RDP 2018-12: Where's the Money? An Investigation into the Whereabouts and Uses of Australian Banknotes 5. The Shadow Economy

A source of currency demand that continues to attract considerable attention in Australia and internationally is the use of cash to facilitate illicit activities in the ‘shadow’ or ‘black’ economy.

Borrowing from ABS (2013) we define the shadow economy as consisting of:

• underground production (deliberate concealment of legal activities to avoid tax payments); and
• illegal production (activities forbidden by law where there is mutual consent, such as illegal drug production and sale).

The System of National Accounts 2008 also includes informal production (the production of goods or services with the primary objective of generating employment and incomes to the persons concerned), household production for own final use (includes production of crops, livestock, construction of own houses, imputed rents, and domestic services) and the statistical underground (production missed by statistical agencies due to deficiencies in data collection) as part of the non-observed economy. But according to ABS (2013), informal production is not believed to be material in Australia, while the latter two categories are unlikely to involve cash transactions and are not considered here.

To estimate the stock of cash used in the shadow economy we must first have an idea about the size of the shadow economy. By its very nature, the shadow economy is difficult to measure. To ensure that our results are as robust as possible we use multiple sources to estimate its overall size, including data from the ABS, the Black Economy Taskforce (BETF), and the Australian Criminal Intelligence Commission (ACIC). We assume that the only material component of illegal production is illegal drug production; this may downwardly bias our estimates slightly, although illegal drug production is likely to be the largest component of total illegal production by some margin (the ABS also took this approach when estimating illegal production in 2009/10).

5.1 ABS Estimates for 2009/10 Applied to 2017/18 GDP Figures

In 2013, the ABS estimated the size of the shadow economy for 2009/10. In particular, underground production was estimated to be 1.5 per cent of nominal GDP in 2009/10, while household final consumption expenditure (HFCE) on illegal drugs was estimated to be 0.8 per cent of total HFCE in 2009/10. Nominal GDP in 2017/18 was $1,848 billion, while HFCE in 2017/18 was $1,044 billion; applying the same 1.5 and 0.8 per cent estimates as for 2009/10 implies annual underground production of $27½ billion and annual nominal spending on illegal drugs of $8½ billion. We will make the assumption that all these transactions are conducted using cash, although in practice it is likely that a growing share are electronic.

To approximate the quantity of cash required to facilitate shadow economy activities, we have to take into account that a single banknote can make multiple payments. To do so we divide total spending by the estimated average number of times the stock of cash is used in a period, that is, velocity. In Section 4.4 we compiled data from the cash cycle to estimate the monthly velocity of the domestically sourced transactional stock of cash. The input variables included data from ATM operators, banks and cash depots. It seems reasonable to assume that when a user sources cash to purchase illicit drugs or pay for underground production, they do so in much the same way as when they source cash for other reasons. Accordingly, we use our previous estimates of velocity as an approximation of the velocity of cash used in the shadow economy. These estimates imply that $2½ billion of cash, or around 3 per cent of the value of banknotes on issue, is used to facilitate underground production, and that a little less than $1 billion of cash, or just under 1 per cent of the value of banknotes on issue, is used to facilitate illegal production and purchase illicit drugs. That is, we estimate the stock of cash used to facilitate shadow economy transactions to be around $3½ billion, or 4 per cent of banknotes on issue.

5.2 Black Economy Taskforce Estimates

Building on the work of the ABS, the BETF recently provided partial estimates of the size of the shadow economy.^[16] Their assessment was that the size of the shadow economy is up to 50 per cent larger than that suggested by the ABS estimates, with the difference in part explained by the BETF including a wider range of shadow economy activities in their analysis (some of which are unlikely to involve material amounts of cash).

Boosting the estimates from Section 5.1 by 50 per cent suggests underground production of around $41½ billion in 2017/18 and illegal production of roughly $12½ billion. Once again, if we assume that all of these transactions were made with cash (likely incorrect) and adjust for the velocity of cash, this implies that around $5 billion of cash, or around 7 per cent of the value of banknotes on issue, is used to facilitate shadow economy activities, with three-quarters used in underground production and one-quarter in illegal production.

