A bilateral monopsony approach to lending, and the hidden economy in LDCs

Under developing-economy circumstances of small and mainly informal firms and a few official corporate conglomerates, an investigation of the developmental role of banking in such economies might be pursued analytically within the context of a bilateral monopsony for loans. Assuming away wage differences and trade between formal and informal sectors, a model is presented in which one firm borrows from one bank with a positive supply curve of loans. The bank monitors firm’s output, which firm produces output underground too, in order to avoid this monitoring and minimize its marginal expenditure on loans by defaulting. The model incorporates also a laborer-consumer who allocates labor between the formal and informal sectors in a way preserving full employment. In this model, the following results obtain: There cannot be underground only economy even in the absence of government national-accounting induced output monitoring once part at least of the output has to be monitored by the bank. The capital employed officially is always more than that underground. Bank monopoly power induces lexicographic preferences towards underground economy income. The stability of the system depends on the relative size of the official to total capital ratio and the response of loan demand to the interest rate. The introduction of government and indirect taxation alter the optimal official to total capital ratio. Yet, the steady-state and stability of the system remain unchanged under a tax financed balanced budget. Government borrowing by a rent-seeking government or to cope with tax-evasion induced budget deficits lowers lending to the firm and leads thereby the system to equilibrium away from steady-state; but tax evasion increases such lending towards steady-state restoration. It is clear that the approach to development leading to these conclusions focuses not on development per se but on how it is shaped based on overt and covert resources and capabilities financed by concentrated banking. The mentality underlying such an approach abides by Hirschman’s (1965) view of development rather than macroeconomic growth. Policy-wise, international trade and foreign direct investment should be encouraging the official economy at the expense of the unofficial one. Also, government borrowing from abroad is expected to be sooner or later recessionary if the money is not channeled to public investment. Special attention should be paid to the design of trade liberalization towards (i) the implementation of non-inflationary government finance means compensating for the subsequent loss of tariffs, and (ii) discouraging the profit shifting by multinationals abroad.