Vast amounts of economic activity are not counted across many parts of the world. In Latin America, estimates of the size of this “shadow economy” – characterized by the avoidance of existing tax, labor, or health regulation, among others — range from 16% of GDP (Chile) up to 60% (Bolivia). While some of these activities can have huge negative social externalities such as violence (ex. drug trafficking) or environmental degradation (ex. illegal fishing), others may be simply encumbered by complex bureaucratic processes and high tax rates (think of all those street food stands!).
Although we have a better sense of the extent of these activities today, this not a recent phenomenon. In fact, throughout history, large portions of the economy have always been “in the shadows”, as states did not have the capacity or interest in regulating, identifying, or taxing every economic transaction. In some cases, it served better the purposes of the state to render certain groups legible but not others (as described in a recent post), or to turn a blind eye to certain activities.
Yet, the size and resilience of this economy is not a purely “state matter” as individuals often go to great lengths to keep certain exchanges beyond the scrutinizing eye of the state, particularly if the transaction in question is forbidden and the potential for gains are high. In the past, the smuggling of opium across Southeast Asia, silver smuggling in South America, or the contraband trade in the Manila galleon, provide some (out of many) examples.
While understanding shadow economies is important in and of itself, they also offer an opportunity to examine how much states matter for economic development. The consensus in the literature is that state presence is an important precondition for economic development. Yet, this effect may vary by the type of activity, period, and the externalities created, among others. In this sense, the coexistence of regulated and unregulated markets can offer, under certain conditions, interesting insights about a) the (dis)advantages of complying with existing state regulations (i.e. the “value added” of state compliance); and b) the conditions under which “any” type of economic activity, even “illicit” ones, may be preferable to no activity at all.
Colonial “Shadow” Economies
In a recent paper, my coauthor Daphne Alvarez-Villa and I tackle these questions in the context of colonial Mexico. Specifically, we examine the long-term economic advantages of complying with the colonial state rules’ by tracing the economic performance of coastal municipalities that served as legal ports of trade vis-à-vis ports that served as smuggling or contraband sites between the 16th century to the 19th century in Mexico. Due to the (intentional) lack of state records on contraband activity at the time, we rely on historical compilations of travel logs by smugglers (also often involved in piracy) as well as on regional histories, which pinpoint the clandestine ports used to (un)load cargo outside the vigilant eye of the state, see Figure 1. While this was not the only way to introduce contraband in the Spanish Empire (see for example, Arteaga, Desierto and Koyama), it was quite prevalent at the time.
The reason why traders relied on clandestine ports was to avoid strict trade regulations set by the Spanish Crown in the Americas during most of the colonial period. Rules specified the frequency, routes and ports of arrival (and departure) for all imports and exports into the Empire as well as the quantity and type of goods that could be introduced. Goods potentially competing with Spanish ones such as textiles and other manufactures were either banned or subject to extraordinary taxes. For example, all goods coming from Europe via Cuba ought to arrive in the port of Veracruz in the Gulf of Mexico whereas those from the East via the Philippines were to arrive to Acapulco on the Pacific side. Legal ports are represented by Crown symbols in Figure 1.
The logic behind these regulations was to control and profit via taxes and captive markets from a highly lucrative trade across its territories and with Europe. The Spanish colonies were awash with vast mineral deposits of gold, silver, and valuable commodities such as cacao or red-dye, making it a lucrative market for European manufactures. According to the British naval commander Sir John Narborough: “[. . .] the inhabitants of Chile had silver buckles to their belts and golden hilts to their swords but lacked the commonest of European manufactures” cited by Christelow, thus highlighting the numerous opportunities for those willing to engage in this business. This meant that European smugglers, generally of British, French or Portuguese origin, as well as Spanish American ones – now Mexicans, Peruvians, or Ecuadorians – all vied for a slice of the profits. By some accounts, around 50% of the silver circulating in Europe at the time came from payments for illegal exports.
