North & South: There's More to Greece Than Meets the Eye

The crucial fact and role of Southern Europe's Shadow Economies

What's the perimeter of the possible for Greece after its exit from the Euro?

I keep coming back to two assumptions:

• Where necessary, money will be improvised (it always is);
• The real Greek economy is likely to be significantly bigger, and significantly healthier, than is currently measured.

Both these mean that the V-shape crisis that would accompany Greece's exit from the Euro is likely to look more extreme on paper than it is on the ground. Quite conceivably, if the right fiscal policies are followed, the recovery could, on paper at least, be extremely dramatic.

The key point is that Greece's economic statistics capture comparatively little of Greek economic activity. The Greeks, we are repeatedly told, are tax dodgers. This is true, but raises really interesting questions: how much tax is dodged? why is it dodged? and what is likely to improve matters?

Surprisingly, we have very good answers to these questions, which can be found in a World Bank research paper called 'Shadow Economies All Over the World', published in July 2010, and which can be downloaded here. I strongly recommend it: it's key reading for the immediate post-Euro future.

 

The paper works out a methodology for estimating the size of shadow economies: ie 'those [otherwise legal] economic activities and the income derived from them that circumvent or otherwise avoid government regulation, taxation or observation.' By its nature, you can't count the shadow economy directly, but the World Bank makes estimates of its size by looking at deviations from various monetary and other ratios which are commonly observed and observable. It reckoned that by 2006, Greek's shadow economy was equivalent to 30.8% of GDP – this was the second-highest proportion in the 25 OECD countries the World Bank looked at (the survey covers 145 countries in all).

If 30.8% of Greece's economy is escaping official detection, its economic and fiscal plight might seem less dramatic than it usually appears. The ECB records that in 2011 Greece's public debt/GDP stood at 165.3%. If 30.8% of the economy is lost in translation, as it were, then the public debt/real GDP ratio is actually more like 126%.

Good news? Unfortunately not, because under current conditions, and certainly under current fiscal plans instituted by the troika of the IMF, ECB and EU, that shadow economy is going to grow, not shrink, relative to the official economy. That, at least, is what the World Bank found: “. . . the driving forces of the shadow economy include an increased burden of taxation, labor market regulations, the quality of public goods and services, and the state of the “official” economy.”

So the troika's austerity plans are likely to be counterproductive not just for the usual Keynesian reasons, but, just also because they'll mean that an even greater proportion of economic activity will opt-out of visibility to statisticians, economists and most importantly, the taxman. Raising taxes simply won't do it.

Actually, the misunderstanding is even more profound than that, and so far we have understated the malignity of current policies – and not just fiscal policies, but the entire gambit of EU regulation. Back to the World Bank: “Wealthier countries . . . find themselves in the 'good equilibrium' of relatively low tax and regulatory burden, sizeable revenue mobilization, good rule of law and corruption control, and a [relatively] small unofficial economy. By contrast, a number of countries in Latin American and the former Soviet Union exhibit characteristics consistent with a 'bad equilibrium': tax and regulatory discretion and burden on the firm is high, the rule of law is weak, and there is a high incidence of bribery and thus a relatively high share of activities in the unofficial economy'. In addition 'the provision and especially the quality of public sector services is also a crucial causal variable for people's decision to work or not to work in the shadow economy'.

So the question for the EU is whether the troika's austerity policies which raise taxes and degrade public services in Greece will entrench the state into a 'bad equilibrium' relative to the rest of the Greek economy. Of course it will!

But this points to a more radical conclusion: austerity policies which should work in countries which start from a 'good equilibrium' – such as Germany and most of Northern Europe – should not be expected to work in countries which start from a 'bad equilibrium' - such as Greece and . . . who else? And at the extreme, they might even be expected to push an economy from a 'good equilibrium' into a 'bad equilibrium'.

If you start from a 'good equilibrium' there is a likelihood that fiscal austerity, though painful, might work. If you start from a 'bad equilibrium' it simply can't, because it intensifies precisely those factors which put the country in a 'bad equilibrium' in the first place.

Or, to put it more bluntly: if you raise taxes in Northern Europe, people grumble but pay up. Try that in Greece, and see how far it will get you. They don't play, they defect.

We can be fairly sure that the relationship between the Greek state and the Greek economy has always been in a bad equilibrium, but what about the rest of Southern Europe? Is the Northern European misunderstanding of the possible in Greece likely to extend to the rest of Southern Europe. The short answer is 'yes' – unfortunately Greece is not (or perhaps was not) a particularly striking outlier in Southern Europe. The chart below shows the track record: by 2006 Northern Europe (UK, Netherlands, Germany, France) had shadow economies equivalent to 15.2% of GDP (unweighted average), whilst those in Southern Europe (Italy, Spain, Portugal and Greece) were equivalent to 27% of GDP. More, they were pretty tightly bunched, with a standard deviation of 1.8 percentage points for Northern Europe, and 3.5 percentage points for Southern Europe.

The conclusion which forces itself upon us from this data is that there is every chance that responses to fiscal austerity which would work in 'good equilibrium' Northern Europe should be expected to fail in 'bad equilibrium' Southern Europe. We should expect not 'rebalancing' but 'defection'.

These considerations also show why EU policymakers are foolish to point to Ireland as a relevant success story for fiscal austerity: from a good/bad equilibrium standpoint, Ireland is very definitely 'North European' with a shadow economy estimated at 17.1% in 2006.

In this piece, I've considered only the predictable short-term failure of Northern European austerity measures on Southern Europe in the context of the Euro crisis. But the implications are far wider for the structure of the European Union single market itself, and for the impact of European-wide structures of regulation across a large number of fields. For the same mechanisms of compliance/defection which mean that tax-raising policies will have predictably different economic impact in Northern and Southern European economies, mean deliver different outcomes over a range of regulatory measures. World Bank again: “Our results further show that the driving forces of the shadow economy include an increased burden of taxation, labor market regulations, the quality of public goods and services, and the state of the “official” economy.” And “reducing the tax burden is the best policy measure to reduce the shadow economy, followed by a lessening of fiscal and business regulation.”

What this is telling is that EU 'harmonisation' measures are, de facto, not likely to foster 'harmonisation', but rather widen already-measurable structural divisions between Northern and Southern Europe.