[Andrew Sheng] Casting light from the shadows

In solving mysteries, the detective Sherlock Holmes used to say that “once you eliminate the impossible, whatever remains, no matter how improbable, must be the truth.”

We have been so used through our conventional training to look for keys under the light of the lamp at night that we often forget to look in the shadows.

We live in an age when we base all decisions on what statisticians produce as “facts and numbers.” The trouble with statistics is that all measurements are subject to errors and omissions. Gross domestic product statistics are notoriously inaccurate because there are both measurement errors and conceptual errors of under-measurement.

A measurement error of 5 percent either way when you are growing at 7 percent per annum is at least discernible, because most of us would be able to know whether a decline of 0.35 percent is meaningful or not. But when the advanced countries are growing only at 1 percent or less, it is so much more difficult to know whether one is recovering or stagnating further.

The conceptual error in under-measuring output and wealth comes from the fact that GDP measures production, but it ignores certain costs that are not easily measurable. The most common ignored output measurement is domestic housework. Statistically, if you married your former housemaid, GDP value goes down by the value of her former wages!

The other areas of under-measurement are spillovers and externalities, such as pollution costs, which are difficult to measure, and also the costs of resource depletion, such as destruction of biodiversity in forests and marine life, including reefs. The World Bank has estimated that if these pollution and resource depletion costs are factored into many developing economies, their GDP growth would have to be reduced by up to 2-4 percent less per annum.

There are of course two parts of the economy -- the officially measured part, called the formal economy, which is subject to law and taxation, and of course, the informal economy. The informal economy or shadow market comprises all activities that are not regulated or protected by the state. These may include illegal activities, but also comprise activities that are typically not subject to taxation (such as legal tax avoidance) or not regulated or measured, such as casual labor and local trading in the rural areas. Actually, in many rural and remote areas, as well as cities, the poor generate business activities that are outside the watch of the police and often below the tax levels.

How big is the shadow economy?

A study made by German professor Friederich Schneider in 2012 estimated that between 1989 and 1990 to 2007, the shadow economy in the Organization for Economic Cooperation Development countries declined from around 16 percent to 13.9 percent, due to better tax and regulatory coverage. After the global financial crisis of 2007, however, the shadow economy may have grown, as people who are unemployed have moved into the informal markets for part-time jobs that do not pay taxes.

More recent analyses suggest that the average size of the shadow economy was 13 percent for advanced countries and 36 percent for emerging markets. This meant that the size of the global shadow economy was nearly 26 percent, since the advanced countries accounted for 42.9 percent of global GDP of $77.9 trillion, while the emerging market and developing economies accounted for 57.1 percent of world GDP in 2014.

If these shadow estimates are correct, world GDP may be underestimated by as much as $20 trillion. In other words, we may have underestimated the resilience of the world economy to stagflation because there is an element of the market that we don’t measure officially.

Advanced economies tend to have smaller shadow economies because of better tax collection and records, but it does mean that the ability of their shadow economy to create jobs in a period of stagflation, as is what is happening now, is limited.

On the other hand, the emerging markets have large informal markets, which means that they have considerable potential to bring the “informal” into the “formal” economy, improve the rule of law and also taxation and output.

Central bankers in emerging markets know very well that the rate of nominal money supply (including currency) needs to grow 2-3 percent faster that nominal GDP to take into consideration the “monetization” of the informal market (namely, its liquidity needs).

Furthermore, the informal economy is growing through increased globalization.  In the last decade, the world has been becoming more interconnected through increased international travel, labor migration and cross-border remittances and capital flows.

The McKinsey Global Institute recently published its globalization and digitization report, which estimated that over the last ten years openness to global flows had raised world GDP by at least 10 percent, or $7.8 trillion, in 2014.

The interesting point is that as global trade grew, more and more trade is in services that are becoming rapidly digitized. This means that e-commerce can deliver goods and services faster and more widespread to more customers, including in the informal sector than ever before.

MGI rightly pointed out that digitization is reaching the emerging markets at speeds and scale unimaginable only a decade ago.

As companies such as Alibaba, Tencent and Flipcart emerge, they are supplementing the dominance of Amazon, Facebook and eBay in reaching out to Internet-savvy customers in almost every corner of the globe. For example, Facebook reaches out to 50 million businesses, whereas Alibaba has over 10 million companies in China selling globally.

In other words, as smartphones and the Internet cover more and more customers, particularly in emerging markets, the lines between the formal and informal markets are going to blur.

What are the social, political and economic implications of the globalization of small and medium-sized start-ups? The first implication is that even if the large advanced markets are aging and struggling with their economic stagflation, there is considerable growth, innovation and interconnectivity in the emerging markets. In the next decade, Chinese, Indian and other emerging Internet platforms will be challenging the dominance of Amazon and Google.

These digital platforms are not confined to domestic borders but are already reaching out to global markets.

The second implication is that these start-ups can not only source talent, inputs and know-how globally, they can also find customers, partners and investors at the global level.

Thus, despite the gloom and doom in the advanced markets, I remain an optimist about the emerging markets. The reason is that never in history have so many (85 percent of the world’s population) had access to Internet knowledge and technology. They may not be wealthy today, but technology, demography and geography are shaping their destiny.

Look for light and hope from the shadows, the neglected bottom part of the economy.

By Andrew Sheng

Andrew Sheng is a distinguished fellow of the Asia Global Institute, University of Hong Kong. -- Ed.

(Asia News Network)