Hiding in the Shadows

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

We are so used to looking for keys under the light of the lamp that we often forget to look in the shadows.

We live in an age when we base all decisions on "facts and numbers." The trouble with statistics is that all measurements are subject to errors and omissions. GDP statistics are notoriously inaccurate because there are both measurement errors and conceptual errors of under-measurement. The conceptual error comes from the fact that gross domestic product measures production, but it ignores costs that are not easily measured. The most commonly ignored output measurement is housework.

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.

There are of course two parts of the economy - the formal, which is subject to law and taxation, and the informal. The informal economy, or shadow market, comprises all activities that are not regulated 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 labour and local trading. 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? Friedrich Schneider estimated that from 1989/90 to 2007, the shadow economy in the OECD (advanced and industrial) countries declined from around 16 per cent to 13.9 per cent due to better tax and regulatory coverage. After the financial crisis of 2007, however, the shadow economy may have grown as people who are unemployed have moved into informal markets for part-time jobs that do not pay tax.

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

If these estimates are correct, world GDP may be underestimated by as much as US$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.

Advanced economies tend to have smaller shadow markets due to 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 happening now, is limited.

On the other hand, emerging economies have large informal markets, which means that they have great 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 that the rate of nominal money supply (including currency) needs to grow 2-3 per cent faster than 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 become more interconnected through increased international travel, labour migration and cross-border remittances and capital flows.

The McKinsey Global Institute recently estimated that over the last 10 years, openness to global flows had raised world GDP by at least 10 per cent, or US$7.8 trillion, in 2014.

As global trade has grown, more and more trade is in services that are being rapidly digitized. This means that e-commerce can deliver goods and services faster and to more customers, including in the informal sector, than ever before. The institute rightly pointed out that digitization is reaching emerging markets at speeds and scale unimaginable only a decade ago. As companies such as Alibaba, Tencent and Flipkart emerge, they are supplementing the dominance of Amazon, Facebook and eBay in reaching out to customers. For example, Facebook reaches 50 million businesses, whereas Alibaba helps over 10 million companies in China to sell globally.

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

What are the implications of the globalisation of small and medium start-ups? The first implication is that even if the large advanced markets are ageing and struggling with stagflation, there is considerable growth, innovation and interconnectivity in emerging markets. In the next decade, Chinese, Indian and other emerging internet platforms will be challenging Amazon and Google.

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

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

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

This article first appeared in the South China Morning Post as For a fuller picture of the world economy, take a look in the shadows

The views expressed in this article are the author's own and do not necessarily reflect Asia Global Institute's editorial policy.