Friday, October 10, 2008

Capital flows: another threat from the secrecy world

As noted in our previous blog, we have just published an article on the comment pages of The Guardian newspaper, noting the threat that tax havens, or secrecy jurisdictions as we often like to call them, pose to the world.

This is not the end of the story, however. We have a wider set of criticisms to make. This time, we are prompted by an article on international cross-border capital flows, by Martin Wolf in the Financial Times. Entitled "Asia's Revenge" it is, as usual, clearly explained and interesting, as far as it goes.

This blog examines a key point from his article, and looks at it with a critical eye. Wolf makes the point here:

"The current banking and economic traumas should not be seen as just the product of risky monetary policy, lax regulation and irresponsible finance, important though these were. They have roots in the way the global economy has worked in the era of financial deregulation. Any country that receives a huge and sustained inflow of foreign lending runs the risk of a subsequent financial crisis, because external and domestic financial fragility will grow."

In other words, he is saying, when considering the causes of the current financial crisis, deregulation is only one of the causes. The other is what has been called a "savings glut" in certain countries, notably the oil producers and in Asia, which have been channeled overseas to places like the US and the UK. Financial "innovation" by major banks meant these savings were loaned to house buyers and others who couldn't afford it, triggering asset bubbles and the like, whose collapses are now being felt.

So far, it seems fair enough. But there is another aspect which Wolf, along with almost the entire economics profession, ignores: the illicit capital flows.

The first point to make about these illicit capital flows is that a very large portion of them are not measured by the conventional analyses. This is absolutely crucial.

Let's start with Raymond Baker's ground breaking book, Capitalism's Achilles Heel. He illustrates the point nicely.

"One of the most common mistakes has to do with "errors and omissions", which is a catchall, residual figure in national accounts, used as a balancing entry when numbers don't add up. Most experts I've talked to about this believe that illegal flight capital passing out of a country shows up within errors and omissions. And because these errors are usually fairly small in most nations' accounts, flight capital must be small and therefore unimportant.

Of course, they are wrong, as Baker explains, citing the following example;

"A Ukrainian dealer in icons and antiquities negotiates with a German gallery for sale of several dozen objets d'art and they come to a price of 200,000 Euros. Then she asks if she can invoice the shipment for 100,000 Euros. Why would she do that? Because together they arrange that, at the same time the invoiced amount of 100,000 Euros is transferred to her Kiev bank account, the additional 100,000 Euros will be deposited into her Frankfurt bank account."

For whatever reason this might be done (perhaps to minimise customs duties on the objets d'art), or to evade future taxes on the income in the account, the fact is that while 200,000 worth of goods has moved from Ukraine to Germany, only 100,000 will be officially recorded as flowing across borders, while the other 100,000 will simply remain within the German banking system. Although 200,000 euros worth of goods moved across borders, 100,000 of that is simply not recorded. Effectively, there has been an illicit capital flow, and it doesn't appear in the trade statistics.

There are many, many versions of this kind of thing, involving flows in both directions. There is trade and transfer mispricing; there are dummy corporations, fake transactions, and so on. It can happen with goods, but also services.

And then there is non-trade capital flight. This might involve moving cash or bearer shares (shares where the person who holds them in their hands owns them, like cash). The Hawala system is another aspect of this unrecorded cross border capital movement. There is, of course, straightforward smuggling (which frequently leads then to illicit cross-border financial flows: when smugglers try to move the money out of the country that receives the smuggled goods, they may create bizarre trade distortions where money that’s derived from goods smuggled in can be moved out as apparent (but mispriced) trade. There might be discrepancies in pricing oil and diamonds moving out of Africa, for example. In aggregated form these unrecorded (and unmeasurable flows) make the official balance of payments and balance of trade statistics even more skewed.

All of these illicit things, and more, are happening around the world, as you read this blog. And Baker adds: "Anything that can be priced can be mispriced." In short, the flows that Martin Wolf is talking about simply exclude a huge part of the equation.

