned enterprises. There were armies of "moonlighters" repairing dwellings and appliances for private customers. Moonshine production was extremely popular in the countryside.

Such widespread illegality in what used to be called a police state could not have happened without rampant corruption in Soviet officialdom, including the police. The extensive existing literature on the "speculation" phenomenon makes it pointless to spend time here. --   The standard references on Soviet corruption include Simis (1977-78, 1982) and Vaksberg (1992). Note   --   A quote from Grossman (1977, pp. 32-33) presents a good general picture:

At the very least one can deduce that the purchase and sale of [official] positions for large sums of money signifies the profound institutionalization in the Soviet Union of a whole structure of bribery and graft, from the bottom to the top of the pyramid of power; that considerable stability of the structure of power is expected by all concerned; and that very probably there is a close organic connection between political-administrative authority, on the one hand, and a highly developed world of illegal economic activity, on the other. In sum, the concept of kleptocracy, developed by sociologists with reference to corrupt regimes and bureaucracies in underdeveloped countries, does not seem inapplicable to at least certain portions and regional segments of the Soviet party-government hierarchy.

For obvious reasons, it is difficult to estimate the actual size of the Soviet illegal economy. According to figures based on a Berkeley-Duke survey of emigrants from the USSR, about one third of the urban population's income was derived from the second economy,   --  Grossman (1987). The estimates refer to the late 1970s. The Berkeley-Duke survey covered 1,061 households from urban areas of the USSR in a sample that contained various biases such as self-selection of the émigrés and nationality-most of the respondents were either Jewish or Armenian. These biases, however, did not appear to be large enough to invalidate the reported estimates, which are, incidentally, quite conservative.Note   --  which employed 10 to 12 percent of the labour force.   --  Treml (1992) Note   --  Presumably, the bulk of this income was illegal. Soviet researchers themselves have offered various estimates of illegal turnover that range from 70 to 90 billion rubles to as high as 300 to 350 billion rubles in the late 1980s.   --  The first estimate is by Koriaina (1988). The second number, which approximated the offical retail trade turnover figures for the entire USSR, is from Argumenty i fakty, no. 37, 1989, p. 5. The aggregate official personal income in 1988-1989 was roughly 522 billion rubles. Rutgaizer (1992) provides a survey of Soviet research on the second economy.Note

The actual dynamics of the underground economy are even harder to discern. Koriagina (1988) estimated that the second economy had grown approximately fourfold between the late 1960s and the mid-1980s. The Treml-Alexeev research (1993) based on official retail trade and income data strongly suggests that the second economy was growing rapidly between 1965 and 1985, but no specific growth estimates could be provided.

We may argue over precise estimates of the size and growth of the Soviet illegal economy, but the fact remains that by the mid-1980s it was clearly having a major impact on overall economic performance. To a considerable extent, illegal economic transactions obviated rationing in consumer markets. For example, Alexeev (1988) has demonstrated that despite the fact that state-owned housing had been one of the most strictly rationed consumer goods and seemingly simple to control, its allocation depended mostly on consumer ability to pay rather than the official non-price rationing criteria. Usually, this redistribution of consumer goods via black markets must have enhanced people's lives: after all, by its very nature it consisted in voluntary exchanges among individuals. Nonetheless, difficulties with disseminating information and enforcing long-term contracts make the underground economy a less than ideal distribution system. Also, in an otherwise highly distorted economy, the introduction of additional market would not always result in more well-being. For instance, the possibility of the resale of officially purchased goods on the black market can easily lead to longer than necessary queues in the first economy when such resale is effectively prohibited.   --  See Stahl and Alexeev (1985) for a rather general model of this phenomenon, and Gang and Tower (1988) for a simple example.Note

Besides redistributing goods in consumer markets, the illegal economy was involved in the reallocation of inputs and outputs in production.   --   For a description of the illegal economy in socialist industry, see Grossman (1982).Note   --  Semi-legal or illegal trades among socialist enterprises often helped these enterprises to fulfil the plan by correcting initial input misallocations. At the same time, the possibility of diverting inputs and outputs to the black market must have lowered the official performance of at least some enterprises. More importantly, even if the black markets facilitated plan fulfilment, that does not imply that they were good for the economy. From the Soviet consumer's viewpoint, some state targets should probably never have been met.

In addition, the illegal economy was partly responsible for weakening and even destroying the feedback from the economy to planners. When a planner misallocated inputs but informal trades among state enterprises corrected this misallocation, the planner had no reason to change future input allocations. In effect, the planners were directing the Soviet economy with a highly distorted map of the economic situation.   --  Treml and Alexeev (1993) provide a more detailed discussion of the illegal economy's impact on Soviet economic performance.Note

The underground economy also played a significant role in altering income distribution in Soviet society. As has already been mentioned, illegal opportunities tended to be inversely correlated with depressed official wages. This does not imply that illegal incomes reduced inequalities, however. Large and highly variable illegal incomes could increase inequality no matter how they related to official incomes. Based on the data from the Berkeley-Duke survey already cited, Alexeev and Gaddy (1993) have calculated that the inclusion of illegal income accentuated income inequality in Soviet regions with highly developed underground economies.

In addition to affecting resource allocation in the economy, the underground economy was responsible for shaping the Russians' image of free markets and providing training grounds for Russian entrepreneurs. In fact one survey found that Muscovites seemed to understand and appreciate the workings of free markets just as well as residents of New York did.   --  Shiller et al. (1991).Note  --    This awareness must have helped create a consensus for market reforms and promote their progress. However, underground markets do not adequately reflect the power of legal free markets reinforced by such modern market institutions as banks and stock exchanges. Perhaps for this reason, markets in Russia often have a bazaar-like image rather than the look of sophisticated mechanisms that can coordinate the smooth operation of a large modern economy.

