Causes of Informality

A little over a month ago, I argued that maybe the size of informal markets played a role in deciding why countries like Spain and Greece saw housing bubbles, and why Germany did not. Quickly, I should mention, now more than then, that I understand the limits to this explanation: there are other factors involved, and it doesn’t apply to all European countries. Nevertheless, I still think it has some explanatory power, or, at the very least, is a thesis worth exploring. I haven’t looked into it further, but I did forward my idea to my International Monetary Theory professor.

He emailed me back, writing that my theory isn’t convincing, because research on informal markets show that they are less likely to be invested into. He cited the work of Hernando de Soto, The Mystery of Capital. It’s a good point, especially because it reveals the fact that not all informal markets are the same.

De Soto’s research shows that societies lacking enforced legal frameworks, especially property rights, are characterized by large informal sectors and low investment. In a sense, the issue is with the liquidity of savings. In the economies which fit de Soto’s description, there are vast savings held in the form of, what de Soto calls, “dead capital.” He estimates that these savings are many times greater the value of foreign aid. More importantly, dead capital can’t be used as collateral for liquidity to fund investments, forming a major impediment to a rising middle class. If this is the way you think about informality, then Spain’s and Greece’s informal markets aren’t helpful in explaining their respective bubbles.

But, both Spain and Greece do have established legal frameworks, with — at one point — thriving private sectors. Yet, both have large informal sectors. How does this fit with de Soto’s research? It doesn’t. To better visualize the distinction, use this neat graphing tool which presents data aggregated in the Heritage Foundation’s2012 Index of Economic Freedom. Type in Spain and Greece, and then you vary the third country to see how the two European markets compare to those of countries listed in de Soto’s book: Peru, Egypt, et cetera.

Spain and Greece have adequate legal frameworks, relatively high “property freedom” (although, Greece substantially less than Spain — both countries are behind most other developed nations), “business freedom,” “investment freedom,” and “trade freedom.” I suspect that most of these categories, on their own, aren’t very useful (and, at first sight, seem redundant). I don’t want to put undue weight on them; my point is that the cause of informality in these societies clearly aren’t the same as those of many developing markets. What is different are “labor freedoms,” where both Spain and Greece are very often below many developing nations with large amounts of “dead capital” (including Egypt, Peru, and Russia, which are three countries discussed in The Mystery of Capital).

I understand the limits to the Heritage Foundation data. Don’t place importance on them; their function is to serve as a basic illustration of my argument. (Also, by itself, “labor freedom” doesn’t mean much; labor being freer in most of the developing world obviously doesn’t imply significant success.)

The kind of informality we see in many developed European economies revolves around things like labor, not capital. It involves payments of incomes outside of the official “grid,” which is decided by the extent of tax collection. In many ways, this kind of informality benefits investment, because many of the costs associated with hiring through official channels are avoided. This is precisely why I reasoned that Greece and Spain suffered from housing booms, while Germany didn’t; they all had similar labor markets (high unemployment), with Germany’s being a bit more flexible, but the periphery had large informal sectors to get around the costs of hiring.

We can even think about the distinction between informal markets in countries like Spain and Peru by thinking about them in terms of a gradient. In the latter, many activities are informal: investment, consumption, labor, et cetera. There simply isn’t the means to enter the formal market. In Spain, there is a well established and accessible formal market, but it’s convenient to oftentimes operate informally. Firms can hire cheaper labor, and, at the same time, have well protected property rights.

Informal markets have various causes. Differences in originating factors — e.g. lack of legal framework versus rigid labor laws — allow for variation in the nature and substance of these informal markets. This heterogeneity means that different informal markets impact the general economy in different ways. Whereas informality in places like Egypt and Russia handicaps economic growth, because it inhibits investment, the same isn’t true in countries such as Spain and Italy. In the latter group, grey markets help private agents circumvent inconvenient interventions. This doesn’t mean that Spanish-style informality doesn’t have its disadvantages. Rather, not all informal sectors can be treated the same, and we can’t assume the same implications for them.

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