Tuesday, February 26, 2008

Capital flows: be braver, and don't forget secrecy

We would like to point out a new FT comment piece, entitled "We must curb international flows of capital," by the well-known economists Dani Rodrik and Arvind Subramanian.

As far as it goes, it contains many good things. It looks at different reasons, historically and in the present day, for large flows of capital across the world. It highlights the by now well-known dangers inherent in willy-nilly international financial liberalisation and contains much else that is sensible, such as this:

As long as the world economy remains politically divided among different sovereign and regulatory authorities, global finance is condemned to suffer deformations far worse than those of domestic finance. Depending on context, the appropriate role of policy will be as often to stem the tide of capital flows as to encourage them. Policymakers who view their challenges exclusively from the latter perspective will get it badly wrong.

This problem of disconnects in the international financial architecture is close to TJN's heart, and in light of the evidence, the conclusion is hard to argue with.

They also offer other sensible ideas that many members of the broad TJN network would agree with, pointing to, for example, huge liquidity in east Asia and the oil-exporting countries, contributing to potentially destabilising cross-border financial flows. One recommendation to reduce these is:

Some variant of petrol tax in the main oil-importing countries (including the US, China and India) is essential to cut demand and reduce oil prices and hence the current account surpluses of oil exporters. That such measures should be taken for environmental reasons or that they would reduce the size of sovereign wealth funds only adds to their attractiveness.

We agree, and have said this elsewhere. They continue:

Measures needed for when capital flows downhill are likely to take a different form. When appetite for emerging market debt is strong, neither prudential regulation nor macroeconomic policies does much to stem capital inflows. Developing nations need to rely on a broader set of instruments, targeting the capital account directly. Deposit requirements on capital inflows and financial transaction taxes are some of the tools available.

Financial transaction taxes are derided by many actors in financial markets - who, like any special interest group, don't want to pay them. Such taxes certainly offer interesting possibilities and must be explored further. The few such schemes that have been implemented financial transaction taxes have been quite successful: witness Brazil's CPMF (Provisional Contribution on Financial Transactions - which is admittedly slightly different because it focuses generally on domestic transactions) Until it was recently shot down by vested interests the CPMF raised $17-22bn a year: to a large degree because, according to The Economist, "it makes tax evasion harder, by giving the revenue service information on money moving between accounts."

It is what the authors have left out of this article that concerns us. The first problem is that the word "secrecy" is nowhere to be found. There are, as the authors point out, many reasons why capital flows across borders - but they fail to note that secrecy is one of the most powerfully pernicious incentives. The capital that flows in pursuit of secrecy is generally the most harmful form: it leads to tax evasion and a loss of tax revenues (leading to greater reliance on foreign aid in poor countries), but, just as importantly, it undermines the integrity of nation states and democratic bargains between rulers and citizens.

We are talking about a lot of money here with respect to cross-border flows of money in pursuit of secrecy. The United Nations Office of Drugs and Crimes and the World Bank, in their StAR Report of June 2007, estimate that the cross-border flow of illicit funds from corruption, criminal activity and tax evasion is between US$1.0 trillion and US$1.6 trillion annually, about one-half from developing and transitional economies.

A second problem with the article is that they focus their attention too heavily on domestic policy-makers' tools and adopt a rather fatalistic approach towards international regulation, calling approaches aiming at better regulation "too optimistic." They seem to take the current international financial architecture as a given, then conclude that regulation generally cannot work too well in light of the current set-up. That may be partly true in light of today's international financial system - the result of ideologies that took hold especially from the 1980s - but why not also call now for much deeper change in an international context? The current unwinding of international financial imbalances will fundamentally alter worldwide acceptance of the old ideologies, and radical change to the international architecture is now becoming possible. Throw in Europe's fast-emerging debates about the international corruption promoted by the pirate state of Liechtenstein, for example, or the OECD's latest (admittedly not-good-enough) efforts against tax havens, or consider Senator Barack Obama's Stop Tax Haven Abuse Act, and it is easy to see that the political climate is changing fast, and this trend appears to be accelerating.

Some have gone as far as to propose a World Tax Organisation to work against international financial secrecy. This inevitably provokes cries of "Big Brother" from many people, but in reality such an organisation (or other form or forum of international co-operation) need not be nearly as intrusive as other international bodies like the World Trade Organisation are: what it would do, instead, would be to promote transparency in international finance, and especially transparency with respect to tax.

What we want to see is a move away from current systems favoured by the OECD and others of "information exchange on request" (that is, tax authorities must already know what they are looking for before requesting it) towards automatic (and multilateral) exchange of tax information between tax authorities. When the American economist Harry Dexter White and his British counterpart John Maynard Keynes were preparing the ground for setting up the Bretton Woods organisations, initial drafts of the documents they drew up contained a strong requirements for international co-operation on capital flows between national authorities, and particularly exchange of information between countries. This requirement was strongly lobbied against by Wall Street institutions, and the final IMF Articles of Agreement were watered down so that co-operation was merely permitted rather than required. More on all this in future blogs.

In summary, we like Rodrik's and Subramanian's latest piece. But we urge its authors to factor secrecy more centrally into their analyses, and to be braver about what might now be possible.


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