The biggest friction in the modern economy

A key component of modern economic theory is production theory. Production theory is the study of the economic process of converting inputs into outputs. Production uses resources to create goods or services that are then sold in the market, explained by the supply and demand theory. The basic model is based on two main inputs – labor and capital – and assumes a closed economy where these resources are not imported of exported. However, during the later part of the 20th century, we witnessed a significant change that implies this production model is no longer as relevant.

Capital became completely mobile – first, through the reduction of regulatory restrictions, such as exchange and capital controls that had previously prevented it from flowing between countries and, later, though the development of technology that reduced the cost of reallocating capital, increased the speed at which it can be transferred, and above all, created access to information in a way previously unimaginable – allowing capital allocators to make decisions extremely quickly.

Globalization can be described as a socio-political phenomenon by which sovereign states have slowly but consistently allowed the movement of capital between states, promoting the increase in trade. But government policies are nothing other than an enabler. Without technology, we would not have witnessed the remarkable change we have experienced.

The increasing speed at which companies are re-allocating their capital and choosing the most efficient jurisdictions continues and has become a subject of attention in the mainstream media.

Looking at the other production input – labor – the picture is completely different. Immigration restrictions, as well as cultural and language barriers, continue to exist today; and while the cost to move millions of dollars from one side of the planet to the other has collapsed to insignificant amounts, the cost of moving people in terms of both money and time has only slightly improved.

Labor markets around the world continue to exhibit significant differences. Wages, even adjusted by cost-of-living, continue to vastly differ across continents and even neighboring countries – this being one of the variables promoting the movement of capital. Simply put, because it has become cheaper and easier to move over the recent decades, capital has followed the most cost-effective labor. This has created a friction in the world economy as the two main production inputs are behaving in an increasingly different manner.

Politicians need votes from the people who provide labor and find themselves competing with other countries for what has effectively become a global pool of capital to provide their voters with better paid jobs. That competition to attract capital has taken many forms, including monetary, regulatory, and tax policies to ensure the most attractive environment for that capital.

After the failed attempts in the 1980s to use monetary policy as a tool in the competition for capital, several governments around the world decided to limit their monetary policies through independent central banks or monetary unions.

Regulatory competition has also been a driver and has lately become prisoner of the endless number of multilateral organizations that attempt to create a forced regulatory union across continents. We have witnessed the formation of several monetary unions and are currently witnessing the creation of regulatory unions mainly through the use of sanctions, imposing policies created by the bigger economies across the world.

The multilateral bodies used to create these global standards are directly or indirectly controlled by the eight major economies of the world, which, while having some differences, have more in common than several other economies.

All these larger economies have relatively big territories. Most have land borders and large populations and have consequently all opted for systems of direct taxation and income tax despite the well-documented fact it is far from being the most efficient system of taxation.  Somehow they have also ended up with relatively large governments that detract from long-term growth potential.

The recent initiative on transparency of beneficial ownership is a clear example of the bigger economies driving an agenda and standard, based on their needs, with little regard to the real issue to be solved or the needs and existing systems in the smaller economies.

The FATF (a subset of the OECD) is a prime example of a cartel of the bigger economies imposing global standards. It has been consistently demonstrated that many small economies are more transparent than the bigger ones, and their systems are more reliable than even the most extreme proposals currently on the table. However, it is clear the latest calls for public central registries are politically motivated.

While all of these eight economies publically voice a desire and commitment to increase transparency, the facts, for some of them, show a completely different picture. The proposals pushed by some of those big economies that have been lacking in transparency themselves seem to fall short in achieving the standards already in place for many years in other economies. Of course, they may satisfy a questionable hunger for public disclosure at the expense of individual privacy.

As monetary policy is put aside and the regulatory pressure is elevated globally (making differentiation less viable), the competition for the global pool of capital will likely increasingly focus on tax differences.

While most countries have given up monetary policy and appear to be willing to give up regulatory autonomy, they have kept their fiscal policy, not relinquishing, unless forced to, their power to determine taxes and government spending.

Calls for a unified tax system are not new and have failed in the past, but as the limitation of monetary policy and the unification of regulatory policy becomes a reality, we should expect increasing discussion in regard to limiting the ability of some countries to compete, based on their fiscal policy, for a global pool of capital.


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Gonzalo Jalles

Formerly the CEO of HSBC Cayman, Mr. Jalles founded his own financial services consulting company, Javelin Group, late last year. Prior to his almost six years leading HSBC in the Cayman Islands, Mr. Jalles worked in HSBC’s London, Bermuda and Argentina offices as Director of International Development, Managing Director/CEO, and Chief Investment Officer, respectively. He also served as President of the Cayman Islands Bankers’ Association from 2009 to 2012. Before joining HSBC, Mr. Jalles worked at Santander Investments, developing the firm’s asset management business for over five years and creating the second largest asset manager in Argentina.

Mr. Jalles has a degree in economics and a Masters degree in Finance. He also holds a Chartered Financial Analyst designation.

Gonzalo Jalles
Chief Executive Officer
Cayman Finance
PO Box 11048
2nd floor, Fidelity Financial Centre
1 Gecko Link, West Bay Road
Grand Cayman, KY1 1007

T: +1 (345) 623 6700
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