Friday, May 30, 2014

Europe Mandates Inclusion of Illegal Activities in GDP Calculations

It has often been said that truth is stranger than fiction and so it is with European GDP calculations. In an attempt to standardize GDP calculations across EU member nations, which is logical, Europe is absurdly mandating that countries include illegal activity in their GDP calculations. Despite decades of closer social and economic ties, there remains diversity in laws across European Union members relating to the sale and use of narcotics and prostitution. The rational for the inclusion of such activities where illegal has been to harmonize the calculations with those nations where the activity is indeed legal. However, the underlying facts are a little more sinister. The 2010 version of the European System of National and Regional Accounts (ESA) is a document of more than 600 pages that dictates the methods by which member nations should calculate economic activity. It states that “Illegal economic actions shall be considered as transactions when all units involved enter the actions by mutual agreement. Thus, purchases, sales or barters of illegal drugs or stolen property are transactions, while theft is not.” In short, any illegal activity should be included in GDP so long as the transaction is mutual agreed upon by the parties involved. Beginning later this year, all EU members will be required to include illegal activity in GDP calculations. Some already do so to varying degrees.

The problems associated with this methodology are numerous and, generally speaking, obvious. By definition, those that are trafficking in illegal economic activities do so in an inconspicuous manner to avoid detection by authorities. This would seem to make measurement of such activity highly inaccurate relative to the measurement of legal activity, which judging by the size and consistency of revisions is fraught with inaccuracy. Indeed, assumptions about the number and size of these transactions vary significantly across nations currently including them in GDP. Apparently the EU is mandating inclusion of illegal activity but has yet to provide guidelines as to the appropriate methodology for calculations.

Not only accurately estimating the size of illegal activity impossible, but this will surely lead to double counting in instances in which perpetrators of such activity are caught and fined. The ESA states that “The payment of taxes, fines, and penalties are by mutual agreement, in that the payer is a citizen subject to the law of the land.” How does one justify estimating the size of a drug lord’s narcotics transactions, including them in GDP,  and then arresting, jailing, and fining him after he is caught? How can you count the fines and penalties levied on the dealer as part of GDP while also counting the revenue from the illegal business for which he has been fined?

Yet the really insidious part of this may lie in the fact that, if not a clear attempt at budgetary chicanery, its  nearly certain to become one. Bloomberg suggests that adding underground economic activity would increase Italian GDP by 2%. This would likely drop the nation’s deficit below the 3% statutory limit in the Maastricht Treaty and result in a primary surplus (i.e. a surplus prior to the payment of interest on government debt). By artificially raising GDP, it would automatically lower the nation’s debt to GDP ratio. By raising Italian GDP, the inclusion of illegal activity allow the Italian government to either spend more while maintaining current fiscal ratios or spend the same amount and claim progress in lowering them. It’s very hard to believe that governments won’t use this phantom increase in GDP to loosen their purse strings given the austerity fatigue that has beset their citizens. Regardless, since illicit activity cannot be taxed, their will be no increase in revenue associated with the supposed increase in economic activity. In short, the economy will increase with no associated revenue increase for the government.

While this change impacts the entire EU, its another indication of the challenge facing the monetary union, which only includes those EU members using the Euro as their currency. A monetary union among economically disparate nations will always be unstable in the absence of fiscal union. At best, the inclusion of illegal activities in GDP is an illogical attempt to capture  a broader understanding of economic activity. At worst, its another ill-fated attempt to systemize economic data across disparate economies while avoiding the Elephant in the room, i.e. the need for fiscal union. In the absence of fiscal union, which will likely require Eurozone nations to become states in a federalized Europe, the monetary union will remain unstable. Yet fiscal union is nowhere on the horizon. As such, rather than being dead, the European debt crisis is simply in hibernation.