Finally, we should mention what Cowell (1993) calls "a kind of demoralization crisis" that could be caused by a large underground economy. Illegal economic activities undermine a population's trust in the fairness of an entire system, whether socialist or capitalist. The perception of injustice in an economic system is detrimental to well-being in and of itself, even if this is difficult to fit into the more conventional framework of cost-benefit analysis.

Perestroika, market reforms, and the Russian underground economy

By the mid-1980s the Soviet leadership began to understand the significance of the underground economy. Even so, however, the leaders displayed a highly ambivalent attitude towards the informal sector during perestroika. On the one hand, realizing its potential for improving Soviet economic performance, the authorities wanted to bring many private economic activities above ground. On the other hand, they feared losing the remnants of their grip on the economy.

This ambivalence resulted in a slow, sometimes contradictory slackening of regulations against private enterprise. Thus, the November 1986 Law on Individual Labour Activity that widened the scope of legal private enterprise in the USSR was preceded by a campaign against "non-labour income" in May of that year. The legislation itself provided but slight relief from anti-private enterprise regulations: it continued to prohibit many private economic activities, gave regional legislatures broad powers to expand the list of prohibited activities, and required every individual who wanted to engage in individual labour activities to obtain a licence from local government.

Throughout the Gorbachev period, the Russian authorities continued to view genuinely private enterprise with deep mistrust. Instead, they lent their support to family-based and cooperative economic forms. Family-based contractual arrangements in agriculture and family contracts for running small state-owned service outlets were strongly encouraged by the authorities in 1987 and 1988. A more radical 1988 Law on Cooperatives opened the way for individuals into many areas of the economy that used to be, legally at least, the exclusive domain of the state. --   "Zakon Soiuza Sovetskikh Sotsialisticheskikh Respublik o kooperatsii v SSSR," in Ekonomicheskaia gazeta, no. 24, June 1988.Note  --    Even this law, however, did not go nearly far enough to bring genuine legal markets into the economy.

The newly permissible cooperative activities were subject to various restrictions. According to the law, cooperatives had limited access to inputs and were forbidden to engage in some important economic activities. The state also retained the right to exercise significant control over the prices charged by producer cooperatives. Local authorities were allowed to place further restrictions on the activities of cooperatives in their jurisdictions. All these constraints handicapped cooperatives in their ability to compete among each other and with state-owned enterprises. Particularly harmful to the goals of reformers were legislative reversals, as, for example, a December 1988 resolution by the Soviet Council of Ministers prohibiting cooperatives from engaging in a number of activities, including medical services, that had been permitted by the original cooperatives legislation. Changes in taxation were especially frequent  --  . For a detailed discussion of the cooperatives during perestroika, see Jones and Moskof (1991) and Murphy (1993).Note

Yet even these half-hearted liberalizing measures were greeted by rapid developments in legitimate non-state enterprises.   --  By 1991, the number of cooperatives in the USSR reached 255,000. They employed almost 6.5 million people producing goods and services worth about 42 billion rubles.Note    --  This growth, however, did not take place at the expense of the "shadow" economy, to use the Soviet term. In fact, the partial legitimization of various private and crypto-private economic activities actually seemed to spur underground development. According to one Soviet researcher, legalization of about 800 million rubles' worth of the shadow economy in 1988 was accompanied by an increase of 1,400 million rubles' worth of various illegal activities.   --   This estimate by T. Koriagina was quoted in Grossman (1990).Note

What led to such an outcome? As already mentioned, some actions of the Gorbachev government contradicted the general direction of reform. For example, the anti-alcohol campaign launched in May 1985 drove alcohol prices sharply upwards and restricted the production of alcoholic beverages by the state. Naturally, the result was an explosion of bootlegging and home brewing. Illegal alcohol sales reportedly increased 42 percent in the first 10 months of 1986. Some Soviet specialists maintained that the reductions in the state-controlled output of alcoholic beverages were fully offset by increased production of moonshine.  --   See Treml (1987) and references therein.Note

Ironically, even the more radical measures proved to be counterproductive in their effects on the underground economy. In fact, it was the 1988 Law on Cooperatives which, with the 1987 Law on State Enterprise, probably bore the principal responsibility for the growth of illegal economic activities in the period 1988-1991. Prior to the Law on State Enterprise, Soviet state-owned firms conducted most of their financial transactions by adjusting their account balances in Gosbank, the state bank. The payment of wages was the only significant transaction conducted in cash. While state-owned enterprises operated under the so-called soft budget constraint for non-cash transactions, the central planners took special care in controlling enterprises' wage funds and cash budgets.   --  The term "soft budget constraint" coined by J. Kornai essentially means that enterprises expected to be virtually automatically bailed out by the state if they ran out of money in the non-cash account.Note  -  Separating the cash ad non-cash money flows in the economy allowed the central planners to alleviate inflationary pressures in consumer markets.

The 1987 law afforded a large degree of autonomy to state-owned enterprises. In particular, it gave them greater independence in allocating their financial resources without imposing serious responsibility for failure. The Law on Cooperatives permitted and even pushed cooperatives and state-owned enterprises into close business relationships and associations. At the same time, state-owned enterprises were allowed to convert their Gosbank balances into cash for transactions with cooperatives. This essentially cracked the "wall" between the two types of money flows.

However, the conversion of non-cash balances into cash heightened inflationary pressures in the economy. What is more, given an environment of continuing price controls in the state sector, this strengthened incentives to engage in black market activities and divert outputs and non-cash balances from state-owned enterprises into cooperatives and private businesses. In other words, the conversion of non-cash into cash was a self-promoting phenomenon that stimulated the growth of the underground economy. In addition, since the diversion of resources from the state sector was usually accomplished by means of at least questionable legality, this diversion itself contributed to the growing share of illegal economic activities.

