Despite new ways of paying for things, cash isn’t going away. It has an important place in today’s economy, particularly the most dynamic part of it – unreported income that makes up an underground economy.
No matter how hard times get, people have to make a living. As regular nine-to-five jobs become more difficult to find people turn to making money where they can – and a lot of it is in cash.
“We have seen the rise of a new generation of people who are much more used to doing things in a freelance way,” says Sudhir Venkatesh, a sociologist at Columbia and the author of a study of the underground economy. “That makes them more amenable to unregulated work. And they seem less concerned about security, which they equate with rigidity.”
The term “underground economy” brings to mind illegal activity such as drug dealing or prostitution. But that’s only a tiny fraction of it the money that changes hands in cold, hard cash. Millions of people earn their money from tips, house cleaning, light construction, and other gigs called “legal source unreported income.”
This economy relies on cash. To many people the only real money is green on one side and plastered with dead presidents on the other. That’s the stuff that is supposed to be going away in an era of plastic, PayPal, and bitcoin. There’s only one problem, however – it’s not working out that way. The analysis of the underground economy starts with an understanding of how much cash is out there and how it circulates.
Follow the money
It’s been reported that as much as 2/3 of the $1 trillion in paper money is estimated to be circulating abroad. Apparently, that’s not even close. A study by University of Wisconsin economist and professor emeritus Edgar Feige, along with the Federal Reserve of New York, reports that a solid 3/4 of that, or about $770 billion is here at home. That comes out to average $2,200 in cash, per person. Why do we need all that money in greenbacks?
The answer is that it is the fuel of a $2 trillion underground economy. That figure comes from a separate study by Feiger, who is has devoted his more than 50 year career to following cash in the economy.
This estimate was calculated by looking at aggregate cash flows through banks and comparing it to more detailed studies over the years to develop a time series of unreported income. The increase in “unbanked,” or purely cash households, suggests that the $2 trillion is a low estimate.
That estimate continues to increase as shown in this graph taken from the report. It looks at two estimates of the total income taken with two different in-depth studies as starting points, but arrives at a similar conclusion. The total income in the United States is 22-24% higher than what is reported today, and growing.
“You normally see underground economies in places like Brazil or in southern Europe,” said Laura Gonzalez, professor of personal finance at Fordham University. “But with the job situation and the uncertainty in the economy, it’s not all that surprising to have it growing here in the United States.”
The report is only an estimate based on the best information available.
The recent increase in “unbanked,” or purely cash households that are completely off of the reporting grid, suggests that the $2 trillion may be low.
What makes up this underground economy? The study shows that it’s around 13% of Gross Domestic Product (GDP), but very little of that is inherently illegal activity. At least 92% of it, by the study, is unreported income from otherwise legal sources. It’s money that is earned by ordinary work but simply not reported as income.
This unreported income means that as much as $500 billion per year in tax revenue is lost by a lack of compliance. The report by Feige credits this large amount to a number of things.
“Federal income tax evasion is an increasing function of the average effective federal income tax rate, the percentage unemployment rate of the civilian labor force, per capita real GDP, and the public’s dissatisfaction with government,” the report concludes.
“It’s typical that during recessions people work on the side while collecting unemployment,” said Bernard Baumohl, an economist at the Economic Outlook Group. “But the severity of the recession and the profound weakness of this recovery may mean that a lot more people have entered the underground economy, and have had to stay there longer.”
More (cash) money, more problems
While the underground economy is primarily the poor simply finding a way to get by, there are macro-economic implications for this large and growing way of doing business.
The underground economy is fueled by the $770 billion in cash turning over through the $2,000 billion estimated overall size. The purely cash economy turns over nearly three times a year on average by a simple ratio. Economists call this turnover the “velocity” of money. If all the cash in the economy isn’t part of the underground economy, that figure is even higher than 3. Anyone paid bi-weekly and lives paycheck to paycheck will have a personal velocity around 26 every year.
One of the features of the current economy has been the rate at which money turns over. Overall, it’s about 1.4 times per year, down from over 2.0 during the boom times of the 1990s. But we can estimate that the velocity in the underground economy is at least double that in the economy as a whole.
That means that the velocity of money is strong function of how much you have, just as it shapes your opinion of what money is. And that is why inequity ultimately hinders growth – because the more money the poor have, the faster the economy as a whole turns over.
Sustainable growth comes, at least in part, from a decent turnover of cash in the economy. That happens easily and more often amongst the poor. Furthermore, how the poor are doing has a lot to do with economic growth because of their much higher contribution to velocity. Income equality is important to a growing economy beyond issues of fairness.
The underground economy of unreported income is thriving as people struggle to get by. It is important not just for its sheer size or the tax revenue that is missed as more people rely on cash to get by. Its growth shows how money, in the hands of those with the least of it, is critical to a dynamic and growing economy.
It also shows that no matter how hard times are, people will find a way to survive.