So how important is this part that is missed? Raymond Baker, whose statistics have been used by the World Bank, estimates the cross-border flow of the global proceeds from criminal activities, corruption, and tax evasion at between $1 trillion and $1.6 trillion per year (yes, trillion) - half out of developing and transitional economies. Not all of that is missed in the statistics that Martin Wolf is talking about, but probably most of it is. But what is clear is that we are easily in the same order of magnitude, when we compare annual illicit flows with those that Wolf is talking about (note that Baker's range, above, is a flow, not a stock.)

Now let's think about what all this means.

Let's deal with the destabilising aspects of capital flows. Capital flows can certainly do a lot of good: they bring productive investment, result in factories creating jobs, and so on.

Martin Wolf and many economists talk about capital flows in the aggregate. We, however, are talking here about only a certain section of the capital flows: we are talking about capital that flows as a result of secrecy, mispricing and other tricks, and offshore incentives. As we indicate above, these are very, very significant in the overall picture. Not all result from the existence of tax havens; many are the result of inadequate accounting standards and several other issues that we are concerned with.

But even that is not all. Raymond Baker focuses on the illicit aspects of the problem. These certainly interest us a lot, but we also take interest in issues which do not involved illegality, such as when a company finds a legal mechanism to pay almost no tax by using special tax gymnastics through secrecy jurisdictions. So we're talking about more -- much, much more -- than Baker's numbers alone. This is big money.

Wolf analyses and notes the destabilising impact of the capital flows that appear in the accounts that he looks at. He argues, rightly, that

"Any country that receives a huge and sustained inflow of foreign lending runs the risk of a subsequent financial crisis, because external and domestic financial fragility will grow."

Absolutely right, as far as it goes. But let's look at the capital flows (legal and illegal) that occur as a result of the fault lines in global finance. Some capital flows could be characterised as productive, and others as harmful. If we are talking about the capital that flows as a result of secrecy, mispricing and other tricks, and offshore incentives (let's call them, to oversimplify somewhat, the secrecy incentives) then substantially all of it falls into the "harmful" category. Let's consider this further.

First, leaving aside the impact of the outflows from countries losing the capital, let's consider the inflows. If they happen as a result of the secrecy incentives (e.g. shifting capital cross border to disguise its origin and to avoid seizure at some later stage) then these essentially portfolio flows will inflate commercial asset prices (including football clubs, real estate assets, and so on), taking pressure off capitalists to do what they do best: entrepreneurship. In fact it does the exact opposite, since company directors can ease off on innovation and simply coast along watching their share values rise in the face of large walls of incoming capital. This leads to a form of rent-seeking: the financial sectors in receiving countries can simply benefit from secrecy (or lax regulation or zero taxation or whatnot) and then watch the money roll in, without having to do much work or shape up. Rent-seeking is anathema to those who want to build more productive economies.

What is more, these inward flows, by raising local assets and costs, exert a"Dutch Disease" effect, squeezing out sectors producing tradeable goods like many forms of manufacturing (see what's happened to Britain's manufacturing sector in recent years, for example - and it is sorely needed, now more than ever.)

Now the Dutch Disease isn't always a problem - if the inflow leads to greater productivity, it can counteract the effects of the higher domestic price levels. But if it isn't bringing higher productivity, as we believe has been the case in Britain and the US in recent years, then it's a problem for the country at the receiving end. Have the flows that result from the secrecy incentives made the receiving countries more productive?

Think about it. Take an example of a harmful capital flow: until recently dirty money coming out of Russia (see here, for a recent comment on that phenomenon), has been fuelling ever more ridiculous London property prices. Now ask yourselves what has that money done to make the British economy more productive? The inflows bring more money, yes - but can anyone really make a case for saying these inflows have led to more output of goods or services or higher productivity? Or brought more innovation and entrepreneurship? Look at what we said in a Guardian comment piece in May 2007:

Tax havens warp the foundations of market capitalism. David Ricardo's theory of comparative advantage says that production should gravitate towards geographically relevant areas: cheap manufactures come from China and France or Chile produce fine wines. But now we have thousands of companies operating from one building in the Cayman Islands, and a former Thai prime minister avoids paying tax on a $1.9bn sale through a British Virgin Islands company called Ample Rich Investments. Small wonder that people lack confidence in the global economy. . . . The offshore economy distorts markets by providing tax loopholes to some businesses but not others."

