What They Do Not Teach You at the GSB

Black Markets and You

By: John Rhoads

Posted: 4/14/05

As the first few weeks of Spring quarter pass, my thoughts turn to the annual joy of calculating and reporting to The Man my economic worth. As is true for the vast majority of Americans, it's a good bet that all the cash you amass in the first few months of the year will end up being paid in taxes. In thinking about this annual ritual of feeding the machine, I wonder how the GSB, the champion of the free market system, somehow excludes from its curriculum the discussion of the ultimate free market. What about the part of the economy that doesn't show up in all those saw-tooth graphs that we see everyday in class?
The black market, the informal, shadow, irregular, illegal, underground, invisible economy, works in the background as a balance to the excess of government regulation and restriction. Here at the GSB, we learn to take on faith the all-mighty law of supply and demand. What we don't hear much about is how this same law drives the creation of an informal economy. This informal economy exists in direct reaction to government restrictions that keep consumers from getting goods they want at a price they will pay.
Surely this other economy must only be significant in countries where the market is hindered by overly-zealous regulators and corrupt bureaucrats! What need would there be for this other economy here in the land of the free? In 1998, the commissioner of the IRS, in testimony to Congress, estimated that Americans had failed to pay about $200 billion of federal taxes that were owed. Assuming a 25% tax rate, this gives us a whopping $800 billion. We should note that this figure does not include undeclared earnings from criminal activity.
All of us have at some time been financiers of this informal economy. Have you ever paid an electrician, gardener, mechanic or maid in cash? Do you think that the tip you left for the bartender at last week's TNDC will be fully reported in the 2005 tax return? Both individuals and America's largest companies benefit from this informal economy, whether through the purchase of illegal narcotics, the use of undocumented labor, or through the legalization of formerly illegal business activities, as in the sale of pornographic movies by Rupert Murdoch's News Corporation through the DirecTV system.
The importance of the informal economy in both the developed and developing world is immense. It has been estimated that the Italian informal economy represents 27% of GDP, while in Bolivia the estimate is 65% of GDP. If we expect to work in a truly international business, the effects of the informal economy can become a major consideration in making important business decisions.
The US dollar now serves as the unofficial currency of this global sector. Today approximately three-quarters of all $100 bills circulate outside the US. While the stock market might rise or fall based on tiny changes in the unemployment rate or GDP growth estimates, what do these numbers really mean if they do not account for 5, 10, or 20% of the nation's economy that isn't accounted for? Does Greenspan consider other "unmeasured" indicators when setting fiscal policy?
Hernando de Soto (my idol), who will be coming to the GSB to speak in the coming months, has spent his career explaining the size, causes and importance of the informal economy in developing countries. His conclusion? To really understand the economy, it must be studied as a whole. Politicians and business leaders who ignore the economic undercurrents do so at their peril, to the detriment of their citizens, customers and employees. Whether through piracy, undocumented workers, or smut (think Microsoft, Wal-Mart, or AT&T), the informal market could play a large role in your future career. We will all be better prepared if we are taught how to make the best decisions in all business environments.