In general, while the restrictions on private and cooperative businesses might have been imposed to combat the diversion of state sector resources, these restrictions only exacerbated disequilibria in the economy: helping to reduce competition and generate excessive profits, they promoted corruption and the growth of the underground. Corruption was further spurred by the fact that Soviet bureaucrats at all levels were in danger of losing many of their traditional privileges through either marketization or popular discontent. This gave them strong incentives to monetize their remaining perks and quickly convert the remaining rents associated with their positions into privately owned assets. Bribe taking, illegitimate privatization of state-owned assets, sweetheart deals between state-owned enterprises and cooperatives set up by local bureaucrats-these were the commonest examples of abuse of official power. Corruption was further facilitated by the dependence of private and cooperative enterprises on the benevoence of local authorities, a situation that often ruled out completely legal for-profit operations. At the same time, the state blessing for private and cooperative enterprise, at least in principle, provided an ideal front for expanding the scale and scope of illegal economic activities. For example, the creation of commercial banks presented opportunities for bank fraud that had been virtually nonexistent.

Another important obstacle to the legalization of the underground economy was the black marketeers' mistrust of the Soviet government's commitment to market-oriented reforms. In the absence of proven commitment, private entrepreneurs were afraid to reveal themselves and the extent of their operations. Such fears were supported by significant reversals in the progress of reforms and the persistence of many old anti-entrepreneurial statutes on the books.   --  Thus, the blanket prohibition of "speculation" was not repealed until January 1992. Litwack (1991) and Boettke (1993) discuss the importance of credible commitment by the government for the success of reforms.Note

The underground economy in reforming Russia

The eventual acceptance in principle of the market economy came with the breakup of the USSR in late 1991. Following 1992 reforms, the Russian economy has no longer been centrally planned in the traditional sense.  --    One might argue that the Soviet economy was not really a planned economy even prior to reform (see, for example, Zaleski, 1980, and Roberts, 1990). Whether we call it central planning or not, commands from the centre used to play a significant role in the functioning of the Soviet economy.Note --   However highly regulated contemporary Russian markets may be, a large portion of the Russian economy is supposed to be open to market forces. Nonetheless, a large and perhaps growing share of the economy continues to operate underground.

The flourishing illegal economy in today's Russia owes its existence to essentially the same factors as in the traditional Soviet economy, even though the relative importance of these factors has changed dramatically. Tax evasion appears to have become the main reason for operating businesses underground, while price controls, regulations, and the remaining prohibitions on private economic activity have become somewhat less significant.

To the extent that the Russian economy suffers from excessive regulation, the role of black markets in contemporary Russia resembles their role in the traditional Soviet economy. On the one hand, black markets help entrepreneurs to get around onerous regulations and thus enhance overall economic performance.   --  In the words of Cowell (1993), "a world of perfect enforcement could be an intolerable place."Note   --  On the other hand, underground enterprises have problems with disseminating and acquiring information and with contract enforcement.

In some important respects, however, the role and impact of the underground economy in reforming Russia differ significantly from those in its Soviet counterpart. First, reforms brought an unusually high degree of uncertainty into the Russian economy about property rights and the future of the entire system. The admittedly inefficient and restrictive traditional Soviet system had been in many ways rather predictable. The elite could count on keeping their privileges through to old age, while ordinary consumers expected prices to stay low and shortages to persist. The system was relatively stable: even the underground economy enjoyed a large measure of stability that allowed black marketeers to plan for the future and put a premium on their reputations.

The volatility and turmoil brought about by radical reforms reduced the value of following the rules, thereby promoting the growth of the underground. However, uncertainty about the future undermines incentives for black marketeers to develop and maintain reputations for the high quality of their services. The generally high level of volatility in the economy not only facilitates illegal economic activities, but also shortens the time horizon for agents operating underground, making them likelier to cheat.

Secondly, growth in the underground economy reduces the tax base, promoting inflation and forcing the government to increase the tax burden on legitimate enterprises. Rising tax rates push even more businesses underground, which leads to still higher tax rates, and so on. Reduced tax revenues lead the government to print money and thus impose an inflation tax on citizens. Inflation in turn creates greater uncertainty with all its negative implications.

Thirdly, the underground economy attracts and promotes organized crime.   --  According to a recent Russian government report, 70 to 80 percent of private enterprises in major cities were paying protection money to organized crime. New York Times, January 30, 1994, p. 1.Note   --   Organized crime or mafias could play a positive role in the economy-for example, by helping to enforce contracts and maintain order in the underground economy or any other circumstances where legal enforcement is not forthcoming.   --  For an insightful discussion of the economics of organized crime, see Schelling (1984), pp. 158-178 and 179-194.Note  --   Mafias, however, may impose serious costs on the economy as well. To begin with, some entrepreneurs may not want to deal with the mafia on moral grounds, or just as a matter of taste. If the only way to run a successful business is to pay protection money to organized crime, these entrepreneurs would not even bother to start up.

