The rules of globalization were written to help elites hide money.

Hernando de Soto believes that economic development and capitalism depends upon formal property rights. He has been advocating for making a clear public record of who owns all real estate and to help entrepreneurs register their ownership of their businesses because millions of poor people in developing nations have not had legal ownership of their homes, farms, and businesses and that fact contributes to trapping them in poverty.

At the same time, there has been a growing movement since the 1980s that has been moving the opposite direction.  Rich people and big corporations have increasingly been using the new rules that were set up to boost globalization to hide their ownership of businesses, real estate, and financial accounts.  This movement was publicized in April 2016 by the leak of the Panama Papers, a massive electronic data dump of the secret account activities of Mossack Fonseca, an international finance company headquartered in Panama that specializes in setting up shell companies in order to help rich people and corporations hide wealth offshore.  German Lopez explains:

[T]he heart of the story — a bunch of individuals and organizations storing their money in secret offshore locations like Panama — isn’t that complicated. Over at Reddit, user DanGliesack gave one of the best explanations I’ve read yet:

When you get a quarter you put it in the piggy bank. The piggy bank is on a shelf in your closet. Your mom knows this and she checks on it every once in a while, so she knows when you put more money in or spend it.

Now one day, you might decide “I don’t want mom to look at my money.” So you go over to Johnny’s house with an extra piggy bank that you’re going to keep in his room. You write your name on it and put it in his closet. Johnny’s mom is always very busy, so she never has time to check on his piggy bank. So you can keep yours there and it will stay a secret.

Now all the kids in the neighborhood think this is a good idea, and everyone goes to Johnny’s house with extra piggy banks. Now Johnny’s closet is full of piggy banks from everyone in the neighborhood.

One day, Johnny’s mom comes home and sees all the piggy banks. She gets very mad and calls everyone’s parents to let them know.

Now not everyone did this for a bad reason. Eric’s older brother always steals from his piggy bank, so he just wanted a better hiding spot. Timmy wanted to save up to buy his mom a birthday present without her knowing. Sammy just did it because he thought it was fun. But many kids did do it for a bad reason. Jacob was stealing people’s lunch money and didn’t want his parents to figure it out. Michael was stealing money from his mom’s purse. Fat Bobby’s parents put him on a diet, and didn’t want them to figure out when he was buying candy.

Now in real life, many very important people were just caught hiding their piggy banks at Johnny’s house in Panama. Today their moms all found out. Pretty soon, we’ll know more about which of these important people were doing it for bad reasons and which were doing it for good reasons. But almost everyone is in trouble regardless, because it’s against the rules to keep secrets no matter what.

Although most of money seems to have been hidden for shady reasons, it is mostly completely legal because the politicians who set up the new rules of globalization want it to be legal for their friends to be able to hide assets and dodge taxes.  It could easily be stopped by our global trade (and finance) treaties if our trade negotiators wanted to stop it.  After all, US law doesn’t allow our financial elites to hide money in Cuba or in Bluffton Ohio.  It is easy to identify the tiny jurisdictions like Panama and Bermuda that specialize in hiding money and it would be simple to clamp down on them by applying a little economic pressure.  We could eliminate it by threatening to cut them off from our banks the same way we cut off Cuba.  We could also incorporate financial transparency rules into our international trade agreements.  Although most people think of trade agreements as being about tariffs on goods and services, finance is undoubtedly the biggest form of international services trade.  International trade agreements include volumes of rules that govern financial flows to make this possible.  For example, the Trans-Pacific Partnership was mostly about harmonizing these kinds of rules and had little to do with tariffs on goods which were already minuscule.  Matt Yglesias explains:

[G]lobal economic integration is about much more than the flow of goods across borders — it’s about the nature of the rules that govern (or don’t) economic activity on a worldwide basis.

…The United States, for example, is a major global exporter of both pharmaceuticals and entertainment products. Many foreign countries where these are not major industries have intellectual property rules that are friendlier to consumers of medicines and TV shows and less friendly to their producers. In …trade agreements, American negotiators typically put a high priority on inducing foreign countries to changing their domestic laws to more closely conform to US practices and the interests of big US-based firms.

America’s bilateral trade promotion agreement with Panama is no exception to this, with the US Trade Representative’s Office touting “important disciplines … related to intellectual property” that are included in the agreement.

…The nature and extent of global economic integration is deeply driven by elite priorities, and [they prioritize intellectual property. Cracking] down on tax evasion isn’t that high of a priority [for them].

In the specific case of Panama, it’s worth recalling that back in 1989 the United States sent a small military force to invade Panama, depose its president, extradite him to the United States, and put him on trial for drug trafficking charges. If there were a strong bipartisan consensus in favor of coercing Panama into changing its laws regarding taxation or shell companies, we could get the job done.

…And illegal evasion is only a small part of the larger picture of perfectly legal tax avoidance. Companies and individuals are perfectly within their legal rights to structure economic activity so as to make as large a share of it as possible take place in low-tax jurisdictions. Hedge funds whose staff is located in New York are often formally incorporated in the Cayman Islands. Apple registers a very large share of its global profits as accruing to its Irish subsidiary rather than its US-based parent company. In both cases, this is to take advantage of a low corporate tax rate.

If these kinds of relatively small countries were acting to undermine the integrity of the global pharmaceutical patent system, they would be stopped. But political elites in powerful countries allow them to undermine the integrity of the global corporate tax system — even when Ireland was desperately in need of bailout funds from the European Union, it was not forced to change its corporate tax system [as a condition of the bailout] — largely because the wealthy and powerful want the global corporate tax system undermined.

Globalization [treaties are] a process of writing common global rules for economic activity.

And it’s sometimes a process of not writing common rules, and implicitly allowing integration to erode standards. Different choices are made on different subjects, and it’s not a coincidence that the choices made have tended to be systematically biased in favor of the priorities of Western economic elites. The Panama Papers, by revealing the quasi-secret activity… offer an unprecedentedly detailed look at how that works in practice.

International elites don’t want to allow international financial flows that hide money for terrorism, drug lords, other criminals, but they are torn because they do like the lax standards that help them hide money from taxation and legal liabilities like divorce settlements.  Yglesias explains:

I was once in Switzerland and talking to a private banker there who complained to me that Americans have a lot of Hollywood-driven misconceptions about Swiss banking. Americans, he said, tend to think of banking secrecy as all about money laundering for terrorists or drug traffickers when the real truth is that it’s mostly for rich people trying to avoid taxes or husbands trying to shield assets from their wives during divorce proceedings.

The basic issue is that even with “offshore” banks you can’t just show up with an oil drum full of cash and no explanation. The bank is going to ask you for some kind of documentation of how you earned the money.

One important reason for that historically has precisely been able to preserve their function as havens for tax evasion and asset-shielding. Neither Switzerland nor the Cayman Islands nor any other offshore banking center is exactly a mighty superpower. Their ability to preserve banking secrecy is based largely on the acquiescence of the world’s major powers. And elites in the United States, United Kingdom, Germany, France, etc. are a lot more likely to wink and nod at tax avoiders than at major drug drealers and mass murderers. Letting too many violent criminals in the door would risk spoiling the whole party.

An international system that is deliberately designed to make it easy to hide money from taxation is going to make it a lot easier for criminals and international terrorists to slip through the cracks, but this is unintentional.  The Panama Papers might shed some light on how much the rules that aid tax-evasion have been helping criminals and terrorists too.  Even if the system were designed for criminals, they are a much smaller part of the global economy than rich tax evaders, corporations, and corrupt officials, so we should expect that only a small percent of the money has come from terrorists and organized crime.  Yglesias explains:

Gabriel Zucman, an economics professor at UC Berkley, has made the most detailed study of [how much wealth is being hidden in shell companies like those revealed by the Panama Papers] for his book The Hidden Wealth of Nations, and estimates that it totals at least $7.6 trillion. That’s upward of 8 percent of all the world’s financial wealth, and it’s growing fast. Zucman estimates that offshore wealth has surged about 25 percent over the past five years…

if you have made a bunch of money illegally (taking bribes, trafficking drugs, etc.) you need to do something with the money that won’t attract the attention of the authorities or the media. A secret offshore shell company is perfect. Not only does it help you avoid scrutiny in real time, but if you are found out its assets can’t be taken from you if you have to flee the jurisdiction or even serve jail time.

But even though various criminal money-laundering schemes are the sexiest possible use of shell companies, the day-to-day tax dodging is what really pays the bills. As a manager of offshore bank accounts told me years ago, “People think of banking secrecy as all about terrorists and drug smugglers, but the truth is there are a lot of rich people who don’t want to pay taxes.” And the system persists because there are a lot of politicians in the West who don’t particularly want to make them.

…a leaked memorandum from a Mossack Fonseca partner revealing the more boring truth that “[n]inety-five per cent of our work coincidentally consists in selling vehicles to avoid taxes.”

…Incorporating your hedge fund in a country with no corporate income tax even though all your fund’s employees and investors live in the United States is perfectly legal. So is, in most cases, setting up a Panamanian shell company to own and manage most of your family’s fortune.

Libby Nelson interviewed Gabriel Zucman, the economist who had estimated that 8 percent of the world’s financial wealth is hidden in these kinds of offshore tax havens.

Zucman… argues that this tax avoidance worsens the vast global gap in wealth and income between the rich and the poor. Hiding vast sums of wealth from taxation makes it easier for the rich to stay rich and avoid tax policies meant to help the poor. Offshore accounts also make it harder for everyone else to get rich, because they’re paying higher taxes to make up for the tax dollars the wealthy don’t pay when they shelter their assets overseas.

“If we want to deal with rising inequality seriously, then we need to make these forms of tax dodging much, much more limited,” Zucman told me in an interview…

LN: How much does this vary across countries?

GZ: Eight percent is a global average that conceals significant heterogeneity. According to my estimates, the US has a bit less than 8 percent of its financial wealth offshore, maybe something like 4 percent. Europe has a bit more, something like 10 percent.

But then if you look at Latin America, more than 20 percent of Latin America’s financial wealth is in offshore tax havens. In Africa, more than 30 percent; in Russia, 50 percent. For many countries in the world, in particularly developing countries, these are extremely important sums. So it means it’s really meaningless to study inequality in Latin American and developing countries without considering this issue. It’s really a very important phenomenon.…

LN: How did you come up with the $8 trillion estimate?

GZ: When you look at the global investment data, you see that there is a big problem, which is that the world’s financial assets fall short of the recorded liabilities. So there’s a discrepancy.

LN: In other words, there’s a lot of money missing from the balance sheets.

GZ: It’s been known for quite a long time, but until recently it was a bit hard to understand the reason for that. I was able to show that the bulk of this statistical anomaly is because the wealth that people own in tax havens is not recorded as assets. It’s recorded as liabilities, but not as assets, and that’s a reason why you have this big imbalance in the global accounts. By using these statistical anomalies I was able to estimate that there is 8 percent of the world’s financial wealth in tax havens.

This fact is why I am always skeptical of claims about rising total debt.  Every person’s debt is another person’s asset.  All of finance is just various forms of debts.  Total debts minus credits for everyone must always equal zero, so there can never be any rise in net debt.  Zucman took advantage of this accounting identity to estimate hidden assets because debtors have no reason to hide their debts from the tax man, but creditors (wealth holders) do.  The fact that financial debts are about 8% larger than financial assets means that the assets must be hidden somewhere.  And there are even more real assets that are being hidden.

The interview continues:

LN: Are there other things this hidden money obscures about the world economy?

GZ: When you look at the official statistics and the net financial positions of nations — who’s a creditor, who’s a debtor — one of the world’s biggest debtor is the eurozone.   And I think that’s just wrong. There’s growing recognition that it’s wrong. This data fails to capture quite a lot of assets, and when you try to reattribute them to the countries that actually own them — to Germany, France, Italy, Greece, Spain, Portugal — this improves the net financial position of these economies. In particular, that makes Europe a net creditor rather than the world’s biggest debtor. For the US, the effect is the same but it’s less strong — the US [would actually be] the world’s biggest net debtor in the statistics, but this [too] exaggerates the reality [because of hidden US assets].

This wasn’t always the case.  Before the 1980s, less than 1% of US equities were in tax havens.  And because offshore shell companies were one of the reasons that US banks avoided regulations that contributed to the 2007 financial crisis, financial reforms since then have clamped down on some of these activities.  Libby Nelson’s interview of Zucman continues:

LN: How long have tax havens been a problem?

GZ: …But from the 1920s to the 1980s, Switzerland was the only well-functioning tax haven. It was mostly used by Europeans. You can look at the fraction of all US equities that belong to offshore financial institutions and to individuals who live in tax havens — that’s data collected since the 1940s by the US Treasury. From 1940s to the mid-1980s, it was very small; about 1 percent of US equities belonged to tax havens.

Then in the 1980s, lots of other tax havens appear — the Cayman Islands, Singapore, Hong Kong, Panama, Bermuda, and so on. And so at the global level, the use of tax havens increases dramatically starting in the 1980s.

LN: What’s causing this increase?

GZ: Changes in financial regulation have made it possible for tax havens to develop and grow. Technological change has made it much easier to move money all over the world. And there have been cultural changes in the ways people see taxes — starting in the 1980s, a growing fraction of the population started thinking it’s okay to really, minimize your taxability and even evade taxes.

You have all these things combined that explain this spectacular increase that continues to this day. Today about 10 percent of all US equities in the data belong to tax havens.

LN: So how should we see the revelations from the Panama Papers in light of everything you already know about the harms tax havens cause?

GZ: …What’s shocking is that we thought we had made quite a bit of progress, in particular in terms of convincing offshore financial institutions to apply the international anti-money laundering regulations. What we discover is they don’t — they just don’t care about these regulations. There’s an important lesson, which is that we should rethink the way we regulate these institutions. It’s good and it’s necessary to have regulations and to ask the countries in the world to apply them and have inspections from time to time, but it’s not enough.

Many banks and financial institutions in tax havens, and many bankers, have become very rich by servicing tax evaders or criminals. If they have nothing to lose in continuing to do this, some of them will continue. That’s what we see in the leaks. In principle, the basic requirement of anti-money laundering regulations is to identify the owners of the wealth that you manage. But the vast majority of the shell companies created by these Panama firms did not even try to identify the initial owners. It was okay to service potential criminals or tax evaders.

