Economic Mismeasurement and the Bias in Policy Choice

The level of economic activity is never measured perfectly because of problems of definition, inaccuracies in data collection, and the existence of the hidden economy. Such mismeasurement implies that government policies based on official statistics can be optimal only by chance. The analysis formalizes this observation in a two-sector economy and attempts to quantify the direction and extent of the bias introduced into policy by the failure to account for the true size of the economy. It is shown that short-term reform (which need not balance the government budget) can be detrimental. When a budget constraint is imposed, this ensures that reforms will be beneficial no matter how bad is the mismeasurement.