Another problem with organized crime's involvement in the economy is its tendency to favour monopoly. Organized crime is interested in maximizing rents, and rents are maximized if the firm has a monopoly. For example, having one restaurant in a district may bring in significant income. If competition is allowed to work, some of this income would be siphoned off by other restaurants. Organized crime could use force to prevent other restaurants from opening.   --  This argument works if the mafia itself is running the restaurant. If, however, a criminal group controls the district and can collect fees from establishments located in it, the group may be able to raise higher revenues by allowing competition.Note

In addition, a large monopoly establishment may be easier than several small firms for organized crime to monitor. A similar argument was commonly used to explain the Soviet planners' preference for building large enterprises which often enjoyed a monopoly position in their segment of the industry. The monopoly advantage is somewhat offset, though, by the fact that competition helps organized crime to monitor enterprises it controls by providing a standard of comparison.   --   In more technical terms, competition eliminates the common uncertainty facing the firms' management, leaving only firm-specific uncertainty to influence its performance (see Holmstrom, 1982). Lower uncertainty leaves less room for the management of the firm to hide its true productive potential from the shareholders-or from the mafia, for that matter.Note  --   Finally, a monopolist might be less likely to complain to the authorities if organized crime shielded him from competition and left him at least a share of monopoly rents.

Organized crime is not new to Russia, of course. In many ways, the traditional Soviet "nomenclature" resembled an organized crime group, particularly with respect to illegal economic activities that took place in the USSR. The nomenclature used to hold a virtual monopoly on rent extraction from both the legal and illegal sectors of the Soviet economy. Underground entrepreneurs usually had to pay off government officials and law enforcement officers in order to stay in business. In this sense, the current situation is distinguished by a higher degree of competition among criminal groups and greater "disorganization" of the rent-extraction mechanism.   --  The relatively disorganized nature of the current organized crime groups is evident from government data indicating that less than 1 percent of an estimated 4,000 "organized criminal groups" in Russia consisted of more than 10 individuals. More than half had only 2 or 3 members. Statistika sotsial'nykh anomalii, p. 19.Note

Despite the changing nature of the Russian underground economy, we could argue that the current situation is an improvement over the past in that a regulated market economy would perform better with the underground economy, all things being equal, than the traditional Soviet system would with the underground economy. While illegal economic activities exert essentially the same ambiguous influences on the rest of the economy, the more market-oriented nature of the official economy should hold an advantage over central planning.  --   I do not want to take this argument too far. For example, the Soviet state might have been much more efficient at extracting rents from the underground economy while the contemporary mafia may do it in a wasteful manner.Note   --  On balance, however, the net impact of the black markets has probably changed from efficiency-enhancing to detrimental. Presumably, even the overregulated market economy would perform better if it was largely legal than if much of it remained underground.

What are the implications of the existence of the large Russian underground economy in terms of evaluating the progress of market reforms and the likelihood of their success? The difficulties involved in quantifying illegal economic activities and incorporating them into the system of national accounts will distort our perceptions of both the pre-reform and the current situations. If the Russian underground has been growing rapidly over the last several years, this would mean that the official data on economic growth are understating the performance of the Russian economy.

Now such bias is particularly dangerous in the present volatile political situation. Any perception of the economic failure of reforms can easily become self-fulfilling by, among other things, weakening the monetary system, further increasing uncertainty, and driving even more entrepreneurs underground. The perceived link between reforms and economic crime provokes calls for limiting the freedom to engage in private economic activities and other restrictions on individual rights. If the reforms become too closely identified with the illegal economy, the fight against crime may lead to serious reversals of reform progress.   --  A more detailed discussion of the relationship between economic crime and reforms can be found in Alexeev et al. (1994).Note

The underground economy modifies the effects of reform measures directed at the official economy. For example, an increase in tax rates may generate greater revenues for government if black markets are underdeveloped. They may, however, reduce revenues sharply if the underground economy presents a viable alternative for the entrepreneur.   --  The recent rollback of cigarette taxes in Canada provides a vivid example of government recognizing the economic power of the underground.Note  --   For their policies to achieve the desired effects, Russian reformers must always try to take into account the existence of the large illegal sector in their country. Indeed, it might be precisely the recognition of the limits of their power in the face of the underground economy that is preventing the Russian government from imposing even more regulations and higher taxes on the Russian economy.

Reformers should also realize that the problems posed by the large and growing underground economy cannot be solved by tighter regulations and tax increases. On the contrary, the reduction of tax rates and the removal of most constraints on legal private activities is the route that can bring much of the illegal economy above ground and improve the performance of Russian markets. Since organized crime thrives on illegal economic activities, this would also reduce the role and power of the Russian mafias. The solution to the problem of economic illegality in Russia lies in the continuing advance of free market reforms.

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Reform and China's Underground Economy

Yue-Chim Richard Wong

Progress of economic reform

Between 1978 and 1993, China's economy was incrementally liberalized and saw extraordinarily rapid output growth as real GNP expanded at an average annual rate of 9.5 percent.  --  All figures quoted in this paper are derived from various issues of the China Statistical Yearbook.Note --   The reforms started in agriculture with the replacement of the communes by a system of household farming on land leased from the state. Between 1979 and 1983, with over three quarters of the population still in agriculture, farm output surged by 8 to 10 percent a year.   --   See Johnson, D.G. (1990), The People's Republic of China: 1978-1990; San Francisco, ICS Press.Note

The dismantling of the commune system was not a matter of conscious policy or design. It was a process that started when local leaders in Sichuan province decided to experiment with the household responsibility system in the absence of official sanction from the central authorities. When this experiment turned out to be a great economic success, it was rapidly emulated throughout the country. Within a year, the commune system had collapsed and agriculture became semi-privatized. The reforms were accorded ex-post legitimacy by the central authorities.

By 1984, the engine of rapid economic growth had shifted to rural light industry, which began to absorb much of the labour force released by productivity gains in agriculture. Small-scale private traders flourished alongside numerous new manufacturing enterprises that were mostly owned by local governments-townships and villages. These businesses, which became the backbone of the new market-driven non-state sector, operated outside the system of official price, output, and financial controls that still governed state-owned production. Non-state sector industrial output soared from 26.65 percent of total output in 1983 to 51.91 percent in 1992.

