From the Second to the Informal Economy

Author(s): Endre Sik

Source: Journal of Public Policy, Vol. 12, No. 2 (Apr. - Jun., 1992), pp. 153-175
Published by: Cambridge University Press
Stable URL: http://www.jstor.org/stable/4007506
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Jnl Publ. Pol., 12, 2, I53-I75

From the Second to the Informal Economy*

E N D R E S I K Sociologist, Budapest University of Economics

ABSTRACT

This paper addresses two related questions: How has the transformation
from a centrally planned to a market economy affected the second
economy and how has the second economy influenced the transforma-
tion? The existence of a second economy compensating for some faults of
the planned economy has been a contributing factor in the non-violent
transformation of the Hungarian economy. Transformation is making
the concepts of a first and second economy obsolete. The informal
economy, which is replacing the second economy, differs from the latter
in its degree of internalization, and in relying upon fulltime rather than
part-time work. It is also increasing in size. The social impact of the
informal economy is also different, increasing income inequality and
regional disparities, thus replacing the gradations of social differences
found in the multi-coloured activities of the second economy with
sharper black and white differences. The analysis is illustrated with data
from Hungary before and after the transformation.

The purpose of this paper is to present a model of changes in the inter

action of the first and second economy in a centrally planned economy as
a consequence of the short-term impact of its transformation (cf. Stark,
1992) into a market economy. The model emphasizes the necessary first
steps in understanding, a specification of concepts that describe the
essential actors and the most crucial processes and relationships. Ques-
tions of measurement and empirical testing are especially difficult when
one is dealing with 'shadow' economies in Eastern Europe.
The macrostructure of the model is very simple. There are two
segments of the economy: the first and the second economy in the rational
redistributive economy (Szelenyi, 1978), and the formal and informal
economy in the market economy (Polanyi, I957). On this level of analysis
two ideal-types are to be compared i.e. communism and capitalism. The

* The first and lengthier version of this working paper was the basis of a seminar at the Centre for
European Studies at the Harvard University. I owe many thanks for their comments to Istvan
Gabor, Peter Galasi, Mityais J. Kovics, Mihaily Laki and Anna Seleny.

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I ,4 Endre Sik

focus is on system-specific differences in the social organization of the

economy as such, and on the regulatory performance of the state in
response.
The analysis is addressed to behaviour at the microlevel, where the
units of analysis are transactions and actors engaged in them such as
households and firms. State authorities on this level are on the one hand
personified by their cadres: on the other hand, as organizations; they are
also involved as actors with their own interests. The time-span of the
model is short term. It begins just before the collapse of the communist
regime in Hungary and ends in the near future. The basic assumptions
with regard to the behaviour of the actors are close to those of the
transactions cost approach (Williamson, I973) and of structural socio-
logy (Wellman and Berkowitz, I988), i.e. bounded rationality, opportun-
ism and network-based strategies.
The two questions posed by this model are: How did the transforma-
tion influence the second economy? How did the second economy
influence the transformation? The answers can be stated in the form of
five hypotheses.

i. In the course of transformation, the term first economy became

meaningless; this has also rendered meaningless talk about the
second economy. We must change our vocabulary and now speak
of the informal economy in order to describe the macrolevel
changes in the course of transformation.
2. Compared to the volume of activity in the former second economy,
the size of the informal economy has increased and will most prob-
ably increase further in the near future. The rate of increase has
been different in the various transactions of the second-to-informal
economy.
3. Although the informal economy has retained several similarities
with the second economy, it has two relevant new features: i) the
internalization of the transactions; ii) the spread of full-time activi-
ties at the expense of part-time ones.
4. The informal economy produces radically different social impacts
on the distribution of income and on geographical inequality than
the second economy, as new types of transactions emerge and
operating conditions change. Whereas the second economy tended
only insignificantly to increase income inequality and to even out
regional disparities, the informal economy seems to widen both.
Due to the growing differences among households and the changing
institutional structure of the second-to-informal economy, there is a
shift in households' economic behaviour. While the second

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 From the Second to the Informal Economy I55

economy represented a multi-coloured variety of household strate-

gies (Katsenelinboigen, I977), the informal economy leads to
polarized household strategies, i.e. it points towards a black and
white economy.
5. The actors of the informal economy have been socialized in the
second economy. Both material and symbolic investment was wide-
spread from low-tech technology, leasing and sharecropping con-
tracts to skills, know-how, networks, and prestige. These
antecedents greatly facilitate the introduction of market institu-
tions, by making the former second economy actors capable and
ready to participate in market activities. But at the same time this
inheritance tends to shape the newborn institutions according to an
outlook acquired in the old economic system.

I. The concept of the second economy and informal economy

The term second economy usually refers to all activities which fell out-
side the direct control of the socialist state. Its simplicity and relevance
to distinctive problems of state planning made this dichotomy particu-
larly suitable for analyzing system-specific features of the second
economy at the macrolevel. However, since the aim here is to offer a
microlevel analysis of the interaction between the second economy and
the transformation, we need a classification that can reveal the variety of
transactions comprised within the second economy.
An amplification of economist Istvan Gaibor's (I979) definition and
classification of the second economy serves this purpose best. He defined
the second economy as the group of economic activities and transactions
which take place outside of the socialist sector. The three dimensions of
his classification include legality, integration and source of income. The
first two dimensions are continuous, their poles are legal vs. illegal,
according to the laws and customs of the given system, and integrated
vs. autonomous, from the point of reference of the socialist state. The
source of income can be labour, position in the first economy and the
networks of both the first and the second economy, and wealth, capital
and productive assets. Table i shows the combination of the three
dimensions and gives some examples.
To define the informal economy I use Portes and Borocz's (I988) defini-
tion: The informal sector is defined as all productive and distributive
income-earning activities which take place outside the scope of public
regulation on the macrosocietal level. This definition can be considered
a generalized version of Gabor's definition, as it retains its dualistic
nature and its focus on the power-centre. In one respect this definition

