Fighting the man

An interesting paper by Rafael La Porta and Andrei Shleifer presented at Brookings this past week explores the connection between activities in the informal economy and economic development. 

Tyler Cowen agrees with the authors that the the registration and growth of official firms is needed to drive economic growth in the developing world. 

The evidence points to the dual view, with the fairly standard implication that the hope of economic development lies in the creation of large registered firms, run by educated managers and utilizing modern practices, including modern technology, marketing, and finance.

This seems pretty obvious in an ideal world where the governments are strong enough to enforce patent protections and thus maintain the level of quality necessary to ensure functioning markets. Obviously, transparency and registration would be ideal, but growth does not advance the way the textbooks predict and the authors fall prey to offering prescriptions that ignore the reality of too many developing countries. Capital flight, both human and monetary, is an all too real phenomenon in many developing countries and the high political risk often dampens the climate for FDI. 

The other problem with their analysis is that they ignore the fact that most elites in developing countries have earned their wealth by staying in bed with ruling politicians. As such, they have little interest in promoting the rule of law necessary to entrench the regulation necessary for the development of large firms. While it is true that the informal economy propagates a shadow regulatory structure (either as organized crime or a corrupt bureaucracy) required to ensure protection and continuation, the alternative of modern practice cannot be developed or sustained until education levels (and equivalent salaries) keep local talent. 

In the meantime, the informal economy keeps people fed and housed. It's a cycle that development professionals have been trying to crack for 50 years. Let's hope future prescriptions don't ignore the political and cultural constraints that economies actually face.