This kind of harmful capital inflow is also accompanied by a much shorter-term mentality: instead of the long investment and profit cycles that accompany manufacturing investment, say, we have high-pressure financial "innovation" (a term that we include in our offshore dictionary) and an overwhelming focus on short-term profitability, stock options and bonuses, especially in the financial sector, and so on.

So there we have it. Tax havens, the secrecy world, and all the problems TJN focuses on, create harm on both sides of Martin Wolf's equation: the lax regulation behind the crisis, and the destabilising capital flows.

And these are just part of the harm they cause. From the May 2007 Guardian piece, there are these elements too:

"The offshore economy . . . corrupts democracy, helping elites to evade their responsibilities to the societies that nurtured them, and breaking fundamental relationships of accountability that are forged when rulers tax citizens. It does not create wealth but redistributes it from poor to rich. Worse, it destroys wealth and slows growth."

And as if that isn't enough, then there's the issue of the poor countries that suffer the capital outflows. But don't get us started on that . . .


Anonymous MyInvestorsPlace said...

A great article with insight. A timely article in this time of financial crisis and wall street issues. I feel that we are standing in the edge of a deep waterfall in this financial world.

MyInvestorsPlace - trading, value, investing, forex, stock, market, technical, analysis, systems

9:59 pm  
Anonymous TJN said...

Anonymous comment via email:
I really think that illicit flows (not necessarily capital flows) and destabilizing flows are quite distinct things and should be treated as such. It seems to me that there is about a 50% chance that an illicit flow will be stabilizing rather than destabilizing, whereas your argument depends upon an overwhelming presumption that illicitness will be predominantly destabilizing.

1:57 am  
Blogger Markus said...

Dear Anonymous Commentator,

I think you are wrong, although I agree that illicit and destabilizing capital flows are different analytical concepts. In practice though I would argue that the flows are much more overlapping than this article suggests. I want to make three points.

1.) licit vs. illicit flows: I would argue that most illicit capital flows are hidden in aggregated balance of payments figures and not in errors and omissions. However, the last 35 years of capital account liberalization have had the (possibly unintended) consequence that we will never be able to prove it. This is because in response to this ideology coherent systems for monitoring the (intrinsically legal concept-led) access to foreign exchange and related cross-border transactions have been dismantled in many countries. The liberalization of the capital account (and investment regimes) meant an automatic conferral of legal accreditation of foreign investors and the reversal of the burden of proof regarding capital flows. In other words, whereas once an investor had to proof that he is pursuing licit purposes, through liberalization this was inversed and the investor has been widely equipped with the unquestioned right to invest across borders. This is precisely why we find it so difficult to disentangle licit from illicit flows: most of the means to do so were abolished in the crusade against what was called ‘financial repression’. This is also the reason we find it so difficult to establish a clear difference between tax evasion and avoidance. I would argue that this came about because of delinking (presumed and empirically flawed) macro-theoretical insights relating to the beneficial effects of foreign direct investment from the concrete regulatory difficulties encountered when trying to differentiate between the regimes of foreign direct investment, portfolio investment and hence capital account control. It was caused by a lack of understanding at best.

2.) illicit flows are not necessarily capital flows: you are right only in a narrow sense because any illicit flow must be matched by an illicit capital flow. Both constitute an illicit transaction.

3.) destabilizing vs. illicit flows:
a) What concept of stability are we talking? Is it some ominous equilibrium which is to be achieved in the long-run under ‘perfect’ conditions? Is it the sort of stability we observe in economic models whose widespread abuse consists in claiming them containing all relevant variables instead delimiting clearly their explanatory power? Far too many (and the wrong people) have been tempted to take such models as the entire truth and as a departure point for policy recommendations.
b) I would suggest that illicit flows are necessarily destabilizing although the opposite needs not to hold true: not all destabilizing flows must be illicit. Illicit flows are necessarily short-sighted and on the move because they need to be ready to escape legal investigation every moment. Thus, portfolio investment is the flow of choice and if there is any consensus at all after Washington, it is that: a) portfolio investment is short-term investment; b) short-term investment flows increase volatility and therefore decrease financial stability.


Markus Meinzer

8:11 am  

Post a Comment

Links to this post:

Create a Link

<< Home