The central government has provided little support to the non-state sector. In particular, the state banking system has been highly reluctant to extend credit facilities. Total state bank loans to the non-state sector as a proportion of total outstanding state bank loans remained at around 12 to 14 percent from 1983 to 1992. Most growth in non-state enterprises had been self-financed during this period.

Foreign trade has been gradually liberalized through the establishment of special economic zones somewhat outside the control of the traditional state trading monopolies. The first and most important zones were in the Pearl River Delta area and connected with the Hong Kong trade.   --  See Sung, Y.W., P.W. Liu, Y.C.R. Wong, and P.K. Lau (1995), The Fifth Dragon: Emergence of the Pearl River Delta: Addison Wesley.Note   --  They became more numerous and broader in the scope of their activities. In time, an export (and import) boom became China's new engine of economic growth. Exports as a share of GNP rose from 5.31 percent in 1979 to 18.76 percent in 1993. Bit by bit, the distinction between the special economic zones and the rest of the economy became blurred. A wide range of state-owned enterprises, township and village enterprises, and private businesses gained more or less equal access to foreign trade through the swap centres where they could buy and sell foreign exchange to finance transactions not included in te state plan. Until a unified foreign exchange market was set up in April 1993, the volume of foreign exchange transactions in the swap centres was reported to be almost 80 percent of total transactions in China. The official exchange rate depreciated significantly from RMB 2.5 yuan to US$1 in 1979 to RMB 8.7 yuan to US$1 in 1993. The depreciation reflected a gradual move towards market levels from an initial position of overvaluation. The process of foreign trade and foreign exchange liberalization was again incremental, responding to enterprises' most urgent needs as they arose.

Incrementalism and the underground economy

China's economic reforms were intended to promote economic growth and revitalize economic performance. The Chinese leadership recognized that their political legitimacy depended on delivering a better standard of living, though internal disagreements over the ultimate goals of economic reform and strategies to achieve those goals continue to rage. Not until 1993 did the creation of a socialist market economy formally become an official objective-and even then the socialist rider was retained, apparently because of the now chronic lack of consensus on goals and strategies.

The Chinese economy was running on a dual track where the traditional system co-existed with the new. Debates on price reforms, foreign exchange reforms, enterprise reforms, and the piecemeal nature of all reforms reflected ongoing conflicts within the leadership. Meanwhile, China's market expanded by diverting resources away from the state sector, growing out of the state plan. The economic reforms did not strip away the rents captured by major interest groups: they merely altered the way in which those rents could be secured. This evolutionary approach explains why reform has been incremental in China, starting with the easy and gradually progressing to the more difficult. Again, this was not a conscious gradualist strategy as is sometimes argued. A more appropriate way of characterizing the process of economic reform in China might be to call it a sequence of breaches in the traditional system at the points of least political resistance.

The massive shift of resources from the state to the non-state sector in agriculture and industry and the growing importance of foreign trade have combined to create a vibrant economy with more or less rational prices that are beginning to reflect economic scarcity. When the reform process began, almost all prices were controlled: today, less than 5 percent of prices are still controlled.

These impressive achievements notwithstanding, China remains a semi-reformed economy in which state-owned enterprises continue to produce almost half of industrial output. These state companies have become a major fiscal burden: one third of them are suffering losses that have to be covered by the state, while another third are being carried by state banks through low-interest loans. Reforming the state sector is the most difficult problem China has to solve before its economy can become truly efficient. There is a growing recognition in China of the need for fundamental change in the system.

Local governments have clearly been the most innovative force, experimenting with new reform measures and policy initiatives. Perhaps the farther from the political centre, the weaker the political resistance to reform. Successful local initiatives have subsequently been anointed by the central government, thus gaining political legitimacy and an enhanced possibility of surviving changes in local leadership.

The policy environment in China during the reform period was a peculiar one. The central bureaucracy, often identified with the interests of the state sector, was naturally hesitant to push ahead at speed. Local governments, generally identified with the interests of the non-state sector, were far more enthusiastic because they had incentives. Senior leaders at the political centre would forge alliances-sometimes with the central bureaucracy, sometimes with local leaders. This reform process resulted in great regional variations that were reinforced by the creation of the special economic zones.

The underground dimension

Defining the scope of the underground or informal economy in China is a daunting task. The Chinese system of law is in a permanent state of flux because of ongoing reforms. New legislation and regulations are constantly being drafted, and institutions are being created to implement and enforce these new laws and regulations. Since power has been devolved from the centre, local enterprises and authorities are often engaged in practices that have not been approved by the central authorities. Had they asked for permission ahead of time, it might not have been granted or been mired in lengthy delays. In consequence, there is an unavoidable element of ambiguity surrounding the legal status of all new local reforms. Indeed, local officials often try to enhance the legitimacy of their initiatives by lobbying senior leaders for support.

Regional and local variations imply that reform measures considered acceptable and legitimate in one area may not be acceptable in others. Provincial and local authorities have frequently approved or condoned practices that contravene policy regulations stipulated and even legislated by the central government. The best example here is the circulation of large amounts of Hong Kong currency in Guangdong province with almost no restriction, though this is in direct violation of central government regulations.