An example of the type of information and “know-how” smugglers’ networks relied on sits at the Naval Museum of Madrid. In it, there is a 1764 map of the Pacific coast of New Spain (now Mexico), yet drawn in Lima, Peru. As highlighted by the historian who found it, the latter is remarkable because Peruvians were not allowed to trade directly with Mexico, if not relying on royal carriers or arriving to the only authorized port on the Mexican Pacific (Acapulco). The fact that the map contains detailed, albeit rudimentary, information on maritime ports (including non-official ones) suggest these were part of smuggling illegal networks. See Figure 2.
As shown, the top panel provides a rough outline of the Mexican Pacific coast (with the notable misrepresentation of California as an island), while the bottom panel has a description of the numerous harbors that populated the Mexican Pacific coast and the availability of supplies and nearby towns.
However, the coasts of what is now Mexico was not the only place where contraband was rampant. In South America, the province and Piura and Paita in what is now Peru, was a hub for illegal merchandise from other parts of the Empire and illegally coming from China. In what is now Chile, the port of Concepcion served as the port of entry for all sorts of illegal merchandise that was then distributed inland. The port of Buenos Aires was in fact founded as a key stop in the contraband of silver produced in Peru and Bolivia. Although all silver had to be shipped to Spain via Panama, the more natural route was to ship from the Atlantic coast, which was nonetheless forbidden until late in the colonial period, as explained by Maloney and Valencia. Finally, the port of Rio Hacha in what is now Colombia, served as the illegal counterpart to the official port of Cartagena. All across Spanish America, “illegal” ports served as trade hubs undermining the Spanish attempted monopoly and profits. However, in the 19th century all of these ports became legal, a tacit recognition of the Crown of the failure of prohibition.
Given the outsized importance of contraband in colonial times, we set out to investigate whether in the Mexican case places experiencing this economic activity saw long-run economic prosperity, despite their “illegality”. To control for potential endogeneity whereby geographic advantages allowing contraband at the time continues to impact economic development today, we first limited our comparisons to neighboring areas of municipalities experiencing contraband (or legal trade) in colonial times. Second, we focus on a sample of natural harbors along the Mexican coastline that captures exogenous geographic variation in the possibility for trade that is no longer relevant today, to account for locations that could have been chosen for some unobservable reasons. Our comparisons of natural harbors are limited to those from the same state, as only these would be clearly substitutes for each other. See Figure 3.
Based on these two strategies, we find that ports with either contraband or legal trade exhibit better economic outcomes in the long-run vis-à-vis nearby areas or other natural harbors that did not have any type of trade. However, it does appear that legal ports in colonial times (namely, those of Acapulco, Campeche and Veracruz), perform better than contraband ones in the long-run. For example, there is a 16-percentage point difference in poverty rates on average, between legal ports and contraband ones today. However, because we only have three legal ports, the latter result should be interpreted with caution.
We think the reason why contraband succeeded in promoting economic development is that these ports were able to capitalize on trade liberalization measures taken by the Spanish Crown in the late 18th and early 19th century. Despite the availability of other ports with similar geographic traits (such as natural harbors), the “know-how” advantages of contraband sites in the form of routes, trading sites and networks (see Figure 2) made them the best candidates for legalization. In turn, state recognition served as a catalyst for further economic activity. Evidence from population levels (Figure 4) and educational outcomes in 1895 supports this idea.
As shown in Figure 4, prior to trade liberalization in the late 18th century, there were few differences in population levels among historical municipios that had a higher share of contraband sites vis-à-vis those that did not (excluding legal ports). If anything, they might have had lower population levels, in-line with official colonial policy. However, between 1800 and 1900 there is a shift in population levels – when trade was liberalized – such that contraband ports saw larger population levels vis-a-vis neighboring municipalities or other natural harbors from the same state. The difference has remained throughout the 20th century until today (2010). These patterns show that the differences we observe today are not simply driven by population settlements in contraband sites during colonial times remaining over time (agglomeration). Rather, these ports may have helped coordinate future economic activity, particularly with a more amenable institutional environment.
Overall, we draw two implications from our findings: first, that there is some “value added” by the state. Legal recognition of former contraband ports facilitated larger population settlements and further economic activities that are visible until today. Still, and second, deviating from the existing colonial law at the time helped the initial development of these ports, particularly in the form of valuable “know-how”. This is not to advocate for illegal markets as a recipe for growth, but in some cases, any economic activity may be better than none at all.