A Response to "The Rise of the Underground"

A recent article in the WSJ, The Rise of the Underground touted itself with an interesting lede:

Economists have long thought the underground economy -- the vast, unregulated market encompassing everything from street vendors to unlicensed cab drivers -- was bad news for the world economy. Now it's taking on a new role as one of the last safe havens in a darkening financial climate, forcing analysts to rethink their views.

Apparently, early evidence of the impacts of the global financial crisis "GFC" suggests that the informal sector actually plays a valuable role in absorbing, at least in part, the most vulnerable to the GFC. Mr. Barta suggests that this is a) contrary to the classical view that the transition to formal employment is a key step towards sustainable economic growth and independence, and b) causing economists to reevaluate the informal sector.

We beg to differ on both fronts. Sure, the informal sector provides useful flexibility, doubtlessly more so in times of crisis. But the very reason that the informal sector is booming is its inherently low costs: it doesn’t pay taxes and rarely observes health and safety, labor or consumer protection standards.

Hence the emphasis on transitioning to a formal sector; those ‘costs’ provide valuable social benefits. ContraMr Barta, with the GFC eating up whatever surpluses developing countries may have had and reducing the pool of available donor funds, increasing formal sector participation is perhaps more important than ever.

The paradox is that the very reasons for which we prefer the formal sector are what encourages informality – it is more expensive to comply with all those standards, and especially to pay taxes, than not to. Further, Mr. Barta's picture of a resurgent informal sector in the developing world does remind us of a regrettably eternal truth in development: that those countries the most in need of economic growth, formal jobs and the other accouterments of a developed formal SME sector are often those least friendly to such businesses.

Famously, when Hernando de Soto tried to register an informal clothing business in Peru it took more than 100 days. No one can reasonably claim that anyone benefited from such delays, although in Peru today it still takes more than 50 days to do what in some countries takes barely two. It is hardly a surprise that Peru's informal economy was estimated in 2000 at 60% of GDP.

Fortunately, this raises a way of squaring the circle, at least partly. Now more than ever, countries with flourishing informal sectors would do well to consider their performance in Doing Business 2009 or Doing Business 2010 (forthcoming this September) and how they might, at often little cost and probably great gain, make the transition from the informal sector to the formal one a little easier.