According to Feige's taxonomy (1990), China's underground economy has the features of being illegal, unreported, unrecorded, and informal.   --  Feige, E.L. (1990), "Defining and Estimating Underground and Informal Economies:The New Institutional Economics Approach," in World Development, vol. 18, no. 7 (July).Note   --  Some activities are illegal: the growth of crime in many areas, including organized crime, is evident in most cities. Some activities are unreported, violating fiscal statutes: tax evasion is pervasive as a consequence of the introduction of the fiscal contract responsibility system whereby the central government engages in annual bargaining exercises to determine the level of taxes local governments and selected state-owned enterprises should pay. As to records, the distortions in China's economy and its evolving accounting system make it hard to measure the scale of economic activity: even estimates of the size of its GNP have a margin of error that is as large as 500 to 600 percent, depending on wheher we use the conventional exchange rate conversion factor or the purchasing power parity measurements. See "Chinese Puzzles," in the Economist, May 15, 1993, p. 79.Note But the most significant underground economic activity is in the informal Chinese economy, where individuals and enterprises engage in widespread violation of legal and administrative rules. As in most developing countries, full compliance with these rules would make economic activity impossible.   --   This problem is highlighted in De Soto, H. (1990), The Other Path: New York, Harper & Row.Note

China today is a transitional economy in which private property rights are poorly defined and enforced. Regulations are pervasive but enforcement is not always effective. The coexistence of the state and non-state sectors in such conditions creates enormous opportunities for rent seeking and corruption. These activities take many forms, but a typical characteristic is the diversion of resources from the state sector, with its low private and social rates of return, to the non-state sector with relatively high rates of return. Liberalization has allowed bureaucrats and managers more freedom to capture profits that should accrue to the state and divert the resources of state-owned enterprises and banks into non-state businesses that they themselves control or own. Some of these businesses may even be incorporated overseas. For the economy as a whole, diverting resources from the state sector is economically efficient to the extent that it results in a higher social rate of return: in China, this isstill largely true, so that we do not see perverse consequences in the economy.

Underground labour

Before the reforms, China had a rigid system of controlling population movements tied to a system of rationing essential consumer goods. This system has collapsed, and the country now has a growing floating population of individuals and households estimated at over 80 million living in major growth cities without residency rights.   --  Figure cited by Xuejin Zuo, "Socioeconomic Impacts of Floating Population in China: An Assessment and Policy Issues," Research Proposal, Shanghai Academy of Social Sciences, 1994.Note   --  These people are urban squatters in search of jobs. They have no access to social welfare, housing, or education without residency rights, but they are tolerated by local governments because economic growth has created tight labour markets in many coastal cities.

Meanwhile, workers in state-owned enterprises who have attractive housing and welfare benefits but poor salaries are taking second jobs with non-state enterprises while holding on to their state-provided benefits. The magnitude of these labour markets is unknown but probably quite sizeable and will continue to grow over time.

Underground foreign trade and investment

Despite trade liberalization, China's tariff and non-tariff barriers remain quite high, a situation that has given rise to a huge smuggling problem. Statistics are difficult to obtain, but Hong Kong's proximity to China makes it a major conduit. It is reported that about 10 percent of all luxury cars in Hong Kong are being stolen and smuggled into China. According to an industry source, the amount of cigarettes smuggled into China is twice the amount officially imported. On the basis of Hong Kong import and consumption figures, it has been estimated that half the television sets imported into Hong Kong are subsequently smuggled into China. Smuggling between Hong Kong and China became so serious that the Hong Kong government was compelled to license high-powered speed boats in a bid to stem the flow of smuggled goods.

Taiwan fishermen routinely conduct barter trade with Chinese fishermen on the open seas. In a bid to regulate such trade activities, the authorities in Fujian province legalized them as "minor trade" in 1985 and stipulated that they take place in designated coastal mainland ports managed by customs officers. From Taiwan's point of view this is still smuggling, however, since the Taiwan authorities technically ban direct trade with China. In the elaborate trading system involving Taiwan, Hong Kong, and China created by this policy, indirect Taiwan trade through Hong Kong to China amounted to US $6.3 billion in 1992.

Actually, Taiwan does conduct three different forms of direct trade with China: transhipment, transit shipment or cargo-in-transit, and illegal direct shipment.  --   See Y.W. Sung (1994), "The Economics of the Illegal Trade between Taiwan and Mainland China": Department of Economics, Chinese University of Hong Kong.Note  --   These three modes accounted for trade worth US $4.7 billion in 1992. In principle, Taiwan businesses cannot openly export to the mainland by transhipping via Hong Kong: transhipment usually involves a through bill of lading and would therefore constitute direct trade. Taiwan customs do, however, allow exporters to leave their final destination open and specify Hong Kong as the port of discharge whence the goods are to be shipped elsewhere. On arrival in Hong Kong, shipping companies can specify a mainland port as the final destination: the Hong Kong government usually allows such cases to pass as transhipment and exempts the goods from import and export tax. Such cases are known as "swith bill" shipments because another bill of lading, consigning the goods from Hong Kong to a mainland port, replaces the original bill consigning the goods from Taiwan to Hong Kong.

Transit shipment or cargo-in-transit involves those cases where ships carrying goods from Taiwan to China make stopovers in Hong Kong. Taiwan exporters claim that their goods are destined for Hong Kong when they leave Taiwan. On arrival in Hong Kong, the shipping company claims that the goods are destined for the mainland. The Hong Kong government treats these goods as cargo-in-transit.

Chinese reexports to Taiwan via Hong Kong amounted to US $1.1 billion and direct exports to Taiwan, US $1.2 billion in 1992. Chinese exports much less than it imports from Taiwan. Total trade between Hong Kong and China was worth about US $9.6 billion in 1993. This trade has served as a major conduit for capital flight from China through transfer pricing. Profits that accrue to Chinese entities are deposited in Hong Kong companies controlled by Chinese officials and entrepreneurs. Since these companies are incorporated in Hong Kong, they are treated as foreign by China though in reality they represent Chinese and not foreign capital. The Chinese call them the "false foreign devils."