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I 56 Endre Sik

TABLE i: Typology of Transactions in the Second Economy

Integrated Autonomous

Legal Illegal Legal Illegal

Labour i. Petty agric. 2. Tip, black 3. Subsistence, 4. Black labour

production, labour self-service
(haztaji)
intrapreneurship

Position, network 5. MRT*, 6. Corruption, 7. Reciprocal 8. Brokerage

intrafirm barter bribe, petty theft exchange of
labour (REL)

Wealth, capital 9. Private Io. Invisible ii. Private 12. Usury,

entrepreneur investment, tax entrepreneur speculation,
evasion smuggling, black
currency

*Managers' Reciprocal Transactions; see Czako and Sik (I988).

widens both definitions of the second and of the informal economy. It is

the notion of income, which I prefer to use in a substantive sense, since
there are several types of non-pecuniary forms of income-saving,
income-substitution activities and transactions which should be covered
by the term second or informal economy.

I. Scope of the Second Economy in the Pre-Transformation period

Since the time-span of the model covers the past immediately before the
transformation, the proper starting point for analyzing the scope of the
second economy is the i980s.
The first source for estimating the scope of the second economy is a
guestimation of the volume of invisible income in the early and mid-
I980s (Galasi and Sik, I988). The term invisible income more or less
covers the scope of illegal activities in Table I category 2: tips and black
labour that is illegal but integrated in the official system, including
working on the side with 'borrowed' tools and supplies at one's official
place of work; category 4: black labour that is autonomous and illegal.
category 6: Corruption, bribery and petty theft; Parts of category I0:
Invisible investment and tax evasion; category I2 Usury and speculation
in such things as currency, real estate and imported goods.
According to three independent expert guestimations, invisible
income as a proportion of GDP in I98I and i985 in current prices was
14 to I5 per cent or I4 to 17 per cent respectively. Using time budget

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 From the Second to the Informal Economy 157
TAB LE 2: GDP Supplemented by Invisible Incomes and Work at Home

1981 I985

Billion Fts % Billion Fts %

Official GDP 635 69 842 67

Invisible Incomes 95 10 130 10
Work done at home I96 21 279 22

Total 926bn Fts 125Ibn Fts

*Source: Galasi and Sik (I988: i64).

information and a skilled worker's monthly average wage in the first

economy, we calculated the volume of domestic production - in Table I
the sum of categories I and 3 - to amount to about 3I per cent and 33
per cent of the GDP in I 98 I and I 985, respectively. Often these transac-
tions are treated as a separate segment called social (Henry, I978; Rose,
I992) or domestic economy (Gershuny, I983). Adding the volume of
invisible income and domestic production to GDP, their share in total
GDP was about one third and slightly increasing (Table 2). Substantial
parts of types I, 9 and i i are covered by the official GDP statistics,
though not the volume of intrapreneurship (Stark, I986). Categories 5
(partly) 8 and Io are missing since there was no way one could estimate
the volume of managers' reciprocal transactions, brokerage and invisible
investment. Therefore, and also because of the missing elements, the
estimation in Table 2 can be considered as conservative.
Another attempt to estimate the volume of the second economy in the
I980s applied the cash demand method. Laczko (i99i) defined illegal
activities as monetized private production, the same as categories I, 2, 4,
9 and i i in Table i. As Figure I indicates, the proportion of illegal
activities in GDP slightly increases during the first half of the I98os, and
skyrockets just before the transformation period began.
To sum up, in the pre-transformation era there was a large and growing
second economy in Hungary which began to increase at a great pace in the
dawn of the transformation.

III. Of the Transformation

Characterizing the essentials of the transformation, faces two major

difficulties. First, there have been numerous changes in an overlapping
and intertwining manner, in which de facto processes and de jure condi-
tions have been, to varying degree, mixed up. Secondly, to understand
the current processes one should pay attention to the constants, especi-

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 158 Endre Sik

3S5

30 -

25 -

20-

15
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

FIG U R E I: Growth in illegal act

Source: Lacko, 1991.

ally at the micro level, processes which originate in the pre-transforma-

tion period and are stable during the transformation.
What are the main trends of the transformation process? The follow-
ing non-exhaustive list of structural changes emphasizes those which are
the most important for understanding the behaviour of the actors in a
segmented economy.
Private ownership becomes the dominant form of property right both
in ideology and in law, and several associations, parties, semi-govern-
mental agencies are formed to express and enforce the interests of the
employers and self-employed;
Growing uncertainty in operating rules and privileges of the state-run
economy; the government no longer rescues bankrupt enterprises, bank
loans are limited or subject to different conditions, monetary restrictions
are more stringent, personal networks are upset, etc.
Privatization, both the initial spontaneous phase and the subsequent
centralized phase, is meant to break down state ownership. During the
spontaneous phase of privatization those possessing economic power
parve out for themselves and their clients valuable slices of the state-
owned cake. The state established a special bureaucracy to control this
process. Reprivatization becomes relevant through land reprivatization,
redistributing the land owned by agricultural cooperatives to their
former owners. While there is now a law of reprivatization, no one really
knows how much land will be distributed and how this process will take
shape.

