The term underground economy refers to economic activities that circumvent the formal system of rules and regulations that organize the processes of production and exchange. Underground economies are classified depending on either the particular set of rules that such activities violate or the nature of production, distribution, and the final product.

Within the first classification, four types of underground economies can be distinguished: the illegal economy, the unreported economy, the unrecorded economy, and the informal economy. Illegal economy refers to the production and exchange of prohibited goods and services, such as drugs or the sex trade. Unreported economy denotes activities that evade tax laws. The unrecorded economy consists of all activities that, under existing rules and regulations, should be recorded in national accounting systems (national income and product accounts) but are not. Finally, the informal economy comprises economic activities that circumvent the administrative rules covering property relationships, commercial licensing, labor contracts, social security systems, and so forth.

Within the second classification, the underground economy consists of "informal" economic activities carried out through illicit means of production and distribution but leading to a licit final product (e.g., a textile firm producing T-shirts and jeans by using informal labor) and "criminal" economic activities, carried out by either licit or illicit means (usually the latter) but necessarily leading to an illicit final product (e.g., drug trafficking).

Because activities in an underground economy defy the law in one way or another, they do not easily lend themselves to observation, so any attempt to study, measure, and classify them remains fraught with problems. The measurement problem becomes even more pronounced when attempting to make cross-national comparisons. Because nations differ in political, legal, and economic structures, nations' underground economies are organized differently and are composed of different activities; all of these factors pose a comparability problem for the researcher.

Despite these problems, scholars capture underground economies' composition, size, and growth rates by one of three methods: the survey approach (also known as direct micro observation methods), the discrepancy approach (also known as the indirect macroeconomic methods), and the qualitative approach. Each of these methods has different strengths and weaknesses.

Direct micro observation approaches involve amassing data on underground activities through conducting surveys, auditing tax returns, or reviewing census reports. Although these methods yield detailed and firsthand information about the underground economy, they have several weaknesses. First of all, they lead to point estimates and fail to capture the big picture, giving little information about the underground economy and its historical development at large. Second, these methods remain costly and time consuming. Third, the lack of uniformity between surveys conducted at different points in time often makes it impossible to draw comparisons, thus decreasing their usefulness in uncovering temporal causes and consequences of underground economic growth. Moreover, because parts of these activities are illegal, survey response rates often remain low, leading to the problem of biased sampling.

Economists generally use indirect macroeconomic methods, also known as discrepancy approaches, to measure the underground economy's size and development over time and across nations. These methods follow the traces that the underground economy leaves behind in the labor, money, and product markets.

The difference between spending and savings accounts, the dissonance between official labor participation rates and the general growth trend, or the amount of currency in circulation above and beyond what is used in official transactions form the indicators of the underground economy. Among the macro approaches' explicit benefits are their low costs, their objectivity (i.e., their insusceptibility to deliberate misrepresentation on the part of respondents), and their ability to provide temporal estimates of the size and growth of underground economic activities. On the downside, these methods do not provide information on the underground economies' inner mechanisms, and because they are based on some a priori assumptions regarding the relationship between macroeconomic indicators (such as labor market or monetary market measures) and underground economic activity, their robustness depends on the reasonableness of the assumptions that underlie them.

The third major method, the qualitative approach, is preferred by anthropologists or ethnographically oriented sociologists interested in uncovering the mechanisms and the norms of exchange, trust, social capital, and reciprocal relations that underlie the underground economy. It entails assembling information on underground economic activities through ethnographic research and participant observation. Like the micro observation methods, the qualitative approach yields detailed information about the underground economy but fails to capture its overall trends.

References:

1) De Soto, Hernando. 1989. The Other Path: The Invisible Revolution in the Third World. New York: Harper & Row.

2) Feige, L. Edgar. 1990. "Defining and Estimating Underground and Informal Economies: The New Institutional Economics Approach." World Development 18(7):989-1002.

3) Portes, Alejandro, Manuel Castells, and Lauren A. Benton, eds. 1989. The Informal Economy: Studies in Advanced and Less Developed Countries. Baltimore: Johns Hopkins University Press.

4) Schneider, Friedrich and D. H. Enste. 2000. "Shadow Economies: Sizes, Causes and Consequences." Journal of Economic Literature 38(1):77-114.

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