When these companies invest in China, they enjoy the preferential tax benefits accorded to foreign investors. The tax rate on profits for foreign and joint venture companies is 15 percent when it can run as high as 50 percent for domestic companies. This simple mechanism provides a way of diverting Chinese government funds into foreign private funds controlled by Chinese officials and entrepreneurs. The percentage of foreign investment in China that is really domestic investment is unknown.

It is estimated that at least 15 percent of the currency issue in Hong Kong, US $1.5 billion, circulates within China where it can be deposited in Chinese banks as foreign currency. Since Chinese banks are not allowed to make foreign currency loans, these deposits are recycled into Hong Kong. It is reported that Chinese enterprises making deposits in China have indirect Hong Kong loan facilities that facilitate their financial transactions in Hong Kong and elsewhere.

Many state-owned enterprises in China are trying to raise funds by selling shares. If they are authorized to place those shares with foreign investors, they become foreign joint venture companies and can enjoy preferential tax treatment. These state companies thus have a huge incentive to sell their shares and assets at discounted values and obtain these tax advantages. Bribes can sweeten the pie, and a further twist may emerge if the foreign investor is in fact a "false foreign devil."

Financial reforms, underground loans, and macroeconomic instability

Prior to the economic reforms, banks were virtually the sole financial institutions in the Chinese economy. They were responsible for meeting planned objectives and in essence passively allocated credit in accordance with the economic plan, relying on the government to cover any loan losses. The People's Bank of China was charged with mobilizing resources from sectors that ran surpluses, mainly households, and passing them on for central allocation to industry and agriculture. China's banking system was basically a counting house: it had little to say about selecting firms to finance, assessing their creditworthiness, or monitoring them, and loan collection was of little concern since losses were routinely covered by the state. Under such a system, non-banking financial services would have been of little use.

In 1984, China started to reform its monobank system. The People's Bank, transformed into a central bank, handed over its day-to-day deposit and loan business to four specialized banks: the Agricultural Bank, the Industrial and Commercial Bank, the Bank of China, and the Construction Bank. Though there was change in the structure of the banking system, however, the process of credit creation remained unaltered. Bank loans were still regulated by a rigid system of quotas set by the central authorities to meet planning requirements. Interest rates on deposits and loans were also set uniformly. To attract deposits, the People's Bank would set interest rates at levels above the rate of inflation, but loan rates were often set very low to make the balance sheets of loss-making state-owned enterprises appear solvent.

As economic decision-making power was devolved to provinces and enterprises, the centre began to lose effective political control over the expansion of credit. Local authorities would pressure branch banks to make loans for local investment projects. When the centre did call for speeded-up economic reforms, the pressure from enterprise managers and local authorities on banks to expand credit increased. Banks would exhaust their lending quotas by mid-year, and the central government would be forced to seek monetary accommodation to meet its fiscal obligations.

A more significant change occurred in 1986 with the legalization of the interbank lending market. The market was originally developed for short-term lending among state banks to solve their liquidity problems, so that banks serving fast-growing regions and sectors with high loan demand could borrow from other banks with unused lending capacity. The imbalance between loans and deposits was a consequence of maintaining a system of rigid bank credit quotas as the economy became more and more liberalized. China's interbank lending market was intended as a mechanism for limited short-term financial flows across regions and sectors outside the plan, and it grew rapidly over time. By 1992 interbank lending had increased to 300 billion yuan, almost one seventh of the total volume of outstanding state bank loans. In 1993, interbank loans became an important cause of the overheating of the Chinese economy as banks sought to circumvent credit quotas by operating in the interbank lending market.

The overheating of the Chinese economy in 1993 can be traced to the enhanced pace of economic reform, which gathered momentum after Deng Xiaoping's trip to southern China in early 1992. In that year, real GDP rose by 12.8 percent, industrial output by 21.7 percent, fixed-asset investment by 37.6 percent, the general retail price index by 5.4 percent, and the cost of living index in 35 major cities rose by 10.9 percent. In the first six months of 1993, real GDP rose by 13.9 percent, industrial output by 25.1 percent, fixed-asset investment by 61.0 percent, the general retail price index by 10.8 percent, and the cost of living index in 35 major cities rose by 17.4 percent; all rates have been annually adjusted. It is worth noting that fixed-asset investment by state-owned enterprises rose by only 33 percent in 1992 but shot up to 70.7 percent in the first six months of 1993. This surge in fixed-asset investment, especially in state-owned enterprises, was the prime cause of 1993's overheated economy. It was repoted in June 1993 that unauthorized interbank lending had risen to 200 billion yuan. State banking funds were being diverted through the interbank market into investment projects or speculation in the emerging securities and properties market. In some instances, even influential state-owned enterprises were able to gain direct access to the interbank lending market. The property development involvements of numerous banks and state-owned enterprises channelled much-needed resources from key infrastructure projects into speculative pursuits, spinning off heady opportunities for corruption.

Many problems can be identified. At the most superficial level, we can blame the diversion of bank funds on the poor state of banking regulation and supervision. Yet a more serious indictment of the inadequacies of China's monetary and banking system lies in the fact that banks suffer from undue political influence by powerful groups that impinge on credit allocation and decisions concerning monetary control. The lack of central bank independence, the arbitrariness of the credit allocation process, and the conflicting pressures arising from government support for state-owned enterprises and the market demands of the non-state sector are key policy matters that have yet to be addressed.

In the mid-1980s, the financial sector began to develop rapidly with a more diversified structure and a broader menu of financial instruments. Some state-owned commercial and development banks were established, first in the special economic zones and later throughout the country. Rural and urban credit cooperatives became more aggressive in loaning to the non-state sector. Numerous non-banking financial institutions were created: trust and investment companies, insurance companies, finance companies, financial leasing companies, and securities companies. These non-banking financial institutions were mainly subsidiaries of state-owned banks, state-owned enterprises, and central and provincial government offices.

