You may find it hard to believe, but that off-duty plumber who fixed your toilet cheaply -- but for cash you knew he would not report to the Internal Revenue Service -- could be part of the reason the government's statistics portray an economy in severe distress.
In a controversial but soundly researched thesis, a University of Wisconsin economist argues that the rapidly growing underground economy skews the information upon which economists forecast and policy makers make policy.
The underground economy -- that thriving network of legal and illegal activities that encompasses some moonlighting, unreported income and income from drug dealing, prostitution and rackets, among other things -- may be one reason that official government statistics inexplicably report severe recession coupled with high inflation and find sharply declining productivity. It also may be the reason economists consistently "underpredict" inflation and "overpredict" real growth and employment.
According to Edgar L. Feige, "The patient is much healthier than we imagine; it is the social thermometer that has gone awry. The problem, I believe, may well lie with our omission of measurements on what I describe as the unobserved sectors of the economy."
Nearly everyone is familiar with some portion of the underground (or to use Feige's word, "unobserved") economy. If you've eaten in a restaurant, the odds are good that you've eaten off a plate washed by an illegal alien. Depending upon where you ate, the cook may well receive only a portion of his salary "on the books." The waiter or waitress is sure to report only a portion of the tip to the IRS.
The moonlighting plumber, the cook and the waiter are all part of the underground economy that puts income in people's pockets and produces both legal and illegal goods and services but also escapes the clutches of the tax man and the eye of the official data collector.
Feige, who admits his evidence is circumstantial, estimates that the underground economy is growing much faster than the observed economy and has been doing so since the start of the 1970s.
Feige estimates the underground economy in 1976 was about $330 billion, or about 27 percent of the official reported gross national product. That is sharply higher than during the 1960s -- not so incidentally.Feige notes, a period when economic theory appeared to work.
That the underground economy exists has been well-known to most economists, who have assumed that its growth corresponds closely to the growth in the official economy.
But if Feige is right that the underground economy is growing much faster than the observed economy, a number of serious distortions are introduced into the picture according to the statistics.
Growth in economic output is higher than reported.
In market economies, the inflation rate is lower than the official figures portray because underground income is not taxed. There would be little reason to hire a moonlighting plumber if he charged the same as the plumber in the phone book.
Productivity is higher than reported.
Unemployment is lower than reported -- because many individuals have jobs but portray themselves as unemployed to the government.
"To those in our economies who suffer the real tragedy of prolonged unemployment and poverty," the notion that many of the perceived problems in the economy are a "statistical artifact" may "seem a cruel and callous hoax," Feige concedes.
He said he is not denying serious hardship among important segments of the population nor arguing that there is not a shift of resources to oil-producing countries or that inflation is not a serious national problem.
However, Feige said, "I maintain that the extent and magnitude of these problems have been exaggerated in the official statistics and, because economic actors have responded to these false signals, we have seriously exacerbated our difficulties."
He noted that, despite the increasing sophistication of economic forcasting, errors are worse than two decades ago. His analysis reveals that in the forecasting model used by the Council of Economic Advisers, 35 percent of the forecast errors in real output, 46 percent of the inflation errors and 40 percent of the unemployment errors (from 1962-79) can be explained by the growth of the underground economy relative to the official economy.
Similary, a good bit of the so-called stagflation rate -- the simultaneous existence of recession and unemployment -- can be accounted for by the underground economy and much of the seeming decline in productivity.
Bad economic policies result, Feige said. "The perception of slowed growth will lead well-intentioned policy makers to overstimulate the economy. . . . The perception of inflation will reinforce these policies' consequences by encouraging current consumption and forcing prices still higher. Indexed wages and social benefits in turn push individuals into higher marginal tax brackets and thus increase the burden of real taxation, which may also be raised by the expansionary efforts of governments to combat the perceived slowdown in growth."
He maintains that all these effects will encourage more individuals to enter the underground economy and increase citizen frustration with the apparent inabilities of governments to manage the economies competently.
As Feige points out, even if he is right and much of the malaise is unreal, social sciences other than economics teach that "the mere perception of malaise and crisis is sufficient to produce the reality of crisis. . . . Unless perceptions of citizens and policy makers are brought back into conformity with underlying economic realities, we may be condemned to suffer economic and even political crises of serious proportions."
In the 1930s, Lord Keynes was able to explain much of the seemingly irregular economic behavior with a revolutionary approach to theory. Feige offers to new revolution in theory but does offer a cogent explanation of why much of the theory that worked in the 1960s fails to work today.
The econometricians and other elegant mathematicians who ply the economics profession are likely to denounce Feige's work as bunk. In an interview the economist admitted that he, too, was "surprised at the size" of the underground economy.
But unless an economist has another "revolutionary" theory to replace Keynesianism, the profession would be well-advised to look seriously at Feige's work.