Feeding on Failure

Why is the underground sector in the world’s poorest countries so large? Two answers are given above. First, it is costly for firms to register themselves. Second, the benefits from becoming registered are small. But these answers raise further questions. Why are the costs of joining the formal sector so large? Why are the benefits so small?

There is no mystery in why the benefits are small. The required set of market-supporting institutions is complex. In the United States and Western Europe, building these institutions was a project of a century or more. In today’s developing countries, it could take decades, and it perhaps presupposes having a democratic government. More of a mystery is why the costs of registration are so large. Why do governments deliberately set rules that force an entrepreneur to wait months and pay a multiple of per-capita GDP just to get a permit to run a fledgling firm? Such a policy does not self-evidently serve these governments’ interests.

The entry barriers might be a remnant of socialist ideology. Lenin wrote that “small production engenders capitalism and the bourgeoisie continuously, daily, hourly, spontaneously, and on a mass scale,” so some believed the state should discourage entrepreneurship. Yet if ideology might explain the origins of the entry barriers, there remains the question of why they persist. Corruption furnishes part of the answer. Onerous licensing requirements create opportunities for low-level bureaucrats to enrich themselves. By paying a bribe, the entrepreneur can short-cut the licensing procedures and get on with doing business. The higher the official fees and the longer the wait, the bigger the bribe. Bureaucrats will therefore resist any attempt to ease entry rules.

However, to explain the existence of staggeringly high entry barriers by citing petty bureaucrats’ desire for bribe opportunities seems a stretch. Where do the clerks who hand out business licenses get the power to determine government policy? They cannot possibly be so influential. Some of the bribes they take filter up to their superiors, to be sure, and perhaps this is enough to explain the size of the entry barriers. But there is another likely set of culprits, people who benefit richly from the rules hindering new firms: the crony capitalists.

In the typical developing country, business is dominated by a few large firms, closely held and politically well connected. In Indonesia, the Philippines, and Thailand, for example, about 10 rich families control about half of the corporate assets. New firms run by hungry entrepreneurs threaten to chip away at the existing firms’ privileges. The last thing the incumbents want to see is the emergence of a home-grown Bill Gates. They might be using their political strength to induce the government to maintain the legal barriers to entry in order to protect themselves from any incipient competition. If so, shifting activity from the underground sector to the formal sector would mean tackling the incumbent large businesses.

The Challenge Ahead

The underground economy is a symptom of the failure of government. We must be precise, though, about the nature of the failure. In the libertarian view, oppressive government regulations bear the full blame. This is simplistic. Oppressive regulations are a part of the story, but only a part. Equally significant is the fact that government is not doing enough: it is failing to provide the contractual mechanisms and the financial-market regulation small firms need to prosper and grow. Moreover, in enacting the oppressive entry regulations, the government may be a tool of big business.

The underground economy brings good news and bad news. Underground markets allow billions of the world’s poorest people to get by. But the lack of supporting institutions means that underground markets are handicapped. Enabling growth out of poverty entails shifting these markets above ground, which means changing the rules of the game. Given the powerful interests involved, that will not be easy to do.