Since these institutions operated outside the state plan, they had little incentive to lend to or invest in loss-making state-owned enterprises. Loans to the non-state sector as a percentage of total outstanding bank loans grew rapidly. Loans by rural credit cooperatives as a percentage of total bank loans rose from 2.33 percent in 1979 to 11.35 percent in 1992: the corresponding figures for urban credit cooperatives were 0.25 percent in 1986 and 1.75 percent in 1991. Loans by non-banking financial institutions rose even more rapidly, from 2.87 percent in 1986 to 6.71 percent in 1991.

These non-banking institutions undoubtedly played an important role in channelling resources to the more efficient non-state sector and contributed to the rapid growth of the more productive sectors of society. The state banking system's near-monopolistic control over loans was weakened, but this compounded the problem of macroeconomic control. In theory, these non-banking financial institutions are not part of the banking system and thus do not issue credit that constitutes money in the usual sense. Given the rudimentary regulatory framework in China, however, the real situation can be very different. It is clear that these institutions have access to the interbank lending market and have diverted these loans into investment projects and other speculative projects.

Corruption

Corruption has emerged as a pervasive feature of the Chinese economy. The recent reforms have created a dual-track system of state and non-state sectors. Economic liberalization has shifted decision making from the central bureaucrats to managers, entrepreneurs, and local bureaucrats. One consequence of this change is to make corruption easier: it has become difficult to monitor the behaviour of so many agents.

Corruption has improved incentives for bureaucrats and managers to enhance their enterprises' profitability and performance, especially in the non-state sector. Corruption has also improved the overall allocation of resources in the economy by diverting resources from the low-yield state sector to the high-yield non-state sector. As resources flow into the production of commodities with a higher social rate of return, the economy grows faster.

Given that most state-owned enterprises are losing money and have to be financed by state banks, growing corruption in the financial sector further complicates the problem with controlling macroeconomic stability. This threatens the momentum for reform. Pervasive corruption is socially disruptive and breeds discontent. As law enforcement agencies themselves turn corrupt, it becomes increasingly difficult to maintain law and order in society. With corruption institutionalized, it may be very difficult to maintain open and competitive markets.

Prospects for economic reform

From 1978 to 1993, China's central government revenue as a proportion of GNP fell from 35 to 15 percent. The fiscal deficit as a percentage of GNP was relatively small, and did not exceed 4 percent. However, the ambiguous financial position of the country's loss-making state-owned enterprises makes it hard for us to calculate the true fiscal deficit. Since policy loans represent forced lending to state-owned enterprises, often at very low interest rates, they should be included as part of China's fiscal deficit. The consolidated fiscal deficit that includes these loans is much larger, and in all likelihood exceeded 10 percent of GNP in 1993. Fiscal deterioration in China is a growing problem.

More than a decade of economic reform has failed to improve the productivity and profitability of state-owned enterprises, many of which continue to rely on the state to cover their losses. Increasing open and hidden fiscal deficits have been financed largely by loans from the state banking system. Macroeconomic instability has become increasingly difficult to handle and has from time to time resulted in open inflation and exchange rate crises that had to be managed with Draconian measures to cool off the economy.

Macroeconomic instability in China is a structural problem directly resulting from failure to reform the state sector. The transition to a market economy is still incomplete, and inflation and exchange rate crises are complicating the reform process by making it politically necessary to reintroduce price and exchange controls in the absence of any effective mechanism and the political will to curb credit expansion. Loss-making state-owned enterprises are the source of China's macroeconomic instability and put further economic reforms at risk.

The solution is not conceptually difficult. Unless the Chinese government is prepared to move quickly and boldly to prepare for the open privatization and restructuring of its state-owned enterprises, economic stagnation in the state sector cannot be averted. Interim measures to create a social security net for discharged workers are obviously needed to avoid widespread social discontent. Resources spent on services to displaced workers will be socially less costly than trying to prop up these unprofitable enterprises. An opportunity must be created for rationalizing the banking and financial system so that the problem of macroeconomic instability can be resolved. This in turn will make scarce financial capital available to the vibrant non-state sector instead of being wasted on the inefficient state sector. China's spectacular success of recent years would then become sustainable.

The current situation in China is best summarized with some recent figures for industrial output in the period January-April 1994.   --   China Economic News, vol. 15, no. 20, May 30, 1994.Note



In this period, state enterprises produced 47.5 percent of total industrial output, but their year-on-year growth rate was a mere 4.72 percent. The non-state sector comprising the collective and private, joint venture, and foreign-owned enterprises grew at a year-on-year rate of between 30 and 40 percent. The non-state sector is forging ahead with the state sector lagging behind.

Will the state sector quietly wither away? This is most unlikely. First, we have to recognize that the state sector includes many heavy and infrastructure industries that are state monopolies. Now the state sector can be bled to death by simply diverting resources away into the non-state sector, but the same industries cannot be recreated in the non-state sector without a shift in policy. Privatizing major state enterprises and opening them up to competition has to be an explicit policy, not an implicit one. Financial arrangements affecting major investments cannot be successfully concluded without a more clear delineation of property rights. Privatization through the back door simply cannot work.

Secondly, if widespread social and economic disruption and macroeconomic instability are to be avoided, China needs a feasible strategic plan for reform that includes the establishment of social security nets for displaced workers in order to move the economy successfully towards the goal of creating a market system. Muddling through as in the past is really not an adequate policy response. The state has to embrace the private enterprise system and the market economy with no "ifs" or "buts." For all this to take place, political reforms are almost inevitable.

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Last Modified: Wednesday, October 20, 1999.