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 From the Second to the Informal Economy I 59

Abolition of travel restrictions means that each Hungarian citizen can

travel wherever he or she wants and can stay as long as he or she wishes.
No visas are required in Europe and it is easier to travel overseas than it
used to be. However, the currency that may be legally purchased from
the state is insufficient to finance tourism and there is hardly any other
legal source of hard currency. Quasi-convertibility of the Hungarian
forint means the end to a state monopoly of foreign trade and freely
negotiated foreign exchange meets individual needs.
Unemployment is accepted as a state policy; there is recognition that
neither the restructuring of production nor privatization can take place
without unemployment. Intrafirm un(or under)employment is converted
into open unemployment.
The problem of evaluating the de facto and the de jure arises because,
even though there is the legal basis for a new banking or monetary
policy, there is also a crude power game involving the old and the new
ruling elite and international sharks. An example of the international
sharks on the Eastern European scene is the 47 year old Mr. Kubiak,
born near the town of Brest-Litovsk, and exiled from Poland in i968
after participating in student unrest at Warsaw University (New York
Times, I992). Mr. Kubiak went to Sweden as a refugee and completed his
education. Immediately after graduating, he entered business for him-
self, selling Western machine tools to Poland in the boom of the I970s,
and developing sidelines in exporting Polish timber and arranging loans
for state-run Polish companies. Although the timber business was con-
trolled by the state, Mr. Kubiak persuaded some officials to mislabel the
best wood and sell it him as if it were of low quality. Poland's transition
to a market economy has only expanded his opportunities. In one deal
he took advantage of tax holidays Poland offered to foreign joint ven-
tures. Just before the deadline for setting up these ventures expired last
year, he registered i 00 shell companies, which he is now offering for sale
at a handsome profit.
Last year Mr. Kubiak donated office space in Warsaw's Marriott
Hotel to the Liberal Party. During this period, a leader of the party,
Privatization Minister Janusz Levandowski, named him special nego-
tiator in a sale of a state-run television tube factory. Mr. Kubiak said he
netted $250,000. As the Liberals' political star waned, Mr. Kubiak
cultivated other alliances. He contributed money to a foundation that
paid the salaries and office expenses of the Civic Committee, a political
group then headed by Mr. Olszewski. After the fall election, Mr.
Olszewski emerged as Prime Minister.
Ex-East Europeans are not the only people to find the disorder of the
economy tempting. Multinationals and small sharks of Western origin
with no previous experience in or network with Eastern Europe are

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i 6o Endre Sik

attracted by the prospect of earning extra profit in what appears to some

as a new land of opportunity. However, since they do not have the
language, the local knowledge and the network, they have to hire experts
in bribing, lobbying and market research which make them more
competitive.
The most important stable components of the transformation process,
linking the immediate pre-reform economy with the present, are:
recession, persistence of inflation and its acceptance and anticipation by
both producers and consumers; fall in real income, pauperizing low-
income people and eroding the positions of middle-income groups;
tightening the already fairly strict tax regulations (e.g. the reduction in
number of exemptions, compulsory wealth declaration, campaign to
identify invisible incomes, etc.).

IV. The impact of transformation on the secondary economy

4.1 The transformation of vocabulary

The structural changes in the course of transformation makes it obvious

that the socialist experiment is over. The demise of the central planning
office, single party system, priority investment projects and COM-
ECON relations, means that the economy can no longer be described as
the first economy of the socialist system. Even though the former general
manager is still in power and is still dependent on the benevolence of the
ministerial bureaucracy and the state and all its agencies remain
predominant, today's economy can no longer be described as a redis-
tributive system. Perhaps the best label we can use to characterize the
contemporary Hungarian economy is as a state-controlled market
economy. As socialism is gone, so too is the system-specific distinction
between first and second economy. In default of any better option, we
must shift to the general term, the formal and informal dichotomy.
The paradox is that had there been no change at all on the microlevel,
the macro-vocabulary would have changed anyway. For example, even
if a private entrepreneur or shopkeeper does everything in the customary
way, his activity overnight became part of the formal economy. Hypo-
thesis i simply follows from the existence of structural changes in the
course of transformation.

4.2 Of the changing size of the second-to-informal economy

Hypothesis 2 postulates an increase in the size of the informal economy,

that is, an increase in the volume of informal transactions identified in
Table i.

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 From the Second to the Informal Economy I6i

Due to structural changes, some parts of the second economy - cate-

gories I 9, i i and parts of i o and 2- do not become parts of the informal
economy. In a capitalist economy private entrepreneurs, retailers, private
farmers and the self-employed are all participants in the formal economy.
In this definitional sense, the informal economy contracts through the
'formalization' of these categories.
Insofar as the informal economy is structurally different from the
former second economy, then Hypothesis 2 becomes more complex.
Instead of having one group of transactions at two points of time we
have two partly overlapping groups of transactions to be compared
before and after the transformation; there are also activities and transac-
tions in the informal economy which did not exist in the second
economy.
The informal economy in the post-transformation period differs from
the pre-transformation second economy in two ways. Due to structural
changes there are activities which could not exist in the second economy
and some activities which used to be the elements of the second economy
but cannot be part of the informal economy. In the light of the above we
have to create a new matrix of economies (Table 3).
The validity of Hypothesis 2 depends upon the sum of the transactions
continuing from the past plus the new informal transactions, less the
second transactions that have disappeared or been 'formalized', being
greater than the pre-transformation second economy. Lacking reliable
time-series data, I present some models based more on behavioural and
time-specific assumptions of the model than on sporadic empirical facts.
The logic of analysis is that if the initial conceptual model is correct, and if

