Cash, Hoarding and the Underground Economy by Michael Pickhardt and Jordi Sardà

Estimates of the size and scope of underground economies3 are often carried out by using a so-called ‘monetary method’. A central assumption of all monetary methods rests on the assertion that everyone involved in underground economic activities has a strong preference to conceal these activities and, therefore, prefers to use cash (currency) in all underground economy transactions. Hence, ceteris paribus the demand for cash should be higher the larger the size of the cash using underground economy.
This idea was pioneered by Cagan (1958) and later Gutmann (1977), Feige (1979, 1989), Tanzi (1980, 1982, 1983), Klovland (1980, 1984), Bhattacharyya (1990), Escobedo and Mauleón (1991) and others developed variants of the monetary method. More recently, however, Breusch (2005a,b) and Ahumada et al. (2007, 2008) have shown that many of the estimates using either the Tanzi or Klovland method suffer from serious econometrical or mathematical shortcomings. Therefore, results obtained from these methods may provide misleading information to policy and law makers. Pickhardt and Sardà (2011, 2012) have made a first attempt to address these issues by developing the Modified-Cash-Deposits-Ratio (MCDR) approach, which they have applied to Germany and Spain, respectively. Moreover, Berger et. al (2012) have applied the approach to Greece.
The purpose of the present paper is to further refine the MCDR approach by incorporating cash hoarding and to discuss in some detail implications of the MCDR approach with a view to identify possible applications and limitations. The remainder of this paper is organized as follows. In the next section we briefly review essential aspects of the MCDR approach and
3 Here we use the term „underground economy” interchangeable with terms such as shadow economy, hidden economy, black economy, etc. (see also Kazemier 2006; Pickhardt and Sardà 2011).

discuss relevant assumptions. In section three we extend the MCDR approach by incorporating estimates of hoarded currency. The final section concludes.

2 The MCDR Approach
In this section we briefly reconsider essential aspects of the MCDR approach. In particular, we first deal with the theoretical and econometrical background and then discuss the underlying implications and assumptions of the approach in some detail.

2.1 Motivation and Background
As noted, the MCDR approach was primarily developed with a view to avoid econometrical and mathematical problems that were discovered some years ago with respect to the popular monetary approaches of Tanzi (1980, 1982, 1983) and Klovland (1980, 1984). Additional motivations were related to: (i) the possible inclusion of cash using illicit economic activities not caused by tax pressure, (ii) simplifying plausibility testing and, (iii) raising the level of transparency (see Pickhardt and Sardà 2011, 2012).
Essentially, the MCDR approach follows a ‘back-to-the-roots path’ by first going back to the pure calculation method of Peter M. Gutmann (1977). Among other things, Gutmann’s approach rests on the assumption that over time agents in the legal economy wish to maintain a constant ratio  of currency to sight deposits.4 Unfortunately, however, for many industrialized countries this assumption does not seem to hold as the growth rates of sight deposits substantially exceeded those of cash or currency during the last decades. As a consequence, the original Gutmann approach may lead to a negative size of the underground economy, which does not seem to be plausible. Pickhardt and Sardà (2011, 149-150), therefore, replace the aforementioned assumption by the equally strong assumption that “all … http://www.bundesbank.de/download/vfz/konferenzen/20120227_29_eltville/01_pickhardt.pdf

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