And the reason is very simple: It is profitable to do this, and right now tax havens and the firms that operate there don’t have much to lose by doing this.

LN: What can be done to change that?

GZ: I think it’s important to acknowledge that there’s been progress through the financial crisis. So in particular before 2008, there was strictly no exchange of bank information between tax havens and foreign countries’ tax authorities. So it was really easy to evade taxes, because there was total bank secrecy.

And this has changed mostly thanks to the US law starting to be implemented right now that forces foreign institutions to automatically tell the IRS about their US clients and their holdings. Now other countries are trying to do the same thing. There’s going to be an automatic exchange of bank information that involves many countries around 2017, 2018. So there’s been significant progress. The problem is it’s not enough to just create laws.

I think we need to clearly say there’s clear evidence that out of the 100,000 shell companies in Panama and the British Virgin Islands, many of them are used for illegal activity. Why do we even tolerate these activities taking place? Why do we tolerate that these countries host such an enormous amount of financial activity?

We should have immediate sanctions against places like that and say that the sanctions will remain in place until you’re able to prove that you’ve correctly identified all the initial owners of all the companies that are incorporated on your territory. We need to have this approach that’s centered on sanctions to change the incentives and the behavior of the countries and the firms and the people involved in this business.

LN: Would sanctions be enough? What about the activity that isn’t necessarily illegal but still leads to losses of [tax] revenue?

GZ: We need to invent new modern transparency tools. I think the main challenge is to create financial registries.

All the wealth in the shell Panama companies and the Swiss bank accounts is not invested in Panama and Switzerland. It’s invested in New York and London real estate and so on. And what the US and European countries could do is say, Okay, let’s start from the wealth that’s on our territory and try to find out who owns it. Who are the actual owners of the real estate, and the equities, and mutual funds and bonds and shares on our territory?

This means creating financial registries of wealth and recording the owners of the wealth, and at the end of the day that’s the main way to make a lot of progress on these money laundering and tax evasion issues.

It will also be a global public good, in particular for developing countries, which right now are totally unable to have any idea of the wealth of their elite, a big fraction of which is in the US and in Europe. Having this register would be a great service to these countries. They are not involved in the talks for automatic exchange of bank information, so at this stage there’s no hope that things are going to improve for them.

LN: That would be an amazing global financial audit. Has anyone tried to create one?

GZ: Well, we have land and real estate registries. They’ve been in place for decades or even centuries.

All countries are very familiar with their logic: If there’s real estate in New York City, we are recording who owns it. Everybody can go online and type any name in the website to find out who owns a building in Brooklyn. This is public, it has been for a very long time, and there’s a long track record. I think we need to start from what exists and works well, and expand the scope of these registries by trying harder to find out who are the initial owners.

Hernando de Soto has been working on expanding these kinds of registries in developing nations for decades.  Many developing nations never bothered to include the real estate that poor people traditionally owned in their official property registries so much of their territory isn’t formally owned by anyone.  The elites who run the government have simply never bothered to record who owns the land in vast areas where poor people live and that makes them vulnerable to being displaced without compensation.  The difference in property registration has created a divide between rich elites and the poor in places like Peru because rich people get secure property rights, and the poor people don’t and that contributes to entrenched poverty.

Shell corporations have been increasingly doing the opposite of what de Soto advocates.  They are increasingly hiding the ownership of property for elites and creating a new economic divide between rich and poor around the world.  Shell corporations are more important for the economies of corrupt nations like Russia where 50% of financial assets are hidden than for rich nations like the US.  Many poor nations are trapped in poverty in part because they suffer from an epidemic of corrupt government officials who rely on shell corporations to embezzle money and hide it in the US and other rich nations.  Although America has tried to create international financial rules that don’t benefit criminals that could directly hurt US interests like terrorists and drug mafia, American interests have turned a blind eye towards corrupt government officials in other nations who are dragging down their people.  This double standard might be due to the fact that it benefits Wall Street when their money ends up in the US.

America could help poor nations develop by reforming international finance and preventing corrupt foreign officials from using shell corporations to hide their stolen money in the US.  International and US laws are set up to make it too easy for them. Although the ordinary citizens in highly corrupt nations currently have more to gain than Americans from reforming global finance to crack down on shell corporations, we have been rapidly moving towards the kind of banana republic system that they have.  There is a giant sucking sound that has been pulling more and more money out of the legitimate US economy into offshore shell corporations and we shouldn’t be complacent about our own self-interest in avoiding Russia’s fate.  Russian elites don’t need to care as much about ordinary Russians because most of elite financial wealth is hidden in offshore shell companies.  US elites have been moving that direction too.

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Posted in Development, Globalization, Public Finance

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