TABLE 3: Typology of Transactions in the Informal Economy

Integrated Autonomous

Legal Illegal Legal Illegal

Labour - 2. Tip, black 3. Subsistence, 4. Black labour,

labour self-service Immigrant labour

Position, network 5. MRT, 6. Corruption, 7. Reciprocal 8. Racketeering

intrafirm barter bribe, petty theft exchange of
labour (REL)

Wealth, capital - io. Tax evasion - 12. Usury, black

currency,
smuggling, drug
and skin trade

Note: Brokerage (Table i: type 8), entrepreneurship (types 9 and ii) and speculation (type 12) are
not informal activities but to a significant extent some transactions closely associated with these
activities remain in the informal economy but in such categories as black labour, corruption or tax
evasion).

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I62 Endre Sik

the characteristics described in the transformation process are relevant,

then factors should behave as here proposed and the volume of
transactions should increase both in the categories continuing from the
second economy and in the new informal categories.
Model i: Property Rights Shif. Privatization and reprivatization are
common insofar as in both cases state ownership is replaced by private
ownership. This change of property rights and its consequences for
ideology and the legal and political system are the most important
elements of transformation in the long run. One element of this struc-
tural change seems to be of crucial importance in determining the size of
the informal economy in the short run. Privatization can be interpreted
as a change of owners whereby the cost insensitive and resource-con-
strained socialist sector of large enterprises will turn into a cost sensitive
and demand-constrained market sector of capitalism (cf. Kornai, I980).
What is the impact on the second economy of the move from cost
insensitivity to cost sensitivity in the short run? First, the privatized
sector is faced with unfavourable market conditions - shrinking
domestic market, difficulty in entering international markets because of
low technological standards and marketing skills, high fixed production
costs such as taxes, raw materials and transport. Since very likely the
unfavourable conditions will not change in the short run and since this
scepticism is widely accepted, entrepreneurs tailor their behaviour to
these forecasts. Second, privatization and reprivatization is undertaken
by poor capitalists' and in an environment where the supply of credit is
scarce and expensive.
If the preceding two arguments are true, we may assume that the
profit, which must be high even in the short run because the new owner
has insufficient reserves, cannot be increased by the rapid build-up of
mass production, by the penetration of new markets, or by implement-
ing new technologies, since neither capital nor experience nor time are
available.
Consequently, there are only two ways to increase profits immedi-
ately: to raise prices and/or to cut costs. As to the former, rising prices is
a common experience in Eastern Europe. Both producer and consumer
have been well socialized to expect inflation. But there are obstacles to a
profit-raising strategy: the effective demand of the impoverishing
population is decreasing, and there are official measures to counteract
inflation.
Cutting costs can be done in two ways: to reduce the quality of the
product or service or to reduce the only non-fixed cost, labour costs.
Reducing quality has been a widely known and applied cost saving
technique in the second economy (Galasi and Kertesi, I985, I987), SO

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 From the Second to the Informal Economy I63

very likely it is also often used nowadays, the more so since there is
almost no obstacle to doing it. The only problem with this cost-saving
method is that it does not increase the profit very much in the short run.
To reduce labour costs is an attractive new solution. There are five
mutually non-exclusive methods which are particularly expedient in the
short run and require no additional inputs to reduce labour costs: lay-
offs and the termination of contracts with homeworkers, contractual self-
employed and sharecroppers; the more intensive use of the remain-
ing workforce;2 replacement of paid labour by domestic labour or
owner's labour (self exploitation instead of market transaction); and tax
and social insurance evasion and the hiring of untaxed black labour.
In the short run, in an environment of unfavourable market condi-
tions and scarce capital and loan supply, privatization and reprivatiza-
tion inevitably result in unemployment, increasingly intensive or
underpaid work, the shrinking of contractual and the increasing of black
labour, and increased self-exploitation and tax evasion.
There is another current trend which is partly related to the shift in
the property rights. As the level of unemployment rises sharply partly
because of privatization, partly because of general recession, partly due
to growing uncertainty in the remnant of the state sector, the intrafirm
informal economy (small thefts, work on the side, troubleshooting
barter, etc.) will shrink because it is easier for the management to
organize and control fewer workers, the threat of unemployment itself is
a disciplining force, and there is no longer the kind of shared interest
between workers and foremen which was also endorsed by plan- and
production-oriented top management (Sabel and Stark, I982; Stark,
I986). On the contrary, since there is ownership and management
change in the course of privatization of large firms, both the former
patron-client networks and the firm-oriented collective consciousness
expire, demolishing the social psychological obstacles of lay-offs.
Finally, partly because privatization and reprivatization offer a
unique and temporary occasion, partly because of the growing
uncertainty in economic policy and partly because of the opening up of
the economy towards the world markets, there are excellent opportuni-
ties to seize the moment and increase wealth, market position and
power. Since the state retains key positions in financial and economic
policymaking and since the overall conditions of production and dis-
tribution are lacking stability, both corruption and managers' reciprocal
transactions (MRT) are likely to increase.
Model 2: The revival offamily business. The growing importance of family
business as a result of privatization, reprivatization and unemployment
expands the scope of subsistence and of self-service. For example, the

