Most people believe that an underground economy exists in defiance of the law. The truth is that they exist because of the law. When legal systems don’t work, the main victims will be investors

Every country in the world has an underground economy. They differ only by degree. Most people believe that an underground economy exists in defiance of the law. The truth is that they exist because of the law. When legal systems don't work, the main victims will be investors.

Legal systems can create underground economies for a variety of reasons. For example, if the law imposes too many burdens on an economy as in irrational regulations or pervasive fees, they will be simply ignored or not paid. Often it is not the regulations themselves that create the problems. It is the people enforcing them. If regulations require constantly escalating payments to rent-seeking bureaucrats, businesses will find it easier to do business outside the system.  

Governments like to utilise the law to control or interfere with the markets. More often than not it has limited or no effect. An example is price controls. To stop inflation governments are fond of putting in place price controls, which only increases hoarding and encourages corruption of the enforcement mechanism. Limits on interest rates within the financial system will often result in the diversion of savings to alternative investments. A government monopoly invariably instigates a gray economy.

An attempt to limit supply for something the market demands is also doomed to failure. The most obvious example has to do with government attempts to limit the practice of supposedly immoral activities like gambling, drugs and sex.

Governments have also attempted to stop expensive loans supplied by loan sharks and cheap labour supplied by illegal migration. But even enforcement obsessed America has failed to stop these practices despite spending hundreds of billions of dollars over decades.

A poor legal infrastructure with corrupt, biased, slow or expensive courts will invariably result in alternative dispute resolution mechanisms. For example, in Afghanistan the Taliban have been very effective in creating a shadow court system that is generally perceived by at least the Pashtuns, as less corrupt and more sensitive to their cultural traditions.

Although underground economies are more pervasive in emerging markets, they certainly exist in developed countries as well. In a recent poll of the European Union's 27 members, almost 30% of some of its most honest citizens-Denmark and the Netherlands-admitted to paying for unlicensed, unregistered or illegal goods and services.

The most accurate measure a legal infrastructure's efficiency is the size of its underground economy. In most of the OECD countries (Organisaion for Economic Co-operation and Development) the estimated size is about 13.8% of GDP. Of course this varies widely. Greece has an estimated black economy that represents 25% of its GDP. Italy's is 22%, and the illegal economies in the US, Switzerland and Austria represent only 7.6%, 8.3% and 8.5% of their GDP respectively.

While the underground economy in the US seems relatively small compared to other countries, it does not mean it is irrelevant. The reported US GDP is close to $14 trillion economy. This means that a trillion-dollar grey, or black, economy goes unreported and untaxed. It escapes economic and financial forecasts. It does not come within the purview of government or private company plans or programmes.

As this problem is multiplied from country to country across the world we start to see major distortions. Greece misses out on €15 billion annually. The Italian tax authority loses €100 billion. Both Greece and Italy are relatively sophisticated developed countries.

The less developed and emerging markets make up far more of the world's economy than ever before. As these economies have grown, so has the size of their subterranean economies, which leaves an ever larger hole in accurate information.

The obvious enormous example is China. China's capricious regulations and state-dominated economy guarantee a large grey economy. It is so large that it dwarfs the economies of many countries. But China's secretive markets are not just about simple illegal activities. They include all forms of finance. The alternative banking system in China comes in various forms. According to the former Financial Times Beijing correspondent James Kynge, they include "off-balance-sheet lending by state banks, the funds under management by 'private' funds and the assets of a booming multitude of unregistered banks and loan sharks."

According to Mr Kynge, the total amount of lending in this underground financial system could top an estimated 6 trillion renminbi. If this amount is added to the reported loans of 7 trillion renminbi, you end up with a money supply that is out of control and certainly heading towards inflation.

Financial professionals and economists pride themselves on the amount and quality of information available to them. Governments pride themselves on their ability to use law to regulate their economies. They both are quite vain about their forecasts. What investors need to know is that they are both wrong and the effects of their mistakes will be something that they can't predict. So perhaps the best strategy is to listen to what they have to say, and bet the other way.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected])