Financial Innovation and the Financial Crisis - paper on Dublin

Two years ago an edition of Tax Justice Focus contained a lead article entitled Shadow Regulation and the Shadow Banking System: the role of the Dublin International Financial Services Centre. Written by Jim Stewart, Senior Lecturer in Finance, Trinity College, Dublin, it looked at the role in the global financial crisis played by the tax haven / secrecy jurisdiction of Ireland, and in particular the Dublin International Financial Services Centre (IFSC.) We added this to our Economic Crisis + Offshore webpage.

Now we have just added to that same web page a major new article by Stewart, which thoroughly updates and significantly expands upon Stewart's article for TJF. Entitled Financial Innovation and the Financial Crisis, it was issued a year ago at a conference in Aalborg, Denmark. We missed it at the time.

It is one of the most important forensic documents on this webpage and a major contribution to the literature on this essential and typically overlooked topic. It also adds to other literature (for example Finlan O'Toole's excellent Ship of Fools) explaining the hubris and nonsense which deluded so many people for such a long time about the true nature of the Celtic Tiger miracle.

The whole document is interesting, particularly from page eight onwards, but we thought we would highlight a couple of relevant parts about the IFSC, which as Stewart notes dominates financial flows for the Irish economy:

Financial centres such as the Irish Financial Services Centre (IFSC) formed a major part of the shadow banking sector.

and

"A further source of risk is poor or non-existent regulation. This is because of the location of ‘shadow banking’ type activities in offshore financial centres one of whose main advantages was ‘light touch regulation’ and in recognised tax havens such as the Cayman Islands. This source of risk typically only becomes apparent in a crisis. As a consequence when markets became aware of the risk associated with these firms, liquidity is reduced, increasing risk further.

And

"In 2008 IFSC investment was over 13 times the size of foreign direct investment and approximately 11 times the size of GNP."

Now note something important about this: by virtue of being offshore business, the portfolio flows washing in and out of Dublin were effectively detached from the real Irish economy and therefore largely untaxed - and, in effect - almost untaxable. This is emblematic of the power of the offshore system. "Don't tax us or we'll go somewhere else," they cry - and the politicians quail in the face of financial capital.

Most conventional measures of Ireland's predicament underplay the issue because they use Gross Domestic Product (GDP) as the relevant measure - which includes this offshore activity. This paints a false picture of economic activity; it would be far more useful in the Irish case (and other tax haven based economies) to use Gross National Product, which strips out the activity attributable to foreign shareholders.

If you're trying to put together a calculation as to how easy it will be for Ireland to raise the tax revenues, you will want to strip out the sector that can't be taxed from that calculation, which means using GNP, not GDP. As acclaimed economist Simon Johnson noted in the New York Times last year:

"The remarkable success of this tax haven means that roughly 20 percent of Irish gross domestic product is actually “profit transfers” that raise little tax for Ireland and are owned by foreign companies (which) should not be counted as part of Ireland’s potential tax base.

A more robust cross-country comparison would be to examine Ireland’s financial condition ignoring these transfers. This is easy to do: a nation’s gross national product excludes the profits of foreign residents. For most nations, gross national product and G.D.P. are nearly identical, but in Ireland they are not."

There is a whole lot more good material in Stewart's article. Now read on.