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I 64 Endre Sik

extremely large number of taxi drivers in Hungary is partly a result of

the fact that young, urbanized and relatively well off (that is, car-own-
ing) people can enter this market to escape unemployment (Sik, I99I).
There are also incentives to increase the reciprocal exchange of labour
(REL), which is an integral extension of household production.
In rural areas, a combination of subsistence and petty commodity
farming, and reciprocal exchange of labour and black labour may often
be the only possibility for survival. This is due to reprivatization (which
offers hope to those who want to become farmers and is a threat for those
who lose their jobs if the co-operatives dissolve), and extremely rapidly
rising unemployment. In October i 99I, 6I per cent of rural respondents
surveyed said they were having a problem making a living in contrast
with 46 per cent of Budapest respondents (Sik, I992). Subsistence and
self-service in housebuilding and maintenance, in services and social
care, combined with REL are likely to increase, because this is an
obvious way to supplement diminishing real income due to inflation.
Model 3: Decreasing shortages. Due to decreasing effective demand and
the liberalization of imports there is no more shortage of production or
consumer goods. The other side of the coin, however, is that there are
growing problems in selling products and services. Consequently, while
bribes to buy shortage goods are becoming rare, bribes and corruption
to sell goods are gaining importance. Galasi and Kertesi (i 990) show on
the basis of content analysis of articles dealing with major corruption
and bribe cases in a police journal between I 966 and I 988 (N= ii 6) that
even in the second economy more than half of major corruption cases
involved selling goods for state agencies (37 per cent) and getting
permissions from state authorities (22 per cent).
The fight to reach or to maintain monopoly positions may go as far as
racketeering and mafia-like organizations, especially in markets offering
windfall profits. While there is a change in the direction of bribing, the
spreading of customary tips remains unchanged; perhaps the net level
diminishes due to the decreasing efficient demand of the ordinary
consumer.
Model 4: Opening borders. Since Hungary's borders have been perhaps
the easiest to cross in the whole of Eastern Europe, and its geographical
location is central, specialized forms of smuggling may quickly develop
and proliferate. The recent history of illegal trading and of illegal
markets, the so called Polish or COMECON markets, illustrates that
there is an uninterrupted development from subsistence peddling
through small-scale marketing to internationally organized illegal trad-
ing. The advantages of economies of scale can be achieved only if trading
relies on stores, sales networks, market research, racketeering and
bribes.

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 From the Second to the Informal Economy I65

Given its geographical location, its liberal policies, bribe-oriented

authorities, underdeveloped monitoring and the political and economic
changes in neighbouring countries, Hungary is at the main crossroads
of international smuggling. Cars are stolen in the West, mostly in
Austria and in Germany, to be sold in the East, mostly in Poland and
in Russia. The skin trade, that is, smuggling would-be migrants from the
Far, Middle, Near East and from former socialist countries to the West
also operates. There is gunrunning from West to East and drug traffick-
ing from East to West.
At the same time, unemployment and general pauperization resur-
rects illegal subsistence trading of a Third World form, whereby an
increasing number of people peddle or go to the market place to sell their
last pieces of junk or small items, depending on the capital they have.
Before and in the first months of the transformation, the liberalization
of travel possibilities, with limited foreign exchange supply and the
quasi-convertibility of the Hungarian forint, together with the craving of
the wide middle classes for conspicuous consumption, have pushed up
both the tourism-smuggling industry and black currency market.
Gradually, however, as the effective demand of the population fell, tour-
ism and the possession of foreign currency became natural, and as
companies enjoyed increased freedom of exports and imports, tourism
and smuggling diminished while the international underworld of cur-
rency dealers and smugglers organized itself in Hungary. The very
liberal Hungarian border control and immigrant policy made it easy for
the international mafia to monopolize the black currency market.
But due to the shortage of cash among the middle classes, the
liberalization of currency conversion, and foreign exchange accounts, as
well as the adjustment of the forint exchange rate to international move-
ments of currencies, the profitability of black currency market activity
has decreased. Nowadays to keep savings in a Hungarian Forint account
is a better deal than buying and selling on the black market, since the
black market prices are constant or even falling. The paradox is that
while the Hungarian forint is convertible in Austrian and German banks
it is not acceptable in former communist countries, except the Czech and
Slovak Republic, since the former transferable ruble-based bilateral
agreements expired together with the COMECON. This produces a
growing black market for lei, zloty, dinar, leva and rubles. The black
market of the Romanian lei is especially important since the overwhelm-
ing proportion of immigrant guest workers comes from Romania, smug-
gling lei into Hungary, and buying lei for the forints they earned in
clandestine employment in Hungary.
In the face of declining profits, currency dealers can only survive by
organizing the market i.e. with a mafia type organization, more violent

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i 66 Endre Sik

fights for market monopolies and by transferring the profits of currency

dealings into other related activities that can be operated through exist-
ing international links and skills such as smuggling, fraud, etc.
As for international migration, while the Iron Curtain is gone,
Western countries built a new Steel Ring around their borders. There-
fore in international migration, Hungary acts as a terminal by default.
Those migrants who do not get permission to enter Western countries
remain in Hungary and set up business or join the unemployed in the
fight for casual jobs. According to recent official estimations, in I99I
about 40,000 temporary labour permits were issued by the authorities
and another ioo,ooo illegal guestworkers did casual work in Hungary.
Most of them work in private construction and agriculture. The average
length of the stay of such immigrants is one to three months.
Model 5: More effective taxation. Although tax rates have not changed
recently, there is a trend towards taxing income sources that have so far
enjoyed exempted treatment. From next year, the increase in wealth will
be monitored and a campaign has been launched to discover invisible or
hidden income. However, the response to such restrictions is likely to be
increased tax evasion. And recalling what was said earlier about diffi-
culties that businesses face leading to the growth in black labour, the
scale of tax evasion, lubricated by corruption, will increase even faster.
In light of the above it is very likely that the informal economy is
greater than the second economy used to be, because:

i. Most types of activity remaining from the second economy have

increased: subsistence and self-service, black labour, managers'
reciprocal transactions, corruption, reciprocal exchange of labour,
tax evasion, and smuggling and black currency. The one clear
exception is the contraction in integrated enterprises of tips and
black labour.
2. There are several rapidly increasing new informal activities:
immigrant labour, racketeering, and drug-dealing and the skin
trade of smuggling immigrants.
3. Large amounts of what used to be formal transactions now appear
as informal activities, that is, petty agriculture production is no
longer part of category i, but moves to category 3; and an increase i
speculation and private entrepreneurship increases the scope of tax
evasion.

