In 1800, average income per capita across the world was around $1,200 (in 2017 dollars). In Europe, it was around $2,000 and in Ottoman Egypt about the same. In the South Indian kingdom of Mysore, it was higher: around $3,500 – similar to that of Europe’s richest economy, the Netherlands. Much has changed since then – mostly for the better.
During the 19th century and into the 20th century, many European countries (and most notably the U.K., the Netherlands, Germany, Switzerland, France, Denmark and Sweden) grew rapidly, as did the U.S., Australia, and Argentina. After the Second World War, some countries returned to growth, while others, including much of Latin America, China, India, and the Soviet Union, stagnated. Japan, South Korea, Taiwan and Hong Kong began growing rapidly. In Africa, many newly-independent countries floundered. And in the past 30 years, China, especially, and India to a lesser extent have experienced rapid growth. Meanwhile, growth in Europe, Japan and the U.S. has been lackluster.
Wherever it has occurred, sustained growth has been the result of innovation, which has resulted in the production of more and better goods and services using fewer inputs. Underpinning this innovation has been competition, which has incentivized entrepreneurs to specialize and to develop new products and production processes in order to create profits. By contrast, where competition has been stymied, usually by some combination of regulation, trade restrictions, and/or distortionary taxes and subsidies, incumbent producers have grown complacent and innovation and growth has stagnated.
Competition and specialization is not inherently constrained by national borders. International trade in goods and services has enhanced the process. Countries that have been more open to such trade have generally experienced more rapid growth as a result. China’s recent growth has in no small part been facilitated by unilateral reductions in trade restrictions, which have reduced the cost of inputs, such as energy (e.g., coal from Indonesia and Australia), enabling producers to leverage other inputs (notably low-cost local labor) and compete with producers facing higher input costs, resulting in a dynamic and innovative manufacturing industry.
The benefits of free trade are not limited to goods. When capital can more freely move across borders, competition ensures that entrepreneurs are able to finance worthwhile investments at lower cost. This is especially true for smaller economies, including most countries in the early stages of growth, where the pool of capital is often very limited.
Development economists recognized the need for capital in the 1950s, but this was interpreted by many as a justification for government subsidies, while private capital, driven by the profit motive, was often seen as “harmful.” The ensuing combination of “aid” (i.e., capital provided by foreign governments and allocated by domestic governments, usually to politically connected companies) and restrictions on private investment and lending inhibited competition and innovation, contributing to the slow rates of growth in much of Africa and South Asia.
By contrast, the emergence of offshore financial centers has been a boon to economies across the world. By offering a well-regulated, tax-neutral environment in which capital can flow freely to its most highly valued uses, these centers have provided an important lubricant to the wheels of innovation and growth.
In addition, by withholding capital from the grubby hands of the governments of over-taxed and over-regulated countries, OFCs help entrepreneurs in those countries who might otherwise be subject to even more onerous taxes and regulations.
As Richard Teather notes in this issue, critics claim that offshore financial centers such as Cayman are engaging in “harmful” tax competition. These dissembling bureaucrats are only able to make such claims by inverting the meaning of “harmful,” so that it applies to OFCs that are well regulated and successful, but doesn’t apply to countries, such as Nauru, that are poorly regulated and unsuccessful. In other words, the EU and its buddies at the (Paris-based) OECD just don’t like it that OFCs threaten the business model (if one can call it that) of their bloated, protectionist member governments. (This point is driven further in this issue by Emanuele Canegrati, who explains the true meaning of various terms used to attack OFCs.)
At one level, OFCs could be viewed as a “technology” that has enabled capital to circumvent harmful government restrictions. In the past decade, a new type of technology has begun to play a similar role. Cryptography, used for thousands of years to send coded messages, has been transformed by the development of modern algorithms and rapid computer processing, enabling safer communication and storage of information. And now it is being used to store and transfer capital.