5.3 New Estimates of Cash Used in the Drug Trade

5.3.1 Estimates of cash used to purchase illicit drugs

Here we estimate spending on illicit drugs via wastewater analysis. Wastewater analysis is a standard method used to measure drug consumption. The method is based on ‘the principle that any given compound that is consumed … will subsequently be excreted’ (ACIC 2018b, p 17) and end up in the sewer system. Calculating the amount of a given compound in wastewater allows for a back calculation factor to be applied to determine the amount of drug that was used by the population connected to the wastewater. National estimates of annual drug consumption are then made by scaling the results to population levels.

ACIC, in conjunction with the University of Queensland and the University of South Australia, performs wastewater analysis at more than 40 sites across Australia each year, covering approximately 50 per cent of the Australian population (ACIC 2018b). Based on the wastewater analysis, the ACIC estimates the national consumption of all economically significant illicit drugs, with the exception of cannabis (left panel of Figure 16; the metabolites of cannabis are more difficult to analyse).

Excluding cannabis, methamphetamine (also known as meth or ice) is the most used illicit drug in Australia by weight, followed by cocaine, MDMA (also known as ecstasy), and then heroin. To estimate cannabis consumption, we use the 2016 Australian Institute of Health and Welfare National Drug Strategy Household Survey (AIHW 2017) to scale estimates made by ABS (2013) (right panel of Figure 16). In particular, we update the estimated number of cannabis users from the ABS study, but assume that the average amount of cannabis consumed per day by a cannabis user has remained unchanged.

To estimate the value of cash used to pay for these drugs, we first assume that all purchases of illicit drugs are made with banknotes. Although this may not be exactly true, it is probably a reasonable approximation: drug users and dealers are unlikely to use conventional electronic payment methods for fear of leaving a traceable record; purchases made with coins are likely to represent a small fraction of total expenditure; and while anecdotal reports suggest that an increasing number of illicit drug purchases are made online using digital currencies such as bitcoin, survey results from the National Drug and Alcohol Research Centre's (NDARC) Illicit Drug Reporting System (Karlsson and Burns 2017) suggest that most drug users still purchase their drugs face to face. Next, we account for the fact that drugs are typically sold at less than 100 per cent purity; to do this, we boost the volumes given in Figure 16 by dividing by average purity levels published by ACIC.^[17] This gives us the estimated quantity of ‘cut’ (as opposed to ‘pure’) drugs consumed. Finally, we multiply these boosted values by estimates of the street value of the drugs as provided by ACIC (2018a) (Figure 17).^[18] These estimates suggest that illicit drug expenditure for the year ending August 2017 was roughly $13½ billion, which exceeds that estimated by BETF (2017) and that implied by scaling the ABS (2013) estimate by growth in nominal HFCE. Based on these estimates, methamphetamine and cannabis account for more than 70 per cent of total drug expenditure in Australia.

Dividing illicit drug expenditure by cash velocity suggests that for the year ending August 2017, the stock of cash used to facilitate purchases of illicit drugs was a little over $1 billion, or almost 2 per cent of the total value of banknotes on issue.

5.3.2 Estimates of cash held by drug suppliers

Evidence from Australian Federal Police drug raids suggests that suppliers of illicit drugs often hold large volumes of cash. To estimate the total of such cash held by drug dealers, we combine our previous estimates of the illicit drug market with data released by the AFP and the ACIC detailing annual cash and drug seizure quantities (ACIC 2017). By comparing the value of cash seized with the value of illicit drugs confiscated, we can estimate how much cash the average drug supplier holds relative to their illicit drug stock. By scaling this number, we obtain economy-wide estimates of the hoarded cash stock, although we note that our estimate is only reliable if those who have drugs and cash seized by the AFP are representative of all those involved in the illicit drug supply chain.

To derive this estimate, we need to make a series of assumptions about the supply chain of illicit drugs; given the inherent uncertainty of this, we frame assumptions in terms of ranges, and compute a final lower and upper bound based on these ranges.

