An engine of growth?

The choice is ours – Analysis by Dragos Negrescu

A recent study by experts of the EU Treasury found that underground economic activity in Romania was 49% of the official figure and that it had doubled its size in only a year. The amount has been cited without any reserves, although methods based on monetary aggregates have serious flaws, especially because they cannot distinguish the contribution of other explanatory variables. Working hypotheses have an overwhelming impact on the results: for instance, estimates for a single year (1976) in the USA ranged in an enormous interval, 2% to 22% of GDP. Even admitting that the amount calculated for Romania is a reasonable approximation of reality, there is nothing exceptional to it. Latin-American countries early this decade displayed similar numbers: 25-50% in Brazil, 50-67% in Peru and even 60-100% in Argentina. Romania is also not alone in the perception of the prevalence of corruption. Among the countries of the old communist bloc, we are next to Bulgaria, approximately halfway between the Vishegrad Group and ex-USSR (Russia and the Ukraine). Corruption has doubtless negative implications on the economy. It stimulates profit-seeking behaviour to the detriment of productive behaviour, fuels inflation by generating higher transaction costs, deprives public finances of significant resources and distorts the structure of budget expenditures. Socially, it deepens inequalities in revenue, and politically it has a dissolving effect on the legitimacy of authority and people’s confidence in the virtues of democracy. Identifying the most efficient ways to combat corruption is a controversial issue. Strong-hand solutions are debatable in terms of civil liberties, and also because they ignore the elementary truth that a disease must be cured at its source. I am afraid the growing concern for the scale of the phenomenon in the Romanian society leads to inefficient proposed solutions, focused on repression to the detriment of prevention. More concerning yet is that reactions and recommendations spring up that threaten to aggravate the phenomenon.

– it is relatively well established in international literature that a proper salary of the public servant compared to other employees reduces the scale of corruption; but public opinion is against “large” salaries in the government apparatus;

– very selective taxation systems are a gold mine for corrupt servants, but the prevailing opinion is that they should be extended (SME, disfavoured areas, industrial parks, high added value products, etc.);

– authorities have been reprimanded for the relative shortage of government orders and major infrastructure project, although recent research identifies them as major sources of corruption.

Cultural peculiarities are important. The state’s intervention in an economy creates more opportunities to corruption, but how much they materialise depends essentially on the quality of the public function: what is feasible in countries with a tradition of honest and competent public servants is not necessarily repeatable everywhere. We should therefore not neglect the other side of the coin: against a background of massive and capricious interventionism, corruption can be the only way to overcome the rigidities created by action of the state and a mechanism that allows those who need time most to save it.

How to steal a million – Analysis by Valentin Lazea

The parallel economy is synonymous with the economy which, for one reason or another, does not pay its dues to the state. In the lines below, we will pay less attention to tax evasion by the shop owner “down the street,” who hires an accounting expert to “fix” his balance, and we are equally uninterested in the mammoth plants which, incapable of working efficiently, live on the back of the budget. Our preoccupation is the new category of “industry champions,” who prosper because they have assimilated a few simple principles:

1) obtain by any means an exemption (or at least a postponement) on the payment of budget dues;

2) in parallel, capture the favours of as many decision-makers as possible, potentially by sharing with them some of the profits made at (1); the support of a few local MPs won’t hurt, but it is important to secure the favours of the centre, so there is no reason to be tight-fisted with party sponsorships, etc.;

3) expand territorially as fast as possible, using all possible arrangements with the SOF, with already privatised companies that have extra space, etc.;

4) give work to as many people as possible, so their hardship can be turned into a social problem of regional, if not national importance.

Once here, the successful businessman can be almost certain he has won the game. Because politicians, with rare exceptions, cannot resist the combination of personal and party gain plus a solution to a social problem (especially unemployment). It does not matter that the budget is going to shambles, that public services decline by the day, that inflation grows, and foreign investors treat Romania as the Far West. After all, inflation grows but unemployment does not; foreign investors are not bringing any votes, whereas local ones do; and if public services cannot unfold for lack of budget revenues, the 22 million Romanians will just have to make do on their own – it’s a market economy.

Nevertheless, successful businessmen should quickly move from the parallel into the official economy, if they want to have police protecting their wealth, roads to transport their goods, an educated and healthy work force, etc. Otherwise, practice will confirm the saying “Greed kills Romania.”