Therefore, the first part of Hypothesis 2 appears valid: the remnants

of the former second economy, plus the new elements of the informal
economy minus the formalized part of the second economy are likely to
be greater than the second economy was before the transformation. The
rapidly increasing trend of I990 is likely to be continuing (cf. Figure i).

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 From the Second to the Informal Economy

As to the second statement of Hypothesis 2, the direction of change in

the near future, it is more difficult to be clear, since the informal sector
comprises activities that are likely to grow at different rates in response
to a variety of influences.

4.3 Of the new characteristics of the informal economy

The majority of the new informal activities involve the internationaliza-

tion of the Hungarian informal economy, as predicted in the first state-
ment of Hypothesis 3. If we also consider that an increasingly popular
form of tax evasion is to buy black currency and to keep it in one's
foreign exchange accounts or private foundations, and there are rumours
that the international cocaine mafia is showing interest in Eastern
Europe where it is easier to launder dirty money, the above argument
seems even more valid.
The second statement of Hypothesis 3 - the shift from the part-time
second economy to the full-time informal economy - is supported by
rising unemployment increasing the number of those who are forced to
make their living doing casual work that used to be their part-time,
auxiliary job. In other words, losing a full-time economy job leads to
full-time involvement in the informal economy. Moreover, the illegal
and autonomous informal economy, especially the internationalized
part, promises high income but requires full-time participation.

4.4 Why has the informal economy different social impact than the second
economy?

There is only one indirect empirical indicator that income inequality has
increased in the course of the shift of the second economy into an
informal economy. Between I989 and i 99I, the total income in the
highest decile compared to the lowest decile has increased, while during
the I 980s it was almost constant. In I 982 the highest income earners had
4.2 times more income compared to the lowest decile; in I987, 4.9; in
I 989, 5.03; and in I 99 I, it was 6.o i (Kolosi and Robert, i 99 i).
Another indirect empirical argument is that invisible incomes used to
be more unequally distributed than the income from the first economy.
Table 4 shows that incomes from informal activities are more unequally
distributed than those of the formal economy and that autonomous
informal activities are more unequal than the ones from integrated
transactions. From this it follows that if the share of autonomous trans-
actions increases in the total informal incomes, then the inequality of
these incomes should also increase. I assume also that there is the same
association between legal and illegal activities i.e. the more illegal the

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i68 Endre Sik

TABLE 4: Inequality of income by segments of the informal economy

N Gini-coefficient

Total income IOII 0.305

Income in the formal economy 777 0.300
Welfare payments 563 0.355
Shadow income of self-subsistence work 952 0.523
Income in the integrated informal economy 437 0.546
Income in the autonomous informal economy 243 0-594

Source: Elteto and Vita, (1987).

transactions are the more unequal their income distribution is. Since
illegal and autonomous activities are increasing at the expense of legal
and integrated activities, income inequality in the informal economy
should also have increased in the course of transformation.
Arguments based on the models support the hypothesis that the
informal economy increases income and territorial inequality, while the
second economy tended to equalize them. The reasons for increasing
income inequality are as follows:

i. The increasing importance of full-time activities results in wider

income inequality as subsistence activities continue even at a lower
income because they are the single source of survival for many.
This is particularly the case because of the loss of the double-
strategy individuals enjoyed under socialism, a small but safe and
effortless income in the first economy, and an income from the
undercontrolled and foolproof second economy. The full-time
informal activity undertaken in the hope of large income has to be
well paid for those involved to cover the increased risk, higher
transaction costs and prestige consumption.
2. Internationalization increases income inequality insofar as foreign
capital recruits a small, loyal and profit-oriented elite group which
is highly overpaid compared to the local income level. Thus a
group with extremely high income emerges.
3. High levels of corruption increase income disparities, as they are
invariably accessible to a small group. And corruption is growing
not only because of its self-inducing tendency (Galasi and Kertesi,
I987) and as the net result of the effects described above, but also
because the emergence of full-time international activities drives up
corruption premiums, and the changes in the state apparatus lead
to the new cadres being carefully tested and tempted, with extra
corruption costs.
4. If it is true that the scale of tax evasion positively correlates with
the size of income, growing tax evasion 5) adds to income disparities.

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 From the Second to the Informal Economy I 69

5. Finally, inflation also increases income inequality, assuming that

inflationary extra profits, the ability to immediately pass on infla-
tion and the inability to fend off inflation have a positive correlation
with the income level.

