To miniaturise or not to miniaturise the parallel economy: That is the question

Dear Editor,

The Minister of Finance, Winston Jordan, recently pronounced a reduction in “free spending” in the economy.  The cause, he says, is the reduction of illegal activities, including narco-trafficking, money laundering activities and logging.  Squeezing the underground economy to a smaller size has reduced the spending power of its participants. In turn, this will push the economy to a new and probably lower equilibrium.  How long will the period of adjustment last, is the million-dollar question. The Stabroek News (May 17) quotes Minister Jordan as saying: “So the more that you go after that [the parallel economy], and the more it will miniaturise, that is the less free spending you will see… it’s going to take a time for the economy to get comfortable with that, but in the meanwhile we will be putting other incentives to stimulate growth in the economy, but one good thing we can say, the economy will grow.”

The Minister touches on three important points: the economy needs time to adjust to declining consumption spending; incentives will be put in place to stimulate growth; and economic growth will continue. Without further empirical analysis, nothing can be said about the first point: how long will it take for the economy to adjust? If the second point leads to a volume of spending that at least compensates for the fall in consumption spending, the economy will probably grow at its mean rate over the last few years. The second point flows into the third: the economy will continue to grow, but at what speed? According to the IMF, the economy seems to be in good shape and is expected to growth by at least 4 per cent in 2015, or 1 per cent more than the previous year (KN, May 24).  Growth in 2016, the IMF says, will be supported by public investment and two new large gold mines.

I infer from the Minister’s argument that consumption spending has been driving the economy and its growth rate perhaps more than any other factor.  What do the data say? In 1960, consumption spending (private and public) comprised 80 per cent of GDP and expanded to 81.3 per cent when the country became independent in 1966.  From that year to 2004, consumption spending fluctuated but with an upward trend, and averaged about 82 per cent during these 37 years.  Guyanese were consuming about the same portion of their GDP as several other countries in the world, including some in Latin America and the Caribbean.  Then something fundamental changed abruptly.  From 86.3 per cent of GDP in 2004, consumption spending surged to 109.8 per cent of output in 2005, and remained at this level until 2014 (data for 2015 are unavailable).  A few other countries in the world ate their entire GDP and more during this period, including Dominica (100.1 per cent), El Salvador (104.0 per cent), and Haiti (104.9 per cent).

Incredibly, the Guyanese appetite apparently grew even as the country’s population was shrinking.  The excess of consumption spending over the mean (82 percent) might be taken as a rough indication of the size of underground economy during 2005 to 2014: about 28 per cent of GDP.

The reason for the surge in Guyanese appetite is unknown, but it is likely attributable to the huge underground economy that developed from around 2005. By its very nature, the underground economy flourished mainly because of a few corrupt and immoral businessmen, politicians and associated others, most of whom are located in Georgetown.  It was not a phenomenon that included a large fraction of Guyanese. The shadow economy was an economy of the perversely rich.  Ok, I see the raised eyebrow.  How can a nation consume more than it produces for over a decade and more?  To get at the heart of this question, we need to introduce a famous macroeconomic identity: Y = C + I + (Exports – Imports), which means that C (private and public consumption), I (private and public investment) and net imports-export exhaust GDP.  If the terms on the right-hand side of the equation are greater than Y, the identity is converted into an inequality. In this case, GDP is smaller than consumption + investment + net import-export; the country is consuming and investing more than it produces and thus living beyond its means.
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Consumption plus investment consistently exceeded GDP since 1976; the former alone was greater than GDP from 2005 (Chart 1). How is this possible? By running a current account deficit (borrowing to fund imports of goods and services), which piles up an external debt stock, and an internal fiscal deficit, which piles up an internal debt stock. As consumption exceeded output, investment-to-GDP ratio began to slide, reaching less than a fifth of output from 2008 to 2014, which was 2 per cent lower than the previous seven years.  The consumption bubble compromised the productive capacity of the economy.

If consumption contracts to its mean from 1966 to 2004 (82 per cent of GDP), its negative impact on the economy will be huge.   It would mean that consumption as a share of GDP would have to shrink by over 25 per cent.  If the government decides to make up for the shortfall, it would have to dole out an equivalent amount of GDP. For example, cutting consumption to 82 per cent in 2014 knocks off US$880 million from the US$3.1 billion GDP for that year!  This raises an important question: would a policy to rapidly decimate the underground economy lead to an economic downturn? It probably will for the simple reason that not all activities in the shadow economy will migrate to the formal economy. Businesses are usually pushed into the parallel economy because of high tax rates or the need to avoid taxes, difficulties of accessing finance, red-tape, bureaucratic delays, and corruption, among others.  To mitigate the adverse effect of the disappearing underground economy, the government will have to remove obstacles to doing business and play a more active role in the economy.  The latter includes a higher rate of public investment, strategic direction, revamping trade policies, marketing assistance and easier access to capital by the private sector. The Minister of Finance spoke about what ought to be done to diversify the productive structure of the economy and to increase value-added of the main commodity bundle, but says little about what the government will actually do (SN, May 17).

Even if the government aggressively reduces the size of the shadow economy and pumps up government spending, there is no certainty that the speed of growth will exceed the historical trend from, say 2000, which is less that 3 per cent. One factor impinges heavily upon the performance of the Guyanese economy – its heavy dependence upon the world economy.  We rely completely on imported oil, capital equipment and accessories, medical supplies and a variety of food and luxury items.  The export commodity bundle is narrow, comprising mainly rice, sugar, bauxite and gold, and we have no control over the prices of imported and exported commodities; gold alone accounts for the overwhelming portion of export earnings (40 per cent in 2015 and 43 per cent in 2015).

We may summarize thus: to miniaturize or not to miniaturize the parallel economy? That the question.

Yours faithfully,

Ramesh Gampat

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