After all, nothing is surprising in this whole process, except for the extremely slow pace. After ten years, we would expect to have gotten somewhere.

Restraining the underground economy – Analysis by Lucian-Liviu Albu

Lately, press disclosures of fraud and corruption cases, as well as international pressure, have increased public interest authorities’ concern in estimating the size of the so-called underground economy, so its causes and deterrents can be found.

In terms of official numbers, the National Statistics Commission (CNS) has taken great strides to assess the size of the underground economy based on national accounts, under a methodology that is being streamlined to match EU legislation. According to the CNS estimates, the underground economy as part of total added value has grown from 6.7% in 1992 to 12.6% in 1994, 19.0% in 1997 and 21% in 1998. Some analysts, however, compiled data supplied by various institutions, such as the Ministry of Labour, SRI, the Finance Ministry, etc., and admitted that the informal economy is much bigger.

In the Romanian economy, as in all other Central and East-European, a so-called deregulation process has first been necessary to allow the transition from a hyper-centralised system to one based on the market economy. Apparently, this has dragged on for too long in our country. In the next stage of transition, a regulatory process had to be deepened, this time oriented towards building a functional market economy. But this second process of institutional reconstruction was again promoted with little firmness. Also, it often interfered with the already mentioned delays in deregulating the old system. The most direct consequence, besides the obvious delay in transition, has been the expansion of the underground economy. This points to the existence of a genuine “systemic tension” or, according to other authors, of a “poorly structured economy.” It is obvious today that in the Romanian economy tension is maintained and aggravated by institutional frailty.

Transition toward market economy has been accompanied in our country by a profound economic crisis. Output in the official sector dropped fast after 1989, and official unemployment grew even beyond current levels in Western countries. Also, revenues in the official sector fell dramatically in a short historic period. Under these circumstances, a large share of the labour force went for the black market. Contrary to the hypothesis that salaries are higher in the informal sector of the economy, many employees on the black are forced to accept lower pay than in the official sector.

On the other hand, the profit rate is always higher in the invisible sector than in the official economy. This is happening for at least two reasons: in the underground economy, no taxes or other social dues are paid, and investment in fixed capital is also minimum. Additionally, there is a relative shortage of consumer goods and services, while the heavy industry and the capital goods industry generally remain state-sector monopolies. Consequently, in the unofficial sector, relatively small capital, usually coming from small entrepreneurs, goes to the production of consumer goods and services, initial capital is low, money circulates fast and profits are high.

Especially in the first phase of transition, when inflation exceeded the interest rate, and the old fiscal system collapsed, these was a massive transfer of activity from the visible side of the economy into the invisible one. With an average family income in an alarming decline, additional supply of labour emerged from categories of the populace not traditionally listed as labour force (pupils, students, retired and housewives), as well as from officially recognised unemployed. At the same time, new differences developed between population categories: one was between working and unemployed people; another, between people working only in the official sector and those working underground or in both. Given the prolonged crisis of output in the official sector, the winners will be those working informally (including those working in both sectors). In the first stage, available revenues caused by such differences will be accumulated and later diverted toward underground activities. But, in a second stage, when the mass of accumulated capital exceeds the absorption capacity of the unofficial sector, the tendency will revert: those enriched in the underground sector will want to make their new status official and consequently will attempt to “whiten” their money and then become “respectable” people by engaging into legal activities. This last phase, which appears to unfold today in Romania, can be considered the end of a cyclical sequence, and the entire alternation – a wave of historic scale. After the stage of “primitive capital accumulation,” East-European economies will probably develop similarly to Western countries. Against the general background of a shrinking underground economy, some fundamental restructuring will continue, including in the invisible sector. Thus, the share of more sophisticated underground activities will increase, to the detriment of “rudimentary” or “amateur” practices.

If and when the economy enters a new spiral of the macro-cycle, remains a matter of the future. Still, we believe a description of the general process of long-term economic development based on a model of endogenous cycles, which explains economic fluctuations through a set of successive waves or chained cyclical phases, as opposed to the relationship between the underground and the visible economy, could be a plausible alternative to models based solely on the short-term developments in the official sector of the economy. In this case, economic evolution as a historic process can be interpreted as a suite of chained, permanent but fluctuating transfers, cohorts of economic factors from the official sector to the underground one and back.