As to the causes of increasing disparities between urban and rural

areas, I would argue that the shift from second to informal economy in
the short run benefits cities, and Budapest in particular. Given the
infrastructural advantages, foreign and local investments and related
informal activities will flow to cities which offer a more convenient
ground for illegal activities (weaker transparency, the concentration of
public administration to be bribed and of illegal migrants, providing a
preferred site for monopolies because of the larger market and lower
transaction costs). In addition, the trends described in Model 2 severely
affect rural areas.
As for the second statement of Hypothesis 4, the polarization of the
economic behaviour to a black and white contrast between households,
this may be the combined result of the shift from auxiliary income, part-
time second economy, to low or high income full-time informal economy;
the emergence of a high-income international informal segment; and
growing inequality between rural and urban areas.
This bifurcation of the informal economy will facilitate the spreading of
the black and the white economies, i.e. criminal and self-subsistence
activities, while hindering intermediate solutions. Within the newborn
informal economy, the process of structural changes creates two separate
sub-economies with different social impacts, a social economy based on
households, self-exploitation and part-time petty commodity produc-
tion; as against an underground economy operating on a large scale,
based on full-time activities, growing more and more international and
combining high risk with windfall income. Such a polarization could
lead to a sort of third-worldization in the long run, if income and ter-
ritorial inequality among households ultimately solidify into overlapping
and lasting social inequalities.

V. Impact of the second economy on the transformation

The creation of the second economy, in the beginning a pacifying policy

from above, or the fact that the second economy was allowed to exist as a
sort of grassroots economy to overcome obstacles was perhaps the most
important economic policy element of the Ka'dairist experiment. It was
strongly linked with supporting mass consumption, toying with the
market and maintaining the status quo on the basis of peaceful coexist-
ence, giving more carrot than stick for as long as possible. The second

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I 70 Endre Sik

economy was instrumental in keeping the first economy operating,

maintaining relatively high standards of living and turning Hungary
into the happiest barrack in the socialist camp.
Of course there was a price to pay. Informality not only lubricated but
also distorted the first economy where everybody from managers to
unskilled workers looked to tricks, lobbying, bargaining and loopholes
rather than improving efficiency or quality, where all sorts of personal
networks and informal organizations run the economy, where the first
and the second economies lived peacefully together, taking advantage of
vulnerable consumers and of soft budgets (see Galasi and Kertesi, I985,
I990). The second economy was neatly controlled and autonomous
(Gabor, I979, i99ia, b). As a result of the rapidly changing short
oppressive and longer laissez faire periods, the second economy
remained labour-intensive, investments were postponed and innovative
skills were consumed in order to survive without positive economic
development. The participants of the second economy were interested in
short-term profit maximization and rightly saw the cheapest and least
risky way of doing so in self-exploitation and, if they could manage it, the
development of miniature monopolies through personal contacts.
The existence of the above conditions for decades led to a nationwide
subculture and a dense personal network in the economy which
socialized the participants and organized their relations. Consequently,
there was practically no escape from participating in the second
economy in one form or another, and typically in both forms, as income
earner and as consumer.
Such a wide and long-lasting kind of subculture and network could
not disappear in the course of transformation. Why should it when it had
been so effective for a long time? Every social formation has a degree of
inertia, so that even if the subculture and network had become
redundant, it would have taken some time before they would have
completely disappeared. In fact, the subculture and networks that
crystallized to overcome past troubles have become coping means at a
time of transformation and upheaval.
Consequently, the informal economy has an increasing importance for
households in making ends meet, not only because of the inertia of the
former second economy and because of the new informal elements, but
because people are rational and they rely on deeply socialized
behavioural patterns, skills and networks for earning their bread-and-
butter. They do it not because of traditionalism, but because they
invested in these assets, and they have proved effective in coping with
economic troubles.

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 From the Second to the Informal Economy I71

5.I Second economy distorts the newborn formal economy

What sort of economy will emerge in the course of transformation? The

answer seems to be simple: it will be a market economy. But there are a
variety of market economies. The marketplace in Dahomey, in ancient
Greece or the medieval market (Polanyi, 1957) does not resemble the
market of the neoclassical or Marxist theory.
Without going into details, let me illustrate with another model that
the quality of a market is largely determined by the behaviour of market
participants. Let us assume as axiomatic that each market participant
makes rational decisions and tries to maximize profits or wages. The
behaviour of the participants is, however, also influenced by social fac-
tors. As Etzioni (1991: 4) puts it: 'Individuals are penetrated by the
institutions and cultures in which they spend their formative years ...
Many ... citizens of post-communist societies ... have acquired specific
personality traits and work habits that cannot be modified in short
order. These include working slowly, without undue exertion, not taking
initiatives or responsibilities, stressing quantity over quality, featherbed-
ding, using work time for other purposes ... promotion based largely on
irrelevant considerations such as party loyalties and connections, barter
of work time and material for other favors, and low-technology
approaches.'
Etzioni's emphasis upon socialization is relevant here because there
used to be a market in Hungary, and most Hungarians could operate as
producer, service-provider, and buyer. However, it was a market that
was threatened, tolerated and often (if the wheels were properly
greased), encouraged simultaneously by the state. The uncertain com-
bination of threat and toleration, and the multiple ways of taking advan-
tage of the in-built corruptive mechanisms of the system, prevented the
formulation of a normal market strategy, be it artisanship or
entrepreneurship, and long-term planning or investments offering long-
term returns (cf. Gabor, 1991 a).
The link between market behaviour and citizenship was broken too.
Szelenyi (i988) notes that the behaviour of rural private entrepreneurs
as citizens and as farmers in socialism was so distorted that they could
hardly be compatible with conditions of a market economy being sought,
since the so-called entrepreneurs of socialist embourgeoisement are more
bourgeois and less citoyen than the small producer in Western societies.
Since there was no difficulty in selling products and services as the
state guaranteed shortages and effective demand, marketing or public
relations were not necessary. Thanks to the low price and poor quality of
products in the state sector, it was easy to excel in the second economy

