Events at CERGE-EI

Prof. Dilip Bhattacharyya

University of Leicester, United Kingdom

Author: Dilip K. Bhattacharyya

Summary: Businesses always use the available information and different types of signals to plan and operate their business activities.  The success of the business thus relies on the utilisation of the information and (or) signals in the correct form and at the correct time. In this paper we argue that the principles and procedures applied by businesses are equally applicable to the government and other regulatory bodies who steer the economy.  We assume that the primary aim of the government and other regulatory bodies is to keep the economy free from extreme turbulence. In this paper we argue that the government and the regulatory bodies either failed or ignored the signals in the ‘hidden economy’ estimates presented by a number of researchers. The analysis in this paper is primarily based on the estimates presented in Bhattacharyya (1990, 1996 & 2005) and consequently in relation to the U.K. economy. We argue that a judicious use of the ‘hidden economy’ estimates would have given the government a measure of the imbalance that has been created by the banks and other financial institutions in recent years. It is clear from the evidence we presented here that a crisis was clearly visible as early as the 1990s.

     The empirical results presented here are based on the ‘hidden economy’ (HD) estimates published in Bhattacharyya (1996 & 2005). The estimates of HD presented in Bhattacharyya and also by other researchers are interpreted as the unrecorded national income. In the existing literature the components of the HD are: (i) tax evaded income and (ii) the income generated by other informal activities. Here we considered that another component of HD is lending by banks and other financial institutions without the traditional collateral. Our maintained hypothesis is that these types of lending started only after the Reagan-Thatcher deregulation became operative. Hence, any year to year increases of HD after 1984 were due to the ‘sub-prime’ lending of banks and other financial institutions. This assumption is supported by the data and discussed in detail in the paper. For the purpose of our calculations we assumed that after 1984’s third quarter, the changes in HD were primarily due to the lending of the banks.

     Following this assumption we estimated the size of the banks’ lending on 1984-3qtr was 0.21 billions pound sterling. In 1990:4 this figure rose to £5.74 billions and the cumulative figure for 1984:4 to 1990:4 was £64.76 billions. In the paper, auxiliary and plausibility tests are conducted to support these estimates. Thus the size of the cumulative risky debt at 1990:4 was nearly 50% of the GDP. Even considering that 50% of the debt was paid off, the outstanding risky debt was still 25% of the GDP in 1990:4. The average growth rate of the risky debt during 1985:1 to 1990:4 was 13.1. Hence, even a very conservative projection of the cumulative sum of risky debt for the period 1996:1 to 2000:4 was £528.4 billions, where we assume the growth rate of the risky debt was 5%. If we consider the cumulative risky debt for the period 1985:1 to 2000:4 the figure is nearer £1000.00 billions. This is a great imbalance in the economy, and actions by the regulatory authorities were necessary to avoid the crisis we are facing now. The crisis could have been predicted if the proper authorities had cared to examine the findings of the research conducted on the HD.

The analysis presented here only relates to the UK. When we take into account the USA and other countries as well, the total risky debt will be considerably higher.             

Full Text: “Predicting 2008 Financial Crisis from the Hidden Economy Estimates”