The underground economy and competitiveness – Analysis by Lucian Croitoru

The underground economy has many components. The most widely known are tax evasion and black labour. But there are many other components, all united by the fact that they are unregistered. All economies have an underground component. Their relationship with the formal, registered economy depends on many factors, including tradition, culture, capacity to impose submission to law, police efficiency, etc. Besides these determining factors, there are the economic ones, especially the structure of incentives and the degree of economic development. In fact, there is a direct positive relationship between economic development and consistent incentives. The more developed the economy, the less distorted is the structure of economic incentives. In developed countries, with a consistent structure of incentives, the underground part of the economy tends to be minimal. One of the positive consequences of the fact that the underground economy tends to remain minimal is that the formal part, supposedly tax-paying, remains sufficiently large to secure the authority of state institutions without requiring an increase in the fiscal burden.

Where the underground economy crosses a certain limit, fundamentally because of the distortions in the structure of incentives, public finances deteriorate, and the state’s authority erodes. Profit seekers become economically powerful and oppose the reforms which are needed to correct that structure and which eventually would rule out profit sources. Partial reforms further encourage profit seeking, which leads to a broader expansion of the underground economy. The formal economy tends to grow at a slower rate than the formal and informal economies combined.

One may say that with the economy on the rise, it does not matter which of the components – formal or informal – experiences growth. What matters is that labour force is occupied. But things are not that simple. Besides the social aspects (e.g., black labour does not entitle to retirement benefits, etc.), there are negative economic consequences that, in the medium and long term, slow down economic growth. Interests that protect profit sources do so by putting a brake on liberalisation and competition. Consequently, domestic producers become less competitive. As imports substitute domestic production and exporters lose foreign markets, output falls, and the payments balance deteriorates.

It is beyond doubt that the underground economy in Romania has reached impressive rates. Politicians lament the fact, blaming the tax burden, which is not entirely wrong. But, every time, this criticism contains veiled suggestions that the expansion of the underground economy has completed some revenues or compensated revenues lost by those who left the formal economy. Which, again, is not entirely wrong in the short term. But in the long turn, there is nothing good in it.

Expansion of the black economy – Analysis by Claudiu Doltu

The black economy is not emerging because people have an inclination toward illegal exchanges around which mafia-like relations are established. People have a natural inclination toward exchange. And when authorities put up enough barriers to free exchange, they continue and protect themselves with connections which – against what the society considers “normal” – are labelled illegal or mafia-styled.

Lack of trust in the market and failure to recognise the fact that economic freedom is in direct relation with the growth in a country’s welfare have permanently “pushed” authorities into cultivating interventionism as a philosophy of general economic policy. But the result today is that, besides poor economic results, interventionism has generated so many barriers in the way of free exchange that people have increasingly taken refuge in the “black economy.”

Interventionism has been imposed by the bureaucratic elite in the early ’90s. Is there any acceptable excuse for those economists who preach the policy of “small steps” and “gradual reforms,” promising the “maximisation” of consensus in the society? Naivete can be accepted only for some segments of the civil society, which have believed and still sincerely believe in the state’s superiority over the market. But when these segments lend legitimacy to prejudice that maintains an institutional system that encourages profit seeking, even naivete is not excusable.

Today it is obvious that the goal of the illusion sellers who promote interventionism is none other than securing a safe profit-seeking environment through a non-systematic implant of market institutions into a state economy. The vehicle of interventionism is the “stop-and-go” policy – initiating an economic policy and abandoning it when it begins to negatively impact voters’ assent. The advocates of interventionism will never admit that poor performance in a economy is the result of distortions induced by government intervention. Denying this evidence, profit seekers fabricate solutions for the economic decline out of new combinations of government interventions. The “stop-and-go” reform policy corresponds to profit seeking interests by the state bureaucracy and the new business elite.

Despite the sterile debates around this cause-and-effect relationship, the sentence is pronounced in people’s behaviour. Increasingly more businesses or their components have moved to an area in the economy where authorities cannot exercise control: the black market. Why? Because the benefits of operating in the black economy have outweighed the costs of moving into the black economy.

Concurrent interests of the state bureaucracy and the business elite have permanently acted towards impairing and undermining reform. This symbiosis has inhibited viable businesses from entering the market. If society does not accept the black market (although it benefits from its existence), it should not expect any spectacular results in curtailing it, from solutions that practically have encouraged its expansion.