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I72 Endre Sik

where it was not imperative to improve quality, but where it was poss-
ible to raise prices. As Galasi and Kertesi (I987) suggested, both the
state and the second economy found their own respective strategies to
earn easy money because it was easier, cheaper and safer to monopolize
than to develop products. The market of the second economy was also
inclined to monopolize whenever possible. It developed local and prod-
uct monopolies or cartels in the absence of antitrust laws, and competi-
tion boards (Sik, i99i).
The various actors of the second economy were socialized by their
experiences and invested in human and network capital in different
ways, in keeping with social differences such as nationality, age, place of
residence and social background (Stewart, I 99 I; Verdery, I 99 I). Except
for the fact that all of them used to be actors in the second economy,
there were very few similarities in their socialization and in the structure
of investment between a prostitute and her pimp, a subcontractor of a
co-operative and skilled worker in an intrapreneurship, a subsistence
farmer and a corrupt manager.
But similarities in socialization and activity in the second economy are
very important in behaviour under new circumstances. To be active in
the second economy meant that one had something to hide. To avoid
cognitive dissonance this could be done only by questioning the
legitimacy of state-imposed policies such as taxes and wage regulations.
To carry out activities within the second economy one should develop
mutual trust among the fellow-transactors and to achieve this one
should develop and maintain dense personal networks.
The transformation can do a great deal, but it cannot erase ingrained
habits and cannot influence people to sacrifice their previous investment
in human and network capital. The former practices will continue to
survive for a considerable time so the spirit and the practice of the
second economy haunts the new Hungarian market economy and shapes
the institutional conditions and the behaviour of those who want to enter
the formal economy.
This is particularly true since there is no reason to change former
habits or abandon already existing networks at a time when there is
nothing better with which to replace them. They are relied upon because
they are tried and tested. In today's polarizing informal economy, which
is tied to the staggering and rather unsteady cart of the formal economy,
both losers and winners may feel that they have hardly anything to rely
upon except that which they learned in the accursed past.

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 From the Second to the Informal Economy 173

5.2 The role of the second economy in preventing violence in tra

One of the favourable effects of the second economy was the birth of a
petite bourgeoisie or a semi-proletariat (Szelenyi, I988), a workers' elite
and a large group of professionals. Although life grew harder for
everybody by the end of the I 98os, the standard of living did not drop
low that it could have sparked off a revolution. In Marxist terms, thanks
to the second economy, people had more to lose than their chains. Or,
using the terms of structural analysis and of transaction cost economics,
Hungarians invested in and developed a sizeable and asset-specific
capital comprising skills, network, knowledge, prestige and know-how;
and rational actors do not let their investments be ruined.
Investment in know-how, position and networks, both vertical
(Csanadi, i99i) and horizontal (Czako-Sik, I988), was especially cru-
cial for those bureaucrats in the party and in state authorities who could
manage to do it. It is plausible to assume that experience in the second
economy and hopes (if not concrete plans) to develop or extend invest-
ments into the wouldbe informal economy could have been one of the
reasons why some of the party cadres were ready to abandon their power
in the first economy, increasing the chances of a non-violent transforma-
tion (Nee, I99I). This was especially relevant for the younger, well
educated state technocrats who spoke foreign languages and were
familiar with protocols of the market outside the Hungarian economy.
It was not simply by creating the relatively higher standard of living
and the certain though limited additional opportunities to maintain or
increase living standards that the second economy pacified the trans-
formation process. The coping means which have been developed to
achieve a higher standard of living, to cope with shortages and to beat
the system, created a special milieu, and little by little a subculture in
which people tried to solve their problems individually on a 'things-will-
work-out-somehow' basis, using personal networks. Such individual-
istic, wheeling and dealing oriented personalized subculture does not
encourage the kind of collective action necessary for revolution.
During the two decades of peaceful coexistence, both state and
citizens have learnt that it is useful to seek compromises, that major
decisions (Big Leaps) usually end up in fiascos and that everybody can
only be a loser in an upheaval. The lesson of how to become depoliti-
cized was learned in the school of the second economy, and it was the
ground for learning the rules of peaceful coexistence. The personal net-
works which ensure the operation of the second economy intertwine
people throughout society. People tend to use violence against strangers
and not against acquaintances. Hence, at the moment of transformation

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174 Endre Sik

networks of the sort represented by the second economy prevented a

violent confrontation.3

NOTES

i. The weak financial conditions of domestic entrepreneurs is shown by a study done by TARKI in
early I99I, a representative sample of iooo limited companies and iooo self-employed. It found
that 55 per cent and 87 per cent respectively have less than three employees, 38 per cent and 40
per cent respectively have their office (or production) space at home; i i per cent and 35 per cent
do not use a telephone and of those who use phones, 40 per cent and 46 per cent have no office
phone.
2. In a survey done by the ILO and the Department of Human Resources at the Budapest
University of Economics in i99i (N=407), privatization turned out to be the strongest factor in
explaining the likelihood of layoffs. While on average there were 4.4 layoffs in I990, among those
firms which have been state-owned in i988 but became private by I99I the average number of
layoffs was ii.6.
3. However, when personal networks are segmented along national, tribal, clan or residential
clusters, this configuration of dense networks and informality increases the chances of con-
flict when there is a power vacuum and the economy is in chaos. This explains why, for example
in Georgia and in Armenia the very well developed second economy fuelled violence instead of
hindering it.

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