The apocryphal Chinese proverb, “May you live in an interesting age”, describes the current international financial environment – from the US FATCA to the various “me too” versions being hastily put forward by European governments, the world’s financial plumbing is being reworked. Lured on by the promise of vast sums of untaxed funds allegedly hidden offshore, many governments are making a grab for those resources by instituting new rules. Unfortunately, in the course of doing so, they risk damaging some of the institutions that are vital to creating prosperity.
In a forthcoming article with Case Western Reserve University Prof Richard Gordon, I argue that we are seeing the clash of two visions of world finance. In the first, which we call “wealth maximisation”, governments’ goal in structuring their financial systems is to promote economic growth. This was the primary goal after the devastation of World War II – the various rules and institutions created during the post-war period can be seen as efforts (not always successful) to expand financial integration, increase trade and boost the world economy.
Capital mobility expanded as exchange controls were lifted, for example. The free floating exchange rates which largely replaced the fixed rates of the Bretton Woods era helped create a vibrant international market in foreign exchange contracts that ultimately led to tools to handle exchange rate risks. The General Agreement on Tariffs and Trade, followed by the World Trade Organisation, reduced barriers to trade. The impact of these policies was to give individuals and firms tools with which to create wealth.
As the wealth maximisation policies took hold around the world, governments became aware of their implications. For example, greater capital mobility restricted governments’ abilities to adopt expansionary macroeconomic policies because currency markets would punish excessive spending or money creation. Law enforcement authorities worried that tracking suspected criminals’ assets in a global system was more difficult. Tax authorities found that taxpayers could structure their affairs to reduce tax liabilities by taking advantage of differences across jurisdictions. This generated an alternative vision, which we label “control first”.
Under the control first framework, the first priority is to stop people from doing bad things with their money. Stopping tax evasion and, increasingly, legal tax avoidance, money laundering, and criminal activity is the focus of the policies generated by a control first vision. This is behind the focus on “automatic” information exchange; and never mind whether the “information” to be exchanged exists or not. It is only a slight exaggeration, and may not be an exaggeration at all by the time this is in print, to say that control first proponents would like each dollar, euro, yen, RMB, etc in the world financial system to carry a unique ID number that enabled every transaction to be monitored and traced so that anyone doing something illegal could be identified. Control first advocates are quick to say they don’t want to cut back on economic growth by killing the goose that lays the golden egg, but the key to their outlook is that when faced with a trade-off between improving the efficiency of financial markets and stopping a transaction from slipping by, they opt for the latter.
There are many problems with the control first agenda, but among the largest is that it threatens to choke off regulatory competition across jurisdictions. Certainly control first proponents like the Tax Justice Network, the OECD’s tax directorate or US Sen Carl Levin appear to not value regulatory competition at all. Indeed, they tend to see jurisdictional competition exclusively in terms of tax rates. This can only represent wilful blindness on their part, since anyone who spends even a few hours with the international tax literature can hardly fail to see the complexity on which tax competition alone occurs: rates are just one of the differences in how various jurisdictions handle taxation. Just as important, for example, are definitions of income and the availability of tax deductions and credits. But tax is only a small part of the regulatory competition that occurs across jurisdictions.
As Profs Erin O’Hara and Larry Ribstein argued in their seminal book, The Law Market, jurisdictional competition pervades the law. Although they focused primarily on US domestic examples of competition among states, O’Hara and Ribstein’s argument readily generalises to competition among jurisdictions internationally. This competition pushes governments to adopt innovations in the law that attract business to rival jurisdictions. For example, London and New York’s competition for financial industry business is a crucial driver to get financial regulation right. When the US adopted the misguided Sarbanes-Oxley regulatory statute, business shifted to London.
This is precisely why politicians and bureaucrats don’t like regulatory competition. It imposes constraints on government policies because people who don’t like a policy have other options. This is true of tax rates – but it is also true of insurance, securities and countless other areas of law. Regulatory competition does more than constrain governments, however. It also spurs them to innovate. Politicians and bureaucrats don’t like this either because it means they have to work harder, but such innovations improve overall welfare. For example, Vermont and the District of Columbia have become homes to many captive insurance businesses. It is unlikely that either would have entered this field but for the competition from Bermuda and Cayman. Similar competition is occurring in Europe, with Guernsey playing a key role. Ongoing competition for captives has led to continued innovation, as described elsewhere in this issue.
From a wealth maximisation perspective, this is all to the good. Regulatory competition means the cost of doing business goes down as jurisdictions innovate. Air travel is undoubtedly cheaper today because aircraft financing became more efficient due to OFC-led competition; everything from trucking to health care is cheaper due to captive insurance; and foreign investors pour money into the US economy through offshore hedge funds which win business because their costs are lower due to more efficient regulation in Cayman and other jurisdictions. But from a control first perspective, these developments are troubling. More entities mean more potential tax avoiders or evaders; more transactions mean more things to monitor.
For those focused on control, that means more regulation is needed to make sure something isn’t slipping by the vigilant tax and regulatory agencies keeping an eye on the public welfare. Just how vigilant some of those regulators are is open to question – Bernie Madoff managed to get cleared by the US Securities and Exchange Commission while he was running history’s largest Ponzi scheme despite Harry Markopolos sending repeated, detailed descriptions of Madoff’s fraud to the agency.
The clash of these two visions can be seen in the debate over banking reforms in the wake of Cyprus, a topic on which we focus in this issue. Is the problem a lack of control, which suggests a need for more centralisation and less competition, or a lack of competition, which suggests a need to open banking to greater market discipline? Control first proponents would point to Cyprus and declare its banking sector “too big” and “too lax”. Sceptics might worry about whether Cypriot banks’ exposure to Greek government bonds was the result of regulatory pressures, and whether the subsequent haircut bondholders took was the result of a failure of control or a failure of competition.
Before we head down the road to global FATCA, however, we need to get a clear understanding of the role of regulatory competition in producing economic growth. OFCs are not just more jurisdictions competing for transactions – they are a different type of competitor from governments in large economies. Adding OFCs to the competitive mix has an impact like yeast in bread dough, it catalyses other jurisdictions to behave better. OFCs have this effect because their small size and dependence on attracting businesses forces them to offer top quality legal systems and regulatory frameworks. This is a point control first proponents often miss, since they seem incapable of distinguishing among legal and regulatory systems based on quality. Dysfunctional governments everywhere from Venezuela to the Angola provide environments characterised by regulatory laxity. What OFCs provide is something quite different – regulators which understand the businesses in their jurisdictions, responsive legislatures committed to keeping laws up-to-date, and a collection of high quality service providers.
The Control First agenda presents a fine example of what economist Bruce Yandle termed a “bootleggers and baptists” coalition. In the American South, some jurisdictions have laws forbidding alcohol sales on Sundays. Yandle argued that such laws come about because of a tacit coalition of bootleggers, who don’t like the competition from legal alcohol sales, and baptists, who oppose the sales on moral grounds. Politicians can’t openly advocate pro-bootlegger policies, but they can use the moral cover provided by the baptists to do so – reaping the rewards of campaign contributions from the bootleggers and votes from the baptists. Similarly, onshore financial interests who don’t like having to respond to competition from abroad cannot argue openly for nakedly protectionist measures.
But politicians can find moral cover in the arguments of groups like the Tax Justice Network to propose measures to limit competition by raising costs internationally. FATCA, for example, has no impact on US financial firms operating domestically, it simply raises costs for both international competitors to those firms and for jurisdictions that compete with the US for financial business. Cayman, for example, will have to collect additional information, staff government offices that handle information exchanges, and hire negotiators to participate in the ongoing international negotiations over implementation. This has two impacts. First, a few dozen employees is mere noise in the US government budget; it is a significant cost for smaller jurisdictions. Second, those employees are diverted from improving an OFC’s competitiveness to working on compliance, reducing the ability of offshore jurisdictions to innovate.
The post-World War II international competition for financial transactions played a significant role in an unprecedented increase in human welfare around the globe. Not only did residents of successful OFCs benefit as their economies grew, but so too did economies that opened themselves to international investment. Transactions costs fell across the board for productive activities, boosting economic growth. The shift toward an emphasis on control over one on wealth maximisation threatens to shut down that process, which will impoverish us all.