• We assume that each point in the drug supply chain holds between one and four months' worth of inventory. While we have no data to support this assumption, and small dealers are likely to hold significantly less, we believe it is a reasonable range of the holdings of large-scale producers and wholesalers.
• We assume that the illicit drug supply chain contains between two and four layers, with each layer holding a similar ratio of cash to drugs.
• We assume that the ratio of total attempted drug supply to total drug consumption is between 1 and 3 times (that is, for every gram of drug consumed, up to 2 grams of the same drug is lost or seized by police). Accounting for ‘spoilage’ is necessary as a significant portion of illicit drugs are removed from the supply chain prior to consumption. For example, the ACIC estimates that in 2016/17 the total weight of cocaine seized exceeded annual national consumption, while the total weight of MDMA seized was roughly equal to annual national consumption.

Data from cash and drug seizures suggest that drug suppliers maintain cash holdings of around 2 per cent of the value of their stock of drugs, on average.^[19] By comparison, the same data suggest that the proceeds of crime (that is, all assets gained through crime, not just cash) equate to approximately 11 per cent of the value of the stock of drugs held. This implies that criminals convert a large share of their cash profits into other assets: they do not solely hoard cash. Combining this with our earlier assumptions suggests that total cash hoarding by the illicit drug supply chain is in the range of $40 million to $1 billion, or somewhere between 0 and 1 per cent of all banknotes on issue.

5.4 Overall Assessment and International Comparison

Our estimates suggest that between roughly $3½ and $6 billion worth of Australian banknotes are used in the shadow economy, split between underground production ($2½–4 billion), purchases of illegal drugs (around $1 billion), and storing the profits of criminal activity (up to $1 billion). This represents between 4 and 8 per cent of all banknotes on issue, with the midpoint of the non-hoarded ‘transactional’ portion equating to around 5 per cent of banknotes on issue.

There exists a branch of literature which estimates shadow economy cash demand by assuming that all growth in outstanding banknotes, from some initial date and above some baseline growth rate (perhaps accounting for population growth and inflation, for example), is driven by shadow economy activity; see, for example, Pickhardt and Sardà (2012) and the references therein for a thorough overview. We do not pursue these techniques, however, as the assumptions needed to generate results seem overly strong (studies often assume, for example, that no legitimate cash hoarding exists, whereas we believe that legal cash hoarding likely accounts for much of the outstanding stock of banknotes).

More broadly, estimates exist for many countries on the size of their shadow economies, and these estimates are likely to be reasonable indicators of the stock of cash used in shadow economy activity. Notably, in 2012 the OECD asked a range of countries to estimate the size of their shadow economy using a set of guidelines (see OECD et al (2002) and Gyomai and van de Ven (2014)). Although Australia was not included in the study, the ABS followed the same guidelines in ABS (2013). As a share of GDP, the Australian shadow economy estimate was similar to that for Canada, the Netherlands and the United Kingdom, which were all between roughly 1 and 3 per cent of GDP; this was below Sweden, Belgium and France for example (roughly 3 to 6 per cent of GDP), and far below Italy (18 per cent of GDP). Some studies estimate much larger shadow economies, in the order of 15 per cent of GDP for Australia (e.g. Schneider, Buehn and Montenegro 2010; Medina and Schneider 2018); we do not have the expertise to comment on the accuracy of these studies, but refer the interested reader to the annex of Gyomai and van de Ven (2014) for a critique of the methods employed, and also note the ABS's assessment that ‘estimates of the order of 15% of GDP for the underground economy are implausible’ (ABS 2013).

Regarding the denomination of banknotes used in illegal activities, although there is no hard data, law enforcement agencies have suggested that $50 banknotes seem to dominate. This is anecdotally supported by images of cash seizures released by police, which typically show bundles of $50 banknotes as the predominant denomination, together with lesser amounts of $20 and $100 banknotes.

Footnotes

The BETF used the ABS estimates discussed above as a benchmark, but updated results where additional or enhanced information had since become available. [16]

In particular, we use median purity as reported by the NSW state police. [17]

Street values listed by ACIC often have quite large ranges; we use the midpoint of the price per gram listed for Victoria, NSW and Queensland (with the exception of cocaine, where we ignore the Queensland value as it appears to be an error). We have crosschecked these prices against those published by NDARC in the Illicit Drug Reporting System, and they are similar. [18]

In particular, over the five years to 2016/17, the ACIC reports total drug seizures worth $6.1 billion and total cash seizures of $100 million (ACIC 2017). [19]