For more than 50 years, payment networks have used encrypted messaging to authenticate transfers of funds. However, until recently there was no safe and reliable digital equivalent of cash. As a result, anyone seeking to move large amounts of capital from one place to another either had to use a payment network that was subject to government reporting and oversight, or convert the funds into physical assets (cash, bearer bonds, diamonds, gold, etc.).
In the 1990s, several companies created digital “cash” in the form of encrypted tokens. But these risked the digital equivalent of counterfeiting, known as the “double spending” problem: in the absence of a means of identifying the uniqueness of each token, there is a risk that it could be spent twice (or more). Issuers initially attempted to solve the problem through centralized authentication systems but these were expensive and faced a risk that the authentication system itself would be hacked. (Other solutions were considered, such as affiliating individual tokens with the biometric information of their holders, thereby ensuring that only the legitimate holder of a token could spend it; but they were not implemented, probably due to cost.)
Then, in 2008, an anonymous cryptographer (or group of cryptographers) known as “Satoshi Nakamoto” published a paper describing a possible solution involving the use of distributed ledgers. Specifically, Nakamoto envisaged the creation of a new digital currency, Bitcoin, whose tokens would be identified by accretions of unique blocks of code and authenticated during each transaction against the ledger (i.e., all other blocks, which are held on all nodes of the network). The authentication process requires a computer to solve a complex algorithm and its solution generates a new token (or a fee, when all tokens are issued). Although Bitcoin was the first such currency to be created and remains the most popular (as of this writing, the total value of Bitcoins in circulation is $62 billion), many others have followed.
While transactions into and out of Bitcoin are readily observable, transactions made with Bitcoin – and other blockchain based currencies – may be made anonymously. As such, they have become a popular means of moving capital away from the prying eyes of government. But that feature has attracted the attention of government officials, who have sought to regulate Bitcoin exchanges or even, as in China, ban them.
One potential problem faced by current blockchain based currencies is their fiat nature, which means that they have no intrinsic value. If Bitcoin were to become a dominant medium of exchange, that problem might disappear. But as Richard Rahn notes, there may be a simpler and more effective solution: create a new blockchain-based currency backed by real assets, such as aluminum or a basket of metals (or other widely tradable and non-perishable commodities).
In the meantime, Singapore has announced that it intends to “tokenize” its currency using a private Etherium-based blockchain, which could improve the speed and reduce the cost of large Singapore-dollar denominated transactions. And the Bank of England has also been looking into the use of blockchain for digitizing the Pound, as have the central banks of Canada, Japan and Russia.
Blockchains are now being developed and used for many purposes beyond currencies, as several authors in this issue highlight. Ron Quaranta explains that some of these involve private blockchains, the purpose of which is to mimic the authentication advantages of a public blockchain while avoiding the potential for disclosure of elements of the transaction.
In many cases, new blockchain based businesses raise funds through “initial coin offerings” (ICOs). These share features of crowdfunding, in that the project only proceeds if sufficient funding is obtained (and if it is not, then the funds raised are returned). But unlike most crowd-funding sites, the purchasers of tokens issued during the offering effectively become shareholders in the project. As Brian Knight and Andrea O’Sullivan note, ICOs raise a host of regulatory issues, from AML/KYC requirements to compliance with securities rules.
One of the earliest ICOs was for Etherium, a blockchain-based smart contract system. The tokens issued during the Etherium ICO were sold in 2014 at an issue price of $0.4 and currently trade at around $250. Smart contracts offer huge potential for disintermediating financial services. The extent and speed with which this process will occur is open for debate, but occur it will.
Therein lies both opportunity and threat for OFCs: opportunity to be at the forefront of the blockchain revolution, by creating an appropriately light touch regulatory framework that enables the operation of exchanges and smart contract-based services (from fund management to insurance) that attracts business away from the less responsive regimes elsewhere. A threat lies in the potential for some of the core activities currently provided by professionals in IFCs to be replaced by robots.