POLICY ILLUSION, MACROECONOMIC INSTABILITY AND THE UNRECORDED ECONOMY

During the decade of the 1970’s the US economy unexpectedly suffered from “stagflation” namely, high unemployment, slowed economic growth and high rates of inflation. During the 1980’s the major macroeconomic problem became high interest rates and massive government deficits. Macroeconomists employed ad hoc supply shocks, rational expectations and natural rate of unemployment theories in an effort to account for these anomalous observed economic events. Our paper puts forth an alternative explanation of these events, namely that they were at least partially the result of the growth of the underground economy during this period. The macroeconomic model developed in the paper demonstrates that when monetary policy is committed to a full employment target, growth of the underground economy will give rise to a continuous stagflation which can only be abetted by the monetary authority shifting to a price stability target. Such a shift took place in October 1979 when the Federal Reserve adopted a price stability target and the fiscal authorities assumed the burden of counter cyclical policy. We show that in the presence of an unrecorded economy, such a policy shift will lead to high interest rates and increasing government deficits. In short, the paper demonstrates how the mere illusion of economic malaise can be translated into the reality of economic chaos. Reference: The Underground Economies: Tax Evasion and Information Distortion. Edgar L. Feige